Macroeconomics
1.1 The Open Economy Circular-Flow Model - Basic Concepts
Q: What is the circular-flow model of the economy? A: The circular-flow model is a simplification showing how the economy works and the relationship between income, production and spending in the economy. It shows the workings of an open economy that is open to foreign trade.
Q: How does an open economy circular-flow model differ from a closed economy model? A: An open economy circular-flow model includes the foreign sector, while a closed economy does not include foreign trade.
Q: What are the four participants in the open economy circular-flow model? A: The four participants are: (1) Households/Consumers, (2) Business Sector/Firms, (3) State/Government, and (4) Foreign Sector.
Households/Consumers
Q: What role do households play in the circular flow model? A: Households are the owners of the services of factors of production. They place their factors of production on the market to be bought by businesses, and they earn income in the form of wages by selling these factors to businesses.
Q: How do households earn income in the circular flow? A: Households earn income in the form of wages by selling their factors of production (labour, land, capital, entrepreneurship) to businesses.
Business Sector/Firms
Q: What role does the business sector play in the circular flow model? A: Businesses use factors of production to produce goods and services. They place goods and services on the product market which is bought by households to satisfy their needs, and businesses receive income (revenue) from these sales.
Q: How do businesses interact with households in the circular flow? A: Businesses buy factors of production from households (paying them wages/income) and sell goods and services to households (receiving revenue).
State/Government
Q: Describe the flow of money and goods between households and the state. A: Households provide the state with labour and receive income (salaries/wages) in return. The state provides households with public goods and services (parks, hospitals). Households pay income taxes to the state which becomes revenue for the state.
Q: Describe the flow of money and goods between the business sector and the state. A: The business sector provides the state with goods and services for which the state pays. The state provides the business sector with public goods and services like infrastructure (roads, electricity, harbours). Businesses pay company taxes to the state.
Foreign Sector
Q: How does the foreign sector interact with businesses in the circular flow? A: There is a flow of goods (imports) from the foreign sector to businesses, for which businesses pay (expenditure). There is also a flow of goods (exports) from businesses to the foreign sector, for which businesses earn money (income).
Q: What are imports and exports in the context of the circular flow? A: Imports are goods flowing to businesses from the foreign sector (expenditure for business). Exports are goods flowing from businesses in the country to the foreign sector (income for business).
Financial Sector
Q: What is the role of the financial sector in the circular flow? A: The financial sector consists of banks, insurance companies and pension funds. It acts as a link between households and firms who have surplus money and supply others in the economy who require funds.
Q: What are savings and investment in the circular flow context? A: Savings is the money which households and firms provide to the financial sector. Investment is when businesses borrow money from financial institutions and use it to purchase capital goods and equipment.
Real Flow and Money Flow
Q: What are the two components of the exchange process in markets? A: The two components are: (1) Real flow - goods and services and factors of production, and (2) Money flow - the earning of money (income) and payments that are made.
Q: Describe the real flow in the circular flow model. A: Households render factors of production to producers and government via the factor market. Goods and services are supplied by producers via the product market to government and households. Government provides public goods and services to households and producers. Producers receive goods and services (imports) from and deliver goods and services (exports) to the foreign sector.
Q: Describe the money flow in the circular flow model. A: Households earn income for their factors of production via factor markets from businesses. Business sectors earn income for goods and services via the product market from households and government. Government receives income from households and businesses. Businesses earn income for exports from the foreign sector and make payments to the foreign sector for imports.
Leakages and Injections
Q: What is a leakage in the circular flow model? A: A leakage represents the withdrawal of money from the economic cycle (local economy). It does not give rise to a further round of income, and domestic purchases on goods and services decrease.
Q: What are the three types of leakages in an open economy? A: The three leakages are: (1) Taxes (T) - less disposable income (direct like PAYE or indirect like VAT), (2) Imports (M) - not all consumption is produced domestically, and (3) Savings (S) - part of income which is not spent.
Q: What is the formula for total leakages? A: L = S + T + M (Leakages = Savings + Taxes + Import expenditure)
Q: What is an injection in the circular flow model? A: An injection represents the injection of money into the economic cycle (local economy). It refers to the flow of any spending which is not derived from income. Additional money enters the economy and increases income, and domestic purchases on goods and services increase.
Q: What are the three types of injections in an open economy? A: The three injections are: (1) Government spending (G), (2) Exports (X), and (3) Investment spending (I).
Q: What is the formula for total injections? A: J = I + G + X (Injections = Investment + Government expenditure + Export Income)
Equilibrium and Disequilibrium
Q: When is the economy in equilibrium in terms of leakages and injections? A: The economy is in equilibrium when leakages are equal to injections: S + T + M = G + I + X (L = J)
Q: What happens to national income when injections are more than leakages (J > L)? A: National income increases. The number of injections which exceed leakages contribute to additional demand. This additional demand must be satisfied, causing an increase in the production of goods and services.
Q: What happens to national income when leakages are more than injections (J < L)? A: National income decreases. The amount with which leakages exceed the injections contributes to decreased demand. Demand for goods and services drops, fewer goods and services are produced, and less income is generated for participants.
Mathematical and Graphical Presentation
Q: What is the formula to calculate total income (Y) in the economy? A: Y = C + I + G + (X - M), where Y = Income, C = Consumption spending, I = Investment, G = Government spending, X = Exports, M = Imports
Q: In the aggregate expenditure graph, what does the 45-degree line represent? A: The 45-degree line (E = Y) separates the 90° angle into two equal portions of 45° each. It represents where expenditure equals income.
Q: What is aggregate expenditure (AE) in the circular flow? A: AE = C + I + G + (X - M). This curve shows the amount which consumers, producers, government and foreign sector plan to spend at every level of income. It also equals aggregate demand.
Q: What happens when planned aggregate expenditure increases in the graph? A: If planned AE increases, this means more money is injected into the economy than what is leaked out. This causes the AE curve to shift upward, and the multiplier causes income (Y) to increase.
Markets in the Four-Sector Model
Q: What role do markets play in the circular flow? A: Markets coordinate economic activities and determine prices for goods and services. Circular flow models show the interaction between participants of the economy via these markets.
Goods/Product/Output Markets
Q: What are goods and product markets? A: These are markets for consumer goods and services. Goods are tangible items (food, clothing, cars) that satisfy human wants or needs. Services are non-tangible actions (wholesale, retail, transport, financial services).
Q: What are the three types of consumer goods traded in product markets? A: (1) Durable consumer goods (e.g., cars), (2) Semi-durable consumer goods (e.g., tyres), and (3) Non-durable consumer goods (e.g., petrol).
Q: What is the capital goods market? A: The capital goods market is for trading buildings and machinery used in production.
Factors/Resources/Input Markets
Q: What do households sell on factor markets? A: Households sell factors of production: rent for natural resources, wages for labour, interest for capital, and profit for entrepreneurship.
Q: What does the factor market include? A: The factor market includes the labour market, property market, and financial markets.
Financial Markets
Q: What role do financial markets play in the circular flow? A: Financial markets are not directly involved in production of goods and services, but act as a link between households, the business sector and other participants with surplus funds. Examples include banks, insurance companies and pension funds.
Q: What is the difference between money markets and capital markets? A: Money markets deal with short-term loans and very short-term funds (products: bank debentures, treasury bills, government bonds; key institution: SARB). Capital markets deal with long-term funds (products: mortgage bonds and shares; key institution: Johannesburg Securities Exchange).
Foreign Exchange Markets
Q: What happens in the foreign exchange market? A: In the foreign exchange market, businesses buy/sell foreign currencies to pay for imported goods and services. These transactions occur in banks and consist of electronic money transfers from one account to another.
Q: What is an exchange rate? A: The exchange rate is the price to pay for another currency. Exchange rates are determined by the forces of demand and supply, which are influenced by the volume of imports and exports.
Q: Where are the most important foreign exchange markets located? A: The most important foreign exchange markets are in London, New York, and Tokyo. The South African Rand is traded freely in these markets.
1.2 NATIONAL ACCOUNTS
Basic Concepts
Q: What is the aim of national accounts? A: The aim of national accounts is to provide a systematic and comprehensive record of national economic activities.
Q: What system does South Africa use for national accounts? A: South Africa uses the System of National Accounts (SNA) as suggested by the United Nations (UN).
Q: What is the SNA (System of National Accounts)? A: The SNA is the internationally agreed standard set of recommendations on how to compile measures of economic activity. It records how production is distributed among consumers, businesses, government and foreign nations, and shows how income flows to these groups and how they allocate flows to consumption, saving and investment.
Q: Are national income figures 100% accurate? A: No, national income figures are NOT 100% accurate. There are many shortcomings or problems when calculating or determining national income figures. Despite these problems, they remain important economic statistics.
GDP and GNP
Q: What is GDP (Gross Domestic Product)? A: GDP is the total value of final goods and services produced within the boundaries/borders of a country for a specified period. Another name for GDP is Gross Value Added.
Q: What is GNP (Gross National Product)? A: GNP is the total value of final goods and services produced by the permanent residents of a country for a specific period, no matter where in the world they are.
Q: What is the key difference between GDP and GNP? A: GDP measures production within a country's borders regardless of who produces it. GNP measures production by a country's permanent residents regardless of where they produce it.
Three Methods to Calculate GDP
Q: What are the three methods used to calculate GDP? A: The three methods are: (1) Production method - GDP(P), (2) Expenditure method - GDP(E), and (3) Income method - GDP(I).
Production Method
Q: What is the production method of calculating GDP? A: The production method (value added approach) determines GDP by calculating the sum of the value added at each stage of the production process. This method yields GDP at basic prices.
Q: Why does the production method only use added values? A: To avoid double counting. Only added values are taken, and the value of intermediate goods and services are not included in the calculation.
Q: What is the formula structure for the production method? A: Primary Sector + Secondary Sector + Tertiary Sector = Gross value added/GDP at basic prices. Then add taxes on production and subtract subsidies on products to get GDP at market prices.
Expenditure Method
Q: What is the expenditure method of calculating GDP? A: The expenditure method measures the total value of expenditure (spending) on final goods and services, at market prices, within the geographical borders of the country in a specific period.
Q: What spending is included in the expenditure method? A: The spending of households, business enterprises, and state on consumer goods, services and capital goods, plus exports of goods and services, minus imports of goods and services.
Q: What is the formula structure for the expenditure method? A: Final consumer spending + Final consumer spending by government + Gross capital formation + Residual items = Gross domestic expenditure. Then add exports and subtract imports to get Expenditure on GDP at market prices.
Income Method
Q: What is the income method of calculating GDP? A: The income method measures the total remuneration earned by the owners of factors of production within the geographical borders of a country for their services in the production process over a period. This method provides GDP at factor cost.
Q: What components make up the income method? A: Compensation of employees + Net operating surplus + Consumption of fixed capital = Gross value added/GDP at factor cost. Then adjustments are made for taxes and subsidies to reach GDP at market prices.
Q: What does net operating surplus include? A: Net operating surplus includes the total value of goods and services less the costs. Costs consist of: (1) Intermediate goods and services, (2) Cost of compensation of workers, and (3) Cost of capital consumption.
National Account Conversions
Q: What are basic prices in national accounts? A: Basic prices relate to when indirect taxes and subsidies are related to the production process and not individual products. With the production method, taxes on production are subtracted as a cost and subsidies on production are added as income.
Q: What are examples of taxes on production? A: Taxes on production include payroll taxes (SITE and PAYE), recurring taxes on land and buildings, business licenses, and other licenses.
Q: What are examples of subsidies on production? A: Subsidies on production include employment subsidies and subsidies paid to prevent pollution.
Q: What is factor cost in national accounts? A: Factor cost is GDP at basic prices MINUS other taxes on production PLUS other subsidies on production. This equals GDP at factor cost (factor income).
Q: How do you convert GDP from basic prices to market prices? A: GDP at basic prices PLUS taxes on products MINUS subsidies on products = GDP at market prices.
Q: How do you convert GDP from factor cost to market prices? A: GDP at factor cost PLUS other taxes on production MINUS subsidies on production = GDP at basic prices. Then PLUS taxes on products MINUS subsidies on products = GDP at market prices.
Net Figures
Q: What are net figures in national accounts? A: Net operating surplus = surplus after taxes. Net income = income after taxes. Net fixed capital formation = after consumption of fixed capital (depreciation). Net exports = exports minus imports.
Domestic vs National Figures
Q: What is the difference between domestic and national figures? A: Domestic figures relate to income and production happening within the borders of the country. National figures relate to income or production by the citizens of the country no matter where they are in the world.
Q: How do you convert GDP to GNI (Gross National Income)? A: GDP at market prices PLUS factor income earned abroad by South Africans MINUS factor income earned in South Africa by foreigners = GNI at market prices.
Nominal vs Real Figures
Q: What are nominal figures in national accounts? A: Nominal figures (also known as money value or national product at current prices) are calculated by multiplying the volume of final goods and services by their prices. Inflation has not yet been taken into consideration.
Q: What are real figures in national accounts? A: Real figures (also known as national product at constant prices) have the rate of inflation as expressed by the consumer price index (CPI) taken into account. Real values are nominal values adjusted for price increases, expressed in prices from a certain base year.
1.3 THE MULTIPLIER
Basic Concepts
Q: What is the multiplier? A: The multiplier shows how an increase in spending (injection) produces a more than proportional increase in national income. The multiplier must always be more than 1.
Q: Does the multiplier work in only one direction? A: No, the multiplier works in opposite directions (both for increases and decreases in spending).
Marginal Propensities
Q: What does the size of the multiplier depend on? A: The size of the multiplier depends on the proportion of any increase in income that is spent. The larger the mpc (marginal propensity to consume), the bigger the multiplier. The smaller the mpc, the smaller the multiplier.
Q: What is the marginal propensity to consume (mpc)? A: The mpc is the proportion of additional income that is spent on consumption. It represents the money that stays in the economy.
Q: What is the marginal propensity to save (mps)? A: The mps is the proportion of additional income that is saved rather than spent.
Q: What is the relationship between mpc and mps? A: mpc + mps always equals 1. Therefore, mps = 1 - mpc and mpc = 1 - mps.
Multiplier Formulas
Q: What is Formula 1 for calculating the multiplier? A: α = 1/(1 - mpc). For example, if mpc = 0.6, then α = 1/(1 - 0.6) = 1/0.4 = 2.5
Q: What is Formula 2 for calculating the multiplier? A: α = 1/mps. For example, if mps = 0.4, then α = 1/0.4 = 2.5
Q: What is Formula 3 for calculating the multiplier? A: K = ΔY/ΔE (or ΔY/ΔI), where ΔY is the change in income and ΔE (or ΔI) is the change in expenditure (or investment).
Q: If investment increases by R10,000m and income increases by R25,000m, what is the multiplier? A: K = ΔY/ΔI = R25,000/R10,000 = 2.5
The Multiplier Process
Q: Explain the multiplier effect process. A: Initially there is an increase in injections (investment, government spending, or export income), which leads to a proportionate increase in national income. The extra spending has a knock-on effect and creates even more spending. The size of the multiplier depends on the level of leakages.
Q: How do leakages affect the multiplier process? A: When households earn income, leakages can occur through income tax, savings, and spending on imports. If leakages amount to, say, 30% of income, then 70% remains in the economy to create further spending rounds.
Q: Give an example of the multiplier effect starting with R1000 investment. A: Firms increase investment by R1000, ordering capital goods from domestic firms. Total spending, production, and income all increase by R1000. When households earn this R1000, if leakages are R300, then R700 is spent on domestic goods, starting the next round of the multiplier effect.
Multiplier Graph
Q: In the multiplier graph, what does the AE curve represent? A: The AE (Aggregate Expenditure) curve represents Aggregate Demand, illustrated by C + I + G. It shows total spending at each level of income.
Q: What happens in the multiplier graph when investment increases? A: When investment spending increases (ΔI = ΔG), the AE curve shifts upward to AE1. The multiplier causes income (Y) to increase to Y1, which is a larger increase than the initial injection.
Three and Four Sector Models
Q: How does the multiplier differ in 3 and 4 sector models compared to a 2-sector model? A: In 3 and 4 sector models, 1 - mpc is no longer equal to just mps because government and foreign sectors are involved. The leakage equals mps + mrt + mpm, where mpm is the marginal propensity to import and mrt is the marginal tax rate.
Q: How do imports affect the multiplier? A: Imports make the multiplier smaller. Part of the increase in investment and consumption expenditure goes to imported goods, not South African produced goods. The greater the marginal propensity to import, the smaller the change in income.
Q: How does income tax affect the multiplier? A: Income tax reduces the multiplier. As tax revenue increases, disposable income increases by less than the increase in expenditure. The higher the marginal tax rate, the smaller the change in income and GDP.
Q: What is the formula for the multiplier in a four-sector model? A: Multiplier = 1/(1 - mpc) = 1/(mps + mpt + mpm), where mpt is marginal propensity to tax and mpm is marginal propensity to import.
TOPIC 2: BUSINESS CYCLES
2.1 Composition and Features
Q: What is a business cycle? (Definition 1) A: A business cycle refers to the phenomenon of successive periods of increasing and decreasing economic activity.
Q: What is a business cycle? (Definition 2) A: A business cycle is defined as the recurrent but not periodic pattern of expansion and contraction in the level of economic activity that occurs within a country.
Nature of Business Cycles
Q: Are business cycles regular and predictable? A: No. Changes in economic activity are recurring but never the same or of the same magnitude. Different circumstances and expectations cause consumers and producers to respond differently to initiating forces.
Q: What are the main characteristics of business cycles? A: Business cycles are characterized by: (1) Two periods - contraction and expansion, (2) Two turning points - trough and peak, and (3) Four phases - recovery, prosperity, recession, and depression.
Typical Business Cycle Components
Q: What is an upswing in the business cycle? A: An upswing is a period where there is a general increase in economic activity. The entire period from the trough to the peak is known as the upswing.
Q: What is a downswing in the business cycle? A: A downswing is a period of general decline in economic activity. The entire period from the peak to the trough is known as the downswing.
Q: What are the upper and lower turning points called? A: The upper turning point is called the peak, and the lower turning point is called the trough. The business cycle oscillates (swings) between these turning points.
Q: What is a boom in the business cycle? A: The boom is the period immediately before and through the upper turning point (peak) of the cycle.
Q: What is a slump in the business cycle? A: The slump is the period immediately before and through the lower turning point (trough) of the cycle.
Q: How is the length of a business cycle measured? A: The length of the business cycle is measured from peak to peak or from trough to trough.
Recovery Phase
Q: When does the recovery phase start? A: The recovery phase starts once a trough (lower turning point) in the business cycle is reached and the level of economic activity starts to gradually increase.
Q: What characterizes the recovery phase? A: There is greater demand for goods and services, leading to an increase in production. More jobs are created, business confidence rises, and there is increased spending by firms and households. Increased economic activity leads the country into prosperity.
Prosperity Phase
Q: What characterizes the prosperity phase? A: There is great optimism in the economy. Bank credit is extended so entrepreneurs borrow more to buy machines and equipment (investment increases). Employment levels rise, salaries and wages increase, and household disposable income increases. Imports increase, and a peak is reached.
Q: What causes the prosperity phase to end? A: A larger amount of money in circulation leads to an inflationary situation as prices rise in the economy, eventually leading to a recession.
Recession Phase
Q: When does the recession phase start? A: The recession phase starts once the peak is reached and the contraction phase begins.
Q: What defines a recession? A: A recession is when there is negative economic growth rate for two consecutive quarters.
Q: What characterizes the recession phase? A: It is introduced by a decrease in business profits due to inflation and overproduction. Firms cut back employment as fewer goods and services are produced, increasing unemployment. Income of households decreases and spending declines. There is decreased economic activity and GDP decreases, resulting in pessimism.
Q: What can a worsening recession lead to? A: As the contraction phase worsens, households and firms obtain less credit and loans from banks, which could turn into a depression.
Depression Phase
Q: What characterizes the depression phase? A: Money is in short supply, leading to further decline in spending. There is negative impact on investment spending, and economic activity is at its lowest (trough is reached). There is competition for employment opportunities with serious levels of unemployment. Cost of production decreases.
Q: What can lead to recovery from depression? A: Decreased costs of production encourage foreign trade and lead to recovery.
Real (Actual) Business Cycle
Q: What is a real (actual) business cycle? A: An actual business cycle is obtained when the effects of irregular events, seasons, and long-term growth trend are removed from the time series data.
Q: How is the length/duration of a cycle measured? A: The length or duration is measured from trough to trough or peak to peak.
Q: What is amplitude in a business cycle? A: The amplitude is the distance of the peaks and troughs from the trend line. It shows the severity of cyclical fluctuations.
2.2 Explanations/Causes of Business Cycles
Exogenous Explanation (Monetarist)
Q: What is the exogenous explanation of business cycles? A: The exogenous explanation (also called sunspot theory or monetarist explanation) believes markets are inherently stable. Deviations from equilibrium are caused by exogenous factors (factors outside the market system).
Q: How do markets respond to disequilibrium according to the exogenous view? A: When disequilibrium exists in the economy, market forces (supply and demand) kick in and bring the economy back to its natural state or equilibrium route.
Q: What is the monetarist view on government intervention? A: Monetarists believe government interference is not part of normal market forces. Governments should not interfere in the markets.
Q: What are the causes of economic fluctuations according to the exogenous explanation? A: (1) Inappropriate government policies, (2) Undesirable increases and decreases in money supply, (3) Weather conditions (droughts, floods), (4) Shocks (sudden/severe increases in fuel prices, wars), and (5) Structural changes in the economy (e.g., electronic development).
Endogenous Explanation (Keynesian)
Q: What is the endogenous explanation of business cycles? A: The endogenous explanation (also called Keynesian approach or Interventionism) holds the view that markets are inherently unstable. The level of economic activity constantly tends to be above or below its potential.
Q: Why do Keynesians believe markets are unstable? A: The price mechanism fails to coordinate demand and supply in markets. Prices are not flexible enough (e.g., wages). The business cycle is an inherent feature of a market economy.
Q: What is the Keynesian view on government intervention? A: Governments must intervene in economic processes to smooth the peaks and troughs as far as possible. They use Monetary and Fiscal Policies to do this.
Types of Business Cycles
Q: What are business cycles in South Africa? A: In South Africa, business cycles last approximately 60 months. There are clear expansion and contraction periods during which major sectors of the economy move up and down more or less together. Their duration is not fixed.
Q: What are Kitchin cycles? A: Kitchin cycles last between 3 to 5 years. They happen because businesses adapt their inventory levels.
Q: What are Jugler cycles? A: Jugler cycles last 7 to 11 years. They are caused by changes in net investments by business and government.
Q: What are Kuznets cycles? A: Kuznets cycles last 15 to 20 years. They are caused by changes in the building and construction industries. They are also called building cycles.
Q: What are Kondratieff cycles? A: Kondratieff cycles last 50 years and longer. They are caused by technological innovation, wars, and discoveries of new deposits (e.g., gold).
2.3 Government Policies to Smooth Business Cycles
General Overview
Q: Why must government intervene with policies in business cycles? A: Government must intervene with policies to smooth out peaks and troughs. Higher peaks lead to inflation, and lower troughs lead to unemployment.
Q: What policies does the state use to smooth the business cycle? A: The state uses monetary policy and fiscal policy to smooth out the business cycle.
Fiscal Policy - Stimulating the Economy
Q: When should fiscal policy be used to stimulate the economy? A: When private sector demand becomes too low, indicated by an increase in unemployment.
Q: What are the three fiscal policy choices to stimulate the economy? A: (1) Decrease taxation (↓T), (2) Increase government spending (↑G), or (3) Increase government spending and decrease taxes simultaneously for a double strength effect.
Q: How does decreasing taxation stimulate the economy? A: Households and producers have more disposable income which they can spend on goods and services. There is an increase in consumption spending (C) which leads to increased demand. The economy is stimulated, leading to employment.
Q: How does increasing government spending stimulate the economy? A: Government spending is achieved with borrowed money due to budget deficit. Total spending increases and demand increases. The economy is stimulated and employment increases.
Q: What happens when government spending increases and taxes decrease simultaneously? A: This creates a double strength effect. Government spending increases while consumers and producers have more disposable income to spend on goods and services. Demand increases and employment increases.
Fiscal Policy - Cooling the Economy
Q: When should fiscal policy be used to cool the economy? A: When private sector demand becomes too high, indicated by inflation.
Q: What are the three fiscal policy choices to cool an overheated economy? A: (1) Reduce government spending (↓G), (2) Increase taxation (↑T), or (3) Reduce government spending and increase taxation simultaneously for a double strength effect.
Q: How does reducing government spending cool the economy? A: Unspent money is preserved (frozen). Total spending decreases, demand decreases, and inflation will decrease.
Q: How does increasing taxation cool the economy? A: Tax income is preserved (frozen). Consumers and producers have less disposable income to spend on goods and services. Demand decreases and inflation decreases.
Q: What happens when government reduces spending and increases taxation simultaneously? A: This creates a double strength effect. Government spending decreases while consumers and producers have less money to spend. Demand decreases and inflation decreases.
Monetary Policy Overview
Q: What does monetary policy use to influence the economy? A: Monetary policy uses interest rates and money supply to expand or contract aggregate demand.
Q: What do large increases in money supply lead to? A: Large increases in money supply lead to inflation.
Q: When is monetary policy most effective? A: Monetary policy can be utilized more effectively to dampen an overheated economy with severe inflationary pressures.
Monetary Policy Instrument 1: Interest Rates
Q: How are interest rates used during an overheated economy/boom? A: Increase interest rates to decrease money supply. This makes credit more expensive and reduces/discourages consumer credit. Demand will decrease.
Q: How are interest rates used during a recession/slump? A: Decrease interest rates to increase money supply. This makes credit cheaper and increases/promotes consumer credit. Consumer demand will increase and stimulate the economy.
Monetary Policy Instrument 2: Cash Reserve Requirements
Q: What are cash reserve requirements? A: Banks are required by law to keep cash reserves at the SARB. The SARB can increase or decrease these cash reserve requirements.
Q: How are cash reserve requirements used during an overheated economy/boom? A: An increase in cash reserve requirements decreases the supply of capital to commercial banks, so banks have less money to lend to consumers. Demand will decrease.
Q: How are cash reserve requirements used during a recession/slump? A: A decrease in cash reserve requirements increases the supply of capital to commercial banks, so banks have more money to lend to consumers. Demand will increase.
Monetary Policy Instrument 3: Open Market Transactions
Q: What are open market transactions? A: The SARB can directly increase or decrease the amount of money in the economy by buying or selling government bonds/securities on the open market.
Q: How are open market transactions used during an overheated economy/boom? A: If the SARB wants to reduce the supply of money in the economy, they sell government bonds/securities on the open market.
Q: How are open market transactions used during a recession/slump? A: If the SARB wants to increase the supply of money in the economy, they buy government bonds/securities on the open market.
Monetary Policy Instrument 4: Moral Persuasion/Suasion
Q: What is moral persuasion in monetary policy? A: The SARB can enter into discussions with banks to morally persuade them to limit credit and increase cooperation to fight inflation.
2.4 The New Economic Paradigm
Overview
Q: What is the new economic paradigm? A: In real circumstances, governments must strive towards economic growth regardless of whether markets are inherently stable or unstable. Governments learned to be pragmatic and apply policies that are not extreme but transparent.
Q: What do economists believe about production under the new paradigm? A: Economists are convinced that production output can rise at a high rate for an extended period without being tripped by supply constraints and without inflationary pressure. This paradigm lies in demand-side and supply-side policies.
Demand-Side Policy
Q: What do demand-side policies focus on? A: Monetary policy and fiscal policy focus on aggregate demand.
Q: Why don't demand-side policies work ideally on their own? A: Growth is often cut short because of bottlenecks that develop in the economy, such as inflation, balance of payments deficits, shortages of skilled labour, etc. Aggregate supply also needs to be managed.
Q: What happens if the cost of increasing production is flexible? A: A greater real production output can be supplied at any given price level.
Demand-Side Policy and Inflation (Graph)
Q: In the inflation graph, what does Aggregate Demand (AD) represent? A: AD is the total spending on goods and services in the economy: AD = C + I + G + (X - M).
Q: In the inflation graph, what does Aggregate Supply (AS) represent? A: AS is the total quantity of goods and services supplied at every price level. It is the total value of goods and services produced in the economy in a given period.
Q: What happens when AD increases and AS responds promptly (long-term)? A: When AD shifts right to AD1 and AS shifts right to AS1, a new equilibrium is formed. A larger production output becomes available (Q to Q1) without any increase in price. This occurs over the long-term because aggregate supply adjusts easier over the long-term.
Q: What happens when AD increases but AS remains unchanged (short-term)? A: When AD shifts right to AD1 but AS remains unchanged, they intersect at a new equilibrium point where real production increases but prices also increase. Inflation increases. This happens because supply does not adjust easily over the short term.
Q: How can the inflation problem from increased AD be solved? A: A situation must be created where supply is more flexible through supply-side measures.
Unemployment and the Phillips Curve
Q: What does the Phillips Curve illustrate? A: The Phillips Curve illustrates the relationship between unemployment and inflation. As unemployment decreases, inflation increases, and vice versa.
Q: What is the natural employment level on the Phillips Curve? A: At point A where the PC intersects the x-axis. At this point unemployment is 14% with no inflation pressures (0% inflation).
Q: What happens when unemployment decreases from 14% to 10%? A: If economic growth causes unemployment to decrease to 10%, more people get jobs and wages increase (people have more money to spend), leading to an increase in inflation to 2%.
Q: What happens when unemployment decreases from 14% to 8%? A: Unemployment at 8% leads to inflation increasing to 6%. This inflation increase is caused by increased wages giving people more purchasing power.
Q: How can supply-side measures affect the Phillips Curve? A: Supply-side measures can shift the PC to the left (PC to PC1), decreasing the natural level of unemployment from 14% to 9%, meaning unemployment is lower at 9% with 0% inflation.
Q: What are three supply-side measures that can shift the Phillips Curve? A: (1) Improved education, (2) Effective training, and (3) Fewer restrictions on migration of skilled labour.
Supply-Side Policy: Reduction of Cost
Q: How do infrastructure services reduce costs? A: Infrastructure services are supplied by government and contribute substantially to the cost of businesses. Improving infrastructure reduces business costs.
Q: How do administrative costs affect businesses? A: Inspections, reports on implementation of laws, and regulations all contribute to increased costs and expenditure of businesses.
Q: How do cash incentives reduce costs? A: Subsidies can be given to businesses when they establish in neglected areas where unemployment is high, reducing their costs.
Supply-Side Policy: Improving Efficiency of Inputs
Q: How do tax rates affect efficiency of inputs? A: High personal income tax is a disincentive to work. Higher company taxes are disincentives to investment. Lower tax rates improve efficiency.
Q: How does capital consumption improve efficiency? A: Replacing capital goods creates opportunities to keep up with technology and compete with competitors.
Q: How do human resources improve efficiency? A: The quality of labour increases the efficiency of businesses. Quality human resources are created by improving health care, education, and training schemes.
Q: How do free advisory services improve efficiency? A: Services that promote exports (research, agricultural services, statistical information) improve business efficiency.
Supply-Side Policy: Improving Efficiency in Markets
Q: What is deregulation? A: Deregulation is the removal of laws, regulations, and all other forms of government control to make markets freer.
Q: How does competition improve market efficiency? A: Competition creates establishment of new businesses and attracts foreign investment.
Q: What does "leveling the playing field" mean in terms of efficiency? A: Private sector businesses cannot compete with public sector enterprises that have legislative protection and government support. Privatization is therefore important to level the playing field.
Effect of Policies Using AD/AS Graph
Q: How does the AD/AS graph show the effect of demand-side policies on inflation? A: AD and AS are in equilibrium. When AD is stimulated and moves to AD1, if supply reacts and shifts to AS1, there is bigger real output without price increases. However, supply is often sticky over the short term, so with increased demand to AD1 and constant supply, real production and prices increase (inflation).
Q: How does the AD/AS graph show the effect of demand-side policies on unemployment? A: Demand-side policies are effective in stimulating economic growth, leading to increased demand for labour, which reduces unemployment. However, this also increases inflation.
2.5 Features Underpinning Forecasting
Definition and Overview
Q: What is forecasting in economics? A: Forecasting is the process of making predictions about changing conditions and future events that may significantly affect the economy.
Q: Is accurate forecasting in the economy possible? A: No, accurate forecasting in the economy is not possible. The best that economists can do is to predict what could happen.
Q: What are the two main types of forecasting methods? A: (1) Quantitative methods - make use of historical time series data/past performance to predict the future, and (2) Judgemental methods - rely on opinion and are more subjective in nature.
Leading Economic Indicators
Q: What are leading economic indicators? A: Leading economic indicators are indicators that change before the economy changes. They give consumers, business leaders, and policy makers a glimpse of where the economy might be heading.
Q: What do rising leading indicators suggest? A: When leading indicators rise, the level of economic activity will also rise in a few months' time.
Q: What are examples of leading economic indicators? A: Job advertising space, inventory/sales ratio, share prices, and building plans passed.
Lagging Economic Indicators
Q: What are lagging economic indicators? A: Lagging economic indicators do not change direction until after the business cycle has changed its direction. They serve to confirm the behaviour of coincident indicators.
Q: What are examples of lagging economic indicators? A: The value of wholesalers' sales of machinery and investment in capital goods.
Q: How do lagging indicators work in prediction? A: If the business cycle reaches a peak and begins to decline, then the value of new machinery sold can be predicted to decline as well (after a delay).
Coincidental Economic Indicators
Q: What are coincidental (co-incident) economic indicators? A: Coincidental indicators simply move at the same time as the economy. They indicate the actual state of the economy.
Q: What is an example of a coincidental economic indicator? A: The value of retail sales.
Q: How do coincidental indicators work? A: If the business cycle reaches a peak and begins to decline, then the value of retail sales will reach a peak and begin to decline at the same time.
Composite Indicators
Q: What are composite indicators? A: Composite indicators are a grouping of various indicators of the same type into a single value.
Q: Why are composite indicators useful? A: The single figure makes analysis easier and more meaningful for forecasting purposes.
The Length of a Business Cycle
Q: What is the length of a business cycle? A: The length is the time it takes for a business cycle to move through one complete cycle (peak to recession to trough, back to recovery, boom and peak). It is also the number of years it takes for the economy to get from one peak to the next.
Q: Why is it useful to know the length of a cycle? A: The length tends to remain relatively constant over time. If a business cycle has a length of 10 years, it can be predicted that 10 years will pass between successive peaks or troughs.
Q: What do longer and shorter cycles indicate? A: Longer cycles show strength in the economy, while shorter cycles show weakness.
Q: What does it mean when cycles overshoot? A: Cycles can overshoot when activity in terms of composite indicators increases beyond its normal level.
Amplitude
Q: What is amplitude in a business cycle? A: The amplitude refers to the vertical difference between a trough and the next peak of a cycle. It measures the distance from the trend line to the peak or trough.
Q: What does a large amplitude indicate? A: A large amplitude during an upswing indicates strong underlying forces, which result in longer cycles. The larger the amplitude, the more extreme the changes that may occur.
Q: Give an example of extreme changes with large amplitude. A: During an upswing, inflation may increase from 5% to 10% (a 100% increase).
Trend Line
Q: What does the trend line represent? A: The trend line represents the average position of a cycle and indicates the general direction in which the economy is moving.
Q: What does an upward trend suggest? A: An upward trend suggests that the economy is growing.
Q: What is typical about the slope of a trend line? A: The trend line usually has a positive slope because production capacity increases over time.
Extrapolation
Q: What is extrapolation in forecasting? A: Extrapolation is when forecasters use past data (e.g., trends) and, by assuming this trend will continue, make predictions about the future.
Q: Give an example of extrapolation. A: If it becomes clear that the business cycle has passed through a trough and entered a boom phase, forecasters might predict that the economy will grow in the months that follow.
Q: Where else is extrapolation used? A: It's also used to make economic predictions in other settings, such as prediction of future share prices.
Moving Average
Q: What is a moving average? A: A moving average is a statistical analytical tool used to analyze changes that occur in a series of data over a certain period.
Q: Why are moving averages calculated? A: They are calculated to iron out small fluctuations and reveal long-term trends in the business cycle.
Q: Give an example of moving average use. A: The moving average could be calculated for the past three months to smooth out any minor fluctuations.
TOPIC 3: PUBLIC SECTOR
3.1 Composition of the Public Sector
Q: What are the three levels of government? A: (1) Central Level - manages and governs the country, headed by the President, makes strategic decisions. (2) Provincial Level - manages and administers the province, nine provinces, headed by the Premier. (3) Local Level - responsible for service delivery in the community, headed by the Mayor.
Q: What are public corporations (SOEs)? A: Public corporations are State Owned Enterprises or Parastatals, such as Eskom, Transnet, and Denel.
Necessity of Public Sector: Supply Public Goods
Q: Why does the public sector need to supply public goods? A: Goods are mostly in the form of services. Government uses policies such as taxation and government spending to supply them, ensuring access to essential services.
Q: What are community goods and their characteristics? A: Community goods (e.g., defence, police, street lighting) are characterized by: (1) Non-excludability - everyone can use them regardless of whether they are prepared to pay, and (2) Non-rivalry - use by one person does not exclude use by another.
Q: What are collective goods? A: Collective goods (e.g., parks, beaches) can exclude free riders or people who don't want to pay by levying fees.
Q: What are merit goods? A: Merit goods (e.g., health, education) benefit people more than private goods. If the public sector doesn't provide them, there will be undersupply. They generate little income, so the private sector is not keen on providing them.
Q: What are non-merit goods? A: Non-merit goods (e.g., cigarettes) are harmful to society. Government imposes taxes and regulations to discourage consumption.
Necessity of Public Sector: Conserve Resources
Q: Why does the public sector need to conserve resources? A: The environment consists of resources that no one owns but everyone can use free of charge (e.g., oceans for fishing, air, natural scenery). Governments must intervene to protect the environment.
Q: How does government conserve resources? A: By making laws and setting up legal structures to protect the economy against issues like poaching of lobster and abalone, extensive fishing, air pollution, and poaching/killing of rhinos.
Necessity of Public Sector: Manage the Economy
Q: Why does the public sector need to manage the economy? A: The government manages the collective interest of its people, creates the social and legislative environment in which businesses and individuals pursue their own interests, and applies suitable and credible economic policies to achieve respected objectives.
Q: What are the five main objectives the government must achieve? A: (1) Job creation, (2) Price stability, (3) Economic growth, (4) Stability of the exchange rate, and (5) Economic equity (justice).
3.2 Problems of Public Sector Provisioning
Accountability
Q: What is accountability in the public sector? A: Accountability means it is expected of a person to explain their decisions, actions, and expenditure. People want to know the number and quality of goods and services they receive in return for taxes they pay.
Q: What are problems with accountability in state enterprises? A: State enterprises are not directly accountable to taxpayers. State officials do not always act on behalf of the public - many times they act in their own interest to benefit themselves. State officials do not have to set profit or loss statements.
Q: What do people want to ensure regarding state officials? A: People want to be sure that government officials do not abuse their position and power through corruption, nepotism, and incompetence.
Efficiency
Q: Does accountability guarantee efficiency? A: No, accountability does not guarantee efficiency.
Q: What does inefficiency in public sector mean? A: Inefficiency means that goods and services are not produced in the desired quantity and quality.
Q: What is Pareto efficiency? A: Pareto efficiency is when it is impossible to make someone better off without making another person worse off. Public goods and services are efficiently produced when Pareto efficiency is achieved.
Q: Why are government objectives not always achieved? A: Objectives such as housing, health, and job creation are not always possible because of limited resources and serious structural weaknesses in the economy.
Assessing of Needs
Q: How does the private sector assess needs? A: In the private sector, supply and demand determine the prices of goods and services. These forces also communicate the needs of consumers.
Q: Why is it difficult for government to assess needs? A: State enterprises are not run by forces of demand and supply. Government provides goods and services according to the needs of people, but it is difficult to determine these needs accurately.
Q: What problem results from difficulty in assessing needs? A: Public goods and services are sometimes oversupplied or undersupplied.
Pricing Policy
Q: Why is pricing difficult for the state? A: The state does not operate within the market system of demand and supply. Prices can be overvalued or undervalued.
Q: What must be considered when the state determines prices? A: Economic considerations, political considerations, social considerations, and public opinion must all be considered.
Semi State Enterprises (Parastatals)
Q: How are parastatals created? A: As a result of nationalization (government controlled enterprises/GCEs) created due to necessity for service delivery. Examples include ESCOM, SABC, ISCOR, TELKOM, Transnet.
Q: What problems have parastatals created? A: Many GCEs obtained exclusive rights and became monopolies. Some encountered large losses, placing a huge financial burden on government. Some function inefficiently, putting pressure on the economy.
Privatisation
Q: What is privatisation? A: Privatisation refers to the transfer of functions, activities, and ownership from the public sector to the private sector.
Q: What are the aims of privatisation? A: (1) To reduce the relative size of the public sector, (2) To stimulate growth of the private sector, (3) To improve overall efficiency and performance of the economy, and (4) To broaden the economic base so tax levels can be reduced.
Q: What are the advantages of privatisation? A: Provides additional funds to government, broadens the tax base (increasing government income), improves efficiency, attracts foreign investment, reduces pressure on government's budget, promotes Black economic empowerment, and reduces personal income tax and government debt.
Q: What are the disadvantages of privatisation? A: Public monopolies are replaced by private monopolies, people lose their jobs (contributes to unemployment), and ownership of assets are transferred without capital investment.
Nationalisation and Regulation
Q: What is nationalisation? A: Nationalisation is the opposite of privatisation. It refers to the transfer of functions, activities, and ownership from the private sector to the public sector.
Q: What is regulation? A: Regulation refers to deliberate actions to put laws, regulations, and prescriptions in place to regulate economic activities.
Q: What is deregulation? A: Deregulation refers to deliberate action by government to remove all unnecessary restrictions placed on economic activities by law, regulations, and prescriptions.
3.3 Macro-Economic Objectives
Economic Growth
Q: What is economic growth? A: Economic growth refers to an increase in the production of goods and services, measured in terms of Real GDP.
Q: When does economic growth occur? A: For economic growth to occur, the economic growth rate must be higher than population growth.
Q: Why is economic growth important? A: Growth and development in a country benefit its citizens because it often leads to a higher standard of living.
Full Employment
Q: What is full employment? A: Full employment is when all the people who want to work and are looking for work are able to get work.
Q: Why is employment an important government objective? A: High levels of employment are the most important economic objective of the government.
Q: What sector should be promoted to increase employment? A: Informal sector activities must be promoted because it is an area where employment increases.
Q: What was GEAR's role in employment? A: GEAR (Growth, Employment and Redistribution) was a strategy implemented to create a positive climate conducive to employment creation by the private sector.
Exchange Rate Stability
Q: Why is exchange rate stability important? A: The economy must be managed effectively using fiscal and monetary policies to keep the exchange rate relatively stable. Depreciation and appreciation of the currency create uncertainties for producers and traders and should be limited.
Q: What change did SARB make to the exchange rate system? A: The SARB changed the exchange rate from a managed floating to a free floating exchange rate.
Price Stability
Q: Why is price stability important? A: Stable prices cause better results in terms of job creation and economic growth.
Q: What is the SARB inflation target? A: The SARB inflation target is 3% - 6%, and they are successful in keeping inflation within this target.
Q: What instruments are used for price stabilization? A: Interest rates based on the Repo Rate are the main instruments used in the stabilization policy. A stable budget deficit also has a stabilizing effect on the inflation rate.
Economic Justice
Q: Why is economic justice necessary? A: Redistribution of income and wealth is essential in South Africa.
Q: How does South Africa achieve economic justice through taxation? A: South Africa uses a progressive income tax system - taxation on profits, taxation on wealth, capital gains tax, and taxation on spending are used to finance free services.
Q: What free social services does the government provide? A: Basic education, primary health care, basic economic services, cash grants to the poor (e.g., child grant), and cash grants to vulnerable people (e.g., disability grants).
Q: What is progressive taxation? A: Progressive taxation means that higher income earners pay higher taxation rates.
3.4 Budgets
Main Budget
Q: What is a budget? A: A budget is a document with expected income and projected expenditures. The main budget is the most important item on the economic calendar.
Q: When is the main budget read and by whom? A: The main budget is read in Parliament during February by the Minister of Finance.
Q: What is the process for the budget to become law? A: It is authorized in Parliament, signed by the President, and becomes law.
Q: What is the financial year of government? A: The financial year runs from 1 April to 31 March the following year.
Q: What is the main source of income for the state? A: The main source of income for the state is income tax.
Q: What does the budget reflect? A: The budget reflects the functional division of government spending and priorities.
Importance and Considerations
Q: Why is long-term planning important for the budget? A: Departments need to know beforehand about their future involvement so they can plan accordingly.
Q: Why is government's dominant role important in budgeting? A: Certain sectors need to know in advance so they can adapt their capacity.
Q: What are the three considerations when setting up the budget? A: (1) Financial considerations - whether taxes should be increased or decreased, (2) Economic considerations - knowing the needs in the economy so taxes and spending meet requirements, and (3) Political considerations - political parties use the budget to implement their policy and reach macro-economic goals.
Types of Budgets
Q: What is the Medium Term Budget Policy Statement (MTBPS)? A: The MTBPS is delivered by the Minister of Finance in the last week of October. It informs Parliament of any changes that occurred since February in the economy.
Q: What is the Medium Term Expenditure Framework (MTEF)? A: The MTEF is more detailed. It consists of 3-year rolling expenditure and revenue projections for national and provincial governments, presented against the backdrop of economic and fiscal goals and prospects for the economy.
Q: What are conditional grants? A: Conditional grants are used to: (1) Promote spending on national priorities, (2) Compensate provinces for providing services beyond provincial boundaries, and (3) Ensure compliance with national norms and standards.
Budget Rules
Q: What is the deficit rule? A: The deficit rule states that shortages on the budget should not be more than 3% of GDP.
Q: What is the borrowing rule? A: The borrowing rule states that borrowing must only be used for capital expenditure. Current expenditure should be financed by current income.
Q: What is the debt rule? A: The debt rule states that public debt and guarantees should not exceed 60% of nominal GDP.
3.5 Fiscal Policy
Description and Features
Q: What is fiscal policy? A: Fiscal policy is any attempt by the state to influence the economy with changes in government expenditure and taxes to achieve economic and social goals.
Q: Why is fiscal policy described as "goal bound"? A: Central government determines economic and social goals. It takes place through the budgetary process, where the budget is used to realize these goals. Provincial and local governments execute the approved budget.
Q: Why is fiscal policy described as "demand biased"? A: Fiscal policy is the main demand-side policy that is used. However, elements of fiscal policy are also used to realize supply-side objectives (e.g., government improving infrastructure, incentives, subsidized human resource development).
Q: Why is fiscal policy described as "cyclical"? A: Business cycles have a direct effect on fiscal policy. During an upswing, profits increase, aggregate demand and expenditure increase, income tax and profits increase, taxation on goods and services increases, government income increases, and government has more money to spend.
Main Variables
Q: What are the instruments of fiscal policy? A: The instruments of fiscal policy are taxation and government spending.
Q: What is a balanced budget? A: When income and expenditure are equal, there is a balanced budget.
Q: What is a budget surplus? A: When income is more than expenditure, there is a budget surplus.
Q: What is a budget deficit? A: When expenditure is more than income, there is a deficit.
Government Spending
Q: What are the two formats for classifying government spending? A: (1) Functional: Social services, defence, economic services, interest. (2) Economic: Current payments, transfers and subsidies, payment for capital assets.
Q: Why does government spend money? A: To provide public and merit goods and services free of charge or at subsidized prices, pay interest on government debt, redistribute income, and influence aggregate demand and supply.
Taxation
Q: Why do governments impose tax? A: To raise income to cover expenditure, discourage use of demerit goods, convert external cost into private cost, prevent pollution, discourage imports, redistribute income, and influence the level of aggregate demand and aggregate supply.
State Debt
Q: How must the main budget balance? A: If there is a deficit, loans are made to balance the budget. If there is a surplus, the money is used to pay off state debt. Loans add to loan debt, also known as public debt.
Effects of Fiscal Policy
Q: How does fiscal policy respond to business cycles? A: During an upswing, fiscal policy contracts. During a downswing, fiscal policy expands.
Income Redistribution
Q: How does progressive taxation affect income distribution? A: Progressive taxation ensures a more even distribution of income. Higher income groups pay more taxation than lower income groups.
Q: How does regressive taxation affect income distribution? A: Regressive taxation causes an uneven distribution of income. Lower income groups pay more taxes than higher income groups.
Q: How does proportional taxation affect income distribution? A: Proportional taxation leaves income distribution unchanged. Everybody pays the same tax rate.
Q: How does spending on social goods affect income distribution? A: Spending on social goods, security goods, and welfare payments supplements income of the poor more than the rich, helping redistribute income.
Consumption
Q: How does taxation influence consumption? A: Direct and indirect taxation influence people's spending patterns. Direct taxation decreases disposable income. The real effect on consumption depends on the marginal propensity to consume and the level of savings.
Q: What happens when there is very little savings and direct taxes increase? A: If there is very little savings, direct taxes will decrease consumption.
Q: How does the income multiplier work with government spending? A: The income multiplier kicks in when government spending increases due to higher levels of employment, higher income, and consumption spending.
Price Level
Q: How does direct taxation affect prices? A: Direct taxation reduces inflationary pressures because aggregate demand declines. However, it can result in cost-push inflation because workers demand higher wages.
Q: How does indirect taxation affect prices? A: An increase in indirect taxation causes an increase in the general price level.
Q: What determines whether government spending is inflationary or deflationary? A: Inflationary and deflationary spending depends on the availability of production factors.
Incentives/Disincentives
Q: How does direct taxation affect incentives? A: Direct taxation (income and company tax) reduces incentives to work, save, invest, and take risks. High and progressive income tax rates discourage people from entering the labour market, accepting promotions, and working long hours.
Laffer Curve
Q: What does the Laffer Curve show? A: The Laffer Curve shows the relationship between tax rates and tax income collected by the government.
Q: What happens at the peak of the Laffer Curve? A: At the peak (tax rate t, revenue R), the state earns maximum revenue from taxation.
Q: What happens if the tax rate increases beyond the peak? A: If the tax rate increases from t to t1, production decreases and tax revenue decreases from R to R1.
Q: Why does revenue decrease when tax rates are too high? A: Less people want to work because of high taxation. Some people will evade and others will avoid payment of taxation. If taxation is 100%, nobody will want to work because all income goes to the state.
Q: What happens if taxation decreases from the peak? A: If taxation decreases to t2, it leads to less tax evasion and avoidance, and encourages people to work harder, save more, and invest more.
Q: Why do economists use the Laffer Curve? A: Economists use this to justify a reduction in the level of taxation.
Discretion
Q: What does the Minister of Finance use discretion for? A: The Minister of Finance uses discretion on fiscal decisions, such as by how much to reduce income tax.
Q: What are the rules for fiscal discretion? A: Deficit rule: not to exceed 3% of GDP. Borrowing rule: only for capital expenditure. Debt rule: not to exceed 60% of nominal GDP.
3.6 Public Sector Failure
Description and Key Features
Q: What is public sector failure? A: Public sector failure is when the public sector fails to manage an economy and the resources under its control optimally.
Q: What is ineffectiveness in public sector failure? A: The public sector is failing when there is: missing targets (regarding inflation, growth, employment) and incompetence in using monetary and fiscal policy and harmonizing them.
Q: What is inefficiency in public sector failure? A: Inefficiency involves wasting resources, such as taxpayers' money. This may occur in relation to protection and social, economic, and administrative services for which money is voted in the budget.
Reasons for Public Sector Failure
Q: How do management failures contribute to public sector failure? A: Politicians tend to promote policies and continue spending money on projects if they can get votes in return. These policies might involve inefficient allocation of resources. Many public-sector entities lack capacity due to lack of skills, meaning funds are often not spent and must be returned to the treasury.
Q: How does apathy contribute to public sector failure? A: Successful public production relies on long-term accountability. If not addressed properly, apathy could lead to inefficiency, corruption, violence, and poor service delivery.
Q: How does lack of motivation contribute to public sector failure? A: Frontline workers rarely receive incentives for successful service delivery. There are little or no stipulations for quality and quantity, effective and productive service delivery, leading to limited service delivery, low quality, and high costs.
Q: How does bureaucracy contribute to public sector failure? A: Individuals and enterprises influence government to act in their interest (e.g., profitable contracts, favourable regulations, ignorance, personal and hidden agendas). These questionable motives promote the welfare of certain groups at the expense of others.
Q: How do politicians contribute to public sector failure? A: Politicians who aim to be re-elected pursue vote-maximizing strategies to secure or retain political offices. Such politicians have a short-term horizon limited to the date of the next election.
Q: How do structural weaknesses contribute to public sector failure? A: Serious structural weaknesses in the economy, including issues with privatization, can result in social goals not being attained.
Q: How do special interest groups contribute to public sector failure? A: Interest groups (such as farmers or organized labour) attempt to influence government to their own advantage.
Effects of Public Sector Failure
Q: How does public sector failure affect allocation of resources? A: When government fails, optimal allocation of resources is not achieved, and consequently resources are wasted.
Q: How does public sector failure affect economic stability? A: Government failure can lead to macroeconomic instability. Government is unable to use fiscal policy effectively.
Q: How does public sector failure affect distribution of income? A: If government fails to use the tax system effectively, there will be an unfair distribution of income in the economy.
Q: How does public sector failure affect social stability? A: When the public sector fails to deliver required social services to the poor, the economy can be destabilized.
TOPIC 4: FOREIGN EXCHANGE MARKETS
4.1 Main Reasons for International Trade
Q: What is international trade? A: International trade is the exchange of goods or services across international borders.
Demand Reasons - Population and Income
Q: Why do countries trade with other countries (general demand reason)? A: Countries trade because they have a demand for goods which they cannot produce themselves, or they don't produce enough themselves and must import the balance.
Q: How does the size of population affect international trade? A: If there is an increase in population growth, it causes an increase in demand, and more needs must be satisfied. If the country doesn't have enough goods and services, they must be imported from other countries.
Q: How do income levels affect international trade? A: Changes in income cause a change in demand for goods and services. An increase in per capita income gives people more disposable income that can be spent on goods and services. This greater demand must be satisfied - if there aren't enough goods and services in the country, they must be imported.
Q: How does change in wealth affect international trade? A: An increase in wealth leads to greater demand for goods. People have access to loans and can purchase bigger and more luxurious goods. If countries cannot supply these luxury and technologically advanced products, they must be imported.
Q: Do developed or developing countries gain more from international trade based on wealth factors? A: These factors (wealth, income, population) are favourable for developed countries but not for developing countries. Developed countries gain more from international trade than developing countries.
Demand Reasons - Preferences and Consumption
Q: How do preferences and tastes affect international trade? A: Preferences and tastes can play a part in determining prices. For example, customers in Australia prefer a specific product which they don't produce and need to import, and it will have a higher value than in other countries.
Q: How do differences in consumption patterns affect international trade? A: Consumption patterns are determined by the level of economic development in the country. A poorly developed country will have high demand for basic goods and services but lower demand for luxury goods, affecting what they import.
Supply Reasons
Q: How do natural resources affect international trade? A: Natural resources are not evenly distributed across countries and can only be exploited where such resources exist. Each country has its own unique mix of natural resources that make it possible to produce certain goods and services more efficiently and at relatively lower prices. Example: South Africa's gold and diamond resources give an advantage in producing gold and diamonds.
Q: How do climatic conditions affect international trade? A: Differences in climatic conditions between countries make it possible for some countries to produce certain goods at lower prices than other countries. Many crops can only be cultivated in certain climatic conditions, areas, and soils. Example: Brazil is the biggest producer of coffee in the world.
Q: How do labour resources affect international trade? A: The quality, quantity, and cost of labour differ between countries. Some countries have highly skilled labour with high productivity rates, enabling them to produce goods and services at lower prices. Certain individuals have greater ability and aptitude for certain tasks. Example: The Swiss have developed skill in watch making.
Q: How do technological resources affect international trade? A: Some countries have access to technological resources that enable them to produce certain goods and services at low unit costs. Improved production processes, availability of equipment and machinery, and other technological factors all influence supply and contribute to differences between countries. Example: Japan.
Q: How does specialization affect international trade? A: Some countries specialize in production of certain goods and services. By specializing, a country can take advantage of economies of scale and produce goods at comparatively cheaper unit costs. Example: Japan specialized in electronic goods and sold them at much lower prices than they could be produced in other countries. This often results in mass production through division of labour, automation, and mechanization.
Q: Why do cost differences occur between countries in production? A: Cost differences occur because goods and services can be produced at lower costs in one country than another, due to the theory of comparative advantage.
Q: How does capital affect international trade? A: Capital cannot be obtained as easily in some countries as in others. Developed countries usually enjoy an advantage over undeveloped countries. Due to lack of capital, some countries cannot produce all required goods themselves or may not have favourable conditions of other countries. In many countries there is lack of physical infrastructure, which inhibits local production.
Effects of International Trade
Q: How does international trade affect specialization? A: Specialization increases the standard of living of people. Specialization and trade cause countries to have more goods which they can sell at the same costs. Certain countries would not have had certain goods without international trade (e.g., Mozambique has no oil, Greenland has no citrus fruit). Only the rich would have been able to access certain goods without trade.
Q: How does international trade enable mass production? A: If domestic demand is added to foreign demand, it makes large-scale production (mass production) possible. Manufacturing of goods requires large-scale production to be affordable and profitable (e.g., computers, cell phones, motorcars). Small countries can only compete with larger countries if they can export successfully. Example: South African businesses export to African countries.
Q: How does international trade improve efficiency? A: Unlimited international trade increases competition. Competition increases efficiency because it eliminates and reduces unnecessary costs and waste. Increased efficiency leads to lower costs and lower prices. Lower prices mean the same income can buy more goods and services, causing an increase in standard of living.
Q: How does international trade relate to globalization? A: International trade is at the heart of globalization. Other elements include information technology, transport, communication, multinational enterprises, capital liberalization, and standardization. As countries become involved in international trade, it spills over to other elements of globalization. As these elements expand and improve, they stimulate international trade. Domestic economic growth follows, leading to increased standard of living.
4.2 Balance of Payments
Description and Value
Q: What is the Balance of Payments? A: The Balance of Payments is a comprehensive and systematic record of all transactions between one country (e.g., South Africa) and all other countries of the world for a specific period, for example one year.
Current Account Components
Q: What is the Current Account in the Balance of Payments? A: The Current Account records international daily transactions in terms of production, income, and expenditure.
Q: What are the five components of the Current Account? A: (1) Goods exported (+) and imported (-), (2) Net gold exports (+/-), (3) Services receipts (+) and payments (-), (4) Income receipts (+) and payments (-), and (5) Current transfer payments (+/-).
Q: What is the Trading Balance in the Current Account? A: Trading Balance = Merchandise exports + Net gold exports - Merchandise imported. This shows the balance of trade in physical goods.
Q: What are examples of services in the Balance of Payments? A: Transport (passenger fares, other), travel, other services (manufacturing services, repairs and maintenance, financial and insurance services, intellectual property usage, ITC, personal/cultural/recreational services, other services).
Capital Transfer Account
Q: What is the Capital Transfer Account? A: The Capital Transfer Account records international transactions in terms of ownership of fixed assets.
Q: What are examples of transactions in the Capital Transfer Account? A: (1) Allowance for non-government organizations that develop property (e.g., housing projects), (2) Transfer of houses, and (3) Debt forgiveness (writing off portions of loans to financially troubled firms).
Financial Account
Q: What is the Financial Account? A: The Financial Account records international investment transactions by South Africans in other countries and by foreigners in South Africa.
Q: What are direct investments in the Financial Account? A: Direct investments are investments in fixed property or the acquisition of a significant share (10% or more) in a business.
Q: What are portfolio investments in the Financial Account? A: Portfolio investments are the purchase of financial assets (e.g., shares) on a share market of another country. Another name is "hot money" because it can be quickly converted into cash.
Q: What are financial derivatives? A: Financial derivatives are investments made in a specific asset with a fixed future value that is paid out on a specific date.
Q: What are "other investments" in the Financial Account? A: Other investments are transactions that don't fall under direct investments, portfolio investments, financial derivatives, or reserve assets. Example: Short-term loans.
Q: What are reserve assets in the Financial Account? A: Reserve assets are financial capital held by monetary authorities (such as a central bank or the IMF) to finance trading disequilibrium.
Unrecorded Transactions and Balancing
Q: What are unrecorded transactions in the Balance of Payments? A: Unrecorded transactions provide for any omissions in the recording of international transactions.
Q: What is the Balancing Account formula? A: Balance on current account + Capital transfer account + Balance on financial account (NOT RESERVE ASSETS) + Unrecorded transactions = Balance of Payments.
4.3 Corrections of Balance of Payments
Interest Rates
Q: How can interest rates correct Balance of Payments disequilibrium? A: Domestic demand can be changed by changing interest rates. If interest rates increase, spending (including on imports) decreases. Simultaneously, foreign savers try to take advantage by increasing investment in the country with higher interest rates. The opposite happens when interest rates decrease.
Q: Is interest rate adjustment effective for Balance of Payments correction? A: This is the most widely used instrument and it works well over the short term.
Import Controls
Q: What are import controls? A: Import controls include import tariffs, other duties, and quotas.
Q: What is the trend regarding import controls? A: The WTO is trying to lower tariffs and other trade barriers for trade liberalization. South Africa complied with WTO policies and reduced its import controls.
Borrowing and Lending
Q: How does borrowing and lending correct Balance of Payments? A: Countries with surpluses often lend money to countries with deficits. Countries with deficits often borrow, which is why some developing countries have lots of foreign debt. In fundamental disequilibrium, member countries may borrow from the IMF.
Q: Is borrowing a long-term solution for Balance of Payments disequilibrium? A: No, borrowing is not a long-term solution for fundamental Balance of Payments disequilibrium.
Change in Demand
Q: How can changes in demand correct Balance of Payments? A: Changes in demand are either domestic or foreign. An increase in domestic demand causes imports to increase (negative effect on Balance of Payments). A decrease has the opposite effect.
Export Promotion and Import Substitution
Q: What is export promotion? A: Export promotion (such as government incentives) is applied to encourage production of goods that can be exported. Example: European countries pay subsidies to farmers.
Q: What is import substitution? A: Import substitution is when government pays incentives to produce goods domestically rather than importing them.
Q: Which does the South African government favour? A: The South African government favours export promotion.
Change in Exchange Rates
Q: How do free-floating exchange rates correct Balance of Payments? A: They work automatically. If imports increase, demand for foreign exchange increases. The currency depreciates due to market forces. Depreciation makes imports more expensive in the depreciating country and exports cheaper in the foreign country. Imports decrease and exports increase, and the currency appreciates.
Q: How do managed floating exchange rates correct Balance of Payments? A: Central banks use their reserves to effect depreciations and appreciations. Over the long term, currencies must find their equilibrium levels.
Q: How do fixed exchange rates correct Balance of Payments? A: Under fixed exchange rates, currencies are devalued and revalued by government action.
Summary of Correction Methods
Q: What are the main methods to correct Balance of Payments disequilibrium? A: Borrowing from IMF, export promotion and import substitution policies, increase aggregate supply to reduce prices and promote exports, higher interest rates to decrease spending on imports, increase import tariffs and controls, exchange control to ration foreign exchange, currency depreciation/devaluation, increase taxes to reduce disposable income and imports, and reduction of reserves by SARB.
4.4 Foreign Exchange Markets
Basic Concepts
Q: What is an exchange rate? A: The exchange rate is the price of one country's currency (e.g., RSA Rand) expressed in terms of another country's currency (e.g., USA Dollar). Example: R1 = $0.1428 or $1 = R7.000.
Q: What is appreciation of a currency? A: Appreciation is an increase in the price of a currency in terms of another currency as determined by supply and demand.
Q: What is depreciation of a currency? A: Depreciation is a fall in the price of a currency in terms of another country's currency as determined by demand and supply.
Appreciation and Depreciation Examples
Q: If the exchange rate changes from $1 = R7 to $1 = R8, what happens? A: The Dollar appreciates (becomes more expensive in terms of Rand). The Rand depreciates (becomes cheaper in terms of Dollar). Imports from USA become more expensive in SA (imports tend to decrease). SA exports to USA become cheaper (exports tend to increase). This has a positive impact on the balance of current account.
Q: If the exchange rate changes from $1 = R7 to $1 = R6, what happens? A: The Dollar depreciates (becomes cheaper in terms of Rand). The Rand appreciates (becomes more expensive in terms of Dollar). Imports from USA become cheaper in SA (imports tend to increase). SA exports to USA become more expensive (exports tend to decrease). This has a negative impact on the balance of current account.
Devaluation and Revaluation
Q: What is devaluation? A: Devaluation is a deliberate action taken by the central bank to lower a fixed exchange rate (lower the value of their currency). This happens when foreign reserves become low.
Q: What is revaluation? A: Revaluation is a deliberate action taken by the central bank to increase a fixed exchange rate (increase the value of their currency). This happens when foreign reserves become too high.
Q: What is foreign exchange control? A: Foreign exchange control refers to various forms of control imposed by a government on the purchase or sale of foreign currencies by private residents.
Supply and Demand of Foreign Exchange
Q: What are the factors affecting demand for foreign exchange? A: (1) Import of goods from foreign countries, (2) Services rendered by foreign countries (shipping, insurance, banking), (3) Expenditure of South African tourists traveling abroad, (4) South Africans pay interest, dividends, and profits to foreign lenders/investors, (5) Repayment of loans to foreign countries, (6) Investments by South Africans in foreign countries, and (7) Speculation in foreign currency (buying foreign currency).
Q: What are the factors affecting supply of foreign exchange? A: (1) Exporting South African goods to foreign countries, (2) South Africa renders services (shipping, insurance, banking) to foreign countries, (3) Spending by foreigners in South Africa, (4) South Africans receive interest, dividends, and profits from foreign lenders/investors, (5) Repayment of loans by foreigners to South Africans, (6) Investments by foreigners in South Africa, and (7) Speculation by foreigners (buying South African Rand).
Exchange Rate Equilibrium
Q: How is the value of a currency determined under floating exchange rates? A: The value is determined purely by the forces of the market - demand for the Rand and supply of the Rand. It is subject to continuous fluctuations.
Q: What is shown on the vertical and horizontal axes of the exchange rate graph? A: The vertical axis shows the Rand per Dollar exchange rate. The horizontal axis shows the quantity of Dollars traded at the equilibrium rate.
Q: What does the demand curve (DD) represent in the exchange rate graph? A: DD is the demand curve for Dollars. It represents South Africans who have Rand and want to buy Dollars (e.g., to pay for imports or make investments in the USA).
Q: What does the supply curve (SS) represent in the exchange rate graph? A: SS is the supply of Dollars. It represents Americans who have Dollars and want to buy Rand (e.g., to pay for exports from South Africa).
Q: What happens at the equilibrium exchange rate? A: At equilibrium, the demand curve (DD) intersects the supply curve (SS), establishing the equilibrium exchange rate (e.g., $1 = R7.00).
Changes to Equilibrium - Excess Demand/Supply
Q: What happens when there is excess demand for Dollars (e.g., at $1 = R5)? A: There is pressure on the price to increase and move toward equilibrium ($1 = R7). When the price rises, quantity supplied rises along the supply curve (more suppliers enter the market) and demand falls along the demand curve.
Q: What happens when there is excess supply of Dollars (e.g., at $1 = R9)? A: Suppliers cannot sell their Dollars and are prepared to accept less Rand for their Dollars. There is a fall in supply along the supply curve. The fall in price increases demand along the demand curve. This continues until equilibrium is reached ($1 = R7).
Demand Changes - Increased Imports
Q: What happens to the exchange rate when imports increase? A: When imports increase (e.g., buying more machines from overseas, South Africans making more investments overseas), more money flows out of the country. Demand for Dollars/foreign exchange increases. The demand curve shifts right (DD to D1D1). A new equilibrium is formed with a higher exchange rate (e.g., $1 = R8). The amount of Dollars purchased increases. The Rand weakens/depreciates against the Dollar. The Dollar strengthens/appreciates against the Rand.
Demand Changes - Decreased Imports
Q: What happens to the exchange rate when imports decrease? A: When imports decrease, the demand curve shifts left (DD to D1D1). A new equilibrium is formed with a lower exchange rate (e.g., $1 = R6). T
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