KIRINYAGA UNIVERSITY

SCHOOL OF BUSINESS & EDUCATION

LECTURE NOTES FOR

BEC 2309: MACROECONOMIC THEORY III

UNIT OBJECTIVES

In this unit you will be introduced to the major macroeconomic theory paying

attention to their applicability in different settings of developing countries. The

general objectives of this unit may be summarized as follows:

1. Explain the meaning of macroeconomic models.

2. Detect strengths and weaknesses of macroeconomic models.

3. Explain how macroeconomic models may be used for proper management

of an economy.

4. Teach macroeconomics after your degree course; and

5. Prepare yourself for more advance studies in economic theory.

1
 INTRODUCTION

You now start your study of the economy as a whole and in the following

lecture you will consider many of the world’s most pressing macroeconomic

problems such as:

• Persistent unemployment.

• Rapid rise in inflation.

• Balance of payment problem.

• Slow economic growth; and

• Uneven distribution of income and wealth.

In order to analyze these problems you need to identify, measures and consider a

number of aggregate in the economy. Examples of aggregates you will examine

include the:

• Total production of good and services

• Total demand for goods and services

• Total employment and unemployment

• The general price level

• The balance of payment

• The rate of economic growth

You are required to have studied prerequisite BEC 104, BEC 204 and

mathematics for economists. These units will help you thoroughly understand

this particular unit.

2
It is my hope that you will enjoy and thoroughly benefit from this cause.

LECTURE 1

INTRODUCTION AND MEASURES OF ECONOMIC

ACTIVITY

INTRODUCTION

In this lecture you will be exposed into the meaning and important of various

basic macroeconomic concepts such as:

• Recession

• Trough

• Recoveries

• Gross domestic products (GDP)

• Gross national product (GNP)

• Real GNP and GDP

• Potential GDP and actual GDP

• Unemployment

• Okun’s law

• Inflation rate

• Philips curve

• Interest rates

• Aggregate demand and aggregate supply

• Price indices

• Exchange rates

3
DEFINITION OF BASIC CONCEPTS

An economy

An economy may be defined as a collection of certain institution or individual

each of whom faces and solves an economizing problem subject to certain

constrains. Example s of economic agents or institutions in an economy includes:

i.) Households

ii.) Firms and

iii.) The government.

Household: refers to group of persons sharing income for purposes of

consumption.

Firms: are producing entities of goods and services either for further production

or final consumption.

Government: is a public authority, which engage in policies with an aim of

improving social welfare subject to some constrains.

Micro-economy

This refers to a system of individual activities undertaken by individual agent

whose aims are to maximize welfare, utility, production etc.

Roles of microeconomics

Microeconomics is useful in the following ways:

1) It helps in the understanding of the working of an economic system.

2) It is used to determine the level of activities that maximizes welfare e.g.

production, consumption etc.

3) It is used to explain how the price-mechanism allocates resources more

efficiently.

4
 Macro-economy

This refers to a system of aggregate activities undertaken by the economic agents

e.g.

• Total production by firms

• Total consumption by household

• Total expenditure by government

• Total savings by household

Roles of macroeconomics

The major role of macroeconomics is that it seeks to explain why fluctuation in

economic variables occur and investigate policies that cam mitigate (remedy) the

fluctuations. Macroeconomic theory therefore, can be considered as the study of

economic fluctuations.

If for example we consider the growth of output for an economy over time, we

shall observe that the growth path is not smooth but irregular. This means that

the economy undergoes recession and recoveries as shown below:

5
Growth in output Peak

Trough

Recovery

Recession

Time in years
Figure 1 (a)

Macroeconomics explains why recession and recoveries do occur in an economy

over time.

Recession: These are periods of contracting economic activities i.e. periods when

activities like production and employment are falling.

Trough: This is the period of stagnant production. It is the end of recession or the

beginning of recovery.

Recovery: This is a period of above-average economic growth following a

recession.

Peak: This is the beginning of a recession.

Gross domestic product (GDP)

This referred to total current production measures at current prices. The term

current in this case refers to one year. GDP therefore, refers to the market value

of total goods and services produced in a given geographical area during one year.

6
Gross national products (GNP)

This is income accruing to nationals of a given geographical area. It is the total

market value of final goods and services currently produced in and economy

using the domestically owned factors of production located in the economy or

elsewhere over a given time period e.g. one year.

Therefore, GNP = GDP – payments abroad + receipts from abroad

There are two measurements of GNP or GDP.

i.) Nominal or constant shilling GNP or GDP

ii.) Real or constant shilling GNP or GDP

Nominal GNP or GDP measures the value of output at the prices prevailing in the

period the output is produced.

Real GNP or GDP measures the value of output in any given period at same base-

year prices. The purpose of measuring real GDP or GNP is to get rid of price

effects in nominal GDP or GNP.

Potential output and actual output

Potential output refers to the total production that is possible when all factors of

production are fully and efficiently employed i.e. with an unemployment rate of

just under 5% is an estimate of unemployment since 100% employment is

literally impossible.

7
Actual output refers to the real physical output actually produced in the economy

and it fluctuates around potential output as the economy goes through successive

recession and recoveries as shown below:

Potential output

Output Actual output

Output gap

0 Time in years

Figure 1 (b)

The difference between potential output and actual output is the output gap. The

larger the output gap, the greater the unemployment rate and vise versa.

Unemployment rate

This is the fraction of the labour force that cannot find jobs at the prevailing wage

rate. Labour force refers to the number of persons aged 18 years or over who is

either working or unemployed.

Okun’s law

This law is named after its discoverer, Arthur Okun who used it to illustrate the

effects of macroeconomic policy. The law states that a 3% increase in real GDP

8
generates a 1% point decrease in the unemployment rate. This relationship acts

as a useful guide to policy because it allows us to ask how a particular growth

target will affect the unemployment rate over time.

Inflation rate

This is the percentage change in the average price of all goods in the economy.

Inflation like unemployment is a major macroeconomic problem.

Philips curve

This shows the relationship between rates of inflation and unemployment. A

British economist by the name A. W. Philips first developed this relationship. The

typical Philips curve shows an inverse relationship between unemployment rate

and inflation rate as shown in figure 1 (c) below:

Inflation rate

Philips curve

0 Unemployment rate

Fig 1 (c)

The policy implication of the Philips curve are that less unemployment can

always be attained by incurring more inflation or inflation can be reduced by

allowing more unemployment.

9
Interest rates

This refers to the amount charged for a loan by a bank or any other lender per

shilling per year expressed as a percentage. It is the cost of borrowing. The

interest rate minus the expected rate of inflation gives us the real rate of interest.

Aggregate demand and aggregate supply

Aggregate demand refers to total demand for goods and services in the economy.

It is the total expenditure on real output of goods and services in the economy.

Aggregate supply relates the general price level to the total output assuming that

resources, technology and institutions are given.

Aggregate demand and aggregate supply together determine price and output

levels in the economy as shown in the figure 1 (d) below:

Price AS = Aggregate supply

P*

AD = Aggregate demand

Y* Output (Y)
Fig 1 (d)
Price indices

These measures changes in the general price levels. There are of two types;

namely

i.) Consumer price index (CPI) and

10
ii.) Whole price index (WPI)

The consumer price index is the cost of living index, which shows changes in the

cost of living over time.

The wholesale price index is a measure of the cost of production, which shows

how costs of production change over time.

Exchange rate

This refers to the amount of foreign currency that can be purchased with one

domestic currency.

The aggregate problem

This major issue in an economy is concerned with determining how big the GDP

is. To determine the size of an economy’s GDP we make use of a set of analytical

assumptions underlying national income accounting. There are three such

assumptions and we need to examine them one by one.

Assumption (1) Total supply of goods and services must equal total demand for

gods and services. This assumption holds on the basis of the argument that goods

and services are scarce in the economy and therefore once produced must be

consumed.

Let: Y = total supply of goods and services

D = total demand for goods and services

11
 C+I+G+(X-M)

Since total supply equals to total demand then

Y = D = [C+I+G+(X-M)]

Suppose p = price index, then

Y.p = C.p + I.p + G.p + (X-M).p

If p = 1

Then, Y=C+I+G+(X-M)

This gives us an expenditure measure of GDP.

Assumption (2) The second assumption comes from the observation that goods

and services in an economy cannot be produced out of nothing but requires factor

inputs. The assumption therefore states that the total value of output must equal

total value of inputs. This assumption is clear from Euler’s theorem whereby

given a production function

Y = f (K, L), Then, Euler’s theorem states that:

dY dY
Y= .K + .L Where:
dK dl

dY
= MPk = r
dK

dY
= MPL = W
dL

Hence, Y = rK + wL this gives us the value added or output measure of GDP

12
Assumption (3) The third assumption emphasizes the fact that households have

limited ways of spending their income.

Therefore, Y = C + S + T + R,

Where:

Y = Income,

C = Consumption,

S = Savings,

R = Transfer payments

T = Taxes.

This gives us the income measure of GDP.

13
LECTURE 2

INTRODUCTION TO INCOME DETERMINATION: THE

MULTIPLIER

INTRODUCTION

In this lecture you will be introduced to the product-income identity that is useful in

analyzing the determination of national output and income levels. The savings-

investment balance will be considered and general expressions of the multipliers will be

derived.

In national income accounting, GNP can be considered as a flow of income or

product. Therefore, the basic identity becomes:

C + I + G + (X – M) = GNP = C + S + T + Rf. ……………………………. (1)

Where:

C = Total value of consumption expenditure

I = total value of investment expenditure

G = Government purchases of goods and services

(X – M) = Net export of goods and services

S = Gross private savings

Rf = Total private transfer payments to foreigners

If we avoid the foreign sector then the identity becomes:

C + I + G + (X – M) = GNP = C + S + T ……………………………(2)

Nominal Y can be broken down into real output (y)and price (p). if we divide

through by real output (y) we have:

Y y. p
= = p = Implicit price deflator.
y y

14
If we deflate all components of nominal output (Y), we obtain real components as

follows:

c + i + g = y = c + s + t ……………………………………...(3)

The savings-investment balance

If we subtract c from equation (3) we obtain:

i + g = s + t …………………………………………………(4)

Equation (4) gives us the savings-investment balance implicit in the basic GNP

identity. On the product side, i + g is the amount of real output that does not go

to consumer expenditure while on the income side s + t shows the amount of

consumer income that is not spent.

If we rearrange equation (4), we obtain the following:

i = s + ( t - g ) …………………………………………………….(5)

Where:

i = total private investment

s = Total private savings

(t – g) = government surplus or government deficit

Equation (5) is therefore just another expression for the savings-investment

balance.

Planned and realized investment

An examination of planned realized investment is the first step in developing

conditions for income to be in equilibrium. The investment component i in

_
equation (3) and (4) includes both intended/planned investment ( i ) and

_
unintended/unplanned investment inv . Intended investment ( i ) is investment

15
that is part of the producer’s plans while unintended investment refers to

unplanned investment that results from unexpected change in the level of

consumption demand. This is the realized investment.

The investment component in equation (4) therefore becomes

_
i = i + inv …………………………………………………..(6)

Replacing equation (6) for (i) in equation (4), we obtain:

_
−
i + inv + g = s + t ………………………………………….(7)

If we include the real consumption component, we obtain:

_
c + i + inv + g = c + s + t …………………………………..(8)

Equation (8) is the first condition for the level of income (y) to be in equilibrium.

The inv component is the balancing item in the identity. This is because if for

example there is an increase in c, then the inv will be negative thus canceling

out the increase in c in the LHS. In the RHS the increase in c is cancelled by a

decrease in s. therefore, the equality is maintained all through.

Tax, Consumption and Savings function

The second step in developing condition for equilibrium income is the

recognition that tax payments, consumption and savings are all increasing

function of the level of income. More specifically, tax revenue is a function of the

gross income i.e.

t = t (y); t/ > 0 ………………………………………………(9)

While consumption and savings are function of disposable income, (y – t (y)) i.e.

c = c(y –t(y)); c/ > 0 ………………………………………….(10)

16
 and s = s(y – t(y)); s/ > 0 …………………………………………..(11)

equation (9) gives the change in tax revenue following a change in income while

equation (10) and (11) split disposable income into consumption and savings.

Graphically, these relationships may be represented as follows:

Uses
of income

s(y0–t(y0)

c(y0–t(y0)

t(y0)
450

0 y0
Income

Fig 2 (a)

From the diagram, we can make the following observations:

The sum of uses of income [c + t + s] equals the income for any given level like y0.

As income increases, each of the wedges showing c, s and t gets wider so that in

general an increase in y leads to increase in t, c and s.

Determination of equilibrium income

In this section, we bring together the material developed in the last two sections

into a simple model of determination of equilibrium income.

17
 _
Equation (7) gave us the saving-investment balance; i + inv + g = s + t , income is

at equilibrium when inv = 0 ,

_
So that i + g = s + t ………………………………………………….(12)

Equation (12) is the equilibrium condition for income (y) and may be presented
as follows:

s+t
i+g
s+t

inv0
−
inv1 i+ g

0 y1 yE y0 y

Figure 2 (b)

−
Income is in equilibrium at yE where i + g = s + t satisfying equilibrium condition

−
shown in equation (12). At any other level of income say y1, i + g  s + t meaning

there is excess demand over supply. Producers or suppliers will therefore expand

output to meet the unexpected increase in demand and as they do so income will

rise towards yE.

−
At the income level y0, i + g  s + t meaning supply exceed demand. Producers

will therefore cut down production and income will fall to yE. Therefore, the

equilibrium income yE is a stable equilibrium.

18
 Effects of an increase in desire to save

Having seen that the equilibrium level of income determined by equation (12) is

stable, it is useful to examine the effects of shifts in the savings function on

equilibrium level of income. More specifically we examine the effects of an

increase in the desire to save under two separate circumstances:

−
i.) When i and g are independent of y and

−
ii.) When i and g are increasing function of y.

−
a) When i and g are independent of y

s+t
i+g s1+t
s0+t

s0+t = s1+t
−
i+ g

0 y1 y0 y

Fig. 2 (c)
The increase in the desire to save is shown by an upward shift in the s+t function

−
from s0+t to s1+t.with the new saving function, and initial income y0 s+t > i+ g .

This make s producers to cut production so that income falls to y 1. Therefore,

19
 −
where i+ g is fixed exogeneously, an increase in the desire to save leads to

unchanged level of s+t but a lower level of income.

−
b) When i and g are increasing function of y (the paradox of thrift)

s+t, i+g s1+t s0+t

s0+t

−
s1+t i+ g

y1 y0 y

Fig 2 (d)

The increase in the desire to save causes a fall in income from y0 to y1 and

reduces the level of realized s+t. the realized s+t fall in income reduces the level

−
of planned investment ( i ), This is so called the paradox of thrift.

The effects of a shift in planned investment

If the level of planned investment shifts autonomously, then income rises from y0

to 1 as shown in figure 2 (e).

s+t, i+g s +t
−
i1 + g
inv0

−
i0+ g

0 y0 y1 y

20
 Fig 2 (e)

− −
The increase in i makes i + g  s + t at the initial income y0 this implies that excess

demand over supply and therefore producers tend to increase production thereby

raising income towards y1. However, the size of the increase in y, following an

−
increase in i or g depends n the slope of s+t function as shown in figure 2 (f).

s+t, i+g (s+t)0

(s+t)1

−
i1 + g

−
i0+ g

0 y0 y2 y0 y

Fig 2 (f)

With the flat (s+t)0 function, income rises from y0 to y1 following a shift of

− −
investment from i 0 to i 1 . With the steep (s+t)1 function, the same shift in

investment raises income from y0 to y2. This observation takes us to the

consideration of the multiplier.

Derivation of the expenditure multipliers

Expenditure multipliers are useful in telling us the amount by which equilibrium

income will change when aggregate demand component change by one unit. In

this section, we shall develop multipliers for changes in investment and

21
government purchases and also for shifts in the tax schedules beginning with an

economy where taxes are levied as lump- sum.

Lump sum taxes

−
When taxes are a fixed sum, t , then basic equilibrium condition becomes:

− − − − −
c( y − t ) + i + g = y = c( y − t ) + s( y − t ) + t …………………………..(13)

Eliminating the consumption component we get:

− − − −
i + g = y − c( y − t ) = s( y − t )) + t ……………………………………(14)

to obtain the change in equilibrium, we differentiate the LHS of equation (13)

holding g and t constant . Thus:

−
c / dy + d i = dy

−
Re arranging: d i = dy − c / dy

−
d i = dy(1 − c / )

−
di
= 1− c/
dy

dy 1
−
= ……………………………………………(15)
di 1− c/

dy 1
If c / = 0.7, then −
= = 3.3
di 1 − 0.7

Interpretation

A unit increase in investment demand yield 3.3 units increase in income.

22
The balanced budget multiplier

− −
From equation (13): y = c( y − t ) + i + g , we can derive general expression showing

− −
changes in y following changes in t , i and g by differentiating that expression to

obtain:

− −
dy = c / (dy − d t ) + d i + dg

− −
dy = c / dy − c / d t + d i + dg

− −
dy − c / dy = −c / d t + d i + dg

− −
dy(1 − c / ) = −c / d t + d i + dg

− −
− c / d t + d i + dg
dy = ………………………………………..(16)
1− c/

−
Equation (16) is a general multiplier expression. To obtain the multiplier for d i ,

− −
we set d t and dg equals to zero and then divide by d i to obtain:

dy 1
−
=
di 1− c/

−
The balance budget exists when dg = d t and if this is substituted into equation

−
(16) while setting d i equals to zero, we get:

− c / dg + dg dg (1 − c / )
dy = =
1− c/ 1− c/

Hence balanced budget multiplier:

dy (1 − c / )
= = 1 ……………………………………………(17)
dg 1 − c /

23
This tells us that if government expenditure changes by one shilling, output also

increase by one shilling.

Taxes as a function of income

When tax revenues are an increasing function of income, then the basic

equilibrium condition becomes:

−
c( y − t ( y )) + i + g = y = c( y − ( y )) + s( y − t ( y )) + t ( y ) ……………….(18)

Eliminating consumption component we obtain:

−
i + g = y − c( y − t ( y )) = s( y − t ( y )) + t ( y ) ……………………………(19)

To obtain the general form of the multiplier with a given tax structure, we

differentiate the LHS of equation (18) to obtain:

−
dy = c / (dy − t / dy + d i + dg

−
dy = c / (1 − t / )dy + d i + dg

−
dy − c / (1 − t / )dy = d i + dg

−
dy[1 − c / (1 − t / )] = d i + dg

−
d i + dg
dy = ……………………………………………………(20)
1 − c / (1 − t / )

Equation (20) is the general equilibrium multiplier expression and the

introduction of the tax has reduced the multiplier. Diagrammatically, this can be

presented as in fig

24
ure 2 (g):

s+t, i+g s( y − t ( y )) + t ( y )

s( y − t ( y )) + t ( y )

−
i0+ g

−
i1 + g

0 yo y2 y1 y

Fig 2 (g)

−
We can observe that with tax revenues fixed at t , an increase in investment

− −
demand from i 0 to i 1 raises equilibrium income from yo to y1. When tax revenues

are an increasing function of income, the same investment increase only raises y

from yo to y2. The presence of the tax function therefore reduces the increase in

disposable income relative to those in total income. The tax system therefore acts

as a built-in-stabilizer, reducing the change in income that is induced by

exogeneous change in investment.

The tax rate multiplier

The tax rate multiplier is very relevant in stabilization policy decision involving

tax changes. The tax function can be simplified by assuming that tax revenues are

proportional to income so that; t(y)=Ty where T=% tax rate. The basic equilibrium

condition now becomes:

25
 −
y = c( y − T y ) + i + g ………………………………………………….(21)

Since d ( T y ) is approximately equal to T dy + yd T then the differential of equation

(21) becomes:

−
dy = c / (dy− T dy + yd T ) + d i + dg

−
= c / (1− T )dy + yd T + d i + dg

−
Therefore, the multiplier with tax rates, i and g all changing becomes:

−
d i + dg − c / yd T
dy = ……………………………………………(22)
1 − c / (1 − T )

The expression − c / yd T gives us the exogeneous consumer expenditure change

that comes from a tax rate change.

26
LECTURE 3

NATIONAL INCOME DETERMINATION: DEMAND SIDE

EQUILIBRIUM

INTRODUCTION

In this lecture you will be introduced to the demand side of the economy. This

involves finding the equilibrium value of interest (r) and output demanded (y) by

consumers, businesses and the government given the price level. You will also be

exposed to the derivation of equilibrium in the product and money markets.

EQUILIBRIUM INCOME AND INTEREST RATE IN THE PRODUCT

MARKET

Equilibrium in the Product market is given by:

y = c( y − t ( y)) + i + g ……………………………………………….(1)

Where:

y = Real GNP

c = Real consumption expenditure as a function of real disposable income.

t = Real tax revenue as a function of real GNP.

i = Real investment.

g = Real government purchase of goods and services.

Investment demand and the interest rates

In lecture two, we assumed that investment ( i ) was exogeneously given. In this

section, we seek to find what determine i . We start by assuming that, the level of

investment depend on the market rate of interest (r). This seems reasonable

27
because, in order to invest, a firm can either borrow or use its own funds.

Whichever the case, the cost of borrowing can be measured by the interest rate

the firm has to pay or forego receiving incase it uses its own funds.

Therefore, i = i (r ) ; i '  0 …………………………………………..(2)

i0

i1

i(r )

0
r0 r1 r

Fig 3 (a)

Figure 3 (a) shows investment (i) as a negative function of interest rate (r).

If we substitute equation (2) into equation (1) we obtain:

y = c( y − t ( y )) + i(r ) + g …………………………………………...(3)

THE IS CURVE

Equation (3) describes pairs of r and y values which maintain equilibrium in the

product market – IS curve. The IS curve traces the r and y pairs that keeps the

money market in equilibrium. The relationship between interest rate (r) and

income (y) can be presented in directly as in figure 3 (b) below.

28
r

IS Curve

0 y

Fig 3 (b)
The logic behind the inverse relationship between r and y is that as r rises,

investments drop and thus through the multiplier reduces y.

Mathematically, we can also derive the IS curve by totally differentiating equation

(3) holding g constant to obtain:

y = c ' (y − t ' y) + i ' r

= c ' y − c ' t ' y + i ' r

= c ' (1 − t ' )y + i ' r

y − c ' (1 − t ' )y = i ' r

y(1 − c ' (1 − t ' ) = i ' r

i ' r
y =
1 − c ' (1 − t ' )

y i'
=
r 1 − c ' (1 − t ' )

29
 r i − c ' (1 − t ' )
= since 1 − c ' (1 − t ' )  0 and i '  0 , then it follows that
'
Hence;
y i '

r
 0 or negatively sloped.
y

The IS curve may also be traced using the four quadrant diagram as shown in the

figure 3 (c).

r0

r1

i (r ) + g IS Curve

i+g 45 0 y0 y1 y

i+ g = s+t (s + t )
(s + t )

Fig 3 (c)
The 450 line equates s + t and i + g thereby ensuring that there is equilibrium

in the product market. The SE quadrant shows savings and taxes as increasing

30
function of income. In the NW quadrant, fixed government purchases (g) and

investment which is a decreasing function of interest rate is plotted.

To over up with an IS curve, we select any interest rate say r0 and trace back to

determine the corresponding level of income (yo).

Numerical Example

Given the following equation, derive the expression for the IS curve.

C = 100 + 0.8Yd (Consumption function)

I = 10- 10r (Investment function)

G = 10 (Government purchases)

T = 0.25 (Tax rate)

Solution

IS curve shows equilibrium in the product market, which is given as:

y = c (y-t(y)) + i(r) + g

=100 + 0.8 (y-0.25y) +10 –10r +10

=100 + 0.8y-0.2y +10 –10r +10

=120+0.6y-10r

y - 0.6y= 120 - 10r

y (1-0.6) = 120 –10r

0.4y = 120- 10r

120 10 r
y= −
0.4 0 .4

31
 y = 300-25r expression for the IS curve

? Using the four-quadrant diagram show the effect of the following on

equilibrium r and y.

i.)An increase in the desire to save

ii.)An increase in government purchases

Equilibrium income and interest rate in the money

market

The money market, like all other markets has both a demand side and a

supply side. The demand for money comprises of speculative demand l (r ) and

transactions demand (ky) hence:

m
= l (r ) + k ( y ) ; l '  0 and k '  0 ……………………………(4)
p

Where: m = Money stock

p = Price level

l = Speculative demand for money which is a negative function of

interest rate.

k = Transactions demand for money which is a positive function of income.

m
= Real money balances.
p

32
 We can therefore rewrite equation (4) as;

m
= m(r , y ) ……………………………………………………….(5)
p

m
If we plot the demand for real balances ( ) against the interest rate (r), we
p

get a different curve for each level of income (y) as shown in figure 3 (d).

m(y0)
m(y1)
m(y2)

0
m
p
Fig 3 (d)

At any given y, say yo, which means transactions demand is fixed, then as r rises,

speculative demand falls reducing total demand. Similarly, at any given r,

meaning speculative demand is fixed, as y rises, transactions demand also

increases thereby increasing total demand.

On the supply side, money supply is exogeneously given by the central bank:
_
hence m = m where m = money supply.

33
If we plot the demand for money and supply of money together, we obtain

equilibrium in the money market as shown in figure 3 (e)

r2

r1 m(y2)
r0
m(y1)
m(y0)

0
M/P
Fig 3 (e)
_

Given the price level, the real money supply is given by m while the demand for
p

money is represented by the functions m (y0), m (y1) and m (y2). From figure 3

(e), we observe that as income rises from y0 to y2, interest rates also rises from r1

to r2 while the money market is in equilibrium. This is because, when income

rises, transaction demand rises and at same time some holders of interest earning

bonds need to shift into money due to higher transaction needs. This leads to a

reduction of demand in the bonds market, which drives bond prices down and

interest rates up. Therefore, the relationship between income (y) and the interest

rate (r) is positive and gives us the LM curve. The LM curve therefore traces the r

and y pairs at which the money market is in equilibrium. This is shown in figure 3

(f):

34
 r

LM curve

0
y
Fig 3 (f)

Mathematically, we can derive the Lm curve by differentiating the money market

equilibrium condition; m = l (r ) + k ( y )
P

If totally differentiated, we obtain:

_
l ' dr + k ' dy = o Since d m = o

l ' dr = −k ' dy

dr k'
=− '
dy l

dr k'
since k '  0 and l '  0 then = − '  0 and thus the LM curve has a positive
dy l

slope.

The LM curve may also be traced using the four- quadrant diagram as shown in

figure 3 (g).

35
 r LM curve

r1

r0 r0

l (r )
Speculative
−
m
Demand y0 y1 y
p1

Transactions
Demand

Fig 3 (g)

In the SE quadrant, the transactions demand is shown as an increasing function

of income. In the NW quadrant, the speculative demand is shown as a negative

function of interest rate while in the SW quadrant the equilibrium condition

equating total supply of money to total demand is drawn.

The LM curve is derived in the NE quadrant by taking any level of interest rate

and then tracing back to get the corresponding level of income.

Numerical example

Given the following equations, derive the LM curve equation.

L = Y-100r (Real money demand)

−
m = 295 (real money supply)

36
Solution

At equilibrium in the money market;

Money demand = Money supply

Y-100r = 295

Thus, Y = 295 +100r. This is the equation for LM curve.

? Using the four-quadrant diagram to discuss the effect of the following

on equilibrium interest rate (r) and income (y).

i.) An increase in money supply.

ii.) An increase in the price level.

Equilibrium in the product and money markets

We have already derived the equilibrium in the product market (IS curve) and in

the money market (LM curve). If we take the IS and the LM equations and solve

simultaneously, we obtain a single pair of r and y that gives equilibrium in both

markets. This corresponds to the point where the IS and LM curves intersect as

shown in figure 3 (h). LM

r0

IS
Fig 3 (h) y0 y

37
Numerical example
The following equations describe a certain economy.

C =100 +0.8Yd (C0nsumption function)

I = 10 –10r (Investment function)

G = 10 (Government purchases)

T = 0.25 (Tax rate)

L = Y-100r (Real money demand)

M = 295 (Real money supply)

Required

i.) IS and LM equations.

ii.) R and y pairs at which the two markets are both in equilibrium.

Solution

i.) IS Equation

Y=C+I+G

=100 +0,8(Y-0.25Y) + 10 – 10r + 10

=120 + 0.6Y – 10r

Y – 0.6Y = 120 –10r

120 10 r
Y= −
0 .4 0 .4
Y = 300 – 25r -IS equation.

LM Equation

Money demand = Money supply

Y – 100r = 295

Y = 295 + 100r -LM equation

For the two markets to be in equilibrium;

IS =LM

300 –25r =295 +100r

125r = 5

38
 r =5/125 = 0.04

Hence r = 4%

To obtain income (y), substitute r into either the IS or LM equation. If we use the IS equation

then:

Y = 300 - 25r but r = 4%

= 300 – 25(4/100)

= 300 – 1 = 299

Therefore, the two markets are in equilibrium when r = 4% and Y = 299.

(6/04)

Activity:

Given the following equations for a certain economy:

Y=C+I+G+X (Income identity)

C =100 +0.9Yd (Consumption function)

I = 200 –500r (Investment function)

X = 100 – 0.12Y –500r (Net export)

G = 200 (Government purchases)

T = 0.2 (Tax rate)

L = Y-100r (Real money demand)

M = 800 (Real money supply)

Required

1. Derive equations for IS and LM curves

2. Determine the r and y pair at which the two markets are clearing

3. Compute the values of C, I, X and L

39
LECTURE 4

INCOME AND PRICE LEVEL ON THE DEMAND SIDE

INTRODUCTION

In the previous lecture, we have studied how the intersection of the IS and LM

curves determine the level of income and interest rate given the price level Po.

In this lecture, we shall vary the price level P so that we may analyze the

effects of the price change on equilibrium output demanded Y. we will derive

the demand curve for the economy and then examine how fiscal policy may be

employed to manage demand in an economy.

In the previous lecture, the following equilibrium conditions have already

Objectives

1. After you study this lecture you should be able to:

2. Derive the demand curve for an economy.

3. Explain why fiscal and monetary policies are referred to demand management policies.

4. List the effects of fiscal policy on r and Y.

5. Derive the fiscal policy multiplier and interprate it.

6. Explain the effectiveness of fiscal policy in changing Y.

been developed:

Product market: s( y − t ( y)) + t ( y) = i(r ) + g = i(r ) + g

40
 −
m
Money market: = l (r ) + k ( y )
p

We have been taking prices as given and therefore, we easily solved for

equilibrium r and y. we shall now drop the assumption of price being fixed

and see what happen to Y as we change P.

To analyze the effects of price level changes on Y, we use the four – quadrant

diagram:

LM1
r LM2

r1

r0

l (r )
Speculative
− −
m m
Demand y1 y0 y
p0 p1

K(y)

Transactions
Demand

Fig 4 (a)
The money market equilibrium condition is first drawn because the price level

enters the money market and not the product market. The IS curve is

41
superimposed to give equilibrium (ro, yo). Therefore, at price Po, equilibrium is at

(ro, yo).

−
If price rises from Po to P1, without money supply m , changing, then the real

− −
m m
money supply shifts inward from to . This shifts the LM curve from LM0
p0 p1

to LM1 changing equilibrium to (r1, y1). The economy therefore settles at (r1, y1).

The logic behind this is very simple. The rise in the price level shrinks the real

money supply leaving excess demand in the money market at any given income

level. This excess demand pushes interest rates up thereby reducing

investment demand. The drop in investment reduces income from y0

to y1 through the multiplier process.

Therefore, the relationship between output demand (y) and prices in the

economy is inverse as shown in the figure 4 (b):

The economy’s demand curve

D
Y
Fig 4 (b)

The demand curve is derived by asking what happens to equilibrium output

demanded as the price level changes allowing other variables such as r to adjust

42
to their equilibrium levels. This brings out two important points

about the demand curve.

1. a) Changes in equilibrium variables such as r and y on the demand

side of the economy as a result of price changes causes movements

along the demand curve.

b) Changes in exogenous variables on the demand side of the

economy such as g, m, t, s or k (y) cause shifts in the demand curve.

2. The demand curve does not reflect the ordinary substitution

effects of a rising price reducing demand. Rather, the rising aggregate

price level, P, reduces equilibrium output demanded, y, by tightening

the interest rate and thus reducing investment.

Monetary and fiscal policy

Monetary and fiscal policies are generally thought of as demand management

policies. This means that the objective of the two policies is to maintain output

near full employment and stability in the prices. This is because excess demand

causes inflation and insufficient demand causes unemployment and deflation.

In the case of excess demand as shown in figure 4 (c), the objective of the two

policies will be to reduce demand from D0D0 t0 D1D1 thus keeping prices at P0

and output at full employment YF.

43
 P D0

D1

P0
D0

D1
YF Y0
Y
Fig 4 (c)

However, if there is a shortage in demand as shown in figure 4 (d), then the

objective of the two policies will be to increase demand from D 1D1 keeping prices

at P0 and output at YF.

D1

D0

P0 D1

D0

Y0 YF Y

Fig 4 (d)
Fiscal policy effects on demand

In analyzing the effects of fiscal policy changes on g and t on equilibrium y, we

use a four quadrant diagram for the IS curve. Since fiscal policy changes do not

affect the LM curve, we can just add a fixed LM curve to the r, y quadrant to get

the initial equilibrium point ro, yo corresponding to an initial price level. The

44
fiscal policy changes will then shift the IS curve along the LM curve changing

equilibrium output demanded, y, and the interest rate, r.

Now suppose with the initial level of government purchases, g0 and tax schedule,

the resulting output level y0, is below full employment. This means there is a lot

of unemployment in the economy. The objectives of fiscal policy in this case will

be to increase demand through: (i) an increase in g or

(ii) a reduction or cut in tax rate

Effects of an increase in g on y

If there is an increase in g from g0 to g1 without taxes changing, then the IS curve

will shift from IS to IS1 as shown in the figure 4 (e):

g1 g0 LM

r2
r0

i ( r ) + g1 r1 IS1

i(r ) + g 0 IS0

i+g 45 0 y0 y2 y1 y

(s + t 0 ( y)
i+ g = s+t (s + t )
Fig 4 (e)

45
The increase in g from g0 to g1 adds directly to y through multiplier so that

increase from y0 to y1. This increase in y causes excess demand in the money

market thereby causing interest rates top rise from r0 to r2. The increase in r,

causes investment to fall and through the multiplier y falls from y1 to y2. The

economy therefore settles at (r2, Y2).

Effects of a tax cut on y

Permanently reducing tax rates or increasing transfer payments instead of

increasing government purchases, could obtain the same effects on the level of r

and y.

g LM

r2
r0

r1 IS1

i (r ) + g IS0

i+g 45 0 y0 y2 y1 y

( s + t1 ( y)

(s + t 0 ( y)
i+ g = s+t (s + t )

46
 Fig 4 (f)

When the rate of interest is r0, the IS curve is IS0. If we impose the LM curve we

obtain y0. A cut in the tax rate, shifts the s + t function out from s + t 0 (y) to s + t1

(y). As a result, the IS curve shifts to IS1 and income rises to y1. The increase in

income causes excess demand in the money market forcing interest rates to rise.

The increase in r reduces investment and so through the multiplier, y falls to y2.

The economy therefore settles at (r2, y2)

Fiscal policy multiplier

We have seen in the previous section that an increase in g leads to an increase in

y. we now seek to determine the amount which y will change following a unit

change in g. this is possible only if we calculate the fiscal; policy multiplier. The

fiscal policy multiplier tells us the amount by which equilibrium income will

change when g or t changes by one unit.

Recall the two equilibrium condition given as:

Product market: y = c( y − t ( y )) + i(r ) + g ……………………………………...(1)

−
m
Money market: = l (r ) + k ( y ) …………………………………………………(2)
P

To observe the effects of change in g on y, totally differentiate equation (1) to

obtain:

dy = c ' (dy − t ' dy) + i ' dr + dg ……………………………………………………(3)

47
 dc
Where: c ' = mpc = 0
dy

dt
t' = 0
dy

di
i' = 0
dr

From equation (3) we can have:

dy − c ' (dy − t ' dy) = i ' dr + dg ……………………………………………..(4)

Rearranging we obtain:

dy − c ' dy − c ' t ' dy = i ' dr + dg

Where:

dy − c ' dy = Additional savings or change in savings.

c ' t ' dy = Change in taxes.

From equation (4), factor out dy so that:

(1 − c ' (1 − t ) ' )dy = i ' dr + dg …………………………………………………(5)

We can obtain the expression for dr from money market:

−
m
= l (r ) + k ( y )
P

−
m
Let = m so that the equilibrium condition in the money market becomes:
P

0 = l ' dr + k ' dy

l ' dr = −k ' dy

k'
dr = − dy
l'

48
Substituting this expression for dr into equation (5) we get:

 ' '
 k'
1 − c (1 − t ) dy = i (− ' dy) + dg ………………………………………………….(6)
l
'

1 − c (1 − t )dy = −i (− kl
'
' ' '
'
dy) = dg

 
i 'k '
1 − c (1 − t ) dy + ' dy = dg
' '

 i 'k ' 
1 − c (1 − t ) + '  dy = dg
' '

 l 

dg
dy =
i 'k '
1 − c ' (1 − t ' ) +
l'

dy 1
= This is the expression for fiscal multiplier.
dg i 'k '
1 − c (1 − t ) + '
' '

Numerical example…

Given the following equations, calculate the fiscal policy multiplier and interprate

it.

C = 100 + 0.8Yd (Consumption function)

I = 1o – 10r (Investment function)

L = Y-100r (Real money demand)

G = 10 (Government purchases)

T = 0.25 (Tax rate)

M = 295 (Real money supply)

49
Solution

Fiscal policy multiplier is given by:

dy 1
=
dg i 'k '
1 − c ' (1 − t ' ) +
l'

From the equation given:

c ' = 0.8, t ' = -.25, i ' = -10, k ' = 1, l ' = -100

dy 1
Hence: =
dr − 1 − (1)
1 − 0.8(1 − 0.25) + −
− 100

dy 1
=
dr 1 − 0.8(0.75) + 0.1

dy 1
=
dr 0.5

=2

Interpretation

An increase in government purchases by one unit will increase equilibrium

output by two shillings.

Slopes of an IS curve

Equilibrium in the product market is given as:

y = c( y − t ( y )) + i(r ) + g

Differentiating we get:

dy = c ' (dy − t ' dy) + i ' dr + dg

Thus: (1 − c ' (1 − t ) ' )dy − dg = i ' dr

50
So that, dr =
1 − c (1 − t )dy − 1 dg
' '

i' l'

Since in equilibrium, the above is true, and then it is also true that:

r=
1 − c (1 − t )y − 1 g
' '

i' l'

So that

dr 1 − c ' (1 − t ' )
=

dy i'

We can now get various slopes of IS curve by assigning different values of the

parameters i ' .

dr
If i ' = 0 , then =  and hence, the IS curve will be vertical as shown in figure 4
dy

(g):

IS curve

dr
=
dy

Fig 4 (g)
dr 1 − c (1 − t ) ' '
If i ' = − , then, = = 0 Meaning that the IS curve is horizontal.
dy i'

51
 IS curve
dr
=0
dy

Y
Fig 4 (h)

If 0  i '  − , then the IS curve will be downward sloping as shown in figure 4 (i).

IS Curve

Y
Fig 4 (i )

Therefore, the slope of the IS curve depend on the slope of the investment

function.

r
i' = 0

0  i '  −

i ' = − IS Curve

Y
Fig 4 (j)

52
Effectiveness of fiscal policy

The fiscal policy is most effective in changing y when the IS curve is vertical as

shown in figure 4 (k):

r IS0 IS1 LM

r1

r0

Y0 y1 Y

Fig 4 (k)

dy
When the IS curve is horizontal i.e. when i ' = − , then = 0 . This is true if you
dg

dy 1 dy
look at the expression: = ' '
if i ' = − then = 0 hence no
dg ik dg
1 − c ' (1 − t ' ) +
l'

change in y. Therefore the fiscal policy is not effective when IS curve is

horizontal.

When IS curve is downward sloping, the fiscal policy use will increase y but not as

much as when IS curve is vertical. This is shown in figure 4 (l):

53
 r1

r0
IS1

IS0

y0 y1 Y

Fig 4 (l)

Activity

1. Explain why S + T = I + G where

S = Change in savings

T = Change in taxes

I = Change in investment

G = Change in government purchases

2. Use the four-quadrant diagram to discuss the effects of the following on y and r

i.) A decrease in g

ii.) An increase in t

54
LECTURE 5

MONETARY POLICY EFFECTS ON DEMAND

INTRODUCTION

In the previous lecture, we studied the fiscal policy effects on demand using the

Hicksian IS-LM framework. We also looked at the circumstances under which the

fiscal policy use may be effective in generating desired changes in real output, y.

In this lecture, we shall use the same Hicksian IS-LM framework to analyze the

monetary policy effect on demand. The monetary policy multiplier will be derived

and the effectiveness of monetary mix will also be looked at.

OBJECTIVES

At the end of this lecture, you shall be able to:

1. Determine the monetary policy effects on r and y using the four- quadrant

diagram.

2. Derive the monetary policy multiplier and interprate it.

3. Explain the meaning of fiscal and monetary policy mix and show effects on r

and y.

−
To analyze the effects of monetary policy change in money supply m , we make

use of the four-quadrant diagram. We shall derive the LM curve and then

superimpose the IS curve to determine the initial r0 and y0 given the price level p0

−
and the initial level of money supply m 0 . The monetary policy change will shift

the LM curve, changing the interest rate and the equilibrium output demanded.

55
More specifically, an increase in money supply will shift the LM curve to the right

as shown in figure 5 (a):

LM0 LM1

r0

r2

r1
l (r )
IS

Speculative
− −
m1 m0
Demand y0 y2 y1 Y
P0 P0

−
m0
k(y)
P0
−
m1
P0
Transaction
Demand

Fig 5 (a)

− −
The figure 5 (a) shows the effects of an increase in money supply from m 0 to m 1 .

− −
m m
This increase in money supply shifts the real money supply out from 0 to 1 . At
P0 P0

the initial output y0, the increase in money supply pushes interest rates down

from r0 to r1 to maintain equilibrium in the money market. This drop in interest

rate increase investment demand thereby raising the level of output along the IS

56
curve. The increase in income in turn raises the transactions demand for money

thus pulling the interest rate up. In the end the economy settles at (r 2, y2) with

both the product market and money market in equilibrium.

? Use the four-quadrant diagram to analyze the effects of a reduction in money

supply on r and y.

THE MONETARY POLICY MULTIPLIER

The monetary policy multiplier tells us the amount by which equilibrium output

changes when money stock changes by one unit taking into account the

interaction between the goods and money markets. It is different from the money

multiplier. The money multiplier tells us the amount by which money stock

changes when high-powered money changes by one unit.

To develop the multiplier for the change in money supply (m) on output (y), we

start with equilibrium conditions in product and money market.

Product market: y = c( y − t ( y )) + i(r ) + g

−
m
Money market: = m = l (r ) + k ( y )
P

Differentiating the money market equilibrium condition we obtain:

−
dm
= dm = l ' dr + k ' dy
P

57
dm = l ' dr + k ' dy

l ' dr = dm − k ' dy

dm k ' dy
dr = ' − '
l l

Differentiating the product market equilibrium condition, we obtain:

dy = c ' (dy − t ' dy) + i ' dr + dg

= c ' (1 − t ' )dy + i ' dr + dg

Holding g constant we get:

dy = c ' (1 − t ' )dy + i ' dr

Substituting the expression for dr we obtain:

i' i 'k '

dy = c ' (1 − t ' )dy + dm − dy
l' l'

i 'k ' i ' dm

dy − c ' (1 − t ' )dy + dy =
l' l'

i 'k ' i ' dm

dy[−c ' (1 − t ' ) + ]dy =
l' l'

i'
dy = l' dm
i 'k '
1 − c (1 − t ) + '
' '

i'
dy l'
Hence: =
dm i 'k '
1 − c (1 − t ) + '
' '

58
This is the multiplier expression for the money supply change or the monetary

policy multiplier. The denominator is the same as the one for the fiscal policy

multiplier.

Numerical example

Given the following equations from a certain economy:

C = 100 + 0.8Yd (Consumption function)

I = 1o – 10r (Investment function)

L = Y-100r (Real money demand)

G = 10 (Government purchases)

T = 0.25 (Tax rate)

M = 295 (Real money supply)

Required

i.) Calculate the monetary multiplier policy and interprate it.

ii.) Suppose equilibrium income increases by 40, by how much must real

money stock increases for the new level of income to be in equilibrium.

Solution

i'
dy l'
(i) =
dm i 'k '
1 − c ' (1 − t ' ) +
l'

But c ' = 0.8, t ' = -.25, i ' = -10, k ' = 1, l ' = -100

− 10
Therefore;
dy
= − 100
dm − 10(1)
1 − 0.8(1 − 0.25) +
− 100

59
 0.1
=
1 + 0.8 + 0.2 + 0.1

= 0.2

Interpretation:

An increase in money supply by one shilling will increase equilibrium income

by0.2 shillings or 20 cents.

(ii) We use the following expression:

i'
dy = l' dm
i 'k '
1 − c (1 − t ) + '
' '

i'
but l' = 0.2
i 'k '
1 − c (1 − t ) + '
' '

Hence dy = 0.2dm

Since, dm = 40 then

0.2dm = 40

Hence dm = 40 / 0.2 = 200

Therefore, money stock must increase by 200.

SLOPE OF LM CURVE

The money market equilibrium condition is given by:

−
m
= m = l (r ) + k ( y )
P

Differentiating, it we obtain:

dm = l ' dr + k ' dy

60
 dm k ' dy
dr = − '
l' l

If the above expression is true, then it is also true that:

m k'
r= − y This is the expression for the LM curve with the slope given by:
l' l'

dr k'
=− ' 0
dy l

The slope of the LM curve determines the effectiveness of monetary policy. If we

assign various values to the parameter l ' , we obtain different slopes of the LM

curve.

dr k' dr
From the expression = − ' ; if l ' = 0 then =  and LM curve is vertical as
dy l dy

shown in figure 5 (b):

LM curv

dr
l ' = 0 and =
dy

Y
Fig 5 (b)
A vertical LM curve implies that the speculative demand for money is insensitive

to changes in interest rates.

61
When l ' = − implying that the speculative demand for money is very sensitive

dr k'
to changes in interest rates, then = − ' =0 meaning that the LM curve is
dy l

horizontal.

r
dr
l ' = − ; =0
dy
LM curve

Y
Fig 5 (c)
When the LM curve lies between zero and negative infinity, i.e. 0  l '  − then

dr k'
the LM curve is upward sloping i.e. = − ' >0
dy l

Hence: r LM curve

0  l '  −

Y
Fig 5 (d)

The shape of the LM curve put together yields:

r LM curve

l' = 0

62
 l ' = − 0  l '  −

Fig 5 (e) Y
EFFECTIVENESS OF MONETARY POLICY

The monetary policy is more effective in the changing output when the LM curve

is vertical as shown in the figure 5 (f)

r LM0 LM1

r0

r1

IS

y0 y1 Y

Fig 5 (f)

The monetary policy use shifts the LM curve to the right thereby raising y from y0

to y1.

We can prove that monetary policy is more effective in changing y when LM is

vertical by looking at the expression:

i'
dy l'
=
dm i 'k '
1 − c ' (1 − t ' ) +
l'

In the RHS multiply up and down by l ' to obtain:

63
dy i'
= '
dm l (1 − c ' (1 − t ' )) + i ' k '

dr i'
if we let l ' = 0 , then = − ' ' thereby giving us a higher value of the multiplier.
dm ik

Therefore, the effect of a change in money supply is greater on y when l ' = 0 than

when l '  0 .

MONETARY AND FISCAL POLICY MIX

We have seen how the two policies can be used separately to attain specific

objectives. The two policies can also be used together especially when the aim is

to change the composition of equilibrium output and not its size.

Suppose for instance, the economy is experiencing interest rates that are too high

to encourage investments, to correct the situation in this economy, a policy mix

may be used to leave y unchanged but change investments and consumption.

More specifically, the following policies may be employed simultaneously:

i.) Fiscal policy; tax rate increase and

ii.) Monetary policy; money supply increase

LM0
r LM1

r0

r1
IS0
IS1

y0 Y

Fig 5(g)

64
At (r0, y0), the interest rate r0, is so high and discourages investment. If we

increase tax rate, the IS curve shifts to IS1 thereby causing disequilibrium in the

money market at the initial interest rate r0. To ensure equilibrium in the money

market, money supply is increased thereby shifting the LM curve to LM 1. This

combination of increase in tax rate and increase in money supply brings the

following results:

i.) Output remains unchanged at y0.

ii.) Interest rates falls from r0 to r1 thereby encouraging investment in the

economy

NOTE: When using the policy mix, make sure that the policy instruments

used move towards the same direction.

(20/04)

65
 Activity

Given the following equations:

Y=C+I+G+X

C = 100 + 0.9Yd (Consumption function)

I = 200 – 500r (Investment function)

M = 0.8Y – 2000r (Real money demand)

X = 100 - 0.12Y – 500r (Net export)

G = 200 (Government purchases)

T = 0.2 (Tax rate)

L = 800 (Real money supply)

Required

1. Derive equation for IS and LM curves.

2. Compute the r and y at which the two markets are clearing

3. Compute the values of C, I, X and M.

4. Calculate the monetary and fiscal policy multipliers and interprate them..

66
LECTURE 6

SUPPLY SIDE EQUILIBRIUM

INTRODUCTIN

In the last three lectures, we develop the demand side of the economy taking the

price P as exogenously determined. We derive the product market and money

market equilibrium conditions as:

IS: y = c( y − t ( y )) + i(r ) + g ……………………………………(1)

−
m
and LM: = m = l (r ) + k ( y ) ………………………………………….(2)
P

We use the equations to find r and y pairs at which the two markets are clearing.

In this lecture, use will be introduced to supply side of our skeletal

macroeconomy by introducing demand and supply in the labour market.

OBJECTIVES

At the end of this lecture, you should be able to:

1. Derive the aggregate demand for and supply of labour function.

2. Determine the equilibrium condition in the labour market.

SIMPLE DEPRESSION MODEL

In the model, labour supply is unlimited such that an increase in demand leads to

an increase in output y and employment N without raising the price level. This

67
means therefore that prices are rigid in this model. The supply curve therefore is

a horizontal line at P0.

The short run production function can be given as:

− dy
y = y( N , k ) ;  0 …………………………………………………(3)
dN

The function tells us that, in the short run, the level of output y is a function of

employment N. the rest of the factor inputs are fixed. For any level of y, the

production function gives the level of employment N needed to produce this y.

this gives us a complete depression model. The presence of massive

unemployment implies that an increase in demand will be followed by and

increase in output and employment without raising prices and wages. This

situation can be represented by a horizontal supply curve at P0 as shown in figure

6 (a).

P0

Aggregate demand curve

0 y0 y
Fig 6 (a)
The production of the resulting equilibrium output y0 gives employment of N0

persons as shown in figure 6 (b)

68
 y

−
y( N , K )

y1

y0

N0 N1 N

Fig 6(b): The short run production function.

Formally, this depression model adds an exogenous price assumption; P = P 0.

……(4),

to equation (1) – (3) thereby forming four equations with four variables; y, r, p

and N.

The major difficulty with this analysis is that the assumption of a fixed price level

is not acceptable if labour supply is not elastic. This is known from empirical

observation. In the 1930s up to 1960s, when there was reasonable

unemployment, an increase in demand leads to an increase in output without

raising prices. However, after 1965, unemployment stood below 4% and therefore

an increase in demand was followed with an increase in prices. Empirical records

in an economy with low unemployment suggests that increasing demand leads to

raising prices while reduction in demand reduces prices or inflation.

Intuitively, we should be able to imaging the quantitative relationship between

prices, wages and level of employment that would occur when an economy is at or

69
near full employment. If demand for goods suddenly rises above supply, prices

will begin to rise.

Higher prices will mean higher profits to producers and so they would expand

production by hiring more labour. The increased demand for labour will take the

form of employers offering higher money wage to hire more labour.

Presumably, however, the workers will be interested in purchasing power of their

money wages. An increase in price therefore will reduce the workers’ real wages.

There is therefore a close relationship prices, wages and employment and this

relationship is more complex than the simple relation model.

DEMAND FOR LABOUR

The production function presented in figure 6 (b) shows that output is an

increasing function of employment (N). However, y increases at an increasing

rate with the first additions of labour to the fixed capital stock. But after some

level of employment shown as N1, y begins to increase at a decreasing rate

showing diminishing marginal return as the fixed capital is spread over more and

more workers.

From the production function, we can derive the average product of labour; AP L,

y dy
( ) and marginal product of labour; MPL, ( ) as shown in figure 6 (c):
N dN

70
 y

−
(i) y( N , K )

N1 N2
N

y
N

(ii)
dy
MPl =
dN

y
APl =
N

N1 N2 N

Fig 6 (c): the production function and its derivatives.

The average product of labour is presented by the slope of a line from the origin

to any point on the production function. As shown in the figure 6 (c), as

employment increases APL first increase and the decrease. The MPL is the slope

of the production function and is shown by the slope of the tangent to the

71
production function at each point N. fr4om figure 6 (c) the following observation

can be made:

dy
R = p. .N
dN

dy
Where: p. or p. MPL = marginal value product of labour (MVPL)
dN

The increase in cost to a firm hiring extra labour is given by: C = W .N where

W = money wage.

If R  C then any profit maximizing firm will hire extra labour. However, if

R  C then a profit maximizing firm will not hire more labour. Therefore, the

firm will hire labour until R = C and

dy
W = p. ………………………………………….(5a)
dN

W dy
or w = = …………………………………………..(5b)
p dN

We shall develop the demand for labour from equation (5)

Suppose the firm faces the market wage W0. It will employ labour until;

dy
p. = W0 . If the wage falls, then the firm will increase employment to maintain
dN

equation (5). Equation (5) therefore can be considered as:

dy
i.) The real wage the firm will offer w = or
dN

dy
ii.) The money wage the firm will offer W = p.
dN

These relationships are shown in figure 6 (d):

72
 W
w=
p

(i)

W0 dy
w=
P dN

N0 N

(ii)

dy
W0 W =
dN

N0 N

Figure 6 (d): competitive firms for labour.

73
MONOPOLISTIC CASE

A perfectly competitive firm faces a given price determined by market forces

while a monopolist chooses the price-quantity combination that maximizes

profit. Therefore, the demand curve for the monopolist can be written as:

 −

p = p  y ( N , K ) , p '  0 ……………………………………….(6)
 

Total revenue is given by:

_
 −

R = y ( N , K ) • p  y ( N , K ) ………………………………………(7)
 

To obtain a change in R following a change in N, we differentiate equation 7:

thus,

dR dp dy dy
=y • +p
dN dy dN dN

dy  y dp 
=p 1 + 
dN  p dy 

But the last term in the bracket is elasticity of demand, thus:

dR  y dp  dy
= p1 +  …………………………………………(8)
dN  p dy  dN

The marginal cost of hiring a new worker is still W and so the monopolist will

maximize profits a when:

 y dp  dy
W = p1 +  …………………………………………..(9)
 p dy  dN

Therefore, the monopolist’s demand curve for labour is the competitive firm’s

demand for labour shifted left by the factor: 1 + 1/e and is as shown in figure 6

(e):

74
 W

 y dp  dy
W = p1 + 
 p dy  dN

Figure 6 (e): Monopolistic firm’s demand for labour.

AGGREGATE DEMAND FOR LABOUR

An economy has a mixture of monopolistic and competitive firms and therefore

the aggregate demand for labour will be the horizontal sum of several industrial

demand curves. It will be given as:

W
w= = f (N ) ……………………………….(10a)
p

Or W = p. f ( N ) …………………………………..(10b)

Graphically the demand for labour is as shown in figure 6 (f):

W
W = p. f ( N )

N
Figure 6 (f): Aggregate demand for labour.

There are two important things to note about the aggregate demand curve:

75
The negative slope reflects the diminishing marginal productivity of labour as

more labour is added to the fixed capital stock.

Since profit-maximizing firms are interested in the real wage they pay (the price

of labour input relative to the price of output) then price enters the money wage

version of the demand function (10b) multiplicatively.

THE SUPPLY OF LABOUR

We did not make any assumption about price or wage expectations of employers

on the demand side of the labour market. This is because employers are assumed

to have good information about prices charged and wage rates paid. Therefore,

W
the employer knows at any time the real product wage to be where W is the
p

money wage and p is the price charged on the products. The workers however do

not have good information concerning price level as employers. There is therefore

the price they expect (pe) and the actual price (p). To develop the supply side of

the labour market, the following question must be answered:

i.) How rapidly or competently do the worker’s expectation of the future

prices pe adjust to changes in the actual price level p?

ii.) Is the nominal wage rate rigid or flexible over time?

If there is immediate and correct adjustment of pe to changes in p then that is

taken to be the classical case in which the supply of labour depend only on the

real wage w. it is known as the classical case because it stems from the traditional

76
theory of consumer behaviour and was at the roots of the pre-Keynesian school of

macro-economic thinking which Keynes dubbed as “classical” in 1936. if there is

no adjustment of pe to changes in p then labour supply will be a function of the

money wage W corresponding to the extreme Keynesian case.

THE INDIVIDUAL’S WORK-LEISURE DECISION

We begin by assuming that the worker seeks to allocate the hours available

between work and leisure so that his objective function becomes:

du du
Max. U = u( y e , S ) ; ,  0 ………………………………….(11)
dy e dS

W
s.t. y e = e
.(T − S ) = w e …………………………………………(12)
p

Where:

U = Utility

ye = Real earnings from work/ expected real income.

S = Leisure

T = total number of working hours.

T – S = Number of working hours.

Pe = Expected price level.

We = Expected real wage.

The work-leisure decision may be presented as shown in figure 6 (g):

ye
W T
1
e
T

77
 y1e

W0eT U1

y 0e
U0

0 S1 S2 T S

Fig 6 (g): the work-leisure decision.

Each indifference curve shows the combination of ye and S that yield the same

level of utility. Points on U1 represent higher level of utility than those on U0. The

entire ye, S space are filled with such curves, non-crossing any other. The worker-

consumer wants to reach the highest indifference curve possible. The limits of his

or her ability to move towards the northeast depend on the number of hours

available and the real wage. Therefore if the worker has T hours available and

choose to have no income at all, then he/she will have T hours of leisure. At the

expected real wage W0e , if he/she chooses not to have any leisure then his/her

income will be W0e .T and leisure can be traded for income along the budget line

connecting these two points. All point above the budget line are unattainable

while those on or below the budget line are attainable or feasible.

The worker will hence maximize utility at the point of tangency between the

budget line and indifference curve. Connecting the points of tangency between

the budget line and indifference curve for various real wage rates with T fixed, we

obtain the labour supply curve TT as shown in the figure 6 (g).

78
THE AGGREGATE LABOUR SUPPLY CURVE

We saw that the number of working hours is given by T – S. let T – S = n so that

we can draw the relationship between the expected real wage W e and the amount

of labour ni offered by the individual as shown in figure 6 (h):

We T We

we = g (N )

ni N =  ni
(a) (b)

Figure 6 (h): Labour supply curves.

Figure (a) shows an individual labour supply curve bending backwards showing

that once wage rates reached a certain high level, further wage increase makes the

worker to increase leisure than working time. If we assume a homogeneous

labour force with a single wage rate, we can sum the entire individual’s labour

79
supply curve for the entire economy as shown in figure 6h (b). For a given value

of pe, the aggregate labour supply curve can be represented as:

N = N (We)

W
Or w e = e
= g ( N ); g '  0 ……………………………(13a)
p

Or W = p e .g ( N ) ………………………………………..(13b)

Equation (13b) is used to derive a labour supply curve in the W, N space of figure

6 (i):

W W = p e .g ( N )

Figure 6 (i): Aggregate labour supply.

EQUILIBRIUM IN THE LABOUR MARKET

We have derive equations both demand and supply of labour to be:

Demand: p. f ( N ) …………………………………………….(14)

Supply: p e .g ( N ) ……………………………………………..(15)

Equating demand to supply gives the labour market equilibrium condition:

80
 p. f ( N ) = p e .g ( N )

W = p e .g ( N )

W0

W = p0 . f ( N )

N0 N

Figure 6 (j): Equilibrium in the labour market.

The graphical solution of the labour market equilibrium is represented by the

intersection of the two curves as shown in figure 6 (j). The actual equilibrium

value of the price level is p0 while the expected price level is pe. Equilibrium

employment is N0 while nominal wage is W0.

? With reference to the income and substitution effects give an account

for the backward bending labour supply curve for the economy.

81
 GROWTH ACCOUNTING

Highlights: Questions

(A) What accounts for differences in wealth between countries?

(B) What will determine our standard of living in the future?

1. Economic growth is due to growth in inputs, such as labour and capital

and to improvements in technology.

2. Capital accumulates through saving and investment

3. The long–run level of output per person depends positively on the savings

rate and negatively on the rate of population growth.

4. The neoclassical growth model suggests that the standard of living in poor

countries will eventually converge to the level in wealthy countries.

Growth Accounting:

Explains what part of growth in total output is due to growth in different factors

of production such as capital and labour.

Growth Theory

Helps us understand how economic decisions control the accumulation of

factors of production. For example how the rate of saving today affects the stock

of capital in the future.

Economic growth results from accumulation of factors of production,

particularly capital and from increased productivity. Savings rates and

population growth determine capital accumulation.

82
 Output grows through increase in inputs and through increase in

productivity due to improved technology and a more able labour force.

The production function provides a quantitative link between inputs and

outputs. If we assume that labour (L) and capital (K) are the only important

inputs, the equation (1) below shows that output (Y) depends on inputs and the

level of technology (A)

Y = Af ( K , L) ……………………………………………………………..(1)

A, represents the level of technology because the higher the

A is, the more output is produced for a given level of inputs.

More inputs means more outputs. Hence the MPL and MPK are both

positive.

The production function (1) can be transformed into a very specific prediction

relating input growth to output growth. Hence the growth accounting equation

becomes:

Y  L  K A
= (1 −  )   + (  )+ ………………………………….(2)
Y  L  K A

Output growth = (labour share x labour growth)+ (capital

share x capital growth) + technical

progress………………………………………………………………...(2)

Where; (1-) and  are weights equal to labour’s share of income and capital’s

share of income. Labour’s share of income is the fraction of total output that goes

to compensate labour like wages, salaries dividend by GDP.

83
 Equation (2) summarizes the contributions of inputs growth and improved

productivity to the growth of output. Thus:

(i) – Labour and capital each contribute an amount equal to their

individual growth rates multiplied by the share of that input in income.

Example

Y = AK  L1−

Y
MPK = = AK  −1 L1−
K

= AK  K −1 L1 L−

AK  L1−
=
K

Y
=
K

Y
MPL = = AK  L1− −1
L

= AK  L1− L−1

AK  L1−
=
L

Y
=
L

(ii) The rate of improvement of technology is A which is also called

technical progress, or the growth of total factor productivity.

The growth rate of total factor productivity is the amount by which output

would increase as a results of improvements in methods of production with all

84
inputs unchanged, Hence there is growth in total factor productivity when we get

more output from the same factors of production.

Accounting for Growth in Per Capita Output

Per capita GDP is the ratio of GDP to population. The growth rate of GDP equals

the growth rate per capita GDP plus the growth rate of the population.

Y y L K k L
= + And = +
Y y L K k L

Y K
Where; y = and k =
L L

To translate the growth accounting equation into per capita terms, subtract

L
population growth, from both sides of equation (2) and rearrange.
L

Y L  L  K A L
− = (1 −  )   + (  )+ −
Y L  L  K A L

Y L L L K A L
− = − + + −
Y L L L K A L

Y L K L A
− = [ − ]+ ………………………………………….(3)
Y L L K A

Rewriting in per capita terms

y K A
=  + ………………………………………………………(4)
y K A

y Y L k K L
Since; = − and = −
y Y L k K L

K
The number of machines per worker, k = also called the capital-labour ratio is
L

a key determinant of the amount of output a worker can produce.

85
The Solow Residual

Changes in the level of technology are also called change in total factor

A
productivity (TFP). Make in equation (2) the subject
A

A Y  L  K
= − (1 −  )  −  
A Y  L  K

A
This changes in TFP, is called the Solow residual.
A

Solow found that the important determinants of GDP growth are technical

progress, increased labour supply and capital accumulation in that order.

While important determinants of growth in per capital GDP are technical

progress and capital accumulation.

Increased population actually decreases GDP per capita even though it

increases GDP. More workers means more output, but output increases less than

proportionately.

Equation (2) tells us that each percentage point of growth in the labour

force leads to a 1 −  percentage point increase in output. Because the output is

less one for one, output grows less quickly than the number or workers and

output per worker (GDP per capita) falls. If you increase the number of workers

without proportionately increasing the number of machines, the average worker

will be less productive because she has less equipment to work with.

Other Factors that Affect Growth

1. Natural resources

Fertile land contributes greatly to growth. Massive developed oil reserves would

also spur growth like it happened in Norway.

86
2. Human capital

Raw labour is less important than the skills and talents of workers. The

economy’s stock of skills is increased by investment in human capital though

- Schooling (proxy for human capital)

- On- the-job training

- Investments in health

Hence the production function becomes

Y = Af ( K , H , L) Where H= Human capital

Mankiw N.G, D. Romer and D. Weil (1992), A contribution to the empirics of

economic growth. Quarterly journal of economics, May suggests that the

production function is consistent with factor shares of one-third each for physical

capital raw, labour and human capital. Differential growth in the three factors

can explain about 80 percent of the variation in GDP per capita across a wide

sample of countries, emphasizing the critical role of factor accumulation in the

growth process.

Immigration boosts per capital output when skilled workers enter the country

(USA) while immigration consisting of war refugees depress per capita output

in short run.

Growth Theory: The Neoclassical Model

It focuses on capital accumulation and its link to

saving decisions. It assumes that there is no technological

progress. This implies that the economy reaches a long-run

level of output and capital called the steady–state

87
equilibrium. This is the contribution of per capita GDP and

per capita capital where the economy will remain at rest,

that is where per capita economic variables are longer

changing, Y = 0 and K = 0 .

The theory involves studying the transition from the economy’s current

position to this steady state. In the final step, technological progress is added to

the model.

The production function is per capita terms is Y= f(K). This is the

relationship between per capita output (Y) and the capital-labour ratio (K)

The economy is at steady state when per capita income and capital are

constant. I.e. Y* and K*. These are values where the investment needed to

provide capital for new workers and to replace machines worn out is just equal to

the savings generated by the economy.

Investment and Savings

The required investment to maintain a given level of k or capital per capita

depends on the population growth and the depreciation rate.

N
(i) Assume that population grows at a constant rate n = . Hence the
N

economy needs investment nK to provide capital for new workers.

(ii) Assume that depreciation is a constant d percent of the capital stock

dK . Thus the investment required to maintain the level of capital per

capita is:

(n + d ) K

88
 (iii) Assume no government sector and no foreign trade or capital flows.

(iv) Assume that saving is a constant fraction s of income, so per capita

savings is sY and since income equal production then sY = sf (K )

Net change in capital K = sY − (n + d ) K i.e. excess of saving over required

investment.

The steady state is defiled by K = 0 which occurs at Y* and K* hence

sY * = sf ( K *)

= (n + d ) K *

89
Graphical representation of steady state

Y Y=f (K) production function

Output per Y* D (n + d) K* investment

Head

Y0

A C sY saving

sY0 B

0 K0 K* K

Capital per head

sY shows the level of saving at each capital-labour ratio. The straight line

(n+d)k shows the amount of investment that is needed at each capital-labour

ratio to keep the capital labour ratio constant. At C, saving and investment

required balance with steady state capital K* the steady state income is read off

the production function at point D.

Growth process

When savings sY exceeds the required investment requirement, then K is

increasing, i.e. sY > (n+d) k then k is increasing and over time the economy is

moving to the right. if It starts from Ko, then saving at A exceed investment

needed to hold K constant at B hence K must increase.

The adjustment process comes to a hold at a point C where capital-labour

ratio neither rises nor falls hence the steady state is reached.

90
Implications

(i) That countries with equal savings rates, rate of population growth and

technology should eventually converge to equal income, although the

converging process may be slow.

(ii) The steady-state growth rate is not affected by the savings rate.

An increase in Saving Rate

According to the neoclassical growth theory, the savings rate does not affect the

growth rate in the long run.

In the short-run, an increase in the savings rate increases the growth rate of

output. It does not affect the long-run growth rate of output, but it raises the long

run level of capital and output per head.

Y f (K)

Output per (n+d)K

Head C/ s/Y

Y**

Y* C sY

0 K* K** K

Capital per head

If saving rate increase the steady–state capital–labour ratio increases from

C to C/

91
This is because people want to save a larger fraction of income, which causes an

upward shift of the savings curve to s/Y

At point C savings has now risen relative to the investment requirement

hence more is saved than required to maintain capital per head constant. Enough

is saved to allow the capital stock per head to increase which will keep upon

rising until it reaches point C/ where higher amounts of savings rate is enough to

maintain higher stock of capital. The economy has returned to its steady state

growth rate of n. Thus with this constant returns to scale production, an increase

in the savings rate will in the long run raises only the level of output and capital

per head and not the growth rate of output per head.

Population Growth

An increase in population growth rate affects the (n+d) k line, which rotates up to

the left leading to:

(i) Reduction in the steady-state level of capital per head, k and output per

head y.

(ii) Increases the steady- state rate of growth of aggregate output.

Growth with Exogenous Technological Change

A
If technology improves, then  0 hence the production function becomes
A

Y = Af (K ) . If technology improves at 1 per year then, year one later:

Y = 1.01 f ( K ) . Two years later, Y = (1.01) 2 f ( K )

92
Output per head y

y2

y1

y0

0 k

Capital per head

An exogeneous increase in technology causes the production function and

savings curve to rise. The result is a new steady-state point at a higher per capita

output and higher capital-labour ratio. Thus increases in technology over time

results in growth of output overtime.

Technology parameter can enter the production function in any of the three

positions.

(a) Labour Augmenting Technology

This is where new technology increases the productivity of

labour due to improvement in skills and more education.

All workers share equally in this improvement.

A = technology

Y= f (K, AN)

93
(b) Total factor productivity/ Neutral Disembodied technical progress.

It augments all the factors and measures all the changes in production that we

can’t account for by changes in input factors. (Solow residual)

The progress consists of organizational improvements that just shift the

production function up through time. It floats costlessly down on the economy.

Y= Af (K,N)

(c) Capital embodied technical progress.

New technology increase the productivity of capital. New machines are efficient

than old ones. Hence increase in investment will reduce the average age of the

capital stock giving an increase in the rate of technical progress.

Y=f (AK, N)

Key Results of Neoclassical Growth Theory

-The growth rate of output in steady state is exogeneous and

equal to n. It is therefore independent of the savings rate s.

-Although an increase in the saving rate does not affect the steady state level of

income by increasing the capital – output ratio

-When we allow for productivity growth we can show that if there is a steady state

the steady- state growth rate of output remains exogenous. The steady state of

growth of per capital income is determined by the rate of technical progress. The

steady state growth rate of aggregate output is the sum of the rate of technical

progress and the rate of population growth.

-The final prediction of neoclassical theory is that of convergence i.e. if two

countries have the same rate and access to the same production function, they

94
will eventually reach the same level of income. In this framework poor countries

are poor because they have less capital but if they save at the same rate as rich

countries and have access to the same technology, they will eventually catch up. If

countries have different savings rates then they reach different levels income in

the steady state but if their rates of technical progress and population growth are

the same their steady state growth rates will be the same.

Endogenous Growth Theories

In the neoclassical growth model capital exhibits diminishing marginal

returns in the production process. This feature of the model prevents it from

providing an explanation for the wide variations across countries in either per

capita income or growth rates, and for the fact that poor countries do not seem to

grow faster than rich ones.

In addition output growth is independent of the saving rate and is

determined only by demographic factors (the rate of population growth) and the

rate of technological process. But since population growth and technological

change are assumed exogeneous, the model does not explain the mechanism that

generates steady-state growth and therefore does not allow an evaluation of the

mechanisms through which government policies can potentially influence the

growth process.

The endogenous growth theories address these limitations by proposing

channels through which steady-state growth arises endogenously.

(a) The role of externalities and the assumption of constant returns to scale.

(b) The role of human capital accumulation and knowledge

95
 (c) The interaction between economic growth and financial development (i.e.

effects of financial intermediation)

(A) Externalities and Increasing Returns

Two approaches have been followed to relax the assumption of

diminishing returns to capital imposed in the basic neoclassical growth model.

(a) Viewing all production inputs as some form of reproducible capital including

not only physical capital but also other types as well especially human capital

(Lucas 1988) or the state of knowledge (Romer, 1986). An example is the Ak

model by Rebelo (1991), which results from setting  = 0 in Yt = At Kt 1-

(production function)

0<<1

if =0, Yt = At Kt 1-0  Yt = At Kt 1

Where Kt = broad measure of capital – a composite measure of the physical and

human capital stock.

The production function is thus linear and exhibits constant returns to

scale but does not yield diminishing returns to capital. The capital accumulation

equation i.e Kt=sYt- kt 0<s, <1

Where s = denotes the propensity to save

 = Rate of depreciation of physical capital.

The equation incorporates the equilibrium condition of the goods market or the

equality between investment It and saving, It= sYt

Steady-state growth per capita TS

^
K t = sYt − K t Since Yt = AKt

96
 ^
K t = sAK t − K t

^
K t = ( sA −  ) K t

^
Kt
= sA − 
Kt

Hence steady-state growth of per capita is

g = sA − 

-This implies that the growth rate is positive (for sA   ) and that the level of

income per capital rises without bound.

-Unlike the neoclassical model, an increase in the saving rate permanently raises

the growth rate per capita

-In addition, the AK model implies that poor rations whose production process is

characterized by the same degree of technological sophistication as other ratios

always grow at the same rate as rich countries, regardless of the initial level of

income.

-The Ak model thus does not predict convergence even if countries share the

same technology and are characterized by the same pattern of saving, a result

that seems to accord well with the empirical evidence.

-Rebelo (1991) analysis demonstrates that endogenous steady-state growth

obtains if a “core” of capital goods is produced according to a constant-returns-

to-scale technology and without the use of non-reproducible factors.

-Alternatively to obtain positive growth requires only that there exists a subset of

capital goods whose production takes place under constant returns to scale does

not require the use of non-reproducible inputs.

97
(b) The second approach is the introduction of spillover effects or externalities in

the growth process. The presence of externalities implies that if one firm doubles

its inputs, the productivity of the inputs of other firms will also increase.

-Introducing spillover effects leads to a relaxation of the assumption of

diminishing returns to capital.

-In Lucas (1988) externalities take the form of public learning, which increases

the stock of all factors of production. While Barro (1990) introduces externalities

associated with public investment.

-Thus in models exhibiting spillover effects and externalities, sustained growth

does not result from the existence of external effects, but rather from the

assumption of constant returns to scale in all production inputs that can be

accumulated.

-Increasing returns are thus neither necessary nor sufficient to generate

endogenous growth.

(B) Human Capital and Knowledge

Lucas (1988) attempts to incorporate the spillover effects of human capital

accumulation in a model built on the idea that individual workers are more

productive, regardless of their skill level, if other workers have more human

capital.

Lucas model

Yt = AK t ( ht )1− , 0    1 (Production process)

Where Kt = Physical capital per worker

ht = human capital per worker (knowledge capital)

Yt = Output

98
 A = level technology

 = Fraction of time that individual devote to producing goods.

-Growth of physical capital depends on the saving rate (It= sYt), while growth rate

of human capital is determined by the amount of time devoted to its production:

•
ht
=  (1 −  ) ,  > 0
ht

-The long-run growth rate of both capital and output per worker is  (1 −  ) , the

rate of human capital growth and the rate of physical to human capital

convergence to a constant.

-In the long run, the level of income is proportional to the economy’s initial stock

of human capital.

-The savings rate has no effect on the growth rate.

-The implication of the external effect captured by the model is that under a

purely competitive equilibrium its presence leads to an under investment in

human capital because private agents do not take into account the external

benefits of human capital accumulation.

-The equilibrium growth rate is thus smaller than the optimal growth rate due to

the existence of externalities.

-Because the equilibrium growth rate depends on the rate of investment in

human capital the externality implies that growth would be higher with more

investment in human capital

-Therefore government policies (subsidies) are necessary to increase the

equilibrium growth rate up to the level of the optimal growth rate.

99
NB “A government subsidy to human capital formation or schooling could

potentially result in a substantial increase in the rate of economics growth”.

Romer (1986) model argues that the source of the externality is the stock of

knowledge rather than an aggregate stock of human capital (Lucas 1988).

Knowledge is produced individual, but since newly produced knowledge can be

only partially and temporarily kept secret, the production of goods and services

depends not only on private knowledge but also on the aggregate stock of

knowledge.

-Romer’s framework determines endogenously the rate of technological progress.

-In Romer’s (1990) model, firms cannot appropriate all the benefits of knowledge

production, in supply that the social rate of return exceeds the private rate of

return to certain forms of capital accumulation

A tax and subsidy scheme can thus be utilized to raise the rate of growth.

Effects of Financial Intermediation on Growth

Pagano (1993) Assumes that 1- of savings is lost as a result of financial disinter

mediation activities.

sYt = I t , 0<<1

Assume that the production technology is described by constant returns to scale

to capital as in Rebelo’s (1991) model, the steady- state growth rate per capital

now is:

g = sA − 

100
NOTE: Rebelo’s 1991.

Yt = At K t1− , 0 <  < 1 (Neoclassical growth model)

^
And K t = sYt − K t , 0 < s,  < 1

S = Propensity to save

 = Rate of depreciation of physical capital

A = Technological progress

g = Rate of total factor productivity derived as a residual.

101
Channels through which financial development affects economic

growth

(i) Raise saving rate

(ii) Raise the marginal productivity of the capital stock (A)

(iii) Increase the proportion of saving allocated to investment (i.e. increase

in  – conduct effect)

(i) Effects of Saving Rate

The development of financial markets offers households possibly of

diversifying other portfolio and increase their borrowing options that affect the

proportion of agents subject to liquidity constraints, which may affect the saving

rate (Japell and Pagano, 1994).

Financial development also tends to reduce the overall level and to modify the

structure of interest rates, the latter by reducing the spread between the rate paid

by borrowers (firms) and that paid to lenders (householders)

(ii) Effects on the Allocation of Capital

-Financial intermediation increases the average productivity of a technical

progress and thus the growth rate) in two ways.

• By collecting, processing and evaluating the relevant information

on alternative investment projects.

• By inducing entrepreneurs through their risk sharing function to

investment in riskier but more productive technologies.

- The more efficient allocation of resources channeled through financial

intermediaries raises the productivity of capital and thus the growth rate

of the economy.

102
 - It enables entrepreneurs to pool risks hence share uninsurable risks and

the diversifiable risk delivering from the variability of the rates of return

on alternative ---

- The possibility of risk sharing affects saving behaviour as well as

investment decisions.

- Bencivenge and Smith (1991) show that banks increase the productivity of

investment both by directing funds to liquids high – yield technology and

by reducing the investment waste due to premature liquidation.

(iii) The Conduit-effect, Financial Repression and Growth

Financial intermediation operates as a tax in the transformation of savings into

investment. It thus has a growth-deterring effect because intermediaries

appropriate a share of private savings.

- A cost associated with it represents payments (fees + commission) that are

received by intermediaries in return for their services.

- In LDCs such absorption of resources results from explicit and implicit

taxation (such as high rates of reserve requirements) and by excessive

regulations, which lead to higher costs and therefore inefficient

intermediation activities.

- If reforms of the financial system lead to a reduction in the cost and

inefficiencies associated with the intermediation process (leading to a rise

in ) the results will be an increase in the growth rate.

103
 Financial repression- financial system is kept small by a sense of government

interventions that have the effect of keeping very low interest rate that domestic banks

can offer to savers motivation for financial repression is a fiscal one, i.e. government

wants to actively promote development but lacks the direct fiscal means to do so

because of either a lack of political will or administrative constraints. It uses the

financial system to fund development in two ways

(i) By imposing large reserve and liquidity requirements on banks thereby creating a

captive demand for its own non- interest bearing and interest bearing instruments

respectively. Thus it finances its own high- priority spending by issuing debt.

(ii) By keeping interest rates low through the imposition of ceiling on lending rates, it

creates an excess demand for credit. It then requires the banking system to set

aside a fixed fraction of the credit available to priority sectors.

- In conclusion where collecting conventional taxes is costly, government

often choose to require their systems to increase revenue.

Harrod – Domar Growth Model

It analyses the requirements of steady growth in an economy. It seeks to

discover the rate of income growth necessary for establishing in the economy.

104
 Lay emphasis on the dual character of investment i.e. creates income

(demand effect) and augments the productive capacity of the economy by

increasing its apital stock (supply effect)

Hence so long as net investment is taking place, real income and output

will continue to expand. To maintain a full employment equilibrium level of

income from year to year, it is necessary that both real income and output

expand at the same rate at which the productive capacity of the rate of the

capital stock is expanding.

Thus if full employment is to be maintained in the long run, net

investment should expand continuously. This further requires continuous

growth in real income at a rate sufficient enough to ensure full capacity use of

a growing stock of capital. The required rate of income growth is the

warranted rate of growth or the full capacity growth rate.

Assumptions

1. There is initial full employment equilibrium level of level and

absence of government interference.

2. Operate in a closed economy and there are no lags in adjustments

between investment and creates of productive capacity. The average

propensity to save is equal to the MPS and MPS remain constant

The capital coefficient i.e. the ratio of capital stock to income is assumed to

be fixed. There is no depreciation of capital goods which posses’ infinite life.

Savings and investment relate to the income of the same year. The general price

level is constant i.e. money income and real income are the same.

105
 There are no changes in interest rates. There is a fixed proportion of

capital and labour in the productive process and fixed and circulation. There is

only one type of product.

The Domar Model

(a) Supply side/increase in productivity capacity

Let annual rate of investment be 1 and the annual productive capacity per

Y
shilling of newly created capital be s =
K

Thus productive capacity of one shilling invested will be (1 x s) per year.

New investment will be at the expense of the old, therefore will compete

for labour market and other factors of production. Hence the increase in annual

output (productive capacity) will be less than 1 x s indicated as:

I Where;  = net potential social average productivity of investment

Y
( )
I

I = Total net potential increase in output of the economy (stigma

effect)

(b) Aggregate demand increase

Explained by the Keynesian multiplier. Let annual increase in income be Y and

S
the increase in investment I and propensity to save  (= ) then increase in
Y

income;

1
= I


1
Y = I


106
To maintain full employment equilibrium level of income aggregate demand

should be equal to aggregate supply.

1
I = I


I = I

Means to maintain full employment the growth rate of net autonomous

I
investment must be equal the MPS x productivity of capital. This assumes the
I

use of potential capacity in order to maintain a steady growth rate of the economy

at full employment.

Any divergence from this path will lead to cyclical fluctuation.

I I
When   the economy would experience boom and when   it suffers
I I

depression.

Empirical example

Let  = 25% per year

 = 12

Y = 150 m Per year

To maintain full employment an amount equal to

1
Y = I


I = Y

=12/100(150)= 18M to be invested

That will raise productive capacity by the amount-invested  times i.e. by

150*0.12*0.25=4.5

107
i.e. Y = Y

The national income will have to rise by the same amount

The relative rise in income will equal the absolute increase divided by the income

Y
itself ( )
Y

12 25

150  100 100 = 12  25 =  = 3%
150 100 100

=0.12*0.25 = 3%

In order to maintain full employment income must grow at 3 per cent per annum.

The Harrod Model

Shows how steady growth may occur in the economy and once steady growth rate

is interrupted and the economy falls in disequilibrium, cumulative forces tend to

perpetuate divergence leading to either secular deflation or secular inflation.

Based upon

(i) Actual growth rate G determined by the savings ratio and the capital-

output ratio and shows short run cyclical variations in the rate of

growth.

(ii) Warranted growth rate Gw i.e. full capacity growth rate in income.

(iii) Natural growth rate Gn that is the welfare optimum/ potential/ full

employment rate of growth.

Actual growth rate Gc=s

Y
Where: G = rate of growth in output =
Y

I
C= net addition to capital =
Y

108
 S
s = Average propensity to save =
Y

Y I S I S
, = Thus = i.e. I = S
Y Y Y Y Y

The warranted rate of growth. GwCv = s

Gw = Warranted rate of growth or full capacity rate of growth of income

which will fully utilize a growing stock of capital that will satisfy the

entrepreneurs with the amount of investment actually made. It is the value of

Y
Y

Cv = capital requirements i.e. the amount of capital needed to maintain

the warranted rate of growth i.e. required capital-output ration. It is the value of

I S
=C s=
Y Y

The equation states that if the economy is to advance at the steady rate of Gw that

S
will fully utilize its capacity, income must grow at the rate of per year i.e. Gw
Cv

S
= is therefore a self-sustaining rate of growth.
Cv

Points of similarities

Harrods s. is Domar’s . Harrods warranted growth rate Gw is Domar’s full

S
employment rate of growth. Harrod’s Gw =  Domar’s 
Cv

Prove

S
= Or S = Y
Y

109
 Y
= Or Y = I
I

Since S = I, substituting S for I we have

Y
= Or Y = s but S = Y
S

Y
= Or Y = Y
Y

Y
Therefore; Gw =  since Gw =
Y

Limitations of Harrod-Domar Models

(i) The propensity to save ( or s) and the capital output ratio  are

constant. But are likely to change in the long run.

(ii) Labour and capital may not be used in fixed proportions since one may

be substituted for the other.

(iii) Fail to consider changes in the general price level

(iv) Interest rates change to affect investment and yet it is assumed that

they do not change

(v) Ignore the effect of government programs

(vi) Neglects entrepreneurial behaviour, which determines the warranted

growth rate.

(vii) Fails to draw a distinction between capital goods and consumer goods.

(viii) Instability of the models lies in the effect of excess demand or supply

on the production decision and not in the effect of growing capital

shortage or redundancy on investment decisions.

110
111
 An Eclectic view of Unemployment

In an economy operating at fairly high levels of resources utilization,

unemployment can be explained without appeal to wage rigidity.

With the labour market in equilibrium there will be search unemployment

with a rotating stock of workers unemployed and looking for work. At any point

in time, the voluntary unemployed job –seekers can be considered to be above

the going wage on the supply curve.

112