1.

Explain the relationship between output, income and Expenditure using the circular flow of
income
Macroeconomics devotes a lot of energy in the understanding of output, income and expenditure in
the economic activities of a given country. It is therefore important to understand the relationship
between these items.
Output is described as the total production of goods and services in a given country or economy.
Income is the total of all payments received by households for labour or services rendered and may
include wages, salaries and interest.
Expenditure is described as the money spent by citizens to buy goods and services for consumption.
From the above descriptions, we can see the movement of money from the firms to the households
and vice vesa. This movement is known as The Circular Flow of Income.
The circular flow of income describes how money moves between the different sectors in the
economy. The expenditure of one sector is the income of another sector. For a closed simple
economy where there are only two sectors, firms and households, firms employ labour to produce
goods and services. Firms spend on labour since households receive income for providing labour.
Household income is spent on goods and services from firms (ZICA, 2007).
Factors of production move from households to firms, for the production of goods and services.
Firms pay factor incomes, such as wages and salaries to households in exchange for the factors. The
income earned by households is spent on goods and services produced by firms (ZICA, 2007).
When we eat food, wear clothing, or go to a movie, we are consuming some of the output of the
economy. All forms of consumption together make up two thirds of GDP. Because consumption is so
large, macroeconomists have devoted much energy to studying how households decide how much to
consume. Chapter 16 examines this work in detail. Here we consider the simplest story of consumer
behavior.
Households receive income from their labor and their ownership of capital, pay taxes to the
government, and then decide how much of their after-tax income to consume and how much to save.
As we discussed in Section 3-2, the income that households receive equals the output of the economy
Y. The government then taxes households an amount T. (Although the government imposes many
kinds of taxes, such as personal and corporate income taxes and sales taxes, for our purposes we can
lump all these taxes together.) We define income after the payment of all taxes, Y −T, as disposable
income (Mankiw, G, 2011).
2. Explain the factors that determine a country’s national income
The Gross Domestic Product (GDP) is the first value arrived at in the national income calculations,
before any adjustments are made. This is often referred to as the value of the output produced in the
country during one year and if it increases in real terms, then it is a sign that the economy has grown.
The GDP is calculated at market prices, but after taxes are deducted and subsidies are added, the
GDP is at factor cost.
Gross National Product (GNP) refers to the value of the output produced by residents of a country in
a year. It is arrived at after including the output produced by companies and individuals of a country
but they are based abroad. In addition, output produced by foreigners and overseas companies in that
country is deducted. This is summarized as net property income from abroad, which maybe positive
or negative.
Capital assets suffer wear and tear as such depreciation, termed capital consumption is deducted
from GNP to arrive at the Net National Product or the National Income in short (Case, et al, 2012).
National Income is not evenly distributed, and the factors determining a country’s national income
can be classified as internal and external, the latter resulting from a country’s relationships with the
rest of the world.
The national income and the economic growth depends on the natural resources of a country, the
quality of the labour force and its participation rate and the capital equipment being used (ZICA,
2007).
The most important internal factors are outlined below:

1. Original Natural Resources

Natural resources are nature-given, such as mineral deposits, sources of fuel and power, climate, soil
fertility, fisheries, navigable rivers, lakes that help communications, wildlife and forests. New
techniques allow natural resources to be exploited while the exhaustion of mineral resources reduces
national income. Some countries are well endowed by nature, and if the resources were well
managed, then the national income would be high.
Where a country’s economy is predominantly agricultural, variations in weather may cause national
income or output to fluctuate from year to year, this happens to be the problem with most developing
countries like Zambia.
2. The nature of the people, particularly of the labour force
Another factor is the quality of the labour force, their state of health, nutritional levels, energy,
inventiveness, judgment and the ability to organize them to cooperate in the production of goods and
services, the production climate, working conditions, peace of mind as well as education and
training.
This includes the quantity of the labour force available for employment. The higher the proportion of
workers to the total population, and the longer their working hours, the greater is the national income
figure.

3. Capital Equipment

Productivity of labour will be increased if the quality of the other factors is high, for example, the
more fertile the land, the greater is the output per man.
In addition, the quality of the capital equipment employed is the most important factor, the output of
workers varies almost in direct proportion to the capital equipment, and the single most important
material progress is investment in capital.
Consider the output per man in countries where the majority of the farmers are using hoes, and in
advanced countries, where farmers use tractors and combine harvesters!
4. Knowledge of techniques

The government can encourage this by financing research schemes to enhance knowledge of
techniques. Alternatively the government can go into partnership with the private sector or offer
incentives such as tax rebates to companies that are spending more money on research and
development. New inventions have the ability to bring in more income into the economy.

5. The organization of resources

One of the known factors that can improve production and therefore national income in most of the
developing countries is the organization and the management of resources.
The leaders of any economy should have a vision for their countries. They have to be focused, set
goals and objectives that are attainable, and have the right people and the resources in order to
achieve those objectives.

6. Political stability

A country has to be politically stable in order to produce. If the resources are being used on warfare,
very little production of goods and services takes place. This again is a common problem in
developing countries. Even if some are well endowed, they are not politically stable and the
organization of resources is poor due to lack of political will (Case, et al, 2012).
The external factors that affect national income are foreign investments and terms of trade:

1. Foreign loans and investments

These are an injection of funds that lead to an addition of stock, which adds to the national income of
the country.
Related to the above, gifts or handouts from abroad for the purposes of economic development and
defence and security also improves the national income of the receiving countries.
2. Terms of trade
This is the rate at which one country’s exports exchange with another country’s imports. The terms
of trade are not constant, they change as export and import prices change.
Developing countries generally deal in the primary sectors and not in the secondary sectors in
production. They export goods at low prices in their raw form, but import goods at relatively high
prices as these are finished goods (Case, et al, 2012).
3. Discuss the problems associated with measurement of national income
Factors of production are the inputs used to produce goods and services. The two most important
factors of production are capital and labor. Capital is the set of tools that workers use: the
construction worker’s crane, the accountant’s calculator, and this author’s personal computer. Labor
is the time people spend working. In measuring national income, we need to compute the total output
of goods and services the economy has produced in a year, the Gross Domestic Product (GDP), after
utilizing the factors of production (Mankiw, G, 2011).
Therefore, GDP is the total market value of a country’s output. It is the market value of all final
goods and services produced within a given period of time by factors of production located within a
country.
First, note that the definition refers to final goods and services. Many goods produced in the
economy are not classified as final goods, but instead as intermediate goods. Intermediate goods are
produced by one firm for use in further processing by another firm. For example, tires sold to
automobile manufacturers are intermediate goods. The parts that go in Apple’s iPod are also
intermediate goods.
The value of intermediate goods is not counted in GDP to avoid double counting, which can also be
avoided by counting only the value added to a product by each firm in its production process. The
value added during the production stage is the difference between the value of goods as they leave
that stage of production and the cost of the goods as they entered that stage (Case, et al, 2012).
In calculating GDP, we can sum up the value added at each stage of production or we can take the
value of final sales. We do not use the value of total sales in an economy to measure how much
output has been produced.
GDP is concerned only with new, or current production. Old output is not counted in current GDP
because it was already counted when it was produced. It would be double counting to count sales of
used goods in current GDP. If someone sells a used car to you, the transaction is not counted in GDP
because no new production has taken place. Similarly, a house is counted in GDP only at the time it
is built, not each time it is resold. In short: GDP does not count transactions in which money or goods
changes hands but in which no new goods and services are produced.
It is sometimes useful to have a measure of the output produced by factors of production owned by a
country’s citizens regardless of where the output is produced. This measure is called gross national
product (GNP).
GDP can be computed in two ways. One way is to add up the total amount spent on all final goods
and services during a given period. This is the expenditure approach to calculating GDP.
The other way is to add up the income, that is wages, rents, interest, and profits, received by all
factors of production in producing final goods and services. This is the income approach to
calculating GDP.
These two methods lead to the same value for GDP for the reason that every payment (expenditure)
by a buyer is at the same time a receipt (income) for the seller. We can measure either income
received or expenditures made, and we will end up with the same total output (Case, et al, 2012).
Unfortunately, there are a number of difficulties that are encountered in measuring national income,
which provides unreliable testimony as to how the real welfare of the people has changed, and when
making comparisons.

1. There are differences in the accuracy of the figures. Different countries collect and invest in data
collection differently.

2. Economic welfare affected by medical and educational facilities per head. There is need to know
what proportion of the national income is spent on the provision of better social sector facilities and
not on security and defence! As with all mathematical averages, per capita income data does not take
into account how the GDP is distributed amongst the population. If the income is unevenly
distributed, then increases in the GDP per capita may disproportionately benefit a small group of
high income earners and have little impact on reducing of poverty. If GDP per capita data is to be
used then its distribution must also be taken into account.
3. When calculating the national income, only those goods and services that are paid for, are
normally included. Do it yourself jobs, such as gardening, repairing one’s own car, housework etc,
are excluded, and their exclusion distort the national income figure. These unpaid for services, which
are normally provided by housewives, are included in the calculation of the national income when
done by someone else. If an individual lives a in a
house for which he pays rent to the landlord, this will be treated differently from owning a house for
which he no longer pays rent

4. Incomplete information attributed to high levels of subsistence sector, barter and black economies
that are more pronounced in developing countries also causes problems in computing national
income.

5. The danger of double counting, for example, the cost of raw materials and that of finished goods
should not both be counted, this is difficult to avoid when using the output method of calculating the
national income.

6. Using any monetary data, such as GDP per capita over time, must recognise that output and
income measures can increase for many reasons other than the country producing more goods.

It is an increase in goods and services that is necessary if poverty is to be alleviated or peoples’ living
standards are to rise. Output and incomes measures may increase because the rate of inflation has
simply increased the money value of goods and service produced rather than their real value. Real
GDP per capital would be a better indicator, as this is a measure of the physical value of goods and
services produced. Real GDP is equal to the nominal GDP adjusted for price changes, (minus
inflation).
The different rates of inflation and the constant variations in the exchange rate within and in different
countries make comparisons difficult.
7. The national income measures the standard of living. This has to relate to the size of the
population. Some countries have a high-income figure and a correspondingly high population.
8. Some countries have high national income figure but are paying a high penalty for living beyond
their means and borrowing heavily.
9. It should be remembered that GDP only includes output that involves a financial transaction, that
is marketable. A considerable amount of Zambia's agricultural output is produced on small-scale
communal farms for subsistence purposes. It is currently estimated that only 25% of production on
communally owned land involves monetary transactions. The rest is
not included in any national income calculations. Likewise the output of the informal sector will not
be included.
10. Increasing national income and growth may occur at the expense of the environment rapidly
growing economies may result in negative externalities. An agricultural sector that increases
productivity by intensive use of pesticides and fertilisers or deforestation, may reduce future land
fertility and worsen the level of poverty for future generations (ZICA, 2007).
4. Explain what the circular flow of income for an open (complex) economy is
Keynesian demand management involves manipulating national income by influencing consumption,
income and government expenditure. Consumption is an endogenous part of the circular flow of
income, the others are injections into the circular flow. Any injection into the circular flow of income
of a country starts a snowball effect (ICU Study Manual, 2012).
For example, if the government decides to build a big hospital in Zambezi district costing K10
billion, the increase in government expenditure through the construction of the hospital provides
incomes to the factors of production employed in the construction of the hospital. Part of the K10
billion goes to the contractor as profits, part of it goes to the workers as wages and part of it is used
for the purchase of building materials. The three groups who will earn the income will spend it.
Any expenditure becomes someone else’s income, which is then in turn spent, generating a whole
series of rounds of additional spending and income generation, this is the snowball effect.
However, not all the income earned is consumed, some of it is saved. Savings is a leakage from the
circular flow, other leakages from the circular flow of income are imports and taxes. The total
amount leaked out is known as the marginal rate of leakages.
A useful way of seeing the economic interactions among the four groups in the economy is a circular
flow which shows the income received and payments made by each group.
WITHDRAWALS/ LEAKAGES
INJECTIONS
Fig 1:The Circular Flow Of Income For An Open (Complex) Economy
Let us walk through the circular flow step by step. Households work for firms and the government,
and they receive wages for their work. Our diagram shows a flow of wages into households as
payment for those services. Households also receive interest on corporate and government bonds and
dividends from firms. Many households receive other payments from the government, such as Social
Security benefits, veterans’ benefits, and welfare payments.
Economists call these kinds of payments from the government transfer payments (for which the
recipients do not supply goods, services, or labuor) Together, these receipts make up the total income
received by the households.
Households spend by buying goods and services from firms and by paying taxes to the government.
These items make up the total amount paid out by the households. The difference between the total
receipts and the total payments of the households is the amount that the households save or dissave.
If households receive more than they spend, they save during the period. If they receive less than
they spend, they dissave. A household can dissave by using up some of its previous savings or by
borrowing. In the circular flow diagram, household spending is shown as a flow out of households.
Saving by households is sometimes termed a “leakage” from the circular flow because it withdraws
income, or current purchasing power, from the system (Case, et al, 2012).
Firms sell goods and services to households and the government. These sales earn revenue, which
shows up in the circular flow diagram as a flow into the firm sector. Firms pay wages, interest, and
dividends to households, and firms pay taxes to the government. These payments are shown flowing
out of firms.
HOUSEHOLDS

FIRMS

Income

Consumpt

Goods Market

Factor Market

SAVINGS

TAXATION

IMPORTS

INVESTMENT

GOVERNMENT

EXPORTS
The government collects taxes from households and firms. The government also makes payments. It
buys goods and services from firms, pays wages and interest to households, and makes transfer
payments to households. If the government’s revenue is less than its payments, the government is
dissaving.
Finally, households spend some of their income on imports, which are goods and services produced
in the rest of the world. Similarly, people in foreign countries purchase exports, which are goods and
services produced by domestic firms and sold to other countries.
One lesson of the circular flow diagram is that everyone’s expenditure is someone else’s receipt. If
you buy a personal computer from Dell, you make a payment to Dell and Dell receives revenue. If
Dell pays taxes to the government, it has made a payment and the government has received revenue.
Everyone’s expenditures go somewhere. It is impossible to sell something without there being a
buyer, and it is impossible to make a payment without there being a recipient. Every transaction must
have two sides (Case, et al, 2012).
The effect on total national income of a unit change in any of the injections into the circular flow
income can be measured, it is called the multiplier.
The Multiplier in a complex, open economy would be lower because all the leakages or withdrawals
from the circular flow of income would be taken into account.
In the multiplier principle, an increase in investment affects income and consumption. When the
economy is expanding, and income as well as consumption is high, then the business sector is
encouraged to produce more goods. Thus investment increases. The increase in investment leads to
an increase in income and consumption, and so on (ZICA, 2007).
5. Discuss the factors that determine consumption, savings and investments
In macroeconomics, there are mainly theories of two schools of thought, the Monetarists and the
Keynessians.
The Monetarists, the famous one being Milton Friedman, their arguments are mostly on the money
supply and the effects of changes in the money supply.
The Keynesians, advocates of Sir John Maynard Keynes. Keynes wrote a book entitled General
Theory of Employment, Interest and Money, published in 1936. His work was at the time of the great
depression.
Spending by households is termed consumption expenditure. It is an endogenous part of the circular
flow of income.
Consumption expenditure depends on an individual’s income, it is therefore a function of income.
C = F (Y).
As Y increases the level of consumption also increases but Lord Keynes maintained that each
successive increment to real income is marched by a smaller increment to consumption expenditure,
the rest is saved.
The extent to which consumption changes with income is termed the marginal propensity to consume
(MPC). The marginal propensity to consume is the proportion of each extra kwacha of disposable
income spent by households. That proportion of each extra kwacha of disposable income not spent
by households is known as the marginal propensity to save (MPS).
If out of the extra kwacha increase, eighty ngwee is consumed, then the marginal propensity to
consume is 80% or 0.8, and the marginal propensity to save is 20% or 0.2.
The nature of the relationship between consumption and income is given by the straight-line
equation: C = a + by
Where; C = consumption
a = C when an individual is not working and income from employment is zero, it is also known as
autonomous consumption.
b = MPC
y = income,
For example, assume K650 000 is required for a family of three people to survive, whether the head
of the family is working or not. The K650 000 has to be found for the family to stay alive; it can
come from social security, dissavings, begging, borrowing and so on.
When in employment, for every extra kwacha earned, 80 ngwee is consumed. The equation becomes:
C = 650,000 + 0.8Y.
Factors influencing consumption are income, interest rates, government policy such as taxation,
which reduces the disposable income, hire purchase and other credit facilities, and invention of new
consumer goods, which are later, introduced on the market (ZICA, 2007).
Note that in any economy households, firms and government undertake consumption of goods and
services
Savings is defined as the part of income not spent, it is a withdrawal or a leakage from the circulation
flow of income.
Y=C+S
∴S=Y–C
Therefore consumption and savings are two sides of the same coin and the consumption function tells
us not only how much households consume, but also how they save. The factors that influence
consumption naturally affect savings.
Investment Expenditure is spent on the production of capital goods (houses, factories, machinery,
etc) or on net additions to stocks such as raw materials, consumer goods in shops, etc.
In national income analysis, investment takes place only when there is an actual net addition to
capital goods or stocks.
Investment is a major injection into the circular flow of income and affects national income and
aggregate demand. Investment through the multiplier is needed to achieve Economic recovery.
Investment is very dynamic, it determines future shape and pattern of Economic recovery.
Economic growth determined by technological progress, increase in size and quality of labour and
the rate at which capital stock is increased or replaced. In addition, stock should be greater than stock
depreciation.
Investment, therefore, determines long-term growth, and both the private and the public sector can
carry it out. If it is undertaken by the private sector, the government is expected to provide an
enabling environment by stimulating business confidence by providing a stable Economic climate.
Setting and achieving macroeconomic targets like low levels of inflation, controlling the money
supply and therefore controlling the interest rates and consumption. The government can offer tax
concessions or finance research schemes, sometimes in conjunction with the private sector (Case, et
al, 2012).
Keynesian demand management emphasizes the importance of the role, which the government plays
to influence investment.
In 2005, the average American family spent about $1,350 on clothing. For high-income families
earning more than $148,000, the amount spent on clothing was substantially higher, at $3,700.
We all recognize that for consumption as a whole, as well as for consumption of most specific
categories of goods and services, consumption rises with income. This relationship between
consumption and income is central to Keynes’s model of the economy. While Keynes recognized
that many factors, including wealth and interest rates, play a role in determining consumption levels
in the economy, in his classic The General Theory of Employment, Interest and Money, current
income played the key role: The fundamental psychological law, upon which we are entitled to
depend with great confidence both a priori from our knowledge of human nature and from the
detailed facts of experience, is that men [and women, too] are disposed, as a rule and on average, to
increase their consumption as their incomes increase, but not by as much as the increase in their
income. Keynes is telling us two things in this quote. First, if you find your income going up, you
will spend more than you did before. But Keynes is also saying something about how much more
you will spend: He predicts, based on his looking at the data and his understanding of people, that the
rise in consumption will be less than the full rise in income. This simple observation plays a large
role in helping us understand the workings of the aggregate economy (Case, et al, 2012).
The assumption that consumption depends only on income is obviously a simplification. In practice,
the decisions of households on how much to consume in a given period are also affected by their
wealth, by the interest rate, and by their expectations of the future. Households with higher wealth
are likely to spend more, other things being equal, than households with less wealth. The boom in the
U.S. stock market in the last half of the 1990s and the boom in housing prices between 2003 and
2005, both of which increased household wealth substantially, led households to consume more than
they otherwise would have in these periods. In 2009–2010, after a fall in housing prices and the stock
market, consumption was less than it otherwise would have been. For many households, interest rates
also figure in to consumption and saving decisions. Lower interest rates reduce the cost of borrowing,
so lower interest rates are likely to stimulate spending (Conversely, higher interest rates increase the
cost of borrowing and are likely to decrease spending.)
Finally, as households think about what fraction of incremental income to consume versus saving,
their expectations about the future may also play a role. If households are optimistic and expect to do
better in the future, they may spend more at present than if they think the future will be bleak.
Household expectations are also important regarding households’ responses to changes in
their income. If, for example, the government announces a tax cut, which increases after-tax
income, households’ responses to the tax cut will likely depend on whether the tax cut is expected
to be temporary or permanent. If households expect that the tax cut will be in effect for only two
years, their responses are likely to be smaller than if they expect the tax cut to be permanent.
We examine these issues in Chapter 16, where we take a closer look at household behavior
regarding both consumption and labor supply. But for now, we will focus only on income as
affecting consumption (Case, et al, 2012).
Keynesian Demand Management outlines that national income determination is a Keynesian concept.
Keynes emphasized the importance of aggregate demand in the economy. The national economy
could be managed by taking appropriate measures to influence aggregate demand up or down
depending on whether there was a deflationary or an inflationary gap in the economy (Dornbusch and
Fischer, 1994).
6. Describe the basic characteristics of money
Money is defined as a medium of exchange, it is anything that is generally acceptable in the
settlement of a debt. Early forms of money were items in common use, but had a number of
limitations, hence a good monetary medium must have a number of characteristics. Money performs
a number of functions in the economy, it is a medium of exchange, unit of account and measure of
value, and it is a store of value and a standard for deferred payments (Case, et al, 2012)..
Money is defined as anything that is generally acceptable in repayment of a debt. It is a medium of
exchange, a legal tender.
The early forms of money where items that were in common use and generally acceptable such as
cattle, hides, furs, tea, salt, shells, cigarettes and so on. These early forms of money had a lot of
limitations, some items like cigarettes are not generally acceptable to be used by all to settle debts.
Other early forms of money like cattle were not easy to carry around, and therefore not convenient.
Some were perishable products like hides and as they were deteriorating with frequent handling
(ZICA, 2007).
In addition, there was no homogeneity in terms of size, colour and weight. The money that is used
now such as the one, ten or fifty kwacha bank notes are similar and they are easily recognizable.
Therefore, a good monetary medium must be:-
1. Generally acceptable: Money must be acceptable to everyone as a medium of exchange.
2. Fairly durable: It must strong enough to avoid easy soiling.
3. Capable of being divided into small units: It should be available in all the required denomination.
4. Easy to carry (portable): Money should small enough and light to be easily carried anywhere and
everywhere.
5. Should be relatively scarce: Scarcity gives money value.
6. Should be uniform in quality: The uniformity of money makes it easily recognizable.
You often hear people say things like,“He makes a lot of money” (in other words, “He has a high
income”) or “She’s worth a lot of money” (meaning “She is very wealthy”). It is true that your
employer uses money to pay you your income, and your wealth may be accumulated in the form of
money. However, money is not income, and money is not wealth.
To see that money and income are not the same, think of a $20 bill. That bill may pass through a
thousand hands in a year, yet never be used to pay anyone a salary. Suppose you get a $20 bill from
an automatic teller machine, and you spend it on dinner. The restaurant puts that $20 bill in a bank in
the next day’s deposit. The bank gives it to a woman cashing a check the following day; she spends it
at a baseball game that night. The bill has been through many hands but not as part of anyone’s
income(Case, et al, 2012).
Having looked at the characteristics of money, then the question arises, what is money?
Most people take the ability to obtain and use money for granted. When the whole monetary system
works well, as it generally does, the basic mechanics of the system are virtually invisible. People take
for granted that they can walk into any store, restaurant, boutique, or gas station and buy whatever
they want as long as they have enough green pieces of paper.
The idea that you can buy things with money is so natural and obvious that it seems absurd to
mention it, but stop and ask yourself: “How is it that a store owner is willing to part with a steak and
a loaf of bread that I can eat in exchange for some pieces of paper that are intrinsically
worthless?”Why, on the other and, are there times and places where it takes a shopping cart full of
money to purchase a dozen eggs? The answers to these questions lie in what money is: a means of
payment, a store of value, and a unit of account(Case, et al, 2012).
Money is vital to the working of a market economy. Imagine what life would be like without it. The
alternative to a monetary economy is barter, people exchanging goods and services for other goods
and services directly instead of exchanging via the medium of money.
Some agreed-to medium of exchange (or means of payment) neatly eliminates the double-
coincidence-of-wants problem. Under a monetary system, money is exchanged for goods or services
when people buy things; goods or services are exchanged for money when people sell things. No one
ever has to trade goods for other goods directly.Money is a lubricant in the functioning of a market
economy (Case, et al, 2012)..
Economists have identified other roles for money aside from its primary function as a medium of
exchange. Money also serves as a store of value—an asset that can be used to transport purchasing
power from one time period to another. If you raise chickens and at the end of the month sell them
for more than you want to spend and consume immediately, you may keep some of your earnings in
the form of money until the time you want to spend it.
The main disadvantage of money as a store of value is that the value of money falls when the prices
of goods and services rise. If the price of potato chips rises from $1 per bag to $2 per bag, the value
of a dollar bill in terms of potato chips falls from one bag to half a bag.When this happens, it may be
better to use potato chips (or antiques or real estate) as a store of value.
Money also serves as a unit of account—a consistent way of quoting prices. All prices are quoted in
monetary units. A textbook is quoted as costing $90, not 150 bananas or 5DVDs, and a banana is
quoted as costing 60 cents, not 1.4 apples or 6 pages of a textbook.Obviously, a standard unit of
account is extremely useful when quoting prices. This function of money may have escaped your
notice—what else would people quote prices in except money? (Case, et al, 2012).
7. Explain demand for money and money supply
The demand for money, according to Keynes, is the desire to hold money, and it is held as active
balances, for the transactions and precautions motive, this depends on an individual’s income and it
is interest rate inelastic. Money is also held as idle balances for speculative reasons, and this depends
on the rate of interest (Case, et al, 2012).
Demand for money also means the desire to hold money, as distinct from investing it. This desire to
hold liquid reserves is known as liquidity preference. According to Lord Keynes there are three
motives for holding money (ZICA, 2007). .
1. The transactions motive: Both consumers and businessmen hold money to facilitate current
transactions. A certain amount of money is needed for every day requirements, the purchase of food,
clothing, to pay casual workers and any other purchases.
2. The Precautionary Motive: Most people like to keep money in reserve, in case an unexpected
payment has to be made, for example illness, funeral, accident, car defects, household appliance
defects, and other payments.
3. The Speculative Motive: This is for the purpose of accumulating more, since holding money in
active balances does not yield any interest.
Speculation depends on the expectation of the future tend in securities, that is attractive shares and
government stock, this generally moves in the opposite direction with interest rates if interest rates go
up, most people think the price of stocks will go down in the future, they will then hold money.
The money supply in any economy is simply made up of notes coins and bank deposits; however,
money supply is a very important part of government policy, and it can be measured both narrowly
and broadly, (Case, et al, 2012). Money supply has to be monitored as a guide to Economic policy.
The argument of the monetarists is based mostly on the money supply. However both the Keynesians
and monetarists accept the importance of money supply.
The money supply is the stock of money existing at any particular point in time. It is basically made
up of coins and notes in circulation as well as bank deposits. Coins and notes make up approximately
only one fifth of the total money supply while bank deposits make up four fifth. This is because
commercial banks ‘create’ money through the creation of credit and the creation of deposits (ZICA
2007)..
The definition of the money supply is carried out in order to measure monetary aggregates. In
practice, money is measured either narrowly or broadly, with a very thin dividing line between the
two.
Narrow Money is money that is available to finance current spending, money that is held for
transaction purposes, it highlights the function of money as a medium of exchange. Narrow money is
designed in different ways, the narrow measure of money starts from MO (Pronounced as ‘m
nought’), is the narrowest definition of narrow money. It comprises mostly notes and coins in
circulation, plus commercial banks operational deposits held by the bank of Zambia.
Broad Money is narrow money plus balances held as savings, that is the function of money as a
medium of exchange and as a store of value. Therefore, broad money is money held for transactions
purposes and money held as a form of saving.
Broad money includes assets, which are liquid but not as liquid as assets under narrow money. Broad
money is also defined in different ways. The first broad definition of money is M4, and when foreign
currency deposits are included, the definition is M3.
8. Explain how interest rate is determined
Interest is the fee that borrowers pay to lenders for the use of their funds. Interest is the price of
money, and in the credit market, it is determined by the market conditions of demand for and supply
of money. According to the Keynesians, the demand for money, liquidity preference is partly depend
on the rate of interest. The supply of money is perfectly inelastic, the supply might increase or
decrease depending on the government policy (ZICA, 2007).
The equilibrium market rate of interest is determined at the point where the supply of money equals
the demand for money.
As in other markets, changes in either demand or supply conditions lead to a change in interest rates.
In the Keynesian model, an increase in the money supply is associated with a fall in interest rates and
vice versa.
Monetarists ensure that there are no three motives for holding money. Monetarists hold the view that
money is held mostly for transactions purposes and enjoyment, and that demand for money is interest
rate inelastic. As a result, any slight change in money supply leads to a big change in the rate of
interest. This explains the need to maintain stability in the money supply in order to maintain stable
interest rates, (ZICA, 2007).
Another argument by the monetarist is the microeconomic view known as the loanable funds theory
Firms and governments borrow funds by issuing bonds, and they pay interest to the lenders that
purchase the bonds. Households also borrow, either directly from banks and finance companies or by
taking out mortgages. Some loans are very simple. You might borrow $1,000 from a bank to be paid
back a year from the date you borrowed the funds. If the bank charged you, say, $100 for doing this,
the interest rate on the loan would be 10 percent. You would receive $1,000 now and pay back
$1,100 at the end of the year—the original $1,000 plus the interest of $100. In this simple case the
interest rate is just the interest payment divided by the amount of the loan, namely 10 percent.
(Case, et al, 2012).
9. Discuss the economic effects of interest changes
Generally, the market forces of supply and demand determine interest rates. Interest rates should
have some degree of stability, as they are very important in Economics and in the business
environment. In practice, there are variations in the rate of interest, which affect savings and loan
repayments (Case, et al, 2012).
Stable interest rates are important in any economy, if there is a large increase in the rate of interest,
then the economy is affected in a number of ways:
1. The cost of credit increases borrowing reduces and investment expenditure reduces.
2. Spending by households also reduces savings is encouraged, since income is either consumed or
saved, an increase in savings reduces consumption expenditure.
3. Investment and consumption expenditure are components of aggregate demand, if spending by
both households and firms reduces, then inflation is likely to be lowered. Low prices and less
borrowing is a sign of less Economic activity.
4. The foreign flow of funds increase financial speculators with ‘hot money’ are likely to be attracted
to the high rates of interest.
5. An increased flow of foreign funds puts pressure on the exchange rate. The high demand for the
kwacha causes the kwacha to appreciate in value.
6. A strong kwacha makes exports less attractive on the international market, reducing the demand
for exports. Some workers are likely to be laid off, this reduces the level of Economic activity
furthers.
7. The business sector is also affected by the likely impact on profitability and investment projects
that are appraised. High costs of borrowing compared to reduced cash flows due to a reduction in
consumption expenditure (ICU Study Manual, 2012).
Interest rates are determined by the market forces supply of and demand for money. In practice, there
are several variations of interest rates that financial intermediaries apply, financial institutions do not
give or charge exactly the same interest rates.
Finance bank, Indo-Zambia bank, Zambia National Commercial Bank etc all have their own rates
that they offer to customers. ‘Lending rates’ given to surplus units (the depositors/savers who supply
funds) and ‘borrowing rates’ charged to deficit units are different.
An individual bank can give or charge different rates to customers depending on estimated
compensation for tying up the money, perceived ‘risk’ of the customer, amount and period of the
loan.
In addition, there is the real rate of interest, which is the nominal rate of interest adjusted for
inflation. The nominal rates of interest are the expressed rates, in monetary terms, hence they are also
known as the money rate of interest. (ZICA, 2007).
The relationship between the inflation rates, the real rate of interest and the money rate of interest
are:
(1 + real rate of interest) x (1 + inflation rate) = 1 + money rate of interest. This is usually
approximated as real rate of interest + inflation rate = money rate of interest (nominal interest rate).
10. Explain the economic role of government through monetary policy and its basic
instruments
The central bank is the primary financial institution in any country, and it performs a number of
functions. The most important of which is banking supervision and controlling the money supply in
the economy, known as monetary policy.
Financial systems are made up of financial institutions and financial markets. Financial institutions
enable the three sectors of the economy, the households, firms and government to borrow and lend to
each other as financial intermediaries (ZICA, 2007).
Some of the functions of financial intermediaries are to provide savings facilities and tangible returns
to savers, maturity transformation, ready source of funds for borrowers, and as a medium for the
implementation of monetary policy.
Monetary policy is becoming increasingly important in Economic management. Fiscal policy is once
a year, in between, the government has to rely on monetary policy to manage the economy. The
central bank controls the money supply in order to help the government achieve its macroeconomic
objectives of economic growth. (ZICA, 2007).
Monetary policy is decisions and actions of the government regarding the supply of money and its
price (the rate of interest). An increase in the money supply, which is loose monetary policy leads to
a lot of borrowing and spending. With too much money in circulation, inflation as well as an external
trade deficit is the likely result.
To reduce the money supply, the central bank has to curtail the borrowing and spending by limiting
the commercial bank’s capacity to create credit, create deposits and thereby ‘create money’.
The instruments that the central bank uses to control the money supply are:
a) Open Marketing Operations: The central bank intervenes in the open market to buy or sell
securities, the central bank can directly influence the size of bankers’ deposits. If the central bank
wants to reduce the rate of inflation, it has to control (reduce) the money supply, it will sale securities
such as treasury bills for a short term measure, or government bonds if it is a long-term measure, and
the central bank receives payment by cheques drawn on commercial banks for these instruments.
This brings about a reduction in commercial banks deposits as well as the amount of money
circulating in the economy. (ZICA, 2007).
b) Bank Rate (interest rate changes): The importance of central bank rate is that other rates of interest
used, depend on it, the rate charged to discount houses, the rates charged on advances to customers
and the rate offered on deposit accounts.
These rates move up or down with central bank rate. In order to check inflation, that is to reduce the
money supply, the interest rate is raised to make credit expensive and as such discourage people from
borrowing.
c) Special Deposits: In order to reduce the cash basis for credit creation and to contract credit, the
central bank can request commercial banks to place specified amount or to increase the percentage of
these specified amounts, which are supposed to be kept in frozen accounts with the central bank. The
government pays interest on the ‘special deposits’.
When following an expansionary policy, to encourage lending, the special deposits are returned to
the commercial banks.
d) Asset Ratios: The central bank dictates or compels commercial banks to keep certain proportions
of specified assets. To control inflation the ratio is raised.
e) Directives (moral suasion): This is a direct instruction from the central bank to the commercial
banks to restrict their lending. The directive can be in two forms:
1. Qualitative, this is when commercial banks are requested to restrict lending only to purposes
regarded as being in the national interest. Commercial banks would be encouraged to lend only to
important sectors in the economy such as agriculture, mining and manufacturing.
2. Quantitative, this is when banks are instructed to reduce their lending by a required amount.
Note that directives are easy to enforce in a command, planned Economic system. In a liberalized
market Economic system, firms including banks have the freedom to meet new market demands
without much government intervention.
In practice, monetary policy is not easy to achieve, not only because of a liberalized market
Economic system, but because it also depends on commercial banks curtailing credit, given the fact
that lending is the most profitable business of commercial banks, the banks find ways of
circumventing the policies.
In addition, central banks face problems in applying monetary policy, for example
1. A central bank may lack adequate, detailed, up to date information on the economy and the money
supply.
2. The central bank has to closely supervise the commercial banks to ensure that they have reduced
their lending to customers, in order to reduce the money supply in the economy.
3. Reducing the money supply results in an increase in the rate of interest, this tends to lower
investments, less economic activity and leads to increased unemployment. This leads to conflicting
objectives of the government. Therefore, the government has to trade inflation for unemployment or
vice versa.
4. The reluctance of the central bank to undermine initiative and commercial banks’ ability to make
profits, as mentioned earlier, as lending is the most profitable business of commercial banks (ZICA,
2007).
END
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