element of economics
TRANSCRIPT
Contents
Introduction 3
Chapter I: The measurement of economic activity 5
Chapter II: Income and consumption 21
Chapter III: Investment and capital 33
Chapter IV: Money and interest 42
Chapter V: Economic growth 53
Chapter VI: Inflation 59
Indicative bibliography 69
Introduction
Economics is the science of the optimal allocation of scarce resources to potentially
infinite needs. The economy is fixed as an objective to say how can, with limited
means, get the maximum (this is what means optimal allocation) of satisfaction of
needs.
Economics in the modern sense of the term begins to prevail from the mercantilist and
develops from Adam Smith an important analytical body, which is generally divided
into two major branches: the microeconomics or study of individual behavior and the
macroeconomics that emerges in the interwar period, with the major work of John M.
Keynes, entitled General theory of employment, interest and money. Nowadays, the
economy applies this corpus analysis and to the management of many human
organizations (public power companies private, cooperatives etc.) and some areas:
international, finance, development, environment, market of work, culture, agriculture,
etc.
Microeconomics is the study of individual behavior, in particular those of consumers,
producers or holders of resources, and the analysis of their interaction. Macroeconomics
examines, meanwhile, the economy as a whole in trying to understand the relationships
between the various aggregates that are income, employment, investment and savings.
This text provides an overview and a clear introduction to economics. The volume's
audience is broad-gauged, academics and students seeking foundations for learning and
research, and practitioners seeking guidance for informing their critical decisions in
economics. Both newcomers to study of the field and those with a deeper knowledge
base will find the material informative and stimulating.
In order to establish boundaries and facilitate learning, I have divided this book into six
chapters:
Chapter I: The measurement of economic activity.
Chapter II: Income and consumption.
Chapter III: Investment and capital.
Chapter IV: Money and interest.
Chapter V: Economic growth
Chapter VI: Inflation
Chapter I. The measurement of Economic Activity
I. Economic activity and economic accounts
Economic activity involves the use of scarce resources (including time) in the
provision of foods to satisfy unlimited wants.
What does an economic good mean?
An Economic good provides satisfaction is relatively scarce, and is disposable.
It may take the form of tangible good such as an automobile or a loaf of Bread,
or it may take an intangible form such as the service furnished to a patient by
his doctor or to a student by his teacher.
Economic goods include goods appearing on markets and economic Activity
includes only activates producing marketable goods.
The difference between marketable goods and non-marketable goods according
to European System of Integrated Economic Accounts:
The goods and services are market, or non-market, that is to say, distributed
free of charge or virtually free of charge.
The classification of activity carried within the household as non-economic is a
generally principle in income Accounting
What are economic accounts?
The Economic accounts of a region, a nation or group of nations are a complete
comprehensive and systematic presentation of economic Transactions of
various types among significant groups of transactors, during successive
periods, and a presentation of the result of the transactions in terms of balance
sheet at the end of successive periods
Balance sheet, according to the Me Craux Hill Dictionary of Modern
Economics:
« A Statement of a firm’s financial position on a particular day of the year; as
of that moment, it provides a complete picture of what the firm owns (its
assets), what it owes (its liabilities), and its net worth well refer to European
System of Integrated Economic Accounts so as to give a terminology peculiar
to this field of the economic activity »
On the basis of a set of uniform definitions and classifications, i twill make it
possible to obtain a coherent, quantitative description of the economies of
member countries.
Moreover this System of Accounts should also improve the comparability of
figures between countries.
There are two kind of analysis, both included in the European System of
Integrated Accounts and the French System These analysis correspond to:
Two different ways of subdividing the economy:
First of all:
- In order to represent processes of production and the balance between the
resources and the uses of good and services, the most important breakdown is
that by branches. These group together units termed units of homogeneous
production.
-In order to describe flows of income and expenditure and financial flows, on
the other hand, the System is based on the breakdown of the economy into
sectors. These groups together, with respect to all their activities, units termed
institutional units
In general, we can Say that « The units, whether institutional or of
homogeneous production, which constitute the economy of a country are those
which have a center of interest on the economic territory of that country.
The term center of interest indicate the fact that economic Transactions have
been carried out on the economic territory of a country for a fairly long period
(one year or more)
A) Total population
On a given date, the total population of a country consist of all persons,
national or foreign, who are permanently settled in that country, even if they
are temporarily absent from it
B) Active population
That part of a nation’s total population which is older than the school- leaving
age and younger than the normal age of retirement
It includes those who are unemployed between these ages
Active population includes :
• Wage and Salary earners
• Self- employed persons
• Unpaid family workers
• the arned forces
- Instituional units
In general, a resident unit is said to be institutional, if it keeps a complete set of
accounts and enjoys autonomy of decision in respect of its principal function
II. Institutional Sectors
It includes Seven Categories:
A) Non financial corporate and quasi-corporate enterprises
The sector non-financial corporate and quasi corporate enterprises consists of
enterprises which are institutional units and which are principally engaged of
the production of goods and non-financial market services, the principal
resources of these units are derived from the Sale of their output, whatever the
price charged may be called.
B) Credit institutions
The sector credit institutions consist of all institutional units which are
principally engaged in finance for example which collect, convert and
distribute available funds. The main resources of these units consist of funds
derived from liabilities incurred (demand and time deposits, cash certificates,
bonds. etc. and of interest received.
C) Insurance enterprises
The principal resources of the sector come from contractual premiums.
D) General Government
The sector general government includes all institutional units which are
principally engaged in the production of non-market services intended for
collective consumption and/ or in the redistribution of national income and
wealth.
The main resources of these units derived directly or indirectly from
compulsory payments made by units belonging to other Sectors.
E) Private non-profit institutions serving house holds
This sector consists of private institutions serving households and recognized
as separate legal entities which are principally engaged in the production of
non-market services intended for particular groups of households, their main
resources, apart from those derived from occasional sales, are derived from
voluntary contributions from households in their capacity as consumers and
from property income (income from Assets).
F) Households
The Sector households cover households in their capacity as consumers and,
occasionally as Entrepreneurs whenever, in the latter case, the income or
financial transactions relating to business cannot be separated from those of
their owners.
-As consumers:
Whose main resources are derived from the remuneration of factors of
production and transfers received from other sectors.
-As Entrepreneurs:
Sole proprietorships and partnerships not recognized as independent legal
entities. Provided the latter do not keep complete accounts or. If they do, are
not very important at a local level.
Or as private non-profit institutions serving households not recognized as
independent legal entities, together with those recognized as independent legal
entities bet which are very important
G) Rest of the world
The rest of the world groups together nonresident units in so far as they carry
out transaction with resident institutional units.
III.The accounts
Each of these accounts relates to one aspect of the Economic System with total
transaction on both sides of the account balancing each other, either because of
the definitions adopted, or by means of a balancing item which is itself
significant for Economic analysis and is carried forward into the next account
A) The goods and services account.
The good and services account shows for the Economy as a whole and for
branches, the total resources (output and imports) and uses of goods and
services (intermediate consumption final consumption, gross fixed capital
formation, change in Stocks, exports).
B) The production Account
The production accounts shows the transactions continuing the production
process proper The Balancing item of the account is gross value added at
Market prices
C) The generation of income account
The generation of income account record the distributive transaction directly
linked to the process of production, which can therefore be broken down both
by branches and Sectors.
The resources consist of gross value added at market prices and subsidies; the
uses include taxes linked to production and imports and compensation of
employees.
Subsidy is a payment to individuals or businesses by a Government for which
it receives no product or services in return
D) The distribution of income account
The distribution of income account records the various transactions involving
the distribution and redistribution of income (interest, distributed profits
current transfers among the different sectors of the Economy.
The balancing item of the distribution of income account is gross disposable
income.
E) The use of income account
The use of income account shows, for those sectors which have some final
consumption, how gross disposable income is allocated between final
consumption and saving. The expenditure of more than one‘s income either
from past savings or from loans. The subtraction of total dissaving from gross
saving gives net saving, the figure used in national income Statistics.
The balancing item of the use of income account is gross saving.
F) The capital account
The capital account records for the different sectors transactions linked to
investment in none-financial assets and also capital transfers involving the
distribution of wealth.
The balancing item of capital account is net lending (+) or net borrowing (-)
G) The financial account
The financial account records for the different sectors the changes in the
different types of financial assets and liabilities
IV.Measuring National product and National Income
A) The circular flow diagram
On the one hand, business firms function both as consumers and resource
suppliers; on the other hand business firms use the resources, organize
production, and sell products of the process. There is a flow of a real
productive service from households to businesses and a return flow of real
good and services from business firms to households.
Business firms pay households money income for the productive services
supplied. In their roles as consumers, households create a counter flow of
consumption expenditure to Business firms. Exchanging their money income
for the real goods and services supplied to them .Thus there is a monetary flow
in on direction to offset each real flow in the opposite direction.
Figure 1: An example of a diagram flow
Most products go through a number of stages in the process of production; they
are sold a number of times before reaching the hands of the final user.
For example, copper wiring and Silicon chips are sold to Electronic companies,
which use them to manufacture TV sets. In calculating national product,
government Statisticians include the TV sets sold to consumers. But they do
not count separately the wiring and chips that went into the sets.
In order to eliminate double counting, only the value of final goods and
services is included in the national income and product accounts
A final product is a good or service that is purchased by the ultimate user and
not intended for resale or further processing.
However:
An intermediate product is one that is intended for resale or further processing.
Sameulson stated « We don’t intermediate products to be double-counted along
with final products » So he recommended using « value-added » to ovoid
double-counting.
Value-added is the value of a firm’s product minus the cost of intermediate
products bought from outside suppliers
-Intermediate consumption
The intermediate consumption of resident producer units represents the value
of all goods (other than fixed capital goods) and of all Market services
consumed during the course of the relevant period in order to produce other
goods and services.
-Final consumption
Final consumption represents the value of the goods and services used for the
direct satisfaction of human wants, whether individual final consumption of
households, or collective (collective consumption of general government and
private non-profit institutions).
A) Main aggregates
Table 1 : Main Macroeconomic aggregates
1) Gross domestic product (GDP)
Cross Domestic Product at Market prices represents the final result of the
production Activity of resident producer units.
It corresponds to the Economy’s Total output of goods and Services less
intermediate consumption and plus taxes linked to imports
Goss Domestic Product (GDP)
Plus+ Net factor income from abroad
Equals Gross National Product (GNP)
Less(-) Depreciation
Equals Net National Product (NNP)
Less(-) Indirect Business Taxes (and
related items)
Equals National income
Less(-)
Less(-)
Corporate profits
Contributions for social insurance
Plus +
Plus+
Plus+
Government transfer payments
Dividends
Other
Equals Personal Income
Less(-) Personal tax and non tax payments
Equals Diaposable personal income
Or GDP at Market prices is equal to the sum of gross value added at market
prices for all different branches, plus taxes linked to imports
GDP is also equal to the sum of gross value added at Market prices for all the
different sectors, less the intermediate consumption of banking services which
is not allocated by sector.
Finally GDP is that part of Gross National product which arises within the
country, i.e. without the adjustment for income from abroad fewer payments
abroad.
2) Gross National Product (GNP)
GNP is defined as the total value of all goods and services produced in the
Economy during one year. We effectively divide or deflate the nominal GNP
by the price deflator to compute the real GNP.
GNP per capita is real GNP divided by the population.
These two aggregates are useful so as to calculate how much the average level
of prices has risen since the base year.
Average price level or average level of prices:
By convention, the average price in the base year is given a value of 100 when
calculating a price index.
Consumer price Index (CPI)
The CPI is based on a fixed market Basket of consumer goods.
To calculate the CPI we first compute the ratio of the current market price of
each good to its base year price. Then we sum up over the ratios, weighting
each by the share of the good in base year expenditure.
Figure 2: US consumer price index
Retail price index
An index of the prices of goods purchased by a typical household.
Producer price index (orPPI) also called wholesale price index
The « basket » in the PPI consists of a large number of items sold at wholesale.
These goods are primarily raw materials and semi-finished goods.
What is the GNP gap?
The gap between the economy‘s output of goods and services and its potential
output at full employment (4% unemployment) without inflation
According to Burda and Wyplosz:
« Measurement of GNP is imperfect, costly and time consuming. A large
amount of Economic Activity is unmeasured such as household services and
the underground Economy. Yet Year-on -year comparisons like annual growth
rates, are less affected by measurement problems
What is not reported sometimes referred to as the black or underground
Economy.
3) Net national product (NPP):
The NPP is defined as the GNP minus an allowance for depreciation.
This allowance for depreciation is an estimate of the value of capital good used
up during the process of production.
All businesses properly run make allowances for depreciation by deciding how
long an asset will last for example by establishing a rate of depreciation and
then proceed to set aside funds which will accumulate into an amount large
enough to replace the asset when time comes to write it off.
P.A Samuelsan presents NNP:
Either as « the total money value of the flow of final product of the
community (good flow approach) ».
Or as « the total of factor earnings (wages, interest, rents and accruing profits
that are the cost of production of Society‘s final goods (earning -flow
approach) ».
4) National Income
The total net earnings received by the factors of production (wages + profit+
interest + rent ) for their productive effort in an economy and for a specified
period of time . This is called also national income at factor cost.
It is thus the income available to the country as a whole and must not be
confused with the notional revenue, which is the income of the government,
derived from taxes and other various sources.
National income at market prices, which incorporate indirect taxes and
subsidies to evaluate national income at the prices actually obtaining in the
market.
5) Personal income
The amount of income that people actually receive.
This measure differs from national income for several reasons. First, only
portions of firm’s profit are paid out as dividends to individuals.
Second, personal incomes excludes the contributions paid for social insurance,
because house -holds do not receive these amounts directly as income.
Next there are a series of adjustments to ensure that to the amount of interest
income in personal income corresponds to the amount that individuals receive.
Finally, various transfer payments appear in personal income but not in
national income.
Public welfare, old age, unemployment and disability payments are all
examples of transfer payments.
6) Disposable personal income
This is first a receipt rather than earnings concept, and it is computed after
taxes have been deducted.
Thus, to go from national income to disposable income we must add receipts
which are not payments for current productive services (government and
business transfer payments).
And we must deduct both earnings not currently received and all taxes (social
security contributions of employees and employers, corporate profit taxes and
retained corporate earnings, and personal taxes).
The government takes a sizable chunk in the form of personal taxes, mainly
the personal income tax.
After these taxes are paid, disposable personal income (DPI) remains.
Households can do three things with this income: spend it on consumption, use
it to pay interest on consumer debt, or save it.
7) Cross National disposable income
This aggregate corresponds to gross domestic product at market prices plus or
minus the net balance between the national economy and the rest of the world
of taxes linked to production and import subsidies, compensation of
employees, property and entrepreneurial income, accident insurance
transactions and current transfers.
The gross national disposable income is equal to the sum of the gross
disposable incomes of all the different sectors.
Real GNP is one of the most frequently used measures of Economic
performance.
Chapter II. Income and consumption
I. the consumption function
The relationship between the various possible levels of disposable income in an
economy and the levels of consumption purchasing that accompany them is
known as « the consumption function ».
The algebric expression of the consumption function
Is: C = F (Yd):
Which simply states in mathematical shorthand that the amount of
consumption purchasing (c) in an economy is a function (f) of the economy s’
level of disposable income (Yd).
Thus, C=fCYd, liquid Assets, credit terms, stock of durable goods expectation,
psychological forces, etc.).
Figure 3: The consumption function
Liquid means:
Easily converted into cash without appreciable loss in value liquid Assets, the
most liquid being cash and bank deposits , are clearly the opposite of “illiquid”
or “frozen” assets such as buildings and land, which may be difficult to sell
quickly without loss in value.
A) Average propensity to consume
Average propensity to consume or APC which refers to the proportion of an
economy’s total disposable income that is devoted to consumption uses.
APC =
B) Marginal propensity to consume
The proportion of each addition to the level of an economy’s disposable
income that will be devoted to additional consumption purchasing is the
economy’s marginal propensity to consume or MPC
MPC = =
Δ :( change in)
II.The saving function
The saving function shows the relationship between disposable income and
saving.
Figure 4: The saving function
A) Average propensity to save
The ratio of saving to income at any given income level.
B) Marginal propensity to save
MPS in the additional saving generated by additional income. It is the ratio of
change in saving to change in income
MPS=
For any particular consumption function, the marginal propensity to save is
equal to 1 minus the marginal propensity to consume, or:
MPS=1-MPC
The propensity-to-consume schedule (or consumption schedule) relates in a
table or curve the level of consumption to level of income.
The propensity to save schedule (or saving schedule) relates saving to income.
Since what is saved is the same thing as what in unconsumed, saving and
consumption schedules are conjoined twins in the sense that:
Saving + consumption = disposable income
3) The break-even point
The break-even point is the income level where net saving in zero. Below it,
there is dissaving or negative saving, above it, positive net saving.
Whenever expenditure exceeds income dissaving may be said to exist clearly,
it can only continue when barrowing or realization of capital is resorted to.
III. Income-consumption Theories
The Economists who have constructed these théories have all begun with “the
theory of individual consumer behavior” and then generalized to cover
aggregate behavior.
A) Methods of Analysis
1) Cross- Sections
Cross-Sectional data provide empirical evidence on how spending varies at
different levels of family income in anyone year.
A cross election of the population = a representative sample of the population.
2) Time Series
Time series data provide empirical evidence on how aggregate spending (or
Spending by all families combined) varies as aggregate income (or the income
of all families combined) changes from one year or on quarter to the next.
B) Theories
1) The absolute income theory Or absolute income hypothesis
The first statement of this hypothesis is probably that made by Keynes in the
general theory. Its subsequent development is primarily associated with James
Folin and Arthur Smithies.
The basic tenet of the absolute income theory is that the individual consumer
determines what fraction of his current income he will devote to consumption
on the bases of absolute level of that income.
What‘s current income?
Most Studies that take current income as the appropriate income concept take
the current year, or sometimes the current and the preceding year, as the time
span that is relevant.
How the consumption of an individual will progress according to this
theory?
Other thing being equal a rise in his absolute income will lead to a decrease in
the fraction of that income devoted to consumption.
2) The relative income hypothesis
The relative income theory which is closely associated with the name of james
S Duesenberry argues that the fraction of a family’s income devoted to
consumption depends on the level of its income of neighboring families and
not the absolute level of the family s’ income .
With incomes rising or falling over the course of years, their spending patterns
change if their relative position changes schema
Thus if a family’s income rises but its relative position on the income scale
remains unchanged because the incomes of other families with whom it
identifies have risen at the same rate, its division of income between
consumption and saving will remain unchanged.
2) The relative income hypothesis
The relative income theory which is closely associated with the name of James
S. Duesend berry, argues that the fraction of family s’income devoted to
consumption depends on the level of its income relative to the income of
neighboring families and not on the absolute level of the family income.
Individuals build up consumption standards that are geared to their peak
income levels. If income declines relative to past income, then individuals will
not immediately sacrifice the consumption standard they have had opted. There
is a ratchet effect, and they will only adjust to a small extent to the decline in
current income.
3) The permanent income theory:
Its point of departure is the rejection of this usual concept of “current income”
and its replacement with what is called “permanent income”.
Friedman approaches, the problem by making a sharp distinction between
incomes actually received, which he calls measured income on which
consumers actually base their behavior, which he calls permanent income. A
similar distinction is drawn between measured and permanent consumption.
Permanent Revenue is determined (by the expected or anticipated income to be
received over a long period of time stretching and over a number of years.
The minimum period of time over which income influences must be
maintained in order to make the receiver of that income regard them as
permanent.
Friedman divides the family’s measured income in the year into permanent and
transitory components, so that its measured income is larger or smaller than its
permanent income, depending on the sum of positive and negative transitory
income components.
For example, if a family wage earner receives an unexpected special bonus at
work in one year and has no reason to expect the same bonus in following
years, this income element is regarded as positive transitory income, and it
raises his measured income above his permanent income.
Otherwise,
If he suffers an unexpected loss of income due, say, to a plant shutdown as a
result of fire, this income element is regarded as negative transitory income,
and it reduces his measured income below his permanent income ».
Finally:
These unforeseen additions to and subtractions from a family‘s income are
expected to cancel out over the longer period relevant to permanent income,
but they are present in any shorter period.
Added to this is the notion of windfall gains or losses:
Another basic argument of Friedman’s permanent income theory is that the
transitory component of consumption is not correlated with the transitory
component of income, This amounts to saying that in a period in which a
family’s measured income contains a negative transitory component, it does
not reduce its consumption in response, nor, under the opposite circumstance,
does it raise its consumption in response.
Unexpected increases or decreases in income thus result in equivalent increases
or decreases in saving, consumption is unaffected by “windfall gains or
losses”. In other words, the marginal propensity to consume out of transitory,
or « windfall » income is held to be zero.
4) The life cycle hypothesis
According to this theory, the rational consumer considers all his existing
resources when planning his consumption. He allocates his income so that
utility is maximized over his lifetime.
Initiators of this theory:
Ando and Modigliani posit a consumption function in which individual
consumption depends on the resources available to the individual, the rate of
return on capital, and the age of the consumer unit.
Let’s observe the three points mentioned by Michael K. Evans in the quote
above, in the first place:
A) What are these resources?
Available resources are defined as existing net worth (wealth) plus the present
value of all current and future no property (that is, labor) earnings.
B) After seeing "nonproperty earnings" of "property income" mentioned
in the first chapter:
Given WL years of working, life WL), income par working year times the
number of working years.
C) Finally, the concept of age is important in this theory in effect:
The life-cycle hypothesis suggests that the propensities of an individual to
consume out of disposable income and out of wealth depends on the person’s
age.
Special case:
When income is expected to increase over a lifetime, consumption smoothing
implies borrowing when young and paying back when older.
The hypothesis of the life cycle:
Also suggests that aggregate saving depends on the growth rate of the economy
and on such variables as the age distribution of the population. The life-cycle
hypothesis views savings as resulting mainly from individuals » desires to
provide for consumption in old age.
The purpose of saving is to enable the household to redistribute the resources it
gets (and expects to get) over its life cycle in order to secure the most desirable
pattern of consumption over life.
A smooth consumption path
A more and more rapidly growing and thus progressively younger population
means a growing number of individuals of income-earning and saving ages in
relation to the number of dissaving individuals of retirement ages and thus a
rising propensity to save in the economy.
Older households appear not to dissave by the amount predicted by the life-
cycle model, but instead leave much of their wealth as bequest to their heirs.
IV. Relationship between aggregate consumption, income and the interest
rate.
A) Aggregate consumption and changes in income
Temporary income disturbances have little effect on consumption such
disturbances (crop failures due to bad weather, say or a series of unsuccessful
commercial opportunities) probably represent the majority of countrywide
income shocks. This explains why consumption is the most stable component
of aggregate demand.
-Aggregate demand
Aggregate demand is made up of consumers ‘purchases, government
expenditure, and perhaps other constituents, e.g. external demand.
Consumption changes only in response to unexpected changes in the whole
path of income, present and future Changes in consumption are largely
unpredictable.
This is the so-called random walk theory of consumption formulated by Robert
Hall of Stanford University It is surprisingly well supported empirically.
Third, a country hit by an adverse income shock is likely to run current account
deficits only if the shock is temporary Only then is it desirable to cushion the
disturbance by dissaving i.e by borrowing.
Permanent disturbances are better met with immediate consumption adjustment
rather than external borrowing or lending.
B) Aggregate consumption and interest-rate changes
-Interest-rate changes in interest rate
According to J.Sachs and F.Larrain and other economists:
« the effect of a rise in interest rates on household saving is ambiguous so that
it is useful to divide the effect of the interest-rate increase into two parts : a «
substitution effect, which always tends to raise saving, and an « income
effect » which may raise or lower saving ».
In fact:
The income effect tends to rise saving for net borrowers and to lower saving
for net lenders.
Interest rate changes are said to have distributive effects between net borrowers
and net lenders.
-Distributive effects
The net aggregate impact of interest rate changes depends on the distribution of
lenders and borrowers.
-Distribution
Net lenders are better off while borrowers are worse off when the real interest
rate increases (with the opposite redistribution when the real interest rate
decreases) for a nation as a whole; the crucial element is ixternal indebtedness.
In general, the presumption is that the income effects of net borrowers and net
lenders tend to cancel each other at the aggregate level so that the substitution
effect tends to dominate.
To cancel each other to cancel out
For this reason, we can usually suppose that a rise in interest rates will reduce
consumption and rise aggregate saving, even though we know that for some
lending households, saving might fall.
Chapter III. Investment and capital
I. What is the meant by investment and capital?
A) Investment
In everyday language « investment « does not always have the same meaning
as in economics … The plain man speaks of « investing » when he buys a
piece of land, an old security, or any title to property . For economists this are
clearly transfer items what one man is buying, someone else are selling there is
net investment only when additional real capital is created.
-Title to property title deed.
Edward Shapiro defined investment in the macroeconomic context as:
« Investment, a word with many meanings in popular usage, has only one
meaning in national income analysis – the value of that part of the economy’s
output for any time period that takes the form of new structures, new
producers » durable equipment, and change in inventories ».
Investment so defined can be viewed, we recall, either in gross or net terms If
we deduct from gross investment expenditures an allowance for the amount of
plan and durable equipment used up in turning out the period’s output, we have
net investment.
B) Capital
Confusion exists because capital may be in the form of money, or good, but
this should be overcome by regarding the first as a necessary precedent of the
other.
We could then say that money capital is accumulated from the proceeds of past
production, and is used to acquire, by a process called investment, capital
goods, which will be used in conjunction with other factors to produce goods
of a capital or consumer nature, or services.
Capital should here be under- stood to mean only the accumulated stock of
plant and equipment held by business.
C) Flow and stock variables
Investment is a flow variable whose counterpart stock variable is capital.
Investment is a flow of resources devoted to the production of future income,
whereas capital is a stock of resources. Thus investment is the annual (or other
time period) increment to the stock of capital.
D) Gross and net investement and disinvestment
If, for the economy as a whole, gross investment in any period equals the
amount of capital used up during that period, there is neither net investment nor
disinvestement and so no change in the stok of capital.
-Disinvestment
This may occur when producers do not renew worn-out capital, or when capital
goods are sold the term negative investment is sometimes used.
If gross investment exceeds replacement requirements, the difference equals
positive net investment, which represents an increase in the stock of capital.
If gross investment is less than replacement requirements, the difference is
negative net investment or disinvestment, which represents a decrease in the
stock of capital.
Therefore, by definition, net investment is an addition to the stock of capital.
II.The decision to invest
The businessman’s estimate of the profit or loss that will accrue from a
particular investment is based on the relationships among three elements: the
capital good in question, the purchase price of that good, and the market rate of
interest.
The crucial factor in the businessman’s evaluation of the prospective
profitability of any investment expenditure is his estimate of the income flow
the capital good will yield over its life.
The contemplated investment may turn out to be profitable or unprofitable
It will be profitable to borrow and invest as long as the rate of return from the
investment exceeds the rate of interest (i) paid on the borrowed funds.
Until the rate of return on the last investment is equal to the marginal cost of
funds for this investment.
A) Marginal efficiency of capital.
At the microeconomic level:
MEC indicates the rate of return expected from a capital asset. The net rate of
return expected on the capital asset
The yield on investments is called the marginal efficiency of capital. It is called
efficiency of capital it is called efficiency because it indicates a rate of net
return over cost ; it is called marginal because it refers only to additions to total
capital, not to the yield of existing capital assets.
The investment purchase needed to obtain potential new capital asset twill be
made any time that the present value of the asset exceeds its supply price – the
price the investor has to pay to obtain the asset.
-Discounted present value
The present value of a potential new capital asset equals the additional
revenues it is expected to generate in the future minus an estimate of all the
additional costs i twill incur except depreciation.
Since this revenue stream will not be actually received until sometime in the
future, it is necessary to discount the earning stream by the interest rate to
determine its present value.
- Discounted value
The marginal efficiency of capital According to Keynes:
« I define the marginal efficiency of capital as being equal to that rate of
discount which would make the present value of the series of annuities given
by the returns expected from the capital asset during its life just equal to its
supply price ».
Similarly, at the macro level:
An economy’s stock of capital will tend to be expanded so long as the rates of
return which additional units of capital are expected to yield exceed the rates of
interest that must be paid to finance their purchase.
- Rate of return
The amount of investment rises as the rate of interest (which represents the cost
of borrowing money for investment) falls.
-Investment financing
If the volume of investment expenditure exceeds the volume of funds currently
saved, where does the money come from?
Basically there are two main sources: the money may come from funds
accumulated in the past by firms or households, or it may be money newly
created by the banking system.
The marginal efficiency of capital at the macroeconomic level:
The expected rate of return on increments to an economy’s stock of capital
when its supply prices, noncapital cost, and revenues are normal in that they
are not being affected by efforts to change the stock is the marginal effected by
efforts to change the stock is the « marginal efficiency of capital or MEC ».
All those additional costs such as labor, normal profits, and materials which the
investor anticipates if he acquires and operates the asset
Otherwise:
It is possible to use « MEC curves to graphically depict the profit-maximizing
or optimum stock of capital for an economy at each level of interest rates.
B) Marginal efficiency of investment (MEI)
Every firm has many different investment projects it might undertake. Suppose
that it knows the present cost and can estimate a stream of expected future
returns for each project.
If all such projects are ranked according to their rates of return over cost for a
given market interest rate, the resulting schedule is known as the marginal
efficiency of investment schedule.
If all firms in the economy do this and we aggregate the schedules horizontally,
we will have an aggregate mei schedule
The investment demand (or marginal efficiency of investment) curve slopes
downward to the right. At a lower interest rate, more investment projects are
undertake
III. The Investment Function
An investment function relates the sum of autonomous and replacement
investment purchasing to the level of total purchasing. Thus, since there will be
a different amount of investment purchasing in an economy at every level of
interest rates, there will be a different investment function for an economy at
every level of interest rates.
Figure 5: Investment function and interest rate
Autonomous investment occurs independently of rising economic activity, as a
result, for example, of the introduction of new products or processes.
In contrast we find:
-Induced investment
The difference between autonomous investment and total investment is
ordinarily called induced investment, meaning investment that is called forth
by or dependent on the level of income.
Furthermore:
Through the additional economic activity that it produces, autonomous
investment in a given industry may generate induced investment in the
economy generally.
IV. The Multiplier
The relationship between the increase in national product and the increase in
investment demand is known as the investment multiplier, or more simply, as
the multiplier.
- Investment multiplier
Formally it is defined:
Investment multiplier =
This concept deals with the magnified impact that changes in investment
spending have on total income.
Investment spending
The money spent in building a new plant, for instance, sets off a chain reaction.
It increases the incomes of the workers directly engaged in its construction, the
incomes of the merchants with whom the workers trade, the incomes of the
merchants’ suppliers, and so on.
The dollars do not multiply indefinitely, however, for people do not ordinarily
spend all their new income; instead they spend part and save part.
This basic idea has been developed into many specialized multipliers, such as
the foreign-trade multiplier, which deals with the effects of changing imports,
and the successive-period multiplier, which deals with the timing of the
multiplier effects.
There are so many unknowns at work in the economy, however, that it is
virtually impossible to discover the precise impact of any multiplier.
V.The accelerator
The theory of the accelerator attempts to explain the level of investment by
relating it, not to the absolute level of national income but to changes in
income.
-Theory of the accelerator
New investment is said to be some multiple, x, of the change in income. The
multiple x is called the accelerator coefficient.
Because increases in output necessitate increases in plant and equipment, while
a constant level of demand can be produced with existing plants, it is changes
in demand, rather than the level of demand , rather than the level of demand
that induce net investment.
VI.The accelerator-multiplier interaction
An economy’s level of investment purchasing may be both affected by changes
in the level of income and have a multiplier effect on the level of income.
To have a multiplier effect on. Thus what happens to an economy when
something causes an initial change in purchasing depends upon the resulting
interaction between the economy’s multiplier and accelerator effects.
Thus, the interaction of the accelerator and multiplier helps to explain not only
the strength of cycles but also why turning points occur-why, for example, a
boom does not continue indefinitely, but instead reaches a peak and turns into a
recession.
Chapter IV. Money and interest
It is a curious phenomenon in economics that frequently the best way to
understand something is to imagine the opposite. This is certainly true with
money. The opposite of a monetary economy is what is called a barter
economy, that, is, an economic system in which no money exists; markets
exist, but no money Thus, in such an economy goods are exchanged directly
for other goods.
I. What is money?
The word « money », as used in economics, has two quite distinct meanings.
Firstly, it has an abstract meaning, in that it is the unit of account or the
measure of exchange value. This simply means that money is a sort of common
denominator, in terms of which the exchange value of all other goods and
services can be expressed.
Second meaning of 'money':
Money in its more concrete or tangible form. By concrete it is not meant that
the money necessarily exists in a physical form ( though it may do so) but that
ownership of it is capable of changing hands and that there is a supply of it,
which to a greater or lesser extent is capable of being measured . This is money
acting as a medium of exchange.
In fact:
The essential characteristic of the medium of exchange is that it is generally
acceptable.
This has given rise to a common definition of money as anything that is
generally acceptable as a means of payment or in final settlement of a debt.
The only items which have complete general acceptability are those which are
legal tender.
Example of physical aspect of money:
The abstract unit of account may have a physical counterpart in the form of, for
example, paper money. The pound note may be regarded as a physical
embodiment of the pound sterling. It is really a piece of paper whose value in
exchange is equal to one pound sterling.
In fact:
Money concrete is usually attributed with two functions, those of acting as a
medium of exchange and as store of value.
-Store of value
In fact:
The medium of exchange represents generalized purchasing power, so that it
may be held and act as a store of value or wealth until the point in time is
reached at which the holder wishes to exercise his purchasing power.
A person’s wealth is the sum of the market values of all his assets –physical
assets, such as a house, clothes, a car ; financial assets, such as common stocks,
bonds and money ; and human assets, the present value of the individual’ s
income stream from human effort over his lifetime.
According to Charles W.Baird:
“Money is defined as the sum of currency held by the public and demand
deposits held by the public”.
In fact:
Each person holds some money. Each person has an average balance in his
checking account, and each person carries some average amount of currency
with him.
In a practical way, we could distinguish three kinds of money:
- Fractional currency or metallic currency that is, coins, fiduciary currency fiat
money fiat currency;
-Fiduciary currency or fiat money that is, paper money (banknotes);
-Deposit money bank money that is, bank demand deposits (or sight deposits).
II. The demand for money
In his General Theory of Employment, Interest and Money, Lord Keynes
suggested that the demand for money could be divided into three separate
demands or motives.
A) The transactions demand for money or transactions demand
It has in this case:
Individuals and business enterprises maintain certain average levels of cash and
deposits because of the need to make day-to-day transactions.
If receipts of income and expenditures were always synchronized perfectly
with respect to time, there would be no need for such idle balances.
Because the typical person is paid once a month or once a week and because he
does not make all his disbursements at exactly the time he receives his income,
he must maintain some amount of cash for the purpose of meeting his
transactions needs.
B) The precautionary demand for money or precautionary demand
It has in this case:
To Keynes the precautionary motive was « to provide for contingencies
requiring sudden expenditure and for unforeseen opportunities of advantageous
purchases and also to hold an asset of which the value is fixed in terms of
money to meet a subsequent liability fixed in terms of money.
In fact:
Precautionary balances enable persons to meet unanticipated increases in
expenditures or unanticipated delays in receipts.
-to meet unexpected
Otherwise:
This type of demand for money may be expected to vary to some may be
expected to vary to some extent with one’s income. Individuals need more
money and are better able to set aside more money for this purpose at higher
income levels.
The precautionary demand may also be expected to vary inversely with the
interest rate.
A precautionary balance is to secure one against a rainy day that may never
come. At a high enough rate of interest, one may be tempted to assume the
greater risk of a smaller precautionary balance in exchange for the high interest
rate that can be earned by converting part of this balance into interest-bearing
assets.
C) The speculative demand for money or speculative demand
People want to hold money, Keynes said, not only for transacting current
business but also as a store of value or wealth. But why, assuming there is a
positive rate of interest, should anyone want to keep their wealth in the form of
non-interest-bearing money rather than in a form that does bear interest?
The reason, or necessary condition « failing which the existence of a liquidity
preference for money as a means of holding wealth uncertainty; uncertainty as
to the future of the rate of interest.
III. The supply of money
Narrowly defined, the money supply (M1) consists of currency and demand
deposits. Currency includes all coin and paper money issued by the
government and the banks.
Since the monetary authorities hold some stocks of currency, only circulating
currency is included in the money supply.
Bank deposits, which are payable on demand, are also regarded as part of the
supply of money; in fact, they constitute three fourths of the total money
supply in the U.S.
Some economists also include near money, or cash liquid assets as commercial
bank time deposits and deposits at savings and loan associations and mutual
savings banks, in the money supply.
The amount of currency in circulation is determined by the public. If
individuals want a greater amount of cash, they withdraw it from their bank
accounts; if they want to hold a smaller amount of cash, they deposit surplus
cash in their accounts.
The volume of demand deposits is determined primarily by the commercial
banks. By increasing their loans and demand deposits,
The banks are able to expand the money supply within the limits of the reserve
requirements set by the Federal Reserve. They cannot expand loans, however,
unless businessmen, consumers, and the government are willing to borrow.
Thus, the total money supply is determined by the banks, the Federal Reserve,
businessmen, the government, and consumers.
Figure 6: Components of the US money supply overtime
IV. The supply of monetary assets and credit
A) Financial intermediaries
Financial intermediation
There are, in fact, many different forms of financial intermediaries that stand
between borrowers and savers. The intermediaries are alike in that they each
create their own form of ‘ intermediate financial assets » and offer hem to
savers in exchange for the savers » monetary assets in the form of coins,
currency, and demand deposits. The intermediaries, in turn, use the funds they
obtain to acquire « primary financial assets » from borrowers.
Financial intermediaries exist when an economy gas deficit sectors which
desire to spend in excess of their incomes and surplus sectors with both
incomes in excess of their expenditure desires and a willingness to exchange
their monetary surpluses for nonmonetary assets.
The financial intermediaries earn an interest differential by reducing the risk of
nonrepayment to the lenders; they, in effect, add their guarantees to the primary
financial assets that the borrowers put up in order to obtain the surplus money
of the savers. The size of the interest differential depends on the degree of risk
and the administrative cost involved in the primary and intermediate assets.
Financial intermediaries include savings and loans associations, insurance
companies, pension funds, investment companies, government lending
agencies, and commercial banks.
Finally note the concept of disintermediation:
The decline in the use of the services of financial intermediaries that results
when the public moves away from holding deposits toward direct holding of
bonds and mortgages.
B) Financial assets
These are of two kinds:
Intermediate financial assets and primary financial assets
Among the financial intermediaries, banks, "commercial banks":
Commercial banks are included because they accept money and, in exchange,
issue intermediate financial assets in the form of demand deposits, savings
deposits, or certificates of deposit.
The banks then use whatever portion of the funds that do not have to be held as
reserves to make loans to borrowers in exchange for primary financial assets
such as the notes, mortgages, and other forms of securities that might be issued
by ultimate borrowers.
Examine more precisely the primary financial assets:
Activity in financial markets involves the exchange of one financial asset for
another. In most exchanges, lenders exchange money for other financial assets
that provide a future return.
In effect they buy a claim against someone’s money holdings at a future date
they buy an IOU (I owe you).
An IOU (abbr.of I owe you) signed paper acknowledging that one owes the
sum of money stated. It is a synonym of acknowledgement of debt.
These IOUs, or « securities », provide an expected return in the form of interest
or dividends securities.
In some cases the lender may hold a security until it matures, that is, until the
borrower repays the loan on the specified date. In other cases, the lender may
sell the security to someone else before it matures.
Thus, although the borrower continues to use loaned funds, the lender is now a
different person we say that lenders « supply loanable funds » to the market
whereas borrowers « demand loanable funds ».
C) The rate of interest
1) Interest and principal
C’est un lieu commun que de dire que :
The rate of interest is the price of money
Interest is one of the forms of income from property, the other forms being
dividends, rents and profits.
According P. and R. Wonnacott:
Real rate of interest = nominal rate of interest- expected rate of inflation
Regarding money interest:
Money interest rate
Interest is essentially measured by the difference between the amount that the
borrower repays and the amount that he originally received from the lender
(which is called the principal)?
The principal
In the case of a loan repaid in one lump sum, the total amount of interest that is
due depends on the principal, O, on the percentage rate of interest per unit of
timer, r, on the number of time units over which the loan is outstanding, h, and
on the number of time units after which the interest obligation is added to the
debt of the borrower, m.
If this obligation is added only once, when the loan matures (that is, if h = m),
the interest is said to be simple.
-Simple interest
If the interest obligation is added more than once, interest is said to be
compounded.
- Compound interest
Interest that is calculated upon the original sum invested or lent plus
accumulated interest.
2) Interest rate ceiling
It is a ceiling imposed by the government on the interest rate that can be
charged by banks.
It has some advantage and disadvantages:
One of the arguments in favor of an interest rate ceiling is that i twill reduce the
burden of interest payments that must be paid by relatively poor individuals
and firms.
However:
The interest rate ceiling has two unfavorable effects on efficiency.
It is a: efficiency loss
In fact: First, it reduces the quantity of loanable funds for investment from Q1
to Q2. And also it increases the: unsatisfied demand for investment funds;
A second reason is that the wrong borrowers may get the limited funds.
So these are: sources of inefficiency
3) The equilibrium rate of interest
Given the money supply and the income level, there is some particular ratio of
interest at which the sum of the transactions and speculative demands for
money will just equal the actual supply of money. The rate of interest that
equates the supply and demand for money is the equilibrium rate of interest.
-Equilibrium rate of interest
In this context, we can resort to: IS/LM model
The analytical tool used in Keynesian theory to study the simultaneous
determination of aggregate output and the interest rate.
in which: IS curve is a graph used in Keynesian theory showing the
combinations of aggregate output and the interest rate which satisfy the
condition that the real demand for money equals the given real quantity of
money.
Figure 7: IS/LM Model
Chapter V. Economic growth
I. Fundamentals of growth economics
Economic growth is an increase in the production of goods and services per
capita Growth requires a transformation of the economy, with a shift of
manpower out of farming into manufacturing and service.
It is possible to identify all societies, in their economic dimensions, as lying
within one of five categories: the traditional society, the preconditions for
takeoff, the takeoff, the drive to maturity, and the age of high mass-
consumption.
The traditional economy, such as that typified by the manorial system, pretake-
off itself, the push to maturity in which technological advance is utilised in the
economy ; and the time of large scale production and mass consumption.
There are three main sources of growth: increases in the availability of labour,
capital accumulation, and technological change.
Capital accumulation or capital formation. The process of adding to the net
physical capital stock of an economy in an attempt to achieve greater total
output. The rate of accumulation of an economy in an attempt to achieve
greater total output. The rate of accumulation of an economy’s physical stock
of capital is an important determinant of the rate of growth of an economy.
The most common method used by economists to decompose output growth
into its various sources «follows an approach developed by Abramovitz 1956)
and Solow (1957) and later refined by Denision (1967) and others.
Growth accounting begins with measurement of factor accumulation and then
imputes output expansion to the inputs that have been accumulated by
assuming that market factor prices reflect marginal value products. The part of
output growth that cannot be attributed to the accumulation of any input, the
famous « Solow residual » is ascribed to technogical progress ».
In practice, this residual accounts for between one-third and one-half of
growth.
-to account for
The accumulation of inputs discussed will be what is referred to as capital
accumulation.
At least since Harrod (1939) and Domar (1946) , economists have looked to
capital formation for their explanation of rising standards of living.
It was Solow (1956) of course who formalized the idea that capital deepening
could cause labor productivity to rise in a dynamic process of investment and
growth.
Capital deepening, according to Gardner Ackley:
“That is, investment which increases the capital intensity of production”.
We could differentiate the concept of capital deepening and the concept of
capital widening which could be defined as investment which accompanies a
growth of total output.
II. Business cycles.
According to Michael Burda and Charles Wyplosz, we call: business cycles
(trade cycles)
« Successive periods of fast growth and consolidation ».
For them:
« One important challenge of macroeconomics is to explain these deviations of
GNP from its underlying trend: why they occur and persist over a few years,
and what can be done, if anything, to avoid disruptions that are associated with
them.
How is a business cycle?
The four phases of expansion, peak, recession, and trough can be distinguished
from seasonal and long-term trends.
The resulting pattern of 8 to 10 year major cycles, shorter minor cycles, and
longer Kuznets construction cycles has been carefully described by statisticians
and historians.
Figure 8: Typical business cycle phases
A) Basic terminology of the business cycle
The expansion phase comes to an end and goes into the recession phase at the
upper turning point, or so-called « peak ».
Recession is the term given to a falling – off in business activity. It could be a
temporary phenomenon, but could continue into a depression.
Similarly, the recession phase gives way to that of expansion at the lower
turning point, or so-called “trough”.
B) Seasonal and long-term trends.
Statistical correction for seasonal variations
We must remove from our statistical data irrelevant, disturbing factors such as
seasonal patterns, and also certain so-called long-term « trends ».
III. Causes of business cycles
One prominent factor is the volatility factor is the volatility of fixed investment
and inventory investment expenditures (the investment cycle), which
businesses » expectations about future demand.
At the top of the cycle income begins to level off and investment in new supply
capacity finally catches up “with demand”.
Leveling up of incomes
This causes a reduction in induced investment and, via contracting multiplier
effects, leads to a fall in national income which reduces investment even
further.
At the bottom of the depression investment may rise exogenously (due, for
example, to the introduction of new technologies) or through the revival of
replacement investment.
In this case, the increase in investment spending will, via expansionary
multiplier effects, lead to an increase in national income and a greater volume
of induced investment.
IV. Length of the cycle
A) Juglar’s eight-year cycle
The first authority to explore economic cycles as periodically recurring
phenomena was probably a French physician, Clément Juglar, in 1860. Other
writers who developed Juglar’s approach suggested that the cycles recur every
nine or ten years, and distinguished three phases, or periods, of a typical cycle:
prosperity, crisis, and liquidation.
Otherwise:
Close study of the interval between the peaks of the Juglar cycle suggests that
partial setbacks occur during the expansion, or upswing, and that there are
partial recoveries during the contraction, or downswing.
Kitchin cycles or inventory cycles
These smaller cycles generally coincide with changes in business inventories,
lasting and average of 40 months.
Other small cycles result from changes in the demand for and supply of
particular agricultural products such as hogs (three to four years), cotton (two
years), and beef (five years in the Netherlands.
B) Kuznets cycles
The long swings in building construction and other series, which average
anywhere between 15 and 25 years in length are often called Kuznets cycles,
being named for the scholar who first noticed them in 1930.
C) Kondratieff cycles
Finally, there are the long waves, or so-called Kondratieff cycles, named for a
Russian economist, Nicolai D.Kondratieff, who showed that in the major
Western countries during the 150 years from 1790 to 1940 it was possible to
distinguish three periods of slow expansions and contractions of economic
activity averaging 50 years in length.
According to w. Rostow:
The fifth Kondratieff Upswing began, at the close of 1972, with an explosion
of grain prices followed by a quadrupling of oil prices the next year.
In both cases, exogenous (external) events played a role; that is, the poor
harvests of 1972-1973 and the Middle East war of October 1973 ».
-Endogenous factors
But a deeper examination makes clear that strong endogenous (internal) forces
were at work in the late 1960 s that decreed, in time, a reversal of post-1951
relative price trends.
Chapter VI. Inflation
Inflation is the percentage change in the price level, normally measured as the
increase in the consumer price index.
The inflation rate measures the rate of change of the average level of prices.
- Inflation rate rate of inflation
It is usually quoted in percentage par year, even when it is measured more
frequently, such as every quarter or every month.
Most of the time, inflation is lower moderate at rates ranging from just above
0% to 6 or 8%.
-low inflation
In the 1970s many European countries experienced double digit inflation, with
rates rising to 10%, 20 %, or more.
I. Inflation origins
A) Cyclical changes
Cyclical variations
In normal times, inflation is related to the business cycle. It tends to rise when
the economy is in a phase of rapid expansion, and to slow down during
recessions.
We note that:
The rate of inflation changes when the rate of capacity utilization varies.
-Rate of capacity utilization
The rate of capacity utilization is a measure of how fully companies employ
their plants and
The inflation rate is generally procyclical: it rises in periods of high growth
and declines in period of slow growth or stagnation In contrast, the behavior of
unemployment is countercyclical.
B) Deficit financing
Public sector deficits can be covered in three ways: borrowing from the public,
using foreign reserves, or printing money.
Governments which have run persistent deficits in the past are likely to have
low international reserves, and they also have difficulties borrowing further.
Thus, eventually, such governments turn to monetary financing.
-Monetary financing
Under fixed exchange rates, deficits financed by printing money are ultimately
financed by a loss of international reserves.
-Financed by printing money
As long as reserves are available, the exchange rate may remain fixed and the
country can avoid inflation. If the deficit persists and reserves are depleted,
however, the central bank will have no option but to devalue (or float the
exchange rate). Then, inflation cannot be avoided.
The inflation tax is the capital loss suffered as a result of inflation by those who
hold money.
-Inflation tax
Economists often refer to the government’s revenue from money creation as
the inflation tax these revenues are also referred to as seignorage.
-Seigniorage
When the government finances its deficit by issuing money, which the public
adds to its holdings of nominal balances to maintain the real value of money
balances constant, we say the government is financing itself through the
inflation tax.
M.Burda et C.Wyplosz said :
Inflation tax! Real revenue that the government obtains by inflation. Inflation
erodes the real value of nominal assets and therefore may improve the financial
condition of the government, reducing the value of its nominal liabilities ».
Seigniorage is the revenue that the government collects by virtue of its
monopoly power to print money; it is equal to the purchasing power of the
money that it puts into circulation in a given period.
The concept « Seigniorage » is a reminder of the Middle Ages when financially
strapped local lords-who had the right of coinage on their land – directly
shaved gold coins ».
Shaved gold corners' means that the Lords did charge a certain amount of gold on the
coins minted.
The concept of “seignorage” is well documented in the manuals of macroeconomics; we
will quote the most recent passages that make reference in the works of Mikael Burda
and Charles Wyplozz, Jeffrey sachs and Felipe Larrain and Robert Barro and Vittorio
Grilli.We will also post a French Claude Gnos article in the Bank journal in 1994, the
Bank seignorage, myth or reality? Before discussing this particular case of employment
by "seigniorage", in a first part, the author indeed, the historical use of this term. We
will quote a single sentence that illuminates well the use of the verb "shaved" in the
above quotation:
Thus, levy on the wealth of the public, the seigniorage historically unequal exchange
process, purchase of a quantity of metal goods using a lesser amount of metal hit.
II. Hyperinflation
We define very high inflation as an annual rate of inflation of 100 percent or
more and hyperinflation as an inflation of 50 percent per month (equivalent to
almost 13 000 percent per year) There have been only 15 cases of
hyperinflation, all of them in the present century.
We can note that:
When inflation is very high it is usually measured on a monthly basis; the term
« hyperinflation » describes situations when this monthly inflation rate exceeds
50%
-Monthly inflation rate
There are some key conditions which gave triggered hyper-inflation. First,
these phenomena have occurred only in regimes of fiat money.
Under metallic money or a gold standard, the stock of precious metal simple
cannot rise at a rate sufficient to support the price increases.
Second, many hyperinflations have tended to occur during or in the aftermaths
of war, civil war, or revolution, as a consequence of strains on the budget.
Expenditures that strain a budget
For example:
In the 1980s, external shocks and high foreign indebtedness of governments
have played a key role.
But it can also be simply:
-Social unrest
Moreover, once a high inflation gets started, the budgetary situation may
become unstable: high inflation causes a sharp drop in tax collections, which in
turn increases the budget deficit and leads to more inflation.
Based on historical evidence, it seems that a persistent money financed budget
deficit on the order of 10-12 percent of GNP leads to hyperinflation.
We can so differentiate between:
Non-monetary financing of a budget deficit:
-through foreign credits
-by borrowing on the domestic bond market
-by borrowing from private banks
And:
Monetary financing of a budget deficit
Typically the government turns to monetary financing when it’s other sources
of financing dry up.
III.Types of inflation
Traditionally we consider that, due to reasons of excess demand, we can
identify three types of inflation:
-demand-pull inflation
-cost-push inflation
-structural inflation
A) Demand-pull inflation
Inflation caused by persistent rises in aggregate demand.
According to this theory, the general price level rises because the demand for
goods and services exceeds the supply available at existing prices
We then observe:
A rightward shift of the demand curve, the demand curve shifts to the right.
There can be:
A single increase in demand (or a « demand shock », the effect is to give a
single rise in the price level.
For inflation to persist there must be continuing rightward shifts in the AD
curve, and thus continuing rises in the price level.
B) Cost-push inflation
A general price increase caused by increases in input cots. In this case, we
observe a leftward shift of the supply curve, the demand curve shifts to the lets
According to Shapiro, one can distinguish two aspects:
« There are two principal causes of inflationary shifts in the aggregate supply
function, both of which represent the exercise of market power by specific
groups in the economy . One is higher money wages secured by labor unions,
and the other is higher prices secured by business firms in monopolistic or
oligopolistic industries. For purposes of classification, we may call these two
principal causes of inflation on the supply side wage-push and profit-push ».
C) wage-push inflation
This is where trade unions push up wages independently of the demand for
labour.We say that it is: inflationary wage claims
D) Profit-push inflation
This is where firms use their monopoly power to make bigger profits by
pushing up prices independently of consumer demand.
Other Cases may be cited:
Import-price-push inflation
This is where import prices rise independently of the level of aggregate
demand. An example is when OPEC quadrupled the price of oil in 1973/1974.
Or
Tax-push inflation
This is where increased taxation adds to the cost of living for example, when
VAT was raised from 8 per cent to 15 per cent in 1979, prices rose as a result.
Finally, with John we insist on the exhaustion of natural resources
If major resources become depleted, the aggregate curve will shift to the left.
Examples include the gradual running-down of North Sea oil, pollution of the
seas and hence a decline in incomes for nations with large fishing industries,
and perhaps the most devastating of all, “the desertification” in sup-Saharian
Africa.
E) Structural inflation
It’s a combination of the rightward shift of the demand curve and the leftward
shift of the supply curve.
IV.Inflation and unemployment
The twin evils of macroeconomics.
In theory, when output increases unemployment will fall (Okun’s law) and
inflation will rise (the Phillips curve).
Okun’s law set a relationship between real growth and changes in the
unemployment rate
Okun’s law says that for every 2 ½ percentage points of growth in real GNP
above the trend rate that is sustained for a year, the unemployment rate declines
by 1 percentage point.
Or else:
Okun’s law states that for every one percentage point reduction in the
unemployment rate, real GNP will rise by 2.5 percent.
It allows us to ask how particular growth target will affect the unemployment
rate over time.
Figure 9: An example of Okun’s Law graph
The Phillips curve
Its message was that there exists a permanent trade-off between unemployment
and inflation »
Thus, output could rise to meet an increase in demand but would, in the process
generate a higher rate of inflation
Since the late 1960s, apparently stable Phillips curves have vanished. Contrary
to the notion of an inflation-unemployment trade-off, both inflation and
unemployment rose in the mid- 1970s and early 1980s; a phenomenon called
stagflation.
Figure 10: The US Philips curve
Indicative Bibliography
Blanchard, O. and Cohen. D, 2001. Macroéconomie, 1th ed:Pearson education.
Burda, M. & Wyplosz. C, 2005. Macroeconomics: A European Text, Oxford Univeristy
Press.
Griffiths, A. and S. Wa, K., 2007. Applied economics. 11th ed. Harlow: Addison
Wesley Longman.
Hornby, W. and B. Gammie, 2001. Business economics. 2nd ed. Harlow: Pearson
Education.
Mankiw, N. G, 2005, Macroeconomics, Worth Publishers.
Mankiw, N.G. and M.P. Taylor, 2011. Economics. 2nd ed. London: Thomson.
Romer, D,2006.$, Advanced Macroeconomics, 3 edn, McGraw-Hill Higher Education.
Sloman, J, 2009. Economics. 7th ed. Harlow: Financial Times/Prentice Hall.
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