Economics

Stage 2
Contents
Part 1:Introduction to Economics
Chapter 1 : Microeconomics 2
Chapter 2: Macroeconomics 34
Chapter 3, Theory, Data and Forecasting 46

Part 2, National Income and Demography

Chapter 1:Concepts of National Income 58

Part 3: Inflation 82

Part 4: Unemployment 99 Part 5, Trade Balance and Exchange Rate

Chapter 1 : Trade Balance 113

Chapter 2, Exchange Rate 127

Part 6: Money

Chapter 1 : Evolution of Money 140

Part 7: Demand and Supply of Money 145 Part 8: Monetary Policy

Chapter 1 : Objectives of Monetary Policy 158 Part 9, Fiscal Policy

Chapter 1 : Objectives of Fiscal policy 165

Part 10: Transmission mechanism of Monetary Policy and the Impact of

Banking Sector Credit

Chapter 1 : Monetary Policy Transmission Channels ' 74

Part 11 : Central Banks and Monetary Policy Regimes 181

Part 12: Impact of Fiscal and Monetary Policies on Equilibrium 192
Part 13: The World Economy:
International Monetary Institutions

202
 By the end
___ Introduction to Economics of
chapter
Chapter 1 Microeconomics you should
be
able to: « Recall the importance of studying economics _ Differentiate between
microeconomics and macroeconomics j- Identify and explain the basic
concepts of microeconomics, i.e. supply^ demand, elasticity and inelasticity,
consumer preferences, supply demand curve and equilibrium ■ Discuss
the production function 0 Discuss the terms opportunity cost, sunk cost,
marginal cost, average cost, production cost

Learning Outcome
Economics is the study of the way in which societies use and develop the scarce resources at their
disposal. Scarcity is the key to the entire study of economics, the concept which underlies all economic
thought and activity, due to mankind’s constant search for ways of overcoming scarcity. What
economists mean by scarcity, however, is quite different to the normal interpretation of the word.

Introduction
An accepted definition of economics is perhaps a useful way to begin. Lord Robbins provided the
The meaning following widely quoted definition of what he called the “basic economic problem" :
and nature of
economics y“Economics is the science which studies human behavior as a relationship between ends and scarce means
which have alternative uses.”

Economics is as old as civilization itself, derived from two Greek words oikos- a house - and nemo-1 manage.
The first practical economists were probably stewards or estate managers concerned with managing the business
affairs of a private individual or nobleman. Gradually over time, economics expanded into managing the
9
business and finances of the state as a whole. One of the earliest treatises on the subject ^ Economicd (300 BC) ^
was concerned with raising revenue from taxation.

In Britain, the foundations of modern economics were laid by a Scottish economist Adam Smith, when he
published “TheWealthofNations”in 1776. Other early economists were David Ricardo who published “Principles
ofPoliticalEconomyandTaxation” in 1817 and John Stuart Mill with “PrinciplesofPoliticalEconomy,, n 1847. The
use of the title ‘PoliticalEconomy'shows the emphasis of the subject at that time and it is a title still used in some of
the older universities.

Economics I Reference Book 15

In the definition stated above, the “economic problem” has been identified — that of ends, means and alternative
resources. We all have our own “basic economic problem” — that of trying to live within our income. In
everyday speech the word “means” is used instead of income, so if we partially rewrite the definition and
substitute “inadequate income” for “scarce means” and, instead of using the word “ e n d s , , , think instead of all
the consumer goods which are always temptingly on offer but which we are unable to afford because our
incomes are limited, then we can identify more closely with the formal definition.

We can say then, that economics is about living within our income. So far we have assumed that resources were
scarce in relation to the needs and wants of individuals or households, but this problem afflicts the whole of
society at every level.

Scarcity at an individual level is only ourselves experiencing the dilemma that all people, firms, organizations and
governments experience. A chancellor or a company director trying to balance the national or company accounts
is acting in the same way as a household trying to satisfy all its wants from its limited income. They are both
allocating limited resources as best they can, deciding which “ends” have to be met first as priorities and
relegating those which must, as a consequence, remain unsatisfied. Disputes about the relative levels of wages
and profits are essentially disputes about the distribution of a limited national income.

Our incomes are limited in relation to all those products which we wish to own and enjoy. One must choose
between them, deciding which wants to satisfy and which to reluctantly ignore. Those choices, however, are only
possible because our incomes have alternative uses and can be spent as we wish. The general term “ends” in the
definition should be broken down into two separate and distinct component parts — needs and wants.

Needs
These are the primary essentials necessary for survival such as food, shelter, and clothing and heating. With these
basic requirements met, life can be sustained and, for most people in our society, these needs are adequately
satisfied. For the majority, only one house can be lived in at a time and only three meals eaten per day.
Improvements in quality are constantly sought, but the quantity demanded is limited once adequacy has been
achieved. In economics it is said that the demand for human needs is limited or finite, i.e. they have a definite
quantitative limit.

Wants
Human wants are believed to be limitless or infinite. These are the commodities which enhance life and bestow it
with a sense of fullness. Certainly our capacity to yearn for and ultimately acquire goods and services such as
cars, foreign holidays, computers arid fitted kitchens seems endless and inexhaustible. Wants are not necessary to
ensure survival-
 they do not sustain life. They are the motor force which drives us to a more complete and satisfactory enjoyment
of it.

The key to our understanding of economic man is that wants must be limitless. If they were not, then with a
given level of income, we could satiate all our consumer desires. We would no longer have to practice choice
because our incomes could afford us to demand all that we wanted. Income is only limited because it is not
and never is, enough, to allow us to demand all that we want.

This problem of scarcity, choice and limited income seems to remain constant,
irrespective of which society we study, of its relative level of economic
development or its place in time. Our desire for wants is relative _ we never have
enough, our income is therefore limited and everything we want is scarce.

Microeconomics and Microeconomics is concerned with the individual parts of the economy, for example how prices of
macroeconomics individual goods are determined.

Macroeconomics is concerned with the economy as a whole, for example what determines the
general level of prices.

A man living alone living on a desert island has little use for money, but he still has to deal with the
Opportunity cost problems of scarcity and choice. His scarce means are the physical resources he finds on and around
his island, including his own skills and knowledge. Even time is a scarce resource since there are only twenty-
four hours in a day - an hour spent building a shelter is an hour not spent gathering food.

Each opportunity taken implies some alternative foregone. Every choice involves a cost. The real cost is not
the price we pay. In the simple one- man economy, money serves no purpose. The real cost of taking one
option is the alternatives foregone, or, to be more accurate, the most attractive alternative foregone.
Economists call this ^opportunity cost. So it could be, for example, that if the government decides that it wants
to hire 1000 extra police it will have to reduce spending on education and 900 fewer teachers can be afforded.
So the opportunity cost of 1000 police would be 900 teachers.

Companies choose between one expansion programme and another because investment funds are limited, as
are the necessary resources available. For the same reason, governments cannot cut taxes, employ more nurses
and re-equip the army all at the same time - ministers must choose. All economic problems are really just the
same problem set in a different context.

Opportunity cost can be illustrated by means of a table called a pi^duction possibility schedule where we
The production
possibility curve
assume a country with given resources and a given level of technology. Let us also assume that the
country can produce two products
- food and guns. The more resources the country puts into the production of food, the fewer are available for
the production

Economics I Reference Book 2

4
 1
hich tdi
' US to
I of guns. Once all resources are being used, the only way the output of one good can be increased is by reducing
the output of the other. There is a trade off between the production of food and the production of guns which can
be seen in the following table.

/\/\COme Table 1-1: Production Possibility Schedule

We could

10
mtoy

Production Possibility Schedule showing possible combinations of food

£ ms to remain
relative levej of and guns production per month
is
reJative 0
!and ev
^mhin„ Food(Thousands of tons) Guns(Thousands) 30
B 1 28 _ C

economy —2 24 .
det
^mined.
D 3 18
for example
E __ 4 10
A
5
but
Hs
scarce Figure 1-1: Production Possibility Curve
fs island.P
u
resource
Gildig

t choice
one to
o
- h one o
'most w
cost”. £

Food {'000 tons)

The horizontal axis measures the quantity of food while the vertical axis measures the quantity of guns. The
curve on the figure shows all those combinations that can be produced if all the nation’s resources are fully
employed. It is called a production-possibility curve. Points outside the curve are those that cannot be
obtained because there are not enough resources to produce them.

iM—pffwoiiiks
 Economic Systems

custom and habit.

The market economy ■%

lapit' or I _ : XXriceh4cS/xS.
A
rttToA ..
Smith called this the invisib^ hand .

What is produced depends on

they are willmg ' 'Afferent methods. Who is going to

their willingness to exercise it. =====f==' closest to the market economy.

.private property - the resources needed for production belong to private iXST are
Fe
atures of a free to use and dispose of them as they see fit. market system
• Freedom of choice - consumers are'ree== hire'hTresources wealth as they choose. Producers are to buy or
hxr the re

they need to produce the goods and services mey price. sellers interact to produce the market price.

Economics I Reference Book 2

6
 Public goods
Public goods are goods and services which cannot be provided through the market and, if we are to enjoy them, they
must be j'ovided by government. These include such servicers public health, law and order, public service
broadcasting and national defense.

Features of public goods are:

• Non-rivalry — the fact that one individual is enjoying a public good does not mean there is any less for anyone else

• Non-excludability — it is not possible to exclude non-payers from enjoying the benefits of public goods.
Merit goods
Merit goods can be provided through the market, but the likelihood is that people could not afford or would not be
willing to spend on'hem as much money as is judged appropriate. goods include education, personaMfiealth care and
cultural and recreational facilities such as parks, sports grounds and theatres.

Externalities
Market prices reflect costs and benefits accruing to individual buyers and sellers. They do not reflect social costs and
benefits which accrue to society as a whole. A producer whose factory is heated by a coal fired furnace will include the
cost of the coal in the price of the product. This will not include the eost of the pollution caused by burning the coal.

The command
Command, centrally planned or socialist economies are the opp6site pf market economies. In a command economy,
the questions what, how and for whom, are decided by a central planning authority appointed by the government.
Examples of command economies are China and the former Soviet J'nion. Most command economies contain some
element of private enterprise such as private food production and small-scale trading.

Features of command
•Public ownership - the means of production are owned and controlled by the community as a whol'and decisions
about their use are made through the central planning authority.

• Limited freedom of choice — individuals are free to choose the goods and services they wish, but this freedom is
limited not just by their funds but also by the range of goods and services available. This range is decided by the
planning authority. Prices are used, but they are set by the planning authority and so do not reflect the underlying
forces of supply and aemand.

• Motivation - the underlying motivation is the common good rather than personal self interest.
• Co-operation — command economies tend to stress the attractions of co-operation rather than competition.

'Planning mechanism - at the core of the command economy is the /central planning authority.

The mixed economy

The mixed economy lies between the market and the command economies and contains elements of both to get the
best of both systems. Britain is an example of a mixed economy. Most goods and services are produced by private
enterprise in response to
market forces. In recent years this has been extended by the govemmenfs privatization programme -the sale of state-
owned industries such as telecommunications, gas and electricity companies. Despite this, there remains a substantial
public sector.

Production
Production is the creation of goods and services which people want and for which they are willing to pay. Production
can also apply to unpaid work as carried out in the home, such as cooking, cleaning, gardening and general
maintenance, which are important for the well-being of any family, but are usually not marketable. Productive
workers are not only those who make things but also those who provide services such as shop assistants, teachers,
bankers and doctors. Production produces output which can be classified as goods and services or according to the
type of industry involved, such as:

•Consumer goods — wanted for their own sakes and satisfy wants directly. Nondurable goods, such as food and
heating, are used up immediately, but durable goods provide a flow of utility over a period or time.

• Capital or producer goods — not wanted for their own sakes but for the consumer goods they can produce. The
demand for them is a derived demand depending on the demand for the consumer goods which they make.
 •Services — as a society becomes more mature and specialized, the demand for services increases. Similarly as
living standards rise, so an increasing proportion of income is spent on services such as entertainment, education,
health care and education.

•Prunary or extractive industries - include agriculture, forestry, fishing, mining and the production of oil.

• Secondary industries — include construction, manufacturing and the production and processing of electricity, gas
and water.

•Tertiary industries — transport, distribution and services in general.

The factors of production
The factors of production are the scarce resources that firms use to produce the goods and services we demand. We,
ll look at these factors under four headings:

• Land

• Capital

• Labor

• Enterprise

Land
Land refers to all natural resources and not just the land itself and includes rivers, lakes and seas, mineral deposits,
fisheries, the climate; in fact any free gift of nature. The total supply of land is fixed, if we ignore land reclamation
and the effects of erosion. The amount of land available for one particular purpose is not fixed since it is possible to
switch land from one use to another.

The land used for farming could be used instead for housing, but at any given location,
such as a busy city centre, there is a fixed amount of land available and while it is possible
to switch the land from one use to another, it is not possible to increase the actual amount
of land. In a country such as Britain where the land has been worked for thousands of
Economics I Reference Book 9
years, there can be very little land which has not been modified in some way by human effort. The income earned from the ownership of land is
called rent.

Capital
Capital consists of those man-made assets such as buildings, tools, machines and equipment which are used in the production of other goods and
services. Capital items are not wanted for their own sake but for the part they play in production. Notice that there is no reference here to money.
Capital, as a factor of production, means the physical resources needed to make other products; it does not mean the money required to purchase
them. In this sense, the capital of a firm is its buildings and equipment and not the money subscribed by its shareholders.

Working capital consists of completed goods, partly finished goods and stocks of raw
materials held by producers. Fixed capital consists of the actual buildings and machines
used in the productive process. Production covers services as well as goods, so the
nation' fixed capital would include hospitals, schools, bank buildings, insurance offices,
railways, airports and so on, including the furnishings and equipment they use. A feature
of capital is that it wears out and has to be replaced. Allowance has to be made for
maintenance and declining value. This is called depreciation. The income earned from the
ownership of capital is interest.
Labor
Labor is the human effort that goes into producing goods and services, including mental effort as well as physical effort. A bank manager is working
and supplying labor when interviewing a customer or deciding whether or not to make a loan; so too is a teller when answering a customer’s query.
Because labor is provided by people and cannot be bought and sold in the same way as land and capital, it must be treated separately.

The supply of labor depends on a number of factors:

•Size of the population — this places an upper limit on the supply of labor.
•Composition of the population — the make-up of the population will affect the number of people available for work. Children and senior citizens
are much less likely to seek employment than people between the ages of 18 and 65.

•Migration - emigration and immigration can affect both the size of the ponulation and its composition.

• Employment legislation — can affect the number of people available for work and how long they may work. A rise in the legal school leaving
age would reduce the supply of workers. A rise in the age of retirement would increase it. Laws governing the length of the working day and
holiday entitlement would also affect the supply of labor.

• Pay - apart from voluntary workers, most people work to earn their living. Their willingness to work is therefore influenced by the rate of Dav
offered. If pay rates are generally low, a rise in the rate of pay is likely to encourage more people to work or existing workers to work longer. As
incomes rise and people become better off, there comes a point where they might prefer leisure to extra income. At this point, a rise in pay rates
could lead to less work being offered.

The efficiency of labor

The demand for labor is a derived demand. Employers hire workers for the work they can do and the goods and services they can produce. Output
is determined not just by the number of workers employed but by how effectively they work. If efficiency can be
improved, the same level of output can be produced by fewer workers, or alternatively, the same, number of workers
can produce a higher level of output.

Efficiency depends on a number of factors:

•Education and training- modern business requires a well-educated and well-trained labor force. Many employers run
their own training schemes and encourage their staff to improve their qualifications.
• Working conditions — a well-organized workplace can increase the efficiency of workers and a pleasant working
environment can improve workers5 motivation. This applies to social as well as physical environment and is one of the
reasons why some employers encourage social and sporting activities for their staff.

• Health and welfare — nobody gives of their best when they are ill. The National Health Service in Britain was set up
for social reasons, but one of its consequences is a healthier workforce.

• Motivation- people work better if they are properly motivated which may be done by financial incentives such as
bonuses, commission and work-related pay. It can also be helped by providing a pleasant working atmosphere,
recognition of effort and good career prospects. The income earned from labor is called wages.

Enterprise
Land, capital and labor must be combined together if production is to be undertaken.
Somebody has to decide what to produce and how to produce it. This somebody is the entrepreneur, the person who
organizes the other factors of production. The entrepreneur is the risk taker. Nobody can know for sure whether a
business will succeed. Future demand and potential costs can be estimated, but there is always an element of
uncertainty. The entrepreneur must hire or buy the factors of production needed before the goods can be made and
sold. Only when all payments have been made or received can it be known for certain if his or her judgment has been
correct.

Some argue that enterprise is merely a specialized form of labor. Professional managers can be hired to direct a
business. The people who run major banks would come into this category. They manage the businesses on behalf of
the owners, the shareholders. It is the owners of the business who carry the ultimate risk. They have a claim over the
profits and it is their money which is at risk should the business fail.

The reward for enterprise is profits. One difference between enterprise and the other factors of production is that the
rewards for land, capital and labor are contractual; rent, interest and wages can all be fixed by agreement or legal
contract.

The reward for enterprise is residual; profits cannot be fixed by contract, they are simply what is left from income or
revenue after all costs have been met.

Production and time

The factors of production may be combined together in a variety of different ways to

produce the same end product. One method may require more capital and less
labor, another more labor and less capital. For example, a Dank can decide to operate
with more equipment, computers and automated tellers, or it can decide to do the same
work with less equipment, but more staff.
The options open to a producer depend on the time available:

•The very short term — the period in which supply is fixed and nothing can be done to vary it.

• The short term — the period during which some factors can be varied but there
Economics I Reference Book
11
 is at least one which is fixed and cannot be changed. For example, a bank branch which suddenly increases its volume
of business can take on more staff to deal with the extra work, but in the short run it cannot increase the size of its
premises. The short term in this instance would be the time it would take to extend or enlarge the branch.

• The long term — in the long temi, all factors can be changed. All that is fixed is the technology and methods of
operating. For example, a bank which finds its business has grown can move to larger premises or redevelop the
existing building.

•The very long term — not only can all factors be varied, but so also can the technology used. The banks have already
introduced many examples of new technology in recent years, including automated teller machines, debit cards and
telephone/internet banking. This process is likely to continue and could lead to major changes in the way those banks
operate.

In the long run everything can change, and in the very long run, even technology. In the short term, however, one
factor (usually land or capital) remains fixed, so output can only be increased by using more of the variable factors.
This changes the proportions in which the fixed and variable factors are used.

Production Function The production function links input to the output. It explains the
technological relationship between the inputs firms use and the output produced. Mathematically, the production
function can be expressed as follows:
q=0(£■■■fm)

Where,
q is the quantity of goods or services produced,
are the quantities of mdifferent inputs used, and 0 tells us that q is a function of/i.e./determines q

Costs in the Short Run

The length of short run is influenced by technological considerations such as how quickly equipment can be
manufactured and installed.

Short Run Variations in Input

In the short run we are primarily concerned with the effect of variable input on output and costs with a given auantity
of the fixed input. The underlying assumption for a simplified production function is tnat the capital is fixed, whereas
the labor is variable. Therefore, the scenario here is that the firm starts with a fixed amount of capital equipment and
then contemplates using various amounts of labor to work with it.
Table 1-2 in the case study shows how output can vary if input is changed. The change in output can be
interpreted in three different ways.

Total Product =the total amount produced during some period of time by all the inputs the firm uses. If all but one of the inputs is held
constant, the product will change as input of the variable factor is changed.

Marginal Product = the addition to total product resulting from the use of one more (marginal) unit of the variable factor
Change in Total product Change in Number of units of variable factor.

Average Product = total product per unit of the variable input Total product Number of units of variable factor
As shown in the case study, as more of the variable input is used, average product first rises and then falls. The point where average product
reaches a maximum is called the point of diminishing average returns. For example, in Figure 1-2, average product reaches a maximum when 7
units of labor are employed.

Ahmed & Sons is a specialist manufacturer of office furniture. It produces one standard product, the “Executive desk”. The firm has a well
equipped factory and is able to vary its output by varying the number of workers it employs. Each worker is of equal skill and makes the same
effort as the rest of the team.

The following table shows how the number of desks produced each month varies with the number of workers employed.

14
 Table 1-2: Total, average and marginal products in the short run
Quantity of Total Output (TP) Average Product (AP) Marginal Product (MP)
Labor(L)

2 v- 3 4
43 43 43'
2 160 80 11.7
3 351 117 191
4 600 150 249
r 875 175 275
6 1152 192 277
7' 1372 196 220
8 1536 192 164
9 1656 184 120
10 1750 175 94
11 1815 165 65
12 1860 155 45

From the table and the diagram we can see that production falls into three phases:

1.Increasing returns — up to and including the employment of the third worker, total output is growing at an increasing rate.
Marginal product is increasing and so too is average product.

2. Diminishing returns — with the employment of the fourth worker, total output continues to increase but at a
reducing rate. Marginal product is positive but getting smaller. Average product is also declining.

3. Total output starts to decline - with the addition of the eighth worker, marginal product becomes negative and
total product falls. There would be no point in employing the eighth worker.

The law of diminishing returns assumes that at least one factor of production is fixed and applies to the short run. Underlying the law of
diminishing returns are other assumptions:

• All units of factors employed are of equal efficiency

• Diminishing returns cannot be explained by using the best workers first and poorer workers
later

• Technology remains unchanged Short Run Variations in Cost

We have now seen how output varies with changes in just one of the inputs in the short run. By costing these inputs, we can discover
how the cost of production changes as output varies. For the time being we consider firms that are not in a position to influence the
prices of their inputs, so they take the prices of these inputs as given.

We now define cost concepts that are closely related to the product concepts introduced earlier.

Total Cost (TC) is the entire cost of producing any given rate of output. Total cost is divided into two parts: Total fixed costs (TFC) and
total variable costs (TVC). Fixed costs are those costs that do not vary with output; they will be the same if output is 1 unit or 1 million
units. These costs are also often referred to as overhead costs or unavoidable costs. All of those costs that vary positively with output,
rising as more are produced and falling as less is produced, are called variable costs.

In previous examples, we kept changing the number of labor as labor is variable input. Therefore the cost o|>labor would be a variable
cost. Variable costs are also called direct costs or avoidable costs.
These costs can be cut down or avoided, for example using machinery instead of labor; therefore this can also be referred to as avoidable
cost.
Average Total Cost (ATC) is the total cost of production per the number of units produced. ATC
may be divided into average fixed costs and average variable costs.

Marginal Cost (MC) is defined as the increase in total cost resulting from raising the rate of production
by one unit. The marginal cost of the tenth unit, for example, is the change in total cost when the rate of
production is increased from nine to ten units per period.

Sunk Cost (also called retrospective cost) is defined as a cost that, once incurred, cannot be reversed. For
example, a worn-out piece of equipment bought several years ago is a sunk cost because the cost of buying it

14
 cannot be reversed.
Sunk costs are sometimes contrasted with prospective costs, which are future costs that may be incurred or changed if an action is
taken. Both retrospective and prospective costs may be either fixed (i.e. they are not dependent on the volume of economic activity,
however measured) or variable (dependent on volume).

Short Run Cost Curves

The three different types of cost defined above are mathematically interrelated. Considering the output numbers used in Table 1-1
in case study 1, we assume that the price of labor is PKR 20 per unit and the price of capital is PKR 10 per unit. Figure 1-3 shows
the computed values.

Table 1-4: Variation of costs with fixed capital and variable labor
Pl—.. Output Total Cost (PKR) Average Cost (PKR) Marginal Cost
(PKR)
Fixed Variabl Tota Fixed Variable Total
1ST (TFC) e l (AFC) (AVC) (ATC)
(TVC) (TC)
3 4 5 6 7 8 9 10

ft 100 20 120 2.326 0.465 2.791 0.465

160 100 40 140 0.625 0.250 0.875 0.171
351 100 60 160 0.285 0.171 0.456 0.105

600 100 80 180 0.167 0.133 0.300 0.080

875 100 100 200 0.114 0.114 0.229 0,073

1152 100 120 220 0.087 0.104 0.191 0.072

1372 100 140 240 0.073 0.102 0.175 0.091

1536 100 160 260 0.065 0.104 0.169 0.122

1556 100 180 280 0.060 0.109 0.169 0.167

1750 100 200 300 0.057 0.114 0.171 0.213

1815 100 220 320 0.055 0.121 0.176 0.308

1860 100 240 340 0.054 0.129 0.183 0.444

Wc

1 /« TC. A- i

Since total fixed cost does not vary with output, average fixed cost is negatively related to output, while marginal fixed cost is zero. In contrast, variable cost

18
is positively related to output, since to produce more requires more of the variable input. Average variable cost may, however, be negatively related to
output at some levels of output and positively related at others. Marginal variable cost is always positive, indicating that it always costs something to increase
output; but, as we will soon see, marginal cost may rise or fall as output rises.

If we look closely at the graph, we will see that the marginal cost curve cuts the ATC and AVC curves at their lowest points. This is another example of the
relation between a marginal and an average value. The ATC curve, for example, slopes downwards as long as the marginal cost curve is below it; it makes
no difference whether the marginal cost curve is itself sloping upwards or downwards.

Going back to Figure 1-3 we can see that the average variable cost curve reaches a minimum and then rises. With fixed input prices, when average product
per worker is at a maximum, average variable cost is at a minimunL The common sense is that each new worker adds the same amount to cost but a
different amount to output, and when output per worker is rising, the cost per unit of output must be falling, and vice versa.

The short-run curves for AVC are often U-shaped. This is primarily dur to the following assumptions:

The average productivity is increasing when output is low, but the ave productivity eventually begins to fall fast enough to cause average ti cost to
increase.

The least cost combination of factors of production

The law of diminishing returns does not tell us which combination inputs and which level of output a producer will choose. We assume businesses
are run to maximize profits and are keen to keep their to a minimum.

Economics | Reference I
 Profit is the difference between total revenue and total costs, but the law of diminishing returns deals in physical inputs and gives no
indication of cost; nor does it show at what price output will be sold.

Using the data in the case study, if we assume that the fixed factor is free, then the lowest per unit of output will be where average
product per worker is highest. This would be when three workers are employed. On the other hand, if the workers are unpaid
volunteers, perhaps working for a charity, then the optimum level of output will be the maximum that can be achieved.(lhis is where
marginal output is zero and corresponds with seven workers being employed.)

In practice, firms have to pay for both their fixed factors and their variable factors. The mix they choose of these will depend on
relative costs.

The cost structure of firms in the long run

In the short run, with only one input variable, there is only one way to produce a given output: by adjusting the input of the variable
factor until the optimal rate of output is achieved. Thus, once the firm has decided on a rate of output, there is only one technically
possible way of achieving it.

By contrast, in the long run all inputs can be varied. The firm must decide both on a level of output and on the best input mix to
produce that output. Specifically, in our two input example this means that firms must choose the nature and amount of plant and
equipment, as well as the size of their labor force. So long run in this context means that the capital stock can be changed, while very
long run means that the technology can change too.

Cost curves in the long run

When all inputs can be varied, there is a least cost method of producing each possible level of output. Thus with given input prices,
there is a minimum achievable cost for each level of output; if this cost is expressed as a quantity per unit of output, we obtain the
long-run average cost of producing each level of output. When this least cost method of producing each output is plotted on a graph,
the result is called a long run average cost curve (LRAC). Figure 1-4 shows one such curve.

This cost curve is determined by the industry’s current technology and by the prices of the inputs. It is a boundary in a sense that
points below i are unattainable;points on the curve, however, are attainable in sufficient time elapses for all inputs to be adjusted. To
move from one point on the LRAC curve to another requires an adjustment in all inputs, which may, for example, require building a
larger, more elaborate factory. The — RAC curve is the boundary between cost levels that are attainable, with Smown technology
and given input prices, and those that are unattainable.

r
jst as the short-run curves discussed earlier in this chapter are derived frcfn the production function describing the physical
relationship between uniputs and output, so is the LRAC curve. The difference is that in deriving tie LRAC curve there are no fixed
factors, so all inputs are treated

20 Economics | Refere
 q
as variable. Because all input costs
o are variable in the long run, we do not need to distinguish between AVC, AFC,
and AT/as we did in the short run.
1 In the long run there is only one long-run average cost (LRAC) for any given
set of inputs. (
|m

Output per period Figure 1-6 : The shape of

the long-run average cost curve

The long-run average cost (LRAC) curve is the boundary between attainable and unattainable levels of cost. Since the lowest of
producing qo is co per unit, the point Eo is on the LRAC curve. Suppose a firm producing at Eo desires to increase output ql.In the
short run it will not be able to vary all inputs, and thus unit costs above cl, say c2, must be accepted. In the long run a plant that is
the optimal size for producing output qi can be built and costs of cl can be attained. At output qm the firm attains its lowest possible
per-unit cost of production for the given technology and input prices.

As the firm varies its output in the long run, average cost may vary for two distinct reasons. First, the prices of its inputs may
change. Second, the physical relation between inputs and outputs may change. To separate these two effects, we assume for the
moment that all the input prices remain constant.

This LRAC curve is often described as U-shaped, although empirical studies suggest it is often “saucer-shaped”.

Demand, Supply In this section we will be examining the forces of demand and supply, the relationships and the between them, and
how the price mechanism operates in the market economy.
Price Mechanism
Demand
Demand is the quantity of a good or service which would be purchased at a particular price over a period of time. Demand is
always related to price. The quantity demanded depends on the price asked. As price changes, so usually does the quantity
demanded. Demand is measured over a period of time such as a week, a month or a year.
 What we are concerned with is effective demand, that is, the willingness and the ability to purchase the product. This should not be confused with
desire, want or need. Typically, the higher the price, the lower the quantity of a product people will purchase and the lower the price, the higher the
quantity. If we look at the purchases of a particular product we might make as individuals during a month, we can draw up what is called an
Individual Demand Schedule. By combining the individual demand schedules of all the people in an economy, we obtain the Market Demand
Schedule.

1-5: ®*" jemand Schedule • M QuantityDemanded »i )per month

10,000

8,000

5.000

2.000

1,000

Demand curve

A demand curve shows the relationship between price and

quantity demanded, assuming all other market conditions
remain constant. A demand curve normally slopes downward Figure 1-7, Market demand curve
to the right. As price falls, there is a movement down the
curve to the right. As price rises, there is a movement up the curve to the left. Other things being equal,a change in
price leads to movement along the demand curve. The demand curve slopes downward to the right because as
price falls, people tend to bov more.

This is due to the operation of two factors:

• The substitution effect

• The income effect

Sabstitution effect

As the price of a product falls, it becomes relatively cheaper compared d alternative goods and services. Some
consumers are likely to '«~tch their purchases to the cheaper product and so the quantity lem-anded increases.

20 Economics | Refere
Income effect

A fall in the price of a product increases the purchaser's real income. He or she is able to buy the same
quantity as before and have some money left over which can be used to finance additional purchases,
althoug it may not all be spent on the same product. The lower price may now place the product within the
reach of people who could not previously afford it. This could further increase the quantity demanded.

Exceptions to the general law of demand

There are three exceptions to the general rule that, as the price of a good falls, more of it is demanded and
as the price rises, less is demanded:

• Inferior goods

• Expected price rises

• Goods of conspicuous consumption

Inferior goods

Usually the substitution and income effects work m the same direction.
As price falls, both the substitution and income effects lead to an increase in the quantity demanded. This is
true for normal goods, but there are some products known as inferior goods where this is not the case.
Inferior goods are low quality products bought by people who can afford nothing j better. As incomes rise,
people switch from inferior goods to more expensive, but more attractive, alternatives. The substitution
effect j continues to operate as for a normal good.

A fall in price encourages the substitution of an inferior good for a mor= j expensive alternative. The income
effect is the opposite of that normal1 good The fall in price increases the purchasers’ real income and allows I
them to switch part of their expenditure away from the inferior good to alternatives. This partially offsets the
increase in quantity demanded due to the substitution effect.

An extreme form of inferior good is a giffen good where the incomcj effect is so great that it completely
wipes out the substitution so that a fall in price results in a decrease in quantity demandedLi

Expected Price rises

A rise in price may sometimes lead to a rise in quantity demanded! purchasers believe this is part of a series
of price rises and more are to expected. People hoping to buy a house by means of a fixed inter® mortgage
might interpret one rise in interest rates as an indication f further increases are imminent. This could result
in a surge in den1 for fixed interest loans to beat future rate increases. On the Stock Excl a rise in the price
of a particular share might increase demand for investors anticipated further rises in price.

Economics I Reference I
Goods of cdAs|>icu|)us consumption

The appeal of some goods is the very fact that they are expensive and beyond the reach of most people. Their high
price adds to their exclusiveness and their attraction. Jewelry, expensive cars and up market branded goods may
all come under this heading.

Determinants of demand

The demand for a good or service, that is, the quantity bought over a period of time, is determined by a number of
factors:

• Price factors, the price of the product - as we have seen from the demand schedule and
demand curve, the quantity purchased of a product depends on the price. Economists often say
it is a function of price.

• Non-price factors, The prices of other products ^ buyers have a choice of competing products
on wmch to spend their limited income. Buyers will take account of the prices or alternative products
when deciding which to purchase. A customer considering whether or not to apply to a bank for a
credit card is likely to compare that bank’s fee and interest rates with those charged by other banks.

7
• Buyers incomes ^ the more people earn, the more they are able to spend and the greater
is likely to be the general level of demand.

7
• Buyers tastes and preferences - each person has his or her
own set of tastes and preferences.

• Market size ^ the number of potential customers will influence the demand for a product. A bank
branch located at the centre of a busy city is likely to face a greater demand for its services than one
located in a rural area.

Demand and utility

Goods and services are desired for utility- in this context meaning 'satisfaction “rather than “usefulness”. As we
get more of a good or service, we increase our satisfaction or add to the total utility we derive from it. However,
the extra or marginal utility we gain from each extra unit of the product becomes progressively less, the more units
we have. This is not as complicated as it sounds. Imagine how you would feel after a long
■ ilk on a hot summer’s day if you were offered a cool, refreshing drink. The tirst glass would be very welcoming
indeed. So too might a second s'ss. but not quite as much as the first. In other words, the utility from tbe second
glass is not as great as that from the first. That from a third be even less. This is sometimes referred to as the Law
of Diminishing Mirsinal Utility which states that:

the quantity of a commodity consumed by an individual increases, tine

marginal utility decreases.

23
 Put another way, the more we have of a good, the less satisfaction we gain from consuming one more unit of
it. It would be helpful if we could measure utility or satisfaction. Unfortunately, nobody has yet invented a
device which can actually measure satisfaction. An alternative approach might be to ask how much a person
would be willing to pay for each extra unit of a good. As more of a product is consumed, each extra unit
becomes less attractive and worth less to the consumer. The amount a person is willing to pay for each extra
unit indicates how much he or she values that unit and reflects the utility or satisfaction derived from it.

Measuring satisfaction or utility is fraught with problems. Using money as a measure of satisfaction is not a
perfect alternative since the satisfaction derived from holding money may change. The satisfaction you would
derive from receiving an extra 100 rupees per week would be much greater than that derived by a millionaire
receiving the same increase. In other words, money is also subject to diminishing marginal utility. A way
around this problem is to accept that we cannot measure utility and instead place our choices in order of
preference. Demand, however, is only half the story and we must now turn to supply.

Supply

Supply is the quantity of a good or service which would be offered for | sale at a particular price over a period of
time. As in the case of demand, j supply is always related to price. Supply is measured over a period of time such
as a week, a month, or a year. Each supplier will have in mind the I quantity he or she would be willing to supply
at each price. Typically, as price rises, the supplier will increase the quantity on offer. As with demand, j this
information can be set out in a table known as a supply schedule. By I combining the supply schedules for each
individual supplier, it is possiW™ to produce a market supply schedule.

Table 1-6:
Market Supply Schedule
Price per Quantity Supplied per
Product month
(PKR)
5 1,000

10 2,000

15 5,000

20 8,000

25 10,000 a.

Economics | Reference 1
Economics | Reference 1
 A supply curve slopes upwards from left to right which implies felt producers will increase their output if
they are offered higher prices, kirfier price gives producers an incentive to produce more and also ~7 es them the
means to produce more since the higher price gives them the income they need to bid for extra resources and can
offset
any
nsng costs.

Demand and supply relationships Interrelated

demand • Joint or complementary

demand
Sometimes demand for one product is closely linked to demand for another, such as strawberries and cream, cars
and petrol, or possibly bricks and mortar. In each case, the two joint products are used or consumed together. A
change in the demand for one of these products is likely to lead to a change in demand for the other.

Two financial services which have joint demand are mortgages and insurance. A person taking out mortgage to
buy a house will probably think it wise to insure their own life and the lender will no doubt insist that the house
which serves as security for the loan is also insured. Home contents and personal possessions may also be
included. Given that mortgages are long-term loans, often for 25 years, it can be seen that home loans can generate
considerably more business than just the original loan. Hence there is a competition between banks for this type of
business.

• Derived demand
In some cases a product is demanded because it is used in the production of some other product. This is known as
derived depa: and. The demand for bank staff is derived from the demand for financial services. As the demand
for financial services increases, other things being equal, the demand for bank staff is likely to increase.

• Composite demand
Some products have a number of different uses; for example, steel can be used in the manufacture of ships, cars,
domestic appliances and many other products. Composite demand is the total demand for a product in all its
different uses.

Competitive demand
Two commodities may be close substitutes for each other, so an increase in the sales of one might reduce the
demand for the other. Life assurance policies and personal pension plans are both forms of long-term saving,
although they each have their own distinctive features. If bank customers were persuaded to increase their
Davments into their pension plans, they might decide they haa less need for life assurance or that they had less
money available for life assurance. Any form of holding wealth could be said to compete with these two products
^ bank accounts, shares, unit trusts, personal equity plans. Physical assets such as property, works of art and
jewelry, are all ways of holding wealth.

25
For most people, the most important form of wealth they hold is their own home. In a sense, all products are in
competitive demand since consumers have limited incomes and must therefore make choices.

Inter-related supply •
Joint supply

In soixTcases, tw^' products are produced together; an example would be wdol and mutton. An increase in the
supply of one leads to a similar increase in the supply of the other.

Competitive supply

Where two products are produced together, it may be that output of one can only be increased at the expense of
the other. A farmer who wishes to keep more livestock on his farm may only be able to do so by cutting back
on arable farming.

The price mechanism

At the heart of the market economy is the price mechanism. Price carries out three important functions:

• Rations

• S

ignals

•Allocates
Rations
Price rations out the existing supply of a product among those who wish i to buy it. If at a given price, the
demand for a product exceeds the supply, j the price will rise. As the price rises, some would-be purchasers
decide it is now too expensive and drop out of the market. Eventually a price is j reached where the quantity
purchasers are willing to buy just matches 1 the quantity suppliers wish to sell.

Signals
Prices provide important information for buyers and sellers in a market which allows them to make informed
decisions and to co-ordinate their activities.

Allocates

Price allocates scarce resources towards the production of goods services that people are willing to buy
and away from the production < those that people reject. If the demand for a product increases then,
('things being equal, its price will rise. This higher price is an incentive 1 the producer to expand output of
the product. It also provides the ] for expanding output. The producer can use the extra money gained i
the price rise to bid for the extra resources needed to increase produc If demand for a product decreases,
the opposite happens. Price falls i the producer’s income is reduced. With less money, the producer is j to
command fewer resources.
Determining price

by to miction of demand and supply. We can curves iJe M ' '

Economics | Reference I
 30
25

20

15

10

0 2,000 4,000 6,000 8,000 10,000 12,000 Figure 1-9,

Equilibrium price
IA h a diagf >! can see that there is only one price at which TO ZTLrSh i ° lS £qUal to the 9^f[
Producers wish

ab0V£ the
equilibrium price, producers would wish to sell more "Uk °™ers Wlsh t0 buy. Supply
would exceed demand and producers
:
===tlh rf St,°Ck-Ther£ W°ud be no p°“ m maintaining r jduction at this level and so production
would be cut back. To clear Mstlng
s,uiplus> producers would need to reduce their price This
?r°cess w°uid conn^ ^ | i the equilibrium price was reached

'producers underestimated the strength of demand and produced less ^ ^ n .he equilibrium level of output, at
below the equilibrium price they Xuld soon find themselves sold out. Some customers would be willing
LZricclT A P?e AtWs WOuld Producers to rais* “ ^ °UtpUt * * the Pra'ss
would continue
TSreated', adjU5tments — * to to work, “ % P ce emg charged and paid, the market price,
may not be -'equilibrium price. However, provided the market forces of demand
t0
E , ' ' PiC£ —tend — the

n0t almyS all Wed t0

° feely. Sometimes for yof motives, governments decide
to interfere with the free operation
ket o tro
f. ihc mar and c n i a particular price or group of prices Tbere are two types of price controls: P or
pnees.
 Price ceilings
In the case of price ceilings, government fixes the maximum price which can be charged for a particular product.
Producers can charge less than this if they wish; they cannot charge more. The aim is to keep prices low so that
poorer people can afford to buy the product. If the maximum permitted price is set above or at the equilibrium price,
it will have no effect, as market forces will move the market price to the equilibrium price.

If the maximum permitted price is set below the equilibrium price, the quantity people wish to buy at the official
price is greater than the quantity producers wish to supply. The result is that, at the official controlled price, demand
exceeds supply and there is a shortage.

2. Price floors
In the case of price floors, the government fixes a minimum price whichJ can be paid for a particular good.
Consumers can pay more than this minimum, if they wish, but not less. If the minimum price is set at or below the
equilibrium price, it will have no effect, as once again market forces will move the market price to the equilibrium. If
the minimuil® price is set above equilibrium, suppliers will offer more than customeia wish to buy. The result will
be a surplus.

In a free market, if supply exceeds demand at any given price, price fall until the quantity supplied just equals the
quantity demanded. Tlfl would also happen with a controlled price unless there is some mechaniJ to enforce the
government’s minimum price.

Elasticity

When a firm considers changing the price of one of its products, it muJ see what effect this will have on sales. In the
case of a normal good, a in price will lead to a fall in quantity sold; a fall in price will lead toaiM in sales. So far so
good, but the firm would probably like somethin|H little more precise than this. For example, if a bank raised the
anmfl charge on its credit card by 20%, it could expect to lose some cardhoIdaH The important question is, how
many? Will it lose just 1% or 2% offll customers, or will it lose a much more substantial number sucftH 30% or
40%? In other words, just how sensitive will customers change in price? I

In economics this is known as price elasticity of demand. I

Price elasticity of demand is defined as the responsiveness of demanded to a change in

price. Price elasticity of demand is saiduAA

•Elastic if a small percentage change in price leads to a larger perce'H change in quantity demanded ■

•Inelastic if H large percentage change in price leads to a smaller

—J
• Unitary or unit elasticity if a given percentage change in price is matched by the same percentage change in
quantity demanded. Price elasticity of demand can be calculated using the equation:

% change in quantity demanded % change in price

Let's use this equation in the example of the bank raising its credit card annual charge.

EXAMPLE
A bank raises the annual charge on its credit card from PKR 1000 to PKR 1200 and finds the number of
cardholders drops from one million to '«00,000. To calculate the price elasticity of demand, we calculate first that
the increase from PKR 1000 to PKR 1200 is a 20% rise in price, while the decrease in the number of
cardholders from one million to 900,000 is a Call of 10%.

Inserting these figures into the equation, we get:

-10% =-0.5
+20%

29
Notice that the answer is negative. This is because price and quantity iemanded normally change in opposite
directions. Usually people find it convenient to ignore the minus sign, but in an examination it is a £: .3od idea to
say that this is what you have done. In other forms of : isticity which we will meet shortly, the sign is important,
so we cannot A ways ignore it.

Interpreting the result is straightforward. If we ignore the sign, ibe value can be anything between zero and
infinity.

_ If the value is greater than 1, price elasticity of demand is elastic _ If the value is less
than 1, price elasticity of demand is inelastic
•.f ine value is 1, price elasticity of demand is unitary

Bllastkity in practice

Jin rr'ctice, when suppliers consider changing price, they are unlikely to iisaass whether demand is elastic or
inelastic, or whether it is greater titoi1 or less than l.What they are interested in is how the price change _ i:! £rect
their sales and whether it will increase or decrease their total However, the effect of a price change on total
revenue depends thtprice elasticity of demand:

_ Siaestk demand ^ price and total revenue change in opposite directions. A -sc in price leads to a fall in total
revenue. A fall in price leads to a rise mictil revenue.

• Imrilastk demand - price and total revenue change in the same direction. A in price leads to a rise in total
revenue. A fall in price leads to a fall
rev enue.
• Unit elasticity of demand — total revenue remains the same when price is changed. Any revenue
lost by a fall in price is just matched by the revenue gained from extra units sold. Similarly, any revenue gained by
raising price is matched by revenue lost because fewer units are sold.

Factors influencing price elasticity of demand Availability

of close substitutes
Price elasticity of demand is much more elastic for products for which close substitutes are readily available at a
similar price. In Britain there is considerable competition between banks for mortgage business and house buyers
are well aware of the going market rate. Any bank which tried to raise its rate significantly above that of its
competitors would find the demand for mortgages very elastic as would-be borrowers turned to other, lower priced
lenders.

Proportion of income spent on a product

If people spend only a very small proportion of their income on a product, they are not very sensitive to changes in
its price. Most people spend very little on items such as pins or nails and would not notice even a 100% increase in
their price.

For these, price elasticity of demand is fairly inelastic. Mortgages are a different matter. For most house buyers,
mortgage interest and repayments represent a significant part of their income and they are very sensitive j to changes
in interest rates. This would make the interest elasticity ofl demand for mortgages fairly elastic.

People seem less sensitive to interest charges when borrowing money 1 for fairly small purchases. Here the interest
elasticity of demand can bd said to be inelastic. Where this is the case, it would take relatively higfcj interest rates to
discourage people from borrowing and spendiiid | This weakens interest rate policy as a weapon for managing the
econoiJ

_ J
Some goods such as tobacco, alcohol and drugs are strongly habit formiB and have no close substitutes. Users of
these substances are not e'W discouraged by price rises and so demand for them is inelastic government may take
advantage of this to raise revenue knowing if high taxes are put on tobacco and alcohol, although there a small fall in
consumption, the total tax revenue will incie'''

Even non-addictve goods may become habit forming. People

the habit of reading a particular newspaper, shopping at a particula''J
or even using a particular bank. This is why banks are so keen to enooi'H
students and young people to open accounts. The hope is to
new customers for life. Once the habit is established and beconid"!
of the daily routine, people are less sensitive to price increases and becomes more inelastic.
Durable and non-durable goods

Demand for durable goods such as cars, televisions and domestic electrical goods tend to be sensitive to price
changes and therefore elastic. These are goods which should last for years and so it is easy if prices rise to postpone
purchases of new models and extend the working life of existing units. Demand for non-durables such as fuel, food
and clothing is more inelastic since, even if prices rise, purchases cannot easily be delayed.

Time
Time can have a major effect on price elasticity of demand. The longer -u) ers have to adjust to a price change, the
more elastic demand becomes.

Width Of Definition

The wider a product is defined, the less elastic is its demand. If a finance rjouse, acting on its own, raises its interest
charges on loans, it can expect to lose business to its competitors. It will find demand for its loans sensitive to
interest rates and therefore elastic. If all banks and finance houses raise their charges simultaneously, the demand
for loans will be —j ore interest inelastic.
Necessities And Luxuries

— ^ ' needs to be treated with caution. It is often assumed that the demand i'r necessities will be inelastic and the
demand for luxuries will be elastic.
>1 is a necessity, yet the demand for individual types of food may be .2 < .:y elastic. If potatoes become dearer,
consumers can switch to bread, rxx and pasta. The key factor is the availability of acceptable substitutes ace not
whether the product is a necessity or a luxury good. Many luxury fece inelastic demand as purchasers are not
very sensitive to price.

.taicoroe elasticity of demand iii«ai*me elasticity of demand is the responsiveness of

demand for a pni to a change in incomes.

pe e already seen that changes in income can lead to changes in H&2 for a product. Income elasticity of demand
can be calculated g me equation:

% change in quantity demanded % change in income

elasticity of demand is said to be:

3 :.he value is greater than 1 v Ae value is less than 1
This is an occasion when the sign is important. For a normal good, the 'signis positive, indicating that income and
demand move in the same direction. As incoijief increases, so more of the good is bought. For an inferior good,
th'sign is negative. Income and demand move in opposite directions. As incomes increase, consumers can afford
to buy dearer, better quality goods and so buy less of the inferior product.

Price elasticity of supply

Price elasticity of supply is the responsiveness of supply to a change in I price. An awareness of price elasticity of
supply helps people to under the consequences for price of a change in the conditions of demanA |

Price elasticity of supply can be calculated as:

% change in quantity supplied —

% change in price

Price elasticity of supply is:

• Elastic if the value of the equation is greater than 1 which implies 1 supply is flexible and changes at a greater
rate than pi
• Inelastic if the value of the equation is less than 1 which implies i supply is less flexible and changes
proportionately less than —
 Factors influencing price elasticity of supply
Elasticity of supply depends on the ease with which output can adji changes in price. This is influenced by a
number of fac

Time
The longer the time period involved, the greater the opportunity to s output and so the greater the elasticity of
supply.

Time required for production

If the production process takes only a short time, it is relatively < adjust output to take account of price
changes. A fast food oi change its output relatively quickly and so its supply is fairly ( farmer may have to
wait a whole year before he can make sig changes in output, so his supply will be much more ii

Number of producers

THe more producers of a good, the more elastic is supply like Available capacity If firms are already
working to full capacity, it will be harder to i output and supply will be inelastic. If firms have spare capacity, iti
easier to increase output
and supply is more elastic.
SlQCdge potential

:
a : ™dUCt T1 bf mfrstored, surPius output can be put into stock r; J mand and pnces are low offered for sale when demand is

Substitutability of factors of production

Inhere is a range of factors of production suitable for making a good and these are interchangeable, producers
are more able to meet any increase m 'emand and supply will be more elastic.

33 Economics | Reference
 Introduction to Economics
Chapter 2 Macroeconomics

Learning Outcome By the end of this chapter you should be able to: n Discuss the basic
framework of macroeconomics, i.e. National Income, Inflation,
Unemployment, Exchange Rate and Trade Imbalances B Discuss the
macroeconomic goals of achieving full employment, economic growth and
stability H Discuss marginal benefit and marginal cost and the relationship
between the two n Discuss consumer and producer surplus a Explain
deadweight loss, overproduction, underproduction a Explain the concept of
trade offs a Describe the characteristics of perfect competition, oligopoly,
monopoly, monopolistic competition * Recall the principles of
macroeconomic policies for a sustainable economy
■ Identify the importance of theory, data and forecasting «i Recall the

controversies in modern macroeconomics

 We need macroeconomics due to the fact that there are forces that affect the economy as a whole that cannot be
fully or simply understood by analyzing individual markets and individual products. Macroeconomics is study of
dealing with economic activities as a whole with respect to the national output, national income, price levels,
international trade, balance of payments, unemployment, and inflation, among other aggregate economic
variables.

1. Economic Growth
Framework of
Per capita output has been facing ups and downs for many decades in most industrial countries, alon'jAdth total
Macroeconomics
output. These long-term trends also impact on average living standards. For instance, in Pakistan the per capita
income has increased to USD 1250 in 2010 from USD 920 in 2008.
EcoAomic growth is the predominant determinant of living standards and the material constraints facing a
society from decade to decade and generation to generation. Macroeconomics has traditionally taken the trend in
output as given and looked at how to minimize deviations from that trend. However, in recent years there has
been discussion of whether the policies used to stabilize activity may also influence the long-term trend. Among
the most important issues in macroeconomics is ldentfyir'

-- ■ i! llimi 41+ III IIIWI

Introduction

33 Economics | Reference
 mus a clear objective of macroeconomic policy.
2. Business Cycles

:he economy is not 'Ways stable and goes through a series of um and jowns, called business cycles. When the
business cycle is in an upward
. __ d __ 0m; WhCreaS Wh£n is a d th.6

1= jery important for economists, entrepreneurs and managers of firms velop an understanding of business
cycles. During recessions most businesses incur heavy
losses, while the survivors face falling profits. On
oth r hand du
* ] , mg a period of boom, businesses do well due to high '£mand f°r p r o d u c t s , r e s u l t s in higher
profits. It is easier for usmesses to expand during boom times while during recession acquisitions, and hostile
take-over and even worse, shutting down of busmesses, are likely to happen. Understanding the business cycle is
thus important for successful businesses. Decisions on whether to expand ra prices, lay ofFsome of the labor
force, introduce new products need
n 0,1 the asis of
' economic situations; therefore it is important or companies to closely
observe the business cycle and try to foresee
right bUSineSS dedSi nS

Inflation

Econ'imc growth and inflation go hand in hand. Swings in economic =ty are us.ufy accompanied by fluctuating
inflation. Therefore it thpC°meSjfiy data* fa- ta government to maintain a balance between rt U°' att£mptS of government ^
control high inflation generally suit m recessions. Therefore an important policy problem that arises
1m
governments is how to stimulate economic activity without T usi'g inflation. The policy makers, during a time
of boom, are often
H ffi ' thdr ro^s t0 brlng Mata 'der control. When flat on falls after a recession, policy makers often feel that they have
so: leeway to stimulate the economy again. Controlling inflation alone =keepmg the economy stable, is not a
simple matter and polio

4. Unemployment

Slowdown in the economy results in unemployment. Unemployment is ery critical matter for the government.
Indeed, it was the high unemployment of the 1930s that led to the establishment of the subject
anLo'al5 maCrf°eC°n°mlcs-------------- ngly, analysis of the causes of, d potential cures for,
unemployment is still very high on the agenda
of macroeconomics. A new bout of high unemployment can never be ruled out, even for those countries where it
has been low for some time.

e ir
Governmentscan
eS era e £ o
reduce unemployment by increasing their spending
ta"xe" ' rnflT ' th g _____________ ent spending and axes to influence the economy is
known as fiscal policy.
 together to coordinate their macroeconomic goals and policies.
Income policies are government attempts to moderate inflation by direct steps, whether by verbal persuasion or
official wage and price controls.

Characteristics of market competition Perfect Competition

The following assumptions should be taken into account relating to perfect competition:

■ Identical goods are produced by all the firms in the market

• There is a large number of independent firms

• Each seller is small relative to the size of the total market

■ Entry or exit is barred from any barriers to entry or exit

When it comes to perfect competition, all firms are price takers. Thr demand curve in this situation is horizontal
to the x-axis due to th** perfectly elastic demand of the products. The firms can sell all of the* output at the
prevailing market price, but if they set their output piioc higher than the market price, they would sell nothing.
Due to the
thaf _ .^ey '■ , i w n -- -^.i ^ n.,
kn n n e e r tn--tdrrr°te * * * resources to discovering the best price at wl QPII *r Proc^uct- A “price-
taker” market is equivalent to a perfe
competiti
!i>
There is ] ^hie e.., e‘,„ I :i,.- :n.ir| A i . |v, !> , _ n:,,h u ,. , -

is based on market supply and demand. The individual fir chedule is

The price
perfectly elastic.

Monopol istk Competitjon

Monopol o > mp e U i a . > n I i a > ( h o fo l l o w i n ; ; m a r k e t e h a I \ K t c - > : .

Alargenumberofindependentsellers:The market share for every fii

relatvely ;
‘-l! iiiii1!) nr: iiMi I :> -hr, Ihli h mail ,n\ ■ i-- -
power ove
! pi Xn,-, I I ,, !V, jv ; i( |v,
price rathi
er t h a n t h e price of i n d i vi d u a l competitors. Collusion ([
fixing) is l 1 1
■ ' i ' ' - ' ■ h . ' l v- .1 i hI I I IIh, I..

DifferentpPducts\Pr°ducts produced by each producer are slightly ^Se

1 1 : 1 1 1 1 1 1 1
f r o m its c c ' " ‘ ’i ' i' ’> 1 -- ! ' ■ a iea -a ! i i ! u ; ! 1 I ! I ih". n n ,, a a .i I I u , competir • ' ' '

1
.He h '■ ■■ . '■!}'■..! I ! ] I i ^ - 1 , > | mi,' : - • -

Frmsconm^teonprice, quality and marketing as a result ofyffrodifferent' a t i o n . Q u a l i t y acts as an

i n t e gr a l product-differentia
characters - a. I > i ! e I - a ». , ■ , , 1 A , , j . l , , p p , m : J e m m a ! , m ■, i h e . . output can he -e' h\
i i a - , . i . ) u a i i i \ a n a [ M i , : ; h a i L. . n i ! e .. h a e a r n .
usually have a strong correlation between them. To inform or coituthl the product’s characteristics to the
m a r k e t , m a r ke t i n g is of ut
importanc -.

UJWtamerstoentry so that firms are free to enter and exit the i New firms can enter the industry if the
existing firms in the indus
earning ec( a mn i a m m m - . demand s
Economics I Reference I

conomics
35
 tKl
X? monopolistic competition the demand curve is highly elastic because nk
of competing products as close substitutes.

Oligopoly is a form of market competition characterized by:

• A small number of sellers

'ff?je?hnd'enCe (d— made by one firm ect the demand, price and profit of

others in the industry)

• Significant barriers to entry that often include large economies of scale ,Prc)ducts that may be similar or

differentiated

Monopoly

Jherejs a monopoly when there is only one seller of a specific well- „ product. This
product has no good substitutes. If a firm has to ^hS^noroisc p
----------------------------- ^ to market entry

stotedeTSr1? ' SingIe,Prke are the —two Possible pricing strategiesnfthe customers are
unable to resell the product to eachother
pr= can be maximized by the monopoly by charging different prices
erent ou s of
f P customers. In the absence of price discrimination the monopoly
5
will charge a single price.

Aggregate Supply and Aggregate Demand

Aggregate supply is the total amount of goods and services that are irelThtefLTthCOhT ^—ply (AS) is a Action of
price s_y= a=f XX A K'* u Wg
Will be ~ 0f
 Aggregate demand refers to the total amounts of goods and services that
Benefit amwi
Marginal Cost
_Jng toHbu/iii a _+H^_ a~ de=

Figure 1.2-2: Aggregate demand curve

Price index for commodities

Real
GDP

(trillions)
Aggregate Supply and

ihe supply and demand curves are often used to help analyze macroeconomic equilibrium. Recall that in the
previous chapter we used' , s~T y and demand curves to analyze the prices and quantities of individual products.
Figure 1.2-3 shows the aggregate supply and

=g=es fOT A °Utj £ntirej^e 31A

Demand Curves

See =hf=sd m a - _ Wh-as the

7 he downward sloping curve is the aggregate demand curve (AD curve) t represents what all entities in the
economy - consumers, businesles frdgners and governments - would buy at different aggregate price levek From
the curve we see that at an overall price level of 150, total

; -J riding SdMto

Economics I Reference Book 15

 The upward sloping curve is the aggregate supply curve (AS curve) This cu've represents the quantity of goods and
services that businesses are willing to produce and sell at each price level (with other determinants ofaggregate
supply held constant). According to this curve, businesses
r nanK ?se PKR 3000 bmcin at a price level of 150; they will want to sell a higher quantity, PKR 3300 billion, if the price rises
to 200. As the
i ?output demanded ns^ businesses will want to sell more goods and services at the higher price level.

Macroeconomic A macroeconomic equilibrium is a combination of overall price and quantity at which neither consumers nor
equilibrium producers wish to change purchases, sales or prices.
Can
the real GDP and the price level that would satisfy
buyers and sellers using AS-AD equilibrium. At point E in Figure 1.2-3
q _and p=15° *e economy is said to be in equilibrium. This is the only point where AS cuts AD, hence at this
point consumers and prod= are satisfied. If the price level were higher than equilibrium, say p=200, then businesses
would want to sell more than purchasers would want to buy. Goods would accumulate on the shelves as firms
produced “JT consumers — As the goods continue to pile up, firms would ~Ut productlon and be§m to curtail the prices. As the price
level declines ~°m J°f§lnaI hgh level of200, the gap between desired spending and desired sales would narrow until the
equilibrium at p=150 and q=3000 is reached. Once the equilibrium is reached, neither buyers nor sellers wish to
change their quantities demanded or supplied and there is no pressure on the price level to change.

The diminishing marginal utility is the basis for consumer surplus. When there is a gap between total utility of a good
Consumer Surplus and its total market value,

If receive more than we pay then that results in surplus. According to the law of diminishing marginal utility, the first
unit’s satisfaction is
f ta to last U"* gamed, although the amount paid for each unit of commodity we buy (from the first to the last unit) is
the same.
L2tt
7*4 /hoWS mer surplus. The total value to society of t= s ofsteel15 'n the total
the consu more tha

amount paid for the 3000 tons ot steel, by an amount represented by the shaded triangle. Figurel.2-4, Consumer
Surplus

roeconomics
41
42
Economics I Reference Book
2
 We can also refer to the consumer surplus for an individual. Assume that the price of a fresh glass of juice is PKR 50. The consumer considers how
many gallons to buy at this price. Since the consumer is very thirsty, he is willing to pay PKR 100 for it. However it would cost him only PKR 50,
therefore the cost for the consumer for the fresh juice will be less than what he is willing to pay, therefore he will enjoy the surplus of PKR 50.

Now consider the second gallon of juice which is worth PKR 90, yet again the customer will be paying only PKR 50, therefore the surplus at this
price will be PKR 40. Thus, the more glasses of juice the consumer buys, the worth of each glass will keep declining until a point where the
consumer’s need is satisfied and the worth of the glass will be less than the actual cost.

Here is one interesting observation about consumer surplus. The consumer paid PKR 100 for two glasses of juice; however the total worth of juice
for him was PKR 190. Thus the consumer has gained a surplus of PKR 90 against the amount he paid. The consumer will consume the good until
Production its worth is more than the actual amount.

Producer Surplus

The industry supply curve, under certain assumptions (perfect markets), is also the marginal societal (opportunity) cost curve. The surplus of the
market price above the opportunity cost of production is the producer surplus. Take for example in Figure 1.25, steel producers are willing to
supply the 2500 tons of steel at a price of PKR 400. The produce surplus is increased by PKR 100 from producing and selling the 2500 tons of
steel for PKR 500. The difference between the total (opportunity) cost of producing steel and the total amount the buyers pay for it (producer
surplus) is at a maximum when 3000 tons are manufactured and sold. This is illustrated in the following figure:

Figure 1.2-5: Producer Surplus

43
44
Economics I Reference Book
2
The allocation of resources, goods, and services by market price, from an economic point of view, has important advantages. When markets are
functioning well, competition and allocation by price lead to an efficient allocation of resources, so that the marginal benefit to society just equals the
marginal cost for the last unit of each good and service produced.

The “marginal” in marginal benefit and marginal cost refers to an additional unit, so the marginal benefit and cost comparison compares the benefit
of one additional unit to the cost of producing the unit. We shall see that the efficient allocation of a society’s resources, and therefore the production
to the efficient quantity of each good or service, is achieved when the benefit to society of producing one more unit just equals the cost to society of
producing that additional unit. We measure the benefit to society as the value that a user places on the additional unit produced. We measure the cost
to society as the opportunity cost of production (i.e., the value of other goods and services we must forego to produce the additional unit).

A good or service’s demand curve shows the decreasing value to customers of additional units of a good or service when markets function well and,
as a result, the opportunity cost of production of additional units of a good or service is illustrated by the supply curve. To show that the fact that each
successive unit consumed will be less highly valued by the consumers, downward sloping demand curves are drawn. To show the fact that the
opportunity cost of producing additional units of goods increases as more and more resources are drawn away from other productive uses to produce
additional units of the good, upward sloping supply curves are drawn.

Based on the above interpretations of demand and supply curves, it can be said that the efficient quantity of any good or service is the quantity where
the demand curve and the supply curve intersect. If the economy produces less than 3000 tons of steel, we have not maximized the benefit to society
of steel production. The value that consumers place on additional units of steel is greater than the value consumers place on the other goods and
services foregone to produce those units. Conversely, if the economy produces more than 3000 tons of steel, each unit above 3000 units requires that
society give up other goods and services more highly valued by consumers than the additional units of steel above 3000 tons. As long as the demand
curve represents the marginal benefit to the society and the supply curve represents marginal cost to society, the benefit to society derived from
producing steel is maximized at 3000 tons.

We have so far discussed that the marginal benefit is depicted by the demand curve and the marginal cost is depicted by the supply curve.
Competition leads us to supply/demand equilibrium. We will now consider how deviations from the^ideal conditions can result in an inefficient
allocation of resources'' the quantity supplied does not maximize the sum of consumer and producer surplus then the allocation of resources is
inefficient^The reduction in consumer and producer surplus due to underproduction or overproduction is called deadweight Wossf)Underproduction
occurs when the goods produced are at a level below foil capacity or beneath the degree of demand, whereas overproduction occurs when goods are
produced m excess of need or stipulated amount.
 Figure 1.2-6:

Pn^WWfJs
Sf Supply (MC)
from
overproduction

PKR 500 Deadweight loss

from
overproduction

Demand (MB)

Quantity (tons)
Figure 1.2-7: Deadweight loss from underproduction

Controversies in modern macroeconomics

There are three schools of thought who have different views on dr J m both aggregate demand and
aggregate supply.

The classical economists believed that the advancements in ~ overtime resulted in shifts in both
aggregate demand and supply. Although classical economists did not use the aggreaatr aggregate
demand analysis we have presented, their view ofmaoc:_ equilibrium is consistent with this analysis.
There is a need assumption that the long-run adjustment of money wages to « employment equilibrium
happens fairly rapidly and that the therefore has a strong tendency toward ftill- employment eqr increase
or decrease in the money wage rate is a result of i_ over-fiill employment. The conclusion of their
analysis was ttatf ~ere the Pnmary impediment to long-run equilibrium ami — distortions in incentives from
taxes were minimized; the efficr of the economy would be possible with increases in labor and < with
improvements in technology.

Economics j
Figure 1.2-7, Deadweight loss from underproduction Price

(PKR/ton)

Figure 1.2-6: Deadweight loss from overproduction Price (PKR/ton)

Controversies in modern macroeconomics
Th~re are three schools of thought who have different views on in both aggregate demand and
aggregate supply.

The classical economists believed that the advancements in t overtime resulted in shifts in both
aggregate demand and supply. Although classical economists did not use the aggregate
aggregate demand analysis we have presented, their view ofmacn?" equilibrium is consistent
with this analysis. There is a need taassumption that the long-run adjustment of money wages to
employment equilibrium happens fairly rapidly and that the therefore has a strong, tendency
toward full- employment eqr* increase or decrease in the money wage rate is a result of rr over-
full employment. The conclusion of their analysis was th* , re the primary impediment to long-
run equilibrium and distortions in incentives from taxes were minimized; the efikr of tjie
economy would be possible with increases in labor and with improvements in technology.

Economics j
John Maynard Keynes believed that the main cause of business cycles was shifts in aggregate demand
due to changes in expectations. Also, that wages were “downward sticky, , , hence reducing the ability of a
decrease in money wages to increase SAS and move the economy from recession (or depression) back towards
the full-employment level of output. The New Keynesians added to this model, asserting that the prices of other
productive inputs in addition to labor are also “downward sticky” presenting another barrier to the restoration of
full-employment equilibrium.

The Keynesian economists’ policy perception was based on directly increasing the aggregate demand through
monetary policy (increasing the money supply) or through fiscal policy (increasing government spending,
decreasing taxes, or both).

Monetarists believe that monetary policy is the main factor leading to business cycles and deviations from
full-employment equilibrium. Their suggestion to keep aggregate demand stable and growing is that the central
bank should follow a policy of steady and predictable increases in the money supply. According to the
monetarists, recessions occur due to inappropriate money supply. They believe that recessions can be persistent
because money wage rates are downward sticky (as do the Keynesians). However, as with the popular belief of
classical economists, they believe that the best tax policy is to keep taxes low in order to minimize the
disruption and distortion that is introduced into the economy by them and the resulting decrease in full-
employment GDP.

45
Part0ne
____ Introduction to Economics
Chapter 3 Theory, Data and Forecasting

Learning Outcome By the end of this chapter you should be able to: ■ Identify the importance
of theory, data and forecasting

Economic An important role of economics is its use to answer questions pertaining to economic Theorizing behaviors, trends and
outcomes. Economists can develop theories based on observation of facts and figures and subsequently attempt to test these theories in order
to answer such questions. These theories can answer questions such as the impact of the internet on economic growth or the expected demand
for wheat in Pakistan in a certain month of the year. We now take a detailed look at what such theories mean and their importance in
understanding economic issues.

Theories Theories are constructed to explain various issues that arise in an economy.
For example, what determines the number of eggs sold in Lahore in a particular week? As part of the
answer to such a question, economists have developed the theoryofdemand.Like any other theory, the theory
of demand is built around definitions, assumptions^fid predictions.

The basic elements of any theory are its variables. A variable is a magnitude that can take on different
possible values. For the theory of the demand for eggs, we define the variable demand as the number of
cartons of eggs consumers wish to purchase during a particular time period.

A theory’s assumptions concern motives, physical relationships, lines of causation, and the conditions under
which the theory is meant to apply, whereas a theory’s predictions are the propositions that can be deduced
from it. For example, a proposition in the theory of demand states, “if the price of eggs rises, consumers will
purchase fewer eggs”. This negative relationship between a product’s price and the amount people wish to
buy applies to all commodities. These propositions are then taken as predictions about real-world events.

Economic Data
Economists seek to explain observations made of the real world. Why, for example, did the price of wheat
rise in some years even though the wheat crop increased? We would be aware of this issue only if we had
numbers for the wheat crop and the price of wheat, and we would need a lot of additional data (such as on
incomes and other prices) to come up with a comprehensive answer.

Real-world observations are also needed to test the predictions of econo • theories. For example, did the
amount that people saved in a partic year rise when a large tax cut increased after-tax incomes? By theory
prediction is that it should have, as more income was made available

44 Economics | Reference
 people. To test this prediction, we need reliable data for people’s incomes and their savings.

In economics there is a division of labor between collecting data and using it to generate and test theories. The advantage is that economists do
not need to spend much of their scarce research time collecting the data they use. The disadvantage is that they are often not as well informed
about the limitations of the data collected by others as they would be if they collected the data themselves.

Once data is collected they can be displayed in different ways, all of which we will see later in this chapter. It can be laid out in tables and can
be displayed in the various types of graphs that we will study later. Where we are interested in relative movements rather than absolute ones,
the data can be expressed in index numbers.

Index numbers

Table 1.3-1 shows how the prices of sugar and wheat varied during the past five years. How do these two sets of prices
compare in instability? It may be difficult to tell from the table because the two prices start at different levels. It is easier to
compare the series if we concentrate on relative rather than absolute price changes. (The absolute change is the actual
change in the price; the relative is the change in the price expressed in relationship to some base price.)
Year Sugar ACTUAL PRICES Wheat

(1) 100.4 146.7

(2) 104.5 146.4

(3) 100.8 129.7

(4) 121.8 126.4

(5) 149.0 136.6

Table 1.3-1 Price of sugar and wheat(average price in each year, Rupees per kg)

Index numbers as relatives

Comparisons of relative changes can be made by expressing each price series as a set of index numbers. To do this we take the price at some
point of time as the base to which prices in other periods will be compared. We call this the baseperiod In the present example we choose the
first ’year as the base period for both series. The price in that year is given a value of 100. We then take the price of wheat in each subsequent
year and then express it as a ratio of its price in the base year and multiply the results by 100. This gives us an index number of wheat prices.
We then do the same for sugar. The details of the calculations for wheat are shown in Table 1.3-2.

47
 Index of Wheat Prices
(1)
(146.7/146.7) x 100 =1 0 0
Quarter
Q
< 146.4/146.7) x 100 = 99.8
(3)
(129.7/146.7) x 100 = 88.4 |
(4)
< 126,4/146.7) x 100 = 86.2
j
i^ m
(136.6/146.7) x 100 = 93.1 j

index numbers are calculated by dividing the current price bytte I base-year price and multiplying the result by 100 For example, thewtT price
in 2001(4) was Rs.126.4 per kg. Dividing by the base year pnce of 146.7 Rs (in 2001(1)) and multiplying by 100 gives an index of 86.2 for
this quarter.

Table 1.3-2 Calculation of an index of wheat prices The formula of any index number is.

Value of index in period t = value in period x 100

Value in base period

An index number merely expresses the value of some series many] period as a percentage of its value in the base period. Thus the Ye~ Index
of sugar prices of 148.4 tells us that the Year 5 price of sugar — 48 4% higher than the Year 1 price. By subtracting 100 from an> i we get the
change from the base year. To take another example, thew index of 93.1 in Year 5 tells us that the price of wheat at this timci only 93.1% of
the price in Year 1,or, what is the same thing, that the fhad fallen by 6.9% over the 4 year period.

Index numbers as averages

Index numbers are particularly useful if we wish to combine different series into some average. Suppose
that we want an mdot* drink beans, and cocoa and coffee beans are the only two prod^ are interested in.

An un-weighted index, for any one year, could be added to Acl indexes for cocoa and coffee and the average could be taken n— would give
us a hot-drinks beans index. However, equal weighti given to the two prices by the index. Such an index is called an Iin index, .
An output weighted index
Wheat is a much more important commodity than sugar mM that much higher volume is produced of wheat than of su~cJ purpose of
illustration, we assume that 9 kg of wheat is every 1 kg of sugar. To get our weighted index of wheat prices, wiej the wheat index value in
Table 1.3-3 by 0.9 and the sugar mdj and sum the two to get the final index. The results are shown .
1.34. The quite different behavior of the two indexes shows the ~ of the choice of weights.

Economics | I
 Year Sugar Wheat
(1) 100.4 100.0

(2) 101.9 100.2

(3) 94.2 89.6

(4) 103.7 89.6

(5) 120.7 98.6

Table 1.3-3 Index of sugar and wheat prices
An index that averages the changes in several series is the weighted average of the indexes for the separate
series, the weights reflecting the relative importance of each series.

Price indexes

Economists make frequent use of the price level covering a broad group of prices apross the whole
economy. One of the most important of these is the Rafail Price Index. RPI covers goods and services that
people buy.
.................................... — Wheat = 0.9 Sugar = 0.1
ACTUAL PRKES
Year Equal Weights ■

100.4 100.0
101.9 100.2
( 2)
89.6

89.6
(4) 103.7
98.
(5) 120.7
6J
labie
^S-4: Comparison of Index with Equal Weight Index and a Weighted Index

W eights matter a lot. The equal weight index is calculated for each period £>' adding Wheat and Sugar
indexes from Table 3.3 and dividing by 2.
----- > e c o n d index is calculated for each period by multiplying the wheat index
by 0.9 and sugar index by 0.1 and then adding the results. These series act quite differently as a result of using
different weights, as chi be seen in Figure 3-B.

i price indexes are compiled using the same method. First the relevant ■rim -"d the base year are chosen. Then
each price series is converted
■ B " B L , n u mb e r s . Lastly, the index numbers are combined to create i"med average index series where
the weights indicate the relative timnce of each price series. For example, in any retail price index a -O -
iianged into index numbers, which are later combined to create it- erage index where the weights show the
relative importance n <1 e series; for example, the price of sardines would be given a iisrakr weight than the
price of living accommodation, as what te the price of accommodation is much more important to —than the
price of sardines.

economic data

txo; !ri:c variable such as unemployment or GDP can come in

49
Cross sections
The first is called cross-sectional data, which means a number of different observations on one variable taken in
different places at the same point in time. Figure 3-A shows an example. The variable in the figure is
unemployment as the percentage of the workforce. It is shown for ten selected cities of Pakistan in a certain
year.

14.00% !

12.00%

10.00%

-]

6.00
8.00%
%
4

2.00
%

0.00
%

Figure 1.3-1 Time

Unemployment of 10 cities of Pakistan in a certain:
series
The second type of data is called time series data. This involves surve on one variable at successive points
in time. Figure 1.3-2 shows a I series for the two indexes of two commodities that were calculated section
on the index numbers.

Sygar-0 : 1

Figure 1.3-2 — Weights matter. The two trend lines represent 1 of prices, however both depict
different pictures. The equal wt line indicates an overall rise in prices over the 5 year perioa. Index
trend line indicates that prices have in fact dropped < period.

Economics | I
 Logarithmic scales
A logarithmic scale is a scale of measurement using the logarithm of a physical quantity instead of the
quantity itself. It is useftil when percentage of data is more important than absolute changes. When data is
graphed on the logarithmic scale, equal distances indicate equal percentage changes. Also, with a log scale a
straight line indicates a constant rate of growth.
Scatter diagrams

Data can also be presented in the form of a scatter diagram. This is the most analytical type of chart. Its
purpose is to show the relationship between two different variables, such as the price of flour and the quantities
of flour sold. To plot a scatter diagram, values of one variable are measured on the x axis and the values of the
second variables are measured on the y axis. Any point on the diagram relates to a specific value of the other.
The two series plotted on a scatter diagram may be either cross sectional or time series. An example of cross
sectional would be a scatter of the price of flour and the quantity sold in a certain month at different places in
Pakistan. Each dot would represent the price-quantity combination observed in a different place at the same
time. An example of a scatter diagram using time series data would be the price and quantity of flour sold in
Karachi for each month over the last ten years. Each of the 120 dots would show a price-quantity combination
observed at the same place in one particular month.
Table 1.3-5 shows data for the income and the savings of ten households in one specific year. They are plotted
on a scatter diagram in Figure 1.3-3. Each point in the fipre stands for one household, showing its income and
its saving. The positive relationship between the two stands out. The higher the income, the higher the saving
tends to be.

■come Annual savings 14

10,000 12
Figure 1.3-3: Savings and 10
Income
20
40 60 80 100 120

Table 1.3-5 Income & Savings of households in a year

 Savings tend to rise as income rises. The table shows the amount of income earned by ten selected
households, together with the amount they saved during the same year.

Graphing The theories are constructed on the basis of assumptions about relationships between the variables. For
economic theories instance, the quantity of generators is assumed to fall during summer as its price rises, and the purchasing
power of an individual tends to increase with an increase in his total income. How| do we express such
relationships mathematically? When one variable is related to another in such a way that to every value of
one variable there | is only one possible value of the second variable, we say that the second variable is a
function of the first variable. When we write these variables j down we are writing down the functional
relationship between them.
We can express functional relationship using mathematical equations* j graphs, numerical schedules or even
in words.

Assume a relationship between a famil/s monthly income, which K shown by the symbol Yand the total
amount it spends on goods anfl services during that year, which is represented by the symbol q
Verbal statement: When income is zero, the family will spe*J|
PKR 800 a year (either by savings or borrowing), and for 1 rupee of
income that it obtains its expenditure will increase llj
0. 80 paisa.
Schedule, The schedule shows the value of the family’s inco«J and the consumption
pattern.

Table 1.3-6: Schedule of the family's monthly income and consum|M|

Monthly Income

Consumption
Reference I

0 ..................................................800 2,500 5. 0 7,500

10.0

Mathematical (algebraic) statement: C = PKR 800 =

equation of the relationship just described in words., you can first see
that when Yis zero Cis PKR 800. Then| substitute any two values of Y
that differ by 1 rupee, r each by 0.80, and see that the corresponding
two ^ consumption differ by 0.80 pai
aisa.

Geometrical (graphical) statement: Figurel.3-4 shotisl points from the schedule

above and the line repi equation given in point 3.

Economics | I
52
 Comparisons of the values on the graph with the values in the schedule, and with the values
2000
derived from the equation just
10000
stated, shows that these are alternative expressions of the same relationships between C and Y.
Household income All these modes of expression
Figure 1.3-4, Income and Consumption
(PKR)
show the same relationship
1000

between total
0

8000
Consumption

4000

2000

consumption 0 and total income. 4000 6000 8000

Functions

After looking at the relationship between income and consumption expenditure, we can state the general
expression for it which is detached from the specific numerical above, and we use a symbol to show the
dependency of one variable to another. Using cf, for this purpose, we can write:

C=f(Y)‘-(i)
This reads that ‘C is a function of YWThisshows that £the amount of consumption expenditure depends upon the
household’s income, .

The variable on the left hand side is the one dependent, since its value depends on the variable that is on the right
hand side, which is the independent variable, since it can be replaced with any value. The letter explains
functional relationship is involved. The value of the variable the right-hand side helps us in interpreting the value
of variable on 'Ae left-hand side which further helps us with the inspection of what the reveals; that the change in
one variable in response to a unit change ai the
other is the same anywhere on the line.

iiiictiofidl Forms
agression given above states that C is related to Y. However, it doesn’t — e form of relationship that exists
between these two variables, term functional form’ refers to the specific nature of the relationship —E variables
in the function. Using the example of the family’s ’me oonsumption, the following functional form of the
relationship
ferived:

C = PKR 800 + 0.8Y .... (ii)

 Equation (i) expresses the general assumption that consum, expenditure depends on the consumer’s
income. Equation (ii) exp the more specific assumption about the relationship between C 2L which is that
C will rise by 80p every time Y rises by a ru]
We must remember that either of these assumptions may or not be or consistent with the facts. But that is the
matter of testing. What we, from each equation is a concise statement of a specific assumpti
Graphing functional relationships

There are different graphs for different functional forms. Figure 1.3^1- an example
of a relationship in which the two variables move togetfci The consumption
expenditure increases or decreases with income. Sirwr both the variables move
together in the same direction (upward or downward), they are said to be
positively related to each other. On the contrary, if the variables move in the
opposite direction, they are said to be negatively related. For example, smoke
pollution falls with an increase in pollution abatement expenditure. The variables
“smoke pollution7 and “pollution abatement expenditure” are inversely related in the
same way as an increase in interest rate will cause a decrease in the money supply.
This relationship can be plotted on the graph.
Figure 1.3-5: Smoke Pollution and Abatement Expenditure

9S.0 100,00 105.00 110.00 115.00 120.00 12S.00 Abatement

2
expenditure(PKR '000)
Both! the graphs are straight lines. In such cases the variables are said to be linearly related to each other.

The slope of the straight line

2
Slopes show the rate of change in one variable with respect to another variable.
2
They show how fast one variable changes as the other variable does and this is why5they are considered
important in economics. The slope is defined as the rate of change in the variable measured on the vertical axis
per unit change in the variable measured on the horizontal axis. Figure 1.3-6 shows a linear relationship
between pollution and abatement expenditure. It shows us how many tons of smoke pollution (P) is decreased
per pound spent on pollution control (E).
0
Pollution,
P
C
O
O

t
0
n

s
p

)
2
1 Economics I Reference Book 52
5

1
 As is evident from the figure, if we spend PKR 500 more, we get rid of 1 000 tons of smoke pollution. This is 2
ton/rupee spent. The slope of any straight line can be calculated using the formula given below:

AP — P2 - P AE E,- E,
In this example P2 = 23,000 tons,PI=22,000 tons, E2=11,000E1=10,500. Therefore the slope of the line comes
out to be -2. (? is the Greek uppercase letter delta which represents a change in something.)

Figure 1.3-6: Linear pollution abatement

240
Slope = A P / A E = -1000/500
235
230
Nflution, 225
f ( 00 tons p.a.) UQ

215
210

205
200

195
95.00 100.00 105.00 110.00 115.00 120.00 125.00
Abatement expenditure(PKR '000)

Non-linear functions
Xon-linear relationships are more common than linear ones. In the case smoke pollution abatement it is
generally cheaper to eliminate the — ft units of pollution. Gradually, as the smoke gets cleaner and cleaner,
cost
of further finishing tends to increase because more expensive —mods need to be used. As a result, the
graph relating expenditure -a batement and amount of pollution usually looksmorelike
Figure
• - han Figure 1.3-6. This figure shows that, as more money is spent, r,: benefit in terms of extra
abatement for an additional1 rupee of " c expenditure becomes less. This is shown by the diminishing i | r^
:-f the curve as we move rightward along the curve.

■ : - fure shows, an extra 1 rupee of expenditure yields two-thirds of 'Win •

iratement (2,000/3,000) when pollution is 8,000 tons but only l fit ---------------------------------- a tone of
abatement (500/3,000) when pollution is 3,000 tons.

55
pan Two National Income and Demography
Concepts of National income
Chapter 1

By the end of this chapter you should be able to,

Learning Outcome ■ Explain economic models

_ List the different measures of national input and output

■ Define National Income and explain why this is important when aiming
to achieve economic growth

■ Define and explain Gross National Product

■ Define and explain Gross Domestic Product _ Recall the formula for

expenditure-approach method of calcut GDP B Explain the Expenditure

approach

Recall the formula for Income approach method of calculating i mExplain the

Income approach
* Explain the output method of calculating GDP and how this; avoids the
problems of double counting

w list the problems in using GNP as a measure of welfare _ Define poverty

reduction strategy papers (PRSPs)

■ Define social safety nets or social economic safety nets

■ List the types of transfers that safety nets usually include

A
KLoreiitz asrveafiid hew H pwtisfsi
difibutiofMf iitceme

Introduction We’ll start by examining the total flow of economic actmtyi country and the basic division between
production and com The latter is organized around households while work or organized around
firms. Such analysis will help us to view process of production in terms of a circular flow of output i
We shall then examine how the national income of a country i innominal and real terms and
consider measurement prc with* determinants of overall national income size.

Well review the main components of aggregate demand in tiat, along with two important
macroeconomic concepts ^ the and accelerator. This will involve an examination of inie leakages in
the circular flow of income and output together! factors which influence the level of investment in
Income is derived from two main sources:
• The performance of personal services such as work
•The ownership of factors of production providing impersonal services,
i. e. land and capital.

Inequality of income arises from differences in payments made for personal services (wage differentials) and
differences in the amount of property owned by individuals. Most people derive the bulk of their income
from tiie provision of personal services. They receive a wage or salary which is supplemented, perhaps, by
investment income from a bank account. Inequalities in income and wealth can be reduced by progressive
taxation. Income can take the form of wages, rent, interest and profit, and all income in an economy is
received by someone. Total income depends upon the total volume of production. Expenditure for one
person or household becomes income for others in the economy providing the goods or services.

The following diagram of the circular flow of income in the economy shows the provision of the factors of
production to firms. In return for their effort, income is paid to the households. This money is spent in the
economy on consumer and investment goods which are supplied by the firms.

In other words, this diagram emphasizes the basic economic concept: National Income = Total

Production = Total Expenditure

With the use of money as a unit of account it is possible to measure these flows in an economy.

FACTORS
OF
PRODUCTI
O
N
■ 1 Land
2 Labour ^
3 Capita!
4 Enterprise

This equality of product, expenditure and income is based on some rather big assumptions, that:
• There is no time gap between earning and spending
• All income is spent
• No goods and services are removed from the flow.

fe practice these provisions cannot, of course, be sustained. Nevertheless, if it is possible to show that leaks
from the circle can be balanced by
injections back into it, then we can see that the total flow can still I* maintained in a state of equilibrium, i.e. the condition when
the fl<T remains the same from one time period to the next. If we consider flow in terms of money, then the following -
leakages can occuBj

Savings These are personal or household savings from incxMMlJ In our definition of savings, we must include
all incomil that is not immediately spent. Savings are seen, then, as consumption”, at least for a “no*- measurable
period of tinrf

Taxation This is deducted either from income in the form rf| direct taxes, such as income or corporation tax, or
deducted expenditure in-he form of value added tax or duties on petn« | and tobacco

Imports Money spent on imported goods, such as food or services, such as foreign holidays, is leaked out of the

59
 circular flow of income. _

However, to offset these leakages there are three types of injections^" increase the circular flow of income:

Investment This is money spent by firms in acquiring means of production. It is an increase of total spending in
adiBj to that brought about by consumer spending on final goo4~H services. Ideally, it would probably be
desirable to disdqfll genuine increases in productic capacity from that expenditure which merely represents the
replacement machines, factory building, etc. In practice, when we arejAA with broad national figures, this is just
not possible. We to remember that firms rarely replace an old machine «dV 11 that ' i similar- they usually buy
better and more equipment, so that we ha assume that all investment is “productive” while also recognizing thaj
there must aliflV some investment that is just replacement. In national analysis, increases in stocks of finished
goods, i.e. which are yet to be bought, are regarded as investment»/'/\J it is always kept separa national

Government expenditure Spending on defense, eilHH

health and social services, etc is largely financed '
and not from charging a price in the market plaoeS~ | of production have to be
employed to provide services - their income becomes part of the cuoiH |

fronfl

Exports Money received for selling goods and services countries enters the circular flow of
income in reward to ' those factors of production engaged in §0 activities.
 drcX fln f mc,0rp0rate these leakages and injections into the ' fl°W °fincome ‘Vm. As the narrative and diagram indicate each leakage 1S
apparently offset by an associated

National income Savings - Investment Taxation - Government

equilibrium expenditure Imports - Exports

H0wever, this does not imply that each “pair” must be in balance. If total targesequaltotal injections from one time period to the next,
then it 's rosatt t0 sfe that total national income - product _ expenditure flow is in equilibrium. In the event of leakages exceeding
injections national income is contracting, whereas if injections exceed leakages the nafl°nal£gJne is sanding from one time period to the
next

5 tC* 7n°mC m0dd, ifwe i®Te the national income n equilibrium and taxation plus imports
is offset by government expenditure plus exports, then
savings must always equal investment.

OUTPUT = CONSUMER GOODS + INVESTMENT INCOME =

CONSUMPTION + SAVING Therefore C + I = c + S Therefore I
=s

~ t eC°n0mies there K a tendency for savings and investment to

nl
Stendef ? CnSUre Mti0naI lncome is 11 equilibrium. Suppose F fA mvestment 1 "ater than intended savings. This meansthat 'n nd£d Pr°ductl0n for
consumption is likely to be less than desired consumption (income which people wish to spend on consumption)
T S
so l>T f®te T^ 1131 people 305 ------------- 4fcP more than is being made ~ stocks of goods fall
(reducing actual investment according to our
10n\ oducers Wl11 find i • 1 1 1 ’ 1 1 1 j-• 1 -t: 1

). goods easier to sell and will seek to raise production and

these developments will tend to bring actual investment and savings together as increased income will generate higher savings.
ex
Penditure, whether or not they balanced depends on government
economic policy and/or the state of the economy. More recently there has been a belief that government expenditure should be
restrained by the amount of tax revenue collected but most governments do have deficits and finance these by borrowing
S£C
_ tT Th£re is n° aut_tic of maintaining S i : £ n lmP°fS
£ S
" XpOrt - limits ^ the result of spending and income levels in the home country and exports are the suit of Similar intentions and
income levels in other countries.

The resultant external imbalance is offset by changes in the level of income and production in a country.

totfiemtal W1 Can See that there are lkeJyt0 be forces tending to bring -alnatonal income and production into equilibrium and other forces
tending to produce disequilibrium.
 Some of the basic terms used when explaining national income statistics are:

Gross Domestic Product (GDP) at market prices

This is the total market value of all the goods and services produced m a country.

National income Gross National Product (GNP) at market prices

terms and
measurement This is the GDP after account is taken of net property income firoM abroad; for example, investment income from
overseas assets minnfj interest paid on domestic government debt to non-residents.

Problems in using GNP as a measure of welfare

GNP is traditionally calculated as the sum of total market activity, L produced and services rendered. In this
computation, factors that are i taken into account are things like capital depreciation and inflatio®« | currency.
Hence, GNP provides a picture of the “ economic health*— country and allows comparison of countries in terms of
prosperity - development vis-a-vis presenting a picture of the “ “ haves” and C£have-nr Economists use the GNP
growth rate as an indicator towards the ow improvement of people’s welfare.
GNP growth rates and targets ! newly industrialized countries of Asia hover over the 5%- 6% r these nations
concentrate on rapidly utilizing resources to furnish j and render prosperity. When the GNP growth slows down or n
the economy is considered to be 'stagnant^ or in a ‘recession, . A i that continues over multiple periods is often
ne sl
termed as a ‘depi ar

Sociological studies do not show any correlation between GNP i and 'quality of life, and this tells us that GNP in fact
doesn’t really ] anything meaningful.A better index than GNP is required to a* development and welfare of a nation
^ an index that measureil tangible wealth and intangibles that are essential to prodti~

A famous anecdote about how GNP works is that a philosopher ta man throw a brick through a window. This
action resulted | creation as one person was hired to prepare the glass for the newi one was hired to fix the glass pane
and a third was hired to fix; the window for protection. The philosopher hence conclude order to increase GNP, it is
the moral duty of every person tt brick at a window and hence create jobs. This anecdote shows theH with GNP that
it is computed only on the basis of a number ibeing produced, without taking into consideration whethT produced is
detrimental or beneficial. Just because a certain! activity helps in creating jobs does not mean that it is a produc If a
job is temporary, low waged or created to resolve probler due to another economic activity, then it is in fact not •
economic health of the country.

62 Economic
 Nationai Product - Socomo ■ Expenditure
m
Th= equals GNP at factor cost less an estimate of capital consumption economy, i.e. depreciation of the existing stock
of capital A similar a justment is made to national income and expenditure figures. The national income figures are
measured in three separate forms:
® National product 6 National income ® National expenditure Other aspects of the

national income Why

measore the oafsooa! income?

The national income is measured in order to assist governments with their economic policy of making and thus
hopefully attaining full employment and economic growth. National income statistics can also be used to measure
improvements in living standards and for making comparisons between various countries.

for comparisons to be meaningful over a period of time inflation must (e taken into account and national income must
be measured in constant

The first column illustrates the measurement of national income in

National Income (PKR million)

bjs
Marke
t Year
0 Year
4

Constant Prices (Year 0)

4,000,000 4,800,000

Pmvides a nominal growth rate of 100% over four

P ces 4
ri years or 25% per ’ — am. In other words, assuming a -0. 000 constant population and distribution :c
income, the 8.°. 000 standard ofliving has doubled. The second column, which -eas^res the national income in constant
or real prices, thus removing ment of mation, reveals a growth rate of 20% or 5% per annum, h is a more realistic measure of
the national income for time itpamons, and is sometimes referred to as the real national income.

temational comparisons, national income is divided by the total to derive per

capita income for individual countries. The per cf mcome "~res have to be treated with a fair degree of caution 1~7~
!&>—value judgments are made on such statistics. It is necessary to : of the cost ofliving in each country —low prices
for goods * <1 $ In China in comparison to Pakistan - along with the extent agriculture in the economy.

_emational comparisons must take account of the distribution m economy

between the rich and poor which influences
the level of economic welfare. Another factor is the level of expenditure on armaments in each country. International
comparisons are complicated by the rates of exchange of the various currencies of the world.

What determines national income size?

As to be expected, the quantity and quality of the four factors of production are important in determining the size and
growth rate of a country’s national income.

1. Labor
The age distribution of the population will determine the size of the available workforce; an ageing population
might reduce the labor force size. Apart from numbers of workers, consideration must also be given to the
education, skills and health of the labor force. The latter part play an important part in determining overall labor
productivity which greatly influences national income size.
2. Land
This cannot be increased to any great extent by man. Climate, water supplies and mineral endowment are gifts
of nature or God. The only way in which this factor can contribute to increasing national income is by the
better utilization of existing resources which generally entails the use of more capital to produce higher returns.
3. Capital
More plant and machinery per head generally results in a higher level of output per head in an economy. The
best prospects for increasing national income may thus be found in a policy of promoting more capital
investment. Not only is it important to increase the amount of equipment for labor, but it is also necessary to
replace existing capital assets fairly rapidly to ensure that workers in all economic sectors are always using the
most up-to-date equipment possible.
4. Enterprise
Management which uses the most up-to-date techniques of organization and control should be able to employ
combinations of the other three factors in the most productive manner possible. Obviously the use of modem
technology by enterprises will tend to accelerate economic growth and add to total output.

Why is national income measurement not precise?

Calculation of the national income statistics for a country is not as precise as an accountancy exercise. The following
points, although not exhaustive, provide some indication of the measurement problems associated with national income
statistics.

Economics | Reference Book 1

 ncomplete information
Income information relies on completed tax returns which often do not disclose a person’s total income. Many
1. people perform services for which they receive a cash payment that is not entered in their tax return.
Such income, output and expenditure is excluded from national income statistics.

2. Unpaid services
Work performed by housewives is excluded from national income calculations in most countries because no
payment of money income takes place. If housemaids were employed and wages were paid, this would be
included in the national income, as income and output. Do-it-yourself work is also excluded from national
income calculations, as there is no money payment for services rendered.

3. Value added
National output figures must consider only value added at each stage of production. From the gross value of a
firm’s output must be deducted the cost of inputs acquired from other firms, otherwise double counting could
result in grossly inflated figure for total output.

4. Estimates
National income statistics involve the use of estimates for capital consumption, stock valuation and imputed
rents for owner- occupied houses. Although such information is not entirely accurate, it does not detract from
the overall value of drawing up national income statistics.

5. Inflation
The depreciation of money via inflation can artincially boost the resultant national income figure.
Unfortunately, no other method of measurement is available for national accounting purposes. The use of real
GNP figures enables realistic comparisons to be made over a period of time. Despite these problems, national
income accounting is a usefixl aid in the management of a country’s economy.

Influences on the national income

We now need to look a little more closely at the main elements in the national product or income, and try to understand
how these are likely to change in response to the influences operating on them.

Consumption
This is the main objective of all economic activity. There are two main Masses of consumption:

< msehold consumption, usually known as consumer expenditure, accounts for approximately 70%
of total expenditure in most advanced

Concepts of National income

 economies. Any small percentage fluctuation in this type ofexper has important implications for the
overall level of economic a<
/ V) hv £Q ~
^Community consumption (defense, education, etc) is expenc undertaken by the government and other agencies on
behalf of the v community. There is a fundamental difference between the Government spending is the result of
political and administmtive deck f hanges may take place therefore, for reasons that are not stn«i economic”, m the
sense that they are not the result of considerations < cost and the availability of finance. Nevertheless, governments now
fin— increasingly that they have to operate subject to various cost (economic^

• Personal consumption is assumed to be purely economic in nature and responsive to economic pressures. We assume,
fairly reasonably, that consumption rises with disposable income, i.e. income left to the consumer after deduction of
direct taxes, national insurance and pension contributions. We can also regard certain other regular payments as avmg a
similar effect to tax, such as house mortgage interest payments. ?ny chan§e m *ect or mcome tax will change disposable
income and th^ Muence consumption. A reduction in income tax or mortgage ,terest rates would be expected to increase
consumption and vice versa. ^Consumption is thus a function of income.

However, it is important to recognize that other factors also influence consumer intentions. People’s spending patterns
may depend partly on *eir exf Rations of the future. If they expect to be earning more in the future, if there is confidence
and a feeling that the economy is expanding, they are likely to be prepared to spend more now, perhaps with the e p of
consumer credit. They are not afraid to commit future income to installment payments. On the other hand, if consumers
are fearful ab~ut the future and expect an economic recession or overtime income to be cut, then they may reduce
present consumption and seek to save more for the uncertain future.

Price expectations can also influence consumption —a rise encourages s^endmg now whereas an expected price fall will
lead to the postponement of major spending decisions, such as car purchase or new furniture, etc.

Saving

paving is income not consumed. It is a residual which is influenced and determmed by consumption decisions - out of a
given level of income, if people consume less then savings increase. Alternatively, if incomes increase then in most
circumstances so also will savings. Savings like consumption, are a function of income as are imports and tax revenues guer
mcomes
encourage the consumption of more foreign goods while or the government, as incomes and spending rises, more
tax is collected.

Marginal propensity to consume (or save).- The marginal propensity to consume is that proportion of any change in
disposable income that will

Economics | Reference Book 1

 be spent on consumption of goods and services. When we think in tsms of disposable (after-tax) income, we see that any
disposable income not consumed must then be saved. Thus, the marginal propensity to consume (MPC) plus the marginal
propensity to save (mps) is equal to one or unity, i.e. equal to the change in disposable income.

Injections into national income

We have so far concluded that consumption is a function of the level of income. However, three important injections ^
investment, government expenditure, exports- into the circular flow are subject to separate considerations and thus initially
may not change in response to domestic income level changes.

Investment expenditure is influenced by a range of factors such as utilization of existing productive capacity, expected
future levels of demand, new technology and the availability/cost of finance. Business firms do not alter investment
decisions directly in response to income changes. Investment in short term economic models is not regarded as a function
of income.

Government expenditure depends on political decisions and thus in the short run is not directly related to the level of
income while exports are a function of income levels in other countries.

The Expenditure Approach defines National Income as comprising of the following major components: '
Expenditure
Approach
• Consumption (C)
• Investment (I)
• Government expenditure (G)
• Plus exports (X) minus imports (M)

It is assumed that investment and government expenditure offset saving and taxation. As we saw in the
circular flow of income, total aggregate demand (expenditure) will equal total national income or
output in an economy.

Mathematically, national income can be represented as follows:

Aggregate demand = C + I + G + (X-M) = National income

Consumption (C)is defined as the Personal Consumption spending by households to acquire finished goods and services
and it forms the most substantial part of National Income. A household will consume both durables goods - appliances,
automobiles, furniture, etc. and nondurable/consumable goods - clothing, food, personal care products, etc. Household
consumption also includes paying for services like electricity, gas, telephone, repair and maintenance and many others.
The second largest component in National Income is Government Expenditures (X).These are the expenses incurred by
the federal, provincial

Concepts of National income

67
 and^ocal governments on final goods and services. These expenditures can be infrastructure expenses such as
construction of roads, dams, canals, parks’ etc. These are also expenses incurred for running the government m the form
of salaries and operational expenses as well as the expenses incurred on defense/military development. It should be noted
here that pensions, welfare payments and any unemployment compensations paid y the government do not count towards
this expenditure.

Given the above, if there is free movement of the factors of production and some are underutilized in the economy, what
will happen if government expenditure increases without a corresponding increase in texation? Assuming such
expenditure is used to pay for goods and services, it becomes income for firms and their employees. This will increase the
general level of income in an economy; national income will be at a new higher equilibrium level assuming other
injections and leakages remain

There is likely to be a natural balance between the levels of saving and investment, as defined for purposes of national
income calculation If saving is greater than investment, given that the other injections and withdrawals are in balance, then
people are not consuming all the goods and services available for consumption. The immediate effect is for stocks
(inventories) of goods to rise, bringing total investment (which includes stocks) back into balance with saving. However,
firms will not continue to produce stocks that are difficult to sell, so they will cut back production. Th~is will involve both
a reduction in real productive investment and a reduction in income. As the income level falls, actual saving will be
reduced, thus restoring equality between saving and investment, but this relationship only holds when other injections and
leakages balance and there is free movement of the factors of production.

The Income Approach is the reverse of the Expenditure Approach as it argues that all the Consumption and the
Government expenditures generate revenues for firms producing goods and services as well as the suppliers, contractors
and the workers involved in producing and delivering those goods and services. Hence, as all expenses result in income
generation, then by adding up all the income generated, this should yield the same result as "attained through the
expenditure approach. The components that are part of the income approach are shown in the following table.

Component of GDP: The Income Approach

National Income Add: Compensation of employees
Proprietor’s income Corporate profits Net interest
Rental income Add: Depreciation Add: Indirect taxes
minus subsidies Less: Net factor payments to the rest
of the world
Less: Other__________
Gross Domestic product
In order to calculate the GDP under the income approach, wc bega® mmkcalculating the National Income. The
National Income is» akalatei as the sum of all the salaries earned, the profits made by 00TperaEk«& the net
interest paid by businesses, the rental incomes earned and Ae iocoiaics of the entrepreneurs and partnership
within the country. Eflfectiny-, tiis sum provides us with a total of all the incomes earned in all the segments of
the economy.
Once the National Income number is determined, the following adjustments are made to reach the GDP figure:
1. The depreciation expense is added since depreciation is a form of expense that does not generate
any income for any household or firm etc. Depreciation is the expense incurred when useful life of the plant,
machinery or any equipment is finished. Therefore it is regarded as an intangible expense that is not causing any
change in cash but is recorded as an expense. So, by adding back depreciation to the National Income number,
we effectively add back the potential income that was lost due to depreciation.
2. National Income also needs an adjustment of the incomes earned by foreigners working in the country as
this income may only be partially spent within the country and the rest may be repatriated by the foreigners.

Economics | Reference Book 1

 Hence, repatriation of funds by foreigners is deducted from National Income. Similarly, income earned by
nationals working abroad also needs to be taken into account. In the case of Pakistan, a large number of
Pakistani nationals work overseas and remit money to Pakistan (home remittance). This inflow of funds creates
economic activity within the country and is considered towards calculating the National Income.
3. Deducting subsidies paid by the government to reduce the costs bome by the consumers of goods.
Subsidies effectively reduce the cost of production and hence increase the net income of the seller of goods and
services, while no services are received for such payments.
4. Finally, indirect taxes such as sales tax, withholding tax, fees, etc are added back to Net Income as these taxes
are included in the prices of goods and services.
The Output Approach: The output approach to calculate GDP is to add
together the total value of all the goods and services produced in an economy. This measure of GDP sums up
the values of output produced by each of the productive sectors in the economy using the concept of value
added. Value added is defined as an increase in the value of a product at each successive stage of production.
The GDP can be calculated using the formula given below:
GDP at market price = Value of output in an economy in a particular year -
intermediate consumption Table 2.1-1 represents the total value of the services produced in Pakistan,
Services Sector of Pakistan (figures in PKR million) ________________________________________________________
2005-2006 2006-2007 2007-2008 2008-2009 2009-2010

Wholesale & Retail Trade 838,426 887,294 934,231 921,375 963,368

Transport, Storage & 496,073 519,486 539,297 558,703 574,101
Communication

Finance and 1 nsurance 265,056 304,514 338,386 312,818 277,555

Ownership of Dwellings 135,820 140,587 145,521 150,629 155,916

Public Administration & 295,959 316,915 320,565 332,108 340,508

Defense
Community, Social & 480,217 518,344 569,044 619,412 667,793
Personal Services

2,577,557 2,687,140 2,847,044 2,895,045 2,979,241

Since there are multiple stages involved in the production of goods and services, the output approach only
considers the final value of goods or services while

Concepts of National income

70
calculating GDP. This is done to avoid the issue of double counting. Double counting occurs when the total value of a good or a service is
included more than once in national output by counting the value of the gdod at each stage of its production.

Because of the complication of the multiple stages in the production of a good or service, only the final value of a good or service is included in
total output. This avoids as described above. Let’s consider an example of meat production, where the value of the good from the farm may be
200 rupees/kg, then 400 rupees/kg from the butchers, and then 450 rupees/kg from the supermarket. The value that should be included in final
national output should be PKR 450/ kg, not the sum of all those numbers, PKR 1050/kg. The values added at each stage of production over the
previous stage are respectively PKR 200, 200 and 50 (total PKR 450). Their sum gives an alternative way of calculating the value of final
output.

The Income Multiplier

Any increase in government spending will result in a more than proportionate change in national income. This is because there is a multiplying
effect created when any given amount of new spending power enters into an economy. If the government spends money on a building contract,
contractors and their employees will receive additional income. Most will be spent in the form of consumer expenditure and will then become
someone else’s extra income, and so on.

Thus, if there is unemployment, an increase in government expenditure (or investment or exports) will lead to more people being employed.
Increased expenditure will have not only primary effects on employment and expenditure but also secondary effects. However, the multiplying
effect will not continue indefinitely, as leakages - savings, taxation, imports -will reduce each successive additional income round. The way in
which an initial increase in expenditure is magnified as it is dispersed through the economic system can be measured by the multiplier. The
employment multiplier, for example, is the ratio of the increment of total employment
Economics | Reference Book 2
which is associated with a given increment of primary employment in the economy. Thus, if increased government expenditure on
the nation’s infrastructure generated 250,000 jobs in the building and road construction industries which in turn increased total
employment by 750,0, this would imply a value of three for the employment multiplier.

One of Britain’s most influential economists in the inter-war period, John MaynardKeynes, produced a formula in 1936 for the
measurement of the income multiplier:

Income multiplier (k) = A I

Where C=marginal propensity to consume,

△I =increase in investment ~ qwl—

It follows that larger the marginal propensity to consume (i.e. the greater the proportion of an increment of income which people
are likely to spend), the greater the multiplier will be in an economy. Alternatively, a high propensity to save reduces the multiplier
effect on income (and employment).

Provided that resources are unemployed in the economy, the rise in investment will generate employment. If the economy is near
full employment, then an increase in investment will result in demand pull inflation which will stimulate a wage price spiral.
However, Keynes in his book The General Theory of Employment, Interest and Money” (1936) was interested in the economic
problems of a depressed economy in the 1930s, when prices were stable or declining ^ a state of deflation ^ together with high
unemployment.

Is the multiplier dynamic?

Even Keynes admitted that the multiplier might not be as dynamic as was believed at first sight. A series of lags exists in an
economy. A consumption lag might exist, as extra income generated might not result in an immediate increase in consumption it
might be saved or used to pay off past debts. An investment lag might exist between planned investment and the actual expenditure
in the economy. Finally, increased consumption might be satisfied initially from existing excess inventories accumulated during a
recession, thus an output lag might exist.

Some of the extra income generated at each round in the multiplier process is lost to savings, which prevents the income generation
process continuing forever. In addition, some of the income generated will be spent on imports and this will become income in
foreign countries. A high propensity of import will therefore reduce the overall size of the multiplier. Another leakage is direct ana
indirect taxation wmch also siphons off some of the increased income. Higher personal income means greater tax liability and thus
nigher tax deductions. Also, most luxury and semiluxury goods are subject to value added tax or customs duty. Although this
increases government tax revenue which could cover some of the initial expenditure from this source (public works), it does of
 necessity reduce the size of the multiplier. This is sometimes referred to as fiscal drag.

This more conservative estimate of the multiplier’s size means that a huge increase in government expenditure
might be needed in an economy to solve unemployment. In most cases this is not possible due to budgetary
constraints, worries over the size of the national debt and possible inflation, together with an increase in
imports which might have a negative impact on economic activity and employment.

The Distribution of Statistics show that during the recession year of 2008, the average (or per Income and Wealth
capita) annual disposable income of Pakistanis was approximately USD
1027. However, almost nobody earns the average income, and it is more revealing to know the distribution of
income, which shows the dispersion of individual
 incomes. Every person in the nation does not earn the same amount of money as the others. Therefore, these
can be sorted according to the income classes. Some of the people belong to the lowest income class which is
below Rs. 5000 of income whereas few go into the income class of over Rs. 100,000.

The assumed income distribution of households is shown in the table below. Column 1 shows the different
income-class intervals. Column 2 shows the percentage of families in each income class. Column 3 shows the
percentage of the total national income that goes to the people in the given income class.

Columns 4 and 5 are computed from columns 2 and 3 respectively. Column 4 shows what percentage of the
total number of families belongs to each income class or below. Column 5 shows what percentage of total
income goes to the people who belong in the given income class or below.
(1) (2) (3) to (5)

Income Class Percentage of Percentage of the Percentage of Percentage of income

all families in total income families in this class received by this class
this class received by families and lower ones and lower ones
in this class

Under Rs. 5000 3.6 0.2 3.6 0.2

Rs. 5,000 - Rs. 9999 6.3 1.1 9.9 1.3

Rs. 10,000-Rs. 14,999 8.1 2.4 16.0 3.7

Rs. 15,000-Rs. 24,999 16.7 8.0 34.7 11.7

Rs. 25,000 - Rs. 49,999 36.3 31.8 71.0 43.5

Rs. 50,000 - Rs. 74,999 17.7 25.7 88.7 69.2

Rs. 75,000 - Rs. 99,999 6.5 13.3 95.2 82.5

Rs. 100,000 and over 4.8 17.5 100.0 100.0

Total 100.0 100.0

The table above shows the wide spread of incomes. Although there’s always room
at the top, not many people can earn enough to reach that income class. Most of the
households belong to the middle classes of income.
Measuring Inequality A useful way to analyze inequalities in distribution of incomes is to check pmong
different the percentage of income that goes to the lowest 50% of the population
income classes or the lowest 10% of the population. This can be checked through the
table above.

If incomes were absolutely equally distributed, then the lowest 20% of the population would receive exactly
20% of the total income, the highest 20% would also get only 20% of the total income, and so forth.

In reality, according to the table given below, the lowest 20% of the families only receive 4.6% of the total
income. Similarly, the most affluent 20% of the families earn nearly 45%, and the upper 5% get almost 18%.

73 Economics | Reference Book 2

 Table 2.1-3: Comparison of actual and polar cases of inequality
Income Shares

a) (2) (3) (4) (5) (6)

Family income Percentage Cumulative Cumulative Percentage of Income

ShdTGof percentageofpeople
Income Absolute Absolute Actual
equality inequality distribution
Lowest fifth 4.6 0 0 0

Second fifth 10.6 20 20 0 -

TMrd fifth 16.5 40 40 0 -

A
aurth fifth 23.7 80 80 0

fifth 44.6 100 100 100

In order to see the polar distribution of inequality, we groupthe population into the fifth with the lowest income,
the fifth with the second-lowest income, and so forth (as shown in column 1).The second column shows the
fraction of total income each fifth receives. In column 3, the income is cumulated for each quintile. Now, we can
compare the actual distribution with the polar extremes of complete equality and inequality.

The degree of inequality can be shown by a wjdely used plrve named the Lorenz Curve which is used to analyze
income and wealth inequality. The figure below is a Lorenz Curve showing the amount of inequality listed in the
columns of the table above. It contrasts the patterns of absolute equality, absolute inequality and actual inequality.

Any actual income distribution would fall between the extremes of absolute equality and absolute inequality.

74
 Figure 2.1-1: Distribution of

Disposable Family Income

00

a
m
O
o
u

o'

o
%

20 30
40 60 80
% of cumulative population 4

Income inequality in The traditional concept of aggregate income or GNP growth is now not acceptable to assess the level of welfare of
Pakistan society. The income distribution pattern among the members of society has become an important factor in
measuring populations^ economic status. The data presented in Table 2.1-4 indicate that the share of the lowest 20
percent income group remained fluctuating, ranging from 5.7 percent to 9.6 percent during the considered period. A
relatively better situation emerged in 2001
2, while the share of the lowest income group and middle income group in total income increased to 9.6 percent
and 48.7 percent respectively, while the share of income group with the highest 20 percent decreased to 41.7 percent
against 49.3 percent in 1990-91. In 1990-91, the share of the lowest 20 percent income group remained the lowest
one (5.7 percent) wideniT; the income distribution gap. Thus the share of the lowest income group remained on
decline in general except in 2001-02. An improvement was observed in the income distribution pattern in 2001-02
with an increase in the income share of the lowest 20 percent as well as the middle 60.0 percent income group,
while this shift resulted in a reduction to the extent of 41.7 percent in such share of the highest 20 percent income
group. The ratio of the highest 20 percent to the lowest 20 percent was the lowest (4.3 percent) in 2001
2, indicating a relatively better share of the lowest income group.
 Table 2.1-4: Income inequality in Pakistan
Income Inequality in Pakistan __________________________
Percentage Share of Income Ratio of Hiahest

Year Lowest Middle Highest 20% to Lowest 20%

20% 60%

1970-1971 8.4 50.1 41.5 4.9

1979-1980 7.4 47,6 45 6.1

1990-1991 5.7 45 49.3 8.6

1998-1999 6.2 44.1 49.7 8

2001-2002 9.6 48.7 41.7 4.3

Source: Pakistan Economic and Social Review Volume 45, No.1(2007)

Trends in income The population of Pakistan can be classified as rural and urban on the basis of location. Income distribution

inequality by in rural areas mainly depends upon the farm land distribution and cultivation right, which is the main source
of income of the rural population. The data given in Table 2.1-5 reveal that the share of the 20 percent
locations
lowest income group remained higher in rural areas throughout the considered period than that of urban
areas, while the income share of the highest 20 percent income group was higher in urban areas relative to
rural areas. This reflected relatively more income inequality in urban areas than in rural areas. However, in
2001-02 the share of income of both groups indicated improvement in the income distribution pattern to the
best level in rural areas, while in urban areas the situation had become worse during the same period, with
the ratio of the highest 20 percent to the lowest 20 percent estimated at 2.3 and 12.4 in rural and urban
areas respectively. However, in the remaining period, this ratio was relatively better in rural areas as
compared with urban areas. In brief, it could be concluded that the income distribution pattern was relatively
better in rural areas.

Table 2.1-5, Household Income Distribution by Locations for Selected Year

Household Income Distribution by Locations for Selected Years _____________________________________
Years Rural Area Uiban Area

Lowest Highest Ratio of Lowest Highest Ratio of

to to
20% 20% Highest 20% 20% Highest
Lowest Lowest

1970-1971 NA NA NA NA

1979-1980 8.3 41.3 5 6.9 48 7

1990-1991 6 47.4 7.9 5.7 50.5 8,9

1998-1999 6.9 46.8 6.8 6 50 BJ

29.6 23 4.E 59.5 12.4

Source: Pakistan Economic and Sooal Rev'WeWN Volume A5, Uo. A U007)

Concepts of National income

 As already mentioned, a common way of assessing income distribution is by using the Lorenz curve, which defines
Applying the Lorenz the relationship between the cumulative proportion of the population and cumulative proportion of the income
approach to the received by those population proportion units, while these units are arranged in ascending order of their income. The
household income Lorenz approach was applied to the data at the country level. The data transformed m Figure 2.1-2 indicate that the
distribution by
Lorenz curve closest to the egalitarian line was of 2001-02, while all other curves remained below it. In this year the
location
lowest 20 percent population segment received the highest share from income for this income group. Moreover, it
became one line matcnmg with the curve of 1979 in the case of the highest 20 percent income group because of
no change in the income distribution pattern in this segment of the population in this particular year. For the periods
1990-91 and 1998-99 the merged lines of curves showed similarity in the social gain pattern. In brief, it could be
concluded that social welfare received by society was the highest in 2001-02. But this comparison leads towards
ambiguous
results on a Lorenz curve intersection pattern basis.
Figure 2.1-2: Lorenz Curve at country level

Cum% o1 Population 1970 »

1S79 ^—1990 HIM 998 2M1

Source: Pakistan Economic and Social Review Volume 45, No.1(2007)

Inequality in Countries show quite different incame distributions depending upon their economic and social structure. Lorenz
different regions curves of four countries are shown in the figure below. It can be seen that the UK and Sweden have less income
inequality than the Unites States. The reason for this li« partly in the high levels of redistributive taxes that have
been imposed in the European countries. In addition, the US has a larger proportion of low-income minority
groups and larger numbers of one-parent families. Amongst the advanced market economies across the globe,
the greatest income equality is found in Japan and West Germany. The most unequal distributions are in the
United States, Canada and France.

76 Eco
 Figure 100
Sweden

Great Britain
d>
E
o
o United States
c
Q)

|40
D
E
3
O 20

Brazil

0204060
% of cumolafive population

Jii5tn6ution of An importantindexofeconomicpoweriswealth,whichisthenetownership of financial claims and tangible property, or net

nealth worth (equal to assets minus liabilities).
Inequality in the distribution of wealth is a factor that is responsible for the inequality of income. Those who are very
wealthyenjoyincomesfarabovetheamountearnedbyanaveragehouseholdThosewithoutwealth are initially in an income
handicap.
Moreover, wealthismuch more unequallydistributedinmarketeconomies than income, as the figure below shows. In the
US,1 percent of the people own about 19% of all wealth and the richest 0.5 percent own fully 14% of the nation’s
wealth. The distribution of income in Great Britain is even more irregular than in the United States. This greater
inequality exists mostly because certain peers and tycoons in Britain own tremendous amounts of land and other
property, although studies show

77
OuBcepts of National income
 Economics I Reference
78
 r
that much of the difference is because middle class Americans often have <3 sgimewMihouef rwemmSnot so
commonaong lower-
income British people.

The sources of In recent years, governments have taken various initiatives to fight inequality and promote equality among
inequality different income groups. Although governments claim that direct attempts are being made to reduce inequality
of income, the issue remains controversial as people disagree strongly about the role of redistributive taxation
and welfare programs. Economists have identified two main sources of inequality which are explained below.

1. i nequality in i abor income

The earnings of labor constitute 80% of factor incomes. will still exist even after
distributing property incomes equally.
Inequality in labor income exists due to various factors. Some ot
them ate as follows:
a. Abilities and skills Every person has different abilities, whether they be physical, mental or
temperamental. However, people's abilities do not help in understanding the inequalities. Abilities
do matter, for instance the ability to score the most goals in football will lead to higher earnings, but
dependency on abilities is limited. The skills of a person are highly valued in the market place and
employers generally compensate on the basis of the number of skills an employee has. The general
trend of the market is to reward on the basis of willingness to take risks, ambition, luck, good
judgment, technical skills and hard work, although none of these factors can be easily measured
using standardized tests.

b. Intensity of work Some jobs require more hours therefore such jobs are compensated
accordingly. Intensity of work also depends on individuals. The workaholics may work for 70
hours a week, not take annual leave, and may postpone retirement indefinitely. Therefore the
difference in income can be on the basis of effort put into work rather than abilities or skills.

c. Differences among occupations It is a known fact that

professions with a lower number of specialized professionals arc high-earning occupations. The
income earned by CFA qualifiedj fund managers is higher than that of fund managers with a
regular postgraduate degree. One profession that seems to make most money, worldwide, is
medicine and dental surgery while, on tfic, other hand, jobs such as fast-food personnel, unskilled
semcri workers, domestic servants belong to the lower end of the scalo

d. Differences in education Education and training also plfl a vital role in creating
disparity among income classes. PeoplJ with higher education or training are expected to have a
valid* of skills and are considered smarter and more competent, beam they are paid more than
people with a lower level of educatirf or training.

79
OuBcepts of National income
 2. Inequality in property income

oCCUr due to
in inheritance and acquired <_ ealth. There are
some people with great fortunes while others have accumulated wealth through savings. Both of
these result in

a. Inheritance- the progeny of the tycoons of an earlier era are amTmg today’s top wealth holders.
The consequence of inheritance =at the helrs move to top of the pyramid of wealth, status

in risk
J* Sav g taking- entrepreneurs and business people ave a tendency to take risks. If luck is with
them, they hit the jack-pot of success and earn a higher income, status and power aij their
expectations. There is a very small fraction of personal health that can be explained by life-cycle
savings. Apparently, the balance is due to other sources such as inheritances or gifts.

Measurement of
and Trends in
Classical economists believe that wages, rent ofland, and profit on capital are
determmed by economic laws and not political decisions. They also e ieve that any
Poverty
attempt by the reformers to alter the social order would Result in violence and chaos. Modern societies, on the
other hand, refuse

finCOme and C

What is Poverty?

Poverf is a condition in which people have inadequatei^mes to fulfill

7£n *er baS1C ne«is °t f°°d sh^ and clothing. Economists have de^sejl certain
techniques to provide the official definition of poverty
lme between -noor and A'cc"u* j. t-' • ±1 r* xi i i
” P non-poor was diiiicult to draw. Economists define poverty as the level
of income below the estimated cost ofliving
LT fV T0 C°nfirm this calcul^M economists have noted
poo ge e lly e
?l f y n ra sp „d ^ their incomes on food
So therefore, by multiplying the cost of a minimum food budget by a factor of 3, the
minimum subsistence income can be calculated.
Although an exact figure is helpful in measuring poverty, a few conceptual issues regardmg it can be brought to
the fore. In measured income, only cash payments are taken into account. Some in-kind benefits, such as alth
care, are neglected. Due to these omissions, poverty is overestimated Moreover, the subsistence budget of each
country would also vary with
wouTd L ° °fthe/0Untry-The —nee budget in Pakistan would be very different from that of the United States or
Canada

of National income
 Trends in Proportion of Poor (%)
Year Pakistan Rural Urban

1984-85 24.47 25.87

21.17
1987-88 17.32 18.32
14.99
1990-91 22.11 23.59
18.64
1992-93 22.40 23.53
15.50
1993-94 23.60 26.30
19.47
1998-99 32.60 34.80
25.90

Source: www.idc.org.cg
Poverty Reduction Strategy Papers
(PRSP)
Poverty Reduction Strategy Papers (PRSP) are a set of documents prepared by
governments with the help of civil society and various developmental agencies to develop a plan for the economic development and poverty
alleviation in a country. PRSPs provide details of a particular country’s macroeconomic, structural and social policies and identify the policy
steps as well as any related external financing that is required to achieve the plans.

^Poverty Reduction Strategy Papers (PRSP) are prepared by the member countries through a participatory
process involving domestic stakeholders as well as development partners, including the World Bank and
International Monetary Fund (IMF). Updated every three years with annual progress reports, PRSPs describe the
individual country’s macroeconomic, structural and social policies and programs over a three year or longer
tmescale to promote broad-based growth and reduce poverty, as well as associated financing needs and major
sources of financing. Interim PRSPs (I-PRSPs) summarize the current knowledge and analysis of a country’s
poverty situation, describe the existing poverty reduction strategy, and lay out the process for producing a fully
developed PRSP in a participatory fashion. The country documents, along with the accompanying IMF/World
Bank Joint Staff Assessments (JSAs), are being made available on the World Bank and IMF websites by
agreement with the member countries as a service to users of the World Bank and IMF websites.

Social safety nets, or socioeconomic safety nets, are defined as contributor transfer programs that target the prevention of the poor, or
those who are vulnerable to shocks and poverty, from falling further below the poverty level (the poverty level is
Social safety nets specified by the various governments).

Safety net programs, generally called safety nets, can be arranged by the public sector ^ the government and aid
donors ^ or by the private sector, including NGOs, charity organizations, private firms and informal household
transfers.
rion-

80 Economics | Reference E
 Safety net transfers include:
• Cashtransfers
• Food-based programs such as supplementary feeding programs and food stamps, vouchers, and coupons
• In-kind transfers such as school supplies and uniforms
• Conditional cash transfers
• Price subsidies for food, electricity, orEpublic transport
• Public works
• Fee waivers and exemptions for health care, schooling and utilities
Spending on the safety net, on average, accounts for 1% to 2% of Real GDP across developing countries (though sometimes it can be much more or
much less).In the last decade, a visible growing expertise in various areas of safety nets has taken place. However, even though an increasing number
of safety net programs are extremely well thought out, correctly implemented, and demonstrably effective, many others face and create serious
challenges.

Safety nets are part of a broader poverty reduction strategy interacting with and working alongside of social insurance; health, education, and financial
services; the provision of utilities and roads; and other policies aimed at reducing poverty and managing risk.

Safety net programs can play four roles in development policy:

.Redistributing income to the poorest and most vulnerable, with an immediate impact on poverty and inequality

• Enabling households to make productive investments in their future that they may otherwise miss, e.g. education, health, income-
generating opportunities

• Helping households to manage risk, at least offsetting harmful coping strategies and at most providing an insurance function which
improves livelihood options

• Allowing governments to make choices that support efficiency and growth The safety net as a whole should provide coverage to three

rather different groups:

yThe chronic poor Even in good times these households are poor. They have limited access to income and the instruments to manage risk, and
even small reductions in income can have dire consequences for them.

Z 2. The transient poor This group lives near the poverty line, and may fall into poverty when an individual household or the economy as a
whole faces hard times.

3, Those with special circumstances Sub-groups of the population for whom general stability and prosperity alone will
not be sufficient. Their vulnerability may stem from disability, discrimination due to ethnicity, displacement due to conflict, social
pathologies of drug and alcohol abuse, domestic violence, or crime. These groups may need special programs to help them attain a
sufficient standard of well-being.

Concepts of National income

 Learning Outcome By the end of this chapter you should be able to, M List and
explain the types of inflation (cost push, =—fi—Ti demand pull, paidH power, sectoral
inflation)
Inflation
® Recall the concept of hyperinflation and fiscal inflation <■ Define and discuss the impact of stagflation,
deflation, disinfla_lj| reflation, depression ,Interpret the negative impacts of inflation _ Interpret the
positive impacts of inflation p Differentiate between inflation rate and the price ieval ■ Define GDP
deflator * Define Consumer Price Index (CPI) or headline inflation _ Recall the formula for
calculating CPI for single and multiple goAAl m List the different price indices used in Pakistan over the
fiscal year

■ Discuss how inflation is measured in Pakistan M Identify the reasons why inflation in Pakistan has

reached dauUi digits in recent years

Introduction Inflation is a rise in the general level of prices and a fall in the value d! money. The rate of inflation is the rate of change of the general
price leia and it can be measured as follows:
Rate of Inflation (year t) = Price level(l) ^ Price level(t-l)
------------------------------------------- X100
Price level (t-1)

The question here is how to measure the price level? Conceptually, the price level is measured at the weighted average of the goods and
services in an economy. In practice, we measure the overall price level by constructing different price indices, which are either consumer
based or producer based. For example, in the year 2009, consumer prices rose by 20.8%. In that year, the prices of all major products rose
including food, beverages, shelter, apparel, transportation, medical care and so forth. Ht! is actually this general upward trend in prices
that is termed inflation, -

82 Economics | Reference E
 However, the prices do not rise by the same amount during inflationary periods. For instance, energy prices may rise by 18%while food prices 11129
rise by 10%.

Inflation is considered as the persistent change (increase) in the price level over time and it is also one of the causes of erosion in the value
(purchasing power) of the currency. Inflation is one of the key indicators of the economy and, if not controlled, it can have negative repercussions for
a country’s monetary system, forcing individuals and businesses to request foreign aid or regress to bartering physical goods. If there is a sudden hike
in price levels but the prices do not continue to rise further, then the economy is not undergoing inflation. Inflation has to be persistent which means it
keeps growing over time, and if there is inflation in the economy,it means that the prices of almost all goods and services are increasing, not just a
single good.

Causes of inflation

Keynesian economists identify two types of inflation:

•demand pull inflation
• cost push inflation

Demand pull Demand pull inflation occurs when total spending in the economy exceeds the total value at current prices of what the economy is able to
inflation produce. In other words, demand pull inflation occurs when the rise in aggregate demand is at a higher pace than the economy’s productive
potential, which results in pulling the prices up to equilibrate aggregate supply and demand. If there is spare capacity, such as unemployed workers
and under-used factories, extra demand may lead to increased production and employment without any rise in prices. However, if total spending
exceeds potential supply, there will not be sufficient goods and services to meet demand at current prices. Prices will rise to match demand with
supply.

Figure 3-1, Demand-pull inflation due to increase in aggregate demand

c !P
AS
\
\\
\\
\v
V
P'
\) N/
f\ K
P 1 11
— AD'

y i' AD
•
1

Quantity
Figure 3-1 shows the process of demand pull inflation in terms of aggregate supply
and demand. Starting from an initial equilibrium at point E, suppose there is an
expansion of spending that pushes the AD curve up to the right. The economy’s
equilibrium moves from E to E, . At this higher level of demand, prices have risen
from P to P, . As a result, demand-pull inflation has occurred.

Inflatio
n
84 Economics |
Experience suggests that prices will start to rise before full < is reached. Not all parts of the economy reach full employmeHT same
time. Production of some goods reaches its maximum whiiiri parts of the economy are still under-employed. There may be i of
skilled workers while some unskilled workers remain out Bottlenecks appear in the economy and the prices of factors i supply begin
to rise; skilled workers, for instance, may find thdri pay rise as employers compete for their services.This relat illustrated in the
Phillips Curve.

The Phillips Curve shows that low rates of unemployment aie i with higher rates of inflation and low rates of inflation are, with
higher rates of unemployment. The Phillips Curve i Part 4 in detail.

Cost push inflation can occur before full employment is re associatedwith a rise in production costs Cost push inflation which is
passed on ii| prices. Since wages account for around three quarters of total] costs in Britain, for example, most attentionis focused on
the 1 and the bargaining power of trade unions. Rising costs of rawi and energy may also lead to cost push inflation in an economjp^
recent years, oil prices have risen three fold and have led to ] prices of many other products. A fall in the foreign exchange, rupee will
lead to a rise in the euro price of imported raw ] could then lead to farther price rises.

AS'

Quantilf
 Most economists, central bankers and politicians now believe that inflation is caused primarily by the
excessive growth of money supply in an economy. Inflation can only occur if there is money available to
finance it. Demand pull inflation can only continue if there is sufficient money to sustain it. Similarly, cost
push inflation depends on people having an increasing amount of money to pay the higher prices.
The monetarist
explanation of Other causes of inflation
inflation
Pricing power is considered as one of the conditions of the rise in sectoral inflation. Pricing power inflation
occurs when producers increase the prices of the finished goods to enhance their profit margins. This type of
inflation is witnessed when the economy is stable and moving towards
~ Konomc b°°m- smce to purchasing power of consumers is strong (due to stable income) producers are
Pricing Power
able to increase the prices of goods. Pncmg Power inflation is often called oligopolistic inflation, as it is the
Inflation
o igopoligs that have the authority to set the prices and take a decision
when chan e the
g m. This type of inflation is also known as administered power inflation.

Sectoral Inflation ythe fourth cause of inflation'sectoral inflation, which is said to take p ce when a Particular sector of industry
increases the price of goods and services which results in an increase in the price of other goods and services.
For instance, ifKESC increases power tariffs, the cost of production will increase for all those sectors that
have a higher consumption of Power- The Producer will eventually pass on the cost to the consumer by
increasing the price of the goods. This is one of the reasons why the ever-increasmg price of fuel has become
an important issue related to the economy all over the world.

Impact of changes in inflation rate

Deflation
Deflation - a falling price level-is the opposite of inflation. It means that fixed income instruments,
including cash and bonds, can offer good real returns. Initially equity shares will perform badly in a
recession environment, but in a long term deflationary environment, with the economy growing, shares
can be good investments. Property,however, would provide significantly poorer returns than in the
inflationary period of recent decades; but once property prices had adjusted, they could offer decent long
run returns through rental yields, provided deflation was not severe.

A move to deflation involves the same mechanisiVas for achieving a fall m the rate of inflation. The
emergence of an “output gap” in the economy,
i. e. spare resources, puts downward pressure on prices and wages so that , t h e overall inflation rate
finally falls so far that it turns negative. It does not necessarily require a recession, merely along enough
period of growth below trend. Once deflation has set in, taking the output gap back to zero will stabilize the
rate of deflation. Thereafter, only a boom will reduce the rate of deflation.

86 Economic
Deflation could make economic downturns more severe than in periods of mild inflation or price stability:

• If prices are falling, people may delay spending on expensive items, or companies may delay investments, expecting
to do them more cheaply later.

• Deflation means that property prices tend to fall which reduces its value as collateral and thus may impact on the
banking system.

When the price level is falling, interest rate policy is much less effective, as interest rate cuts from already low levels are
unlikely to boost investment and consumer spending. Expansionary fiscal policy, i.e. government spending and tax
cuts, are likely to have a muted impact on the economy. Tax cuts might just be saved. Rather than issuing bonds to
finance a fiscal deficit it could be financed by printing money; the mechanism being that the government issues bonds
which are bought by the central bank. This can be regarded as combined fiscal and monetary policy and will be
effective if done on a large enough scale. All this might appear academic after decades of inflation.

Disinflation
> iother type of inflation, which is more related to deflation, is disinflation, isinflation occurs due to a decline in the rate
of inflation. Disinflation can lead toEEwhich is a decrease in the generalEEof goods and services, provided inflation is
too low to start witK

For instance, the inflation rate for the first month of a fiscal year is 10%. The prices in the second month are reduced by
1%, but they still increase at an annual rate of 9%. Now if the current inflation rate is 1% and the prices fall by 2% the
following month, then disinflation will occur as the price will now decrease at an annual rate of 2%.

Disinflation generally occurs after a period of higher inflation. It is usually confused with deflation. Disinflation is
different from deflation because during the period of disinflation the prices of prominent commodities such as fuel, oil,
and food, as well as estate/property, fall but the general price level still increases, albeit at a slower rate than during
normal, yet low, inflation. The annual inflation rate keeps falling until it is eventually at a zero percent annual rate.
Further decline then leads the economy to deflation.

Reflation

Reflation is the opposite of disinflatiojn. It is the act of stimulating the economy by increasing the money supply or by
tax reduction/Originally it was used to describe a recovery of price to a previous desirable level after a fall caused by a
recession) Today it also (in addition to the above) describes the(first phase in the recovery of an economy which is
beginning to experience increasing prices at the end of a slumpj With rising prices, employment, output and income
also increase till tMe economy reaches the level of full employment

Reflation is generally used by governments to induce economic activity in the country. Therefore it can refer to
economic policy whereby
government uses fiscal or monetary stimulus in order to expand the output ofa country This can be achieved by
imposing such policies that include changing the money supply, tax reduction or even adjusting interest rates to
increase the money supply. Reflation is considered to be an antidote to defl ation.

Depression

Th' economy is hit by depression during recessions. Depression is a pro onged period during which there is high
unemployment, low output, neghpble investment, deflating prices, shattered business confidence and a high rate of
hostile take-overs, mergers or, even worse, closing down of

Economics | Reference Book 1

Ec=0 fists have conflicting views on the definition of depression. Due
tL chlr'Yt "tagreed/efimtion> and the stron§ ne§ative associations, i?12n °fany period as a "depression" is controversial owever
this term was frequently used for regional crises from the early
870 ~ k £ 193°SJ and fOT the mOTe widespread crises of the
1870s and 1930s, but economic crises since 1945 have generally been
t0 a
( s recessions, with the 1970s global crisis referred to as , not 3 d^ressM—
o
Tta niy two eras commonly referred ~ at the current time as depressions are the 1870s and 1930s. The late- ~OOOs
recession, which is the most significant global crisis since the Great
1929
beenTeZd -°CCUrred ™d t0 ™d 1931), has at times
been termed a depression but this terminology is not widely used

tomrnroi f? PUtS eC°nomists in ~nce the tools designed

to control inflation may completely deteriorate the economy or vice
a
; v A T i ationisnotebieAA
eory, inflation and recession were regarded as mutually exclusive and also because stagflation has generally proven
to be difficult and, in human terms as well as budget deficits, very costly to eradicate once it starts ^ ^ □
Table 3-1, Stagflation in Pakistan
GDP (% Inflation (%
change)
change)

2006-2007 6.8 7.8

2007-2008 3.7 12.0

2008-2009 1.7 20.8

Fiscal Inflation

a g0vemmenfs spending exceeds its income it creates a budget efiat In order to bridge this deficit, the
government needs to rafse lading from internal or external sources. This action results in fisVgf m ation as these
funds now bear a cost which is effectively passed on to
the economy. Another way of looking at this is that when the government starts borrowing from within the country's
capital and banking markets, it is making less funds available for business activity, hence making mone*- more
expensive and resulting in infl ation.

P~kis~an s economy is faced with fiscal inflation as government revenue ~Hch Isudnven maMy by taxes is much less than
government spending Hence, the government raises funds from the banking sector and this is in turn causes fiscal
infl ation.

Fiscal stimulus is the idea that, if the government starts borrowiiwl money and spending it on development or
welfare of the state, hencx rising outputs and reducing unemployment and poverty, it would effectively raise the
overall state of the economy. This concept is challenged on various levels including the fact that government
spending is often more inefficient than private sector spending as the private sector is more critical of controlling
expenditure and improving profitability. Hence, a
guvcinment coma create hscal stimulus only if its spending were efficient enough to offset the cost that it would pass
on to the economy of borrowiT ;
One form of fiscal stimulus is the proposition that if the governmei* were to borrow funds and distribute them among
the poor, it would effectively create demand and hence stimulate economic activity. In practice, the government would
borrow from banks and use the funcs to provide subsidies on commodities like fertilizer and fuel in the case Pakistan.
The subsidies would effectively reduce costs, hence consumm Jave moe I I for spending and this in turn would increase
demand ~or goods.As demand rises, supply must also increase to control inflation; however, since banking sector funds
are diverted to funding the government, the private sector has lower funding, hence restricting suppJ growth and
resulting in inflation. '

Hyperinflation

Also referred to as runaway inflationp^alloping inflation, hyperinflatioJ ^ a state where

inflation runs out of control. An economy is termed n>| be in a state of hyperinflation
when its currency rapidly starts loosing isj v, lue in comparison to foreign currencies and
the purchasing power irffl
cm-rency stmts to drop so rapidly that price levels may increase MM5/6to 10% in a single day.

The highest rate of hyperinflation was witnessed in Hungary in 1Q tfj a~er World War II. The war caused enormous
losses to the open econo^i of Hungary and in 1946 inflation rates ran out of control as the goverranol p^Mted massive
amounts of money to cover its expense. The devaluatial of the Hungarian currency pengo was such that on October
30, 1945 ifl USD was equivalent to 8,200 pengo and by November 31, 1945 1 equaled
108,0 pengo. By July 31,1946 1 USD was equivalent to 4.69 1029 pengo. Hyperinflation, most commonly
witnessed post wars* usually ghort lived and results in complete breakdown of a counti^l monetary system. 1

Hyperinflation becomes visible when there is an unchecked increase the money suppy, usually accompanied
by a widespread unwillingn'l °n the partofhe local population to hold the hyperinflationary moiafl for more than the
time needed to trade it for something non- monetaH

Economics | Reference I
 to avoid ftirther loss of real value. Hyperinflation is often associated with wars (or their aftermath), currency
meltdowns, political or social upheavals or aggressive bidding on currency exchanges.

How is Inflation Jnfl ation is the change in prices of goods. When economists sav that inflation is rising” they are referring to the
measured? movement in a price index.

Pnce mdex is a weighted average of the prices ofa number of goods a^'d services. The
prices of the goods which are of more importance in
e, omy are assigned more weightage while constructing the price index, thus the
weighted average of the prices of these goods is high. The =st popular price indices are the Consumer Price Index
(CPI) and GDP deflator.

Consumer Price Index (CPI)

T le CPI
i measures the average change from month to month in the prices of consumer goods and services, but it
differs in the particular households jj'epresents' the range of goods and services included, and the way the

Each month, the current prices of the chosen items are collected around country,multiplied by
their respective weights and added together.
I ttfttan divlded _the ^ of an the weights to produce a single
• sure , se year for the index isgiven a value of 100 and the monthly m,x m<dcates how prices in general have changed since
that date. An index of 110 would show that prices on average had risen by 10%.

' SIOUM be remembered that the CPI is an average showing what has appenedto the general level of prices. It does not
show what has happened to individual pnces.Over the past twenty years, prices on average have nsei'ome prices
have risen at a faster rate than the general trend and afUally Men, SUch “ P°cket calculators and digital watches. it :usfb= ; -
hcuare ' ' ' ' — but

I'the different prices are added up or they are weighted according to thT mass or volume, the result will be highly
inaccurate. Therefore in order to calculate CPI accurately, a price index is constructed by assigning weights to each
price of the commodity according to its economir impomnce'he weights assigned to each commodity are fix'd'dkT
proportion with its relative importance in consumer expenditure budgets The more the consumption of a particular
commodity, the heavier is the weight assigned to that particular commodity. Therefore, the weights are g'iemlly
revised annually as the older weights create divergence between the current expenditure pattern and that of the
weight reference period.

When calculating CPI, any particular year is made a base year, also called lhe mudexre?rence
Period- This index reference period often differs mthe weight-reference period and the price- reference period. The base
year serves as a reference point and helps in calculating the CPI for years
o come It also rescales the whole time-series to make the value for the index reference period equal to 100.
Calculating the CPI

The CPI can be calculated using the following three steps:

1. Find the cost of the CPI basket at base-period prices

2. Find the cost of the CPI basket at current-period prices

3. Calculate the CPI for the base period and the current period
We can use a numerical example to help clarify our understanding of how inflation is measured. Assume that
consumers buy three commodities: food, shelter and medical care. A hypothetical budget survey finds that
consumers spend 20% of their budgets on food, 50% on shelter and 30% on medical care.

The table below is constructed to calculate the base period prices for 2009 using 2000-01 as the base year.lt
shows the weights of the commodities and the prices in the base period and current period.

Table3-2: The Cost of CPI Basket at Base-Period Prices (2009) _________________

Item Weight (%) r Price Cost of CPI Basket PKR
PKR (Weight x Price)
Food 20 20 4.0
Shelter 50 30 15.0
Medical 30 25 7.5
Care
Cost of CP basket at base-period prices 26.5

Assume that in 2010 food prices rise by 10% PKR 22, shelter prices rise by 6% to 31.8 and medical prices are
up by 10% to 28. The change in the prices is calculated using the formula given below:

New price = Previous Price x (1+ percentage change)

For example, the price of food was PKR 20 in 2009. It grew by 10% in 2010; therefore the new price is:

20 x (1+10%) = 22

We can now calculate the CPI for 2010 as follows:

Table 3-3: The Cost of CPI Basket at Current-Period Prices (2010)
Item Weight (%) Price Cost of CPI Basket PKR
PKR (Weight x Price)
Food 20 22 4.4
Shelter 50 31.8 15.9
Medical 30 28 8.4
Care
Cost of CPI basket at base-period prices 28.7

After calculating the cost of the CPI basket at base-period prices and current- period prices, the third step is to
find the CPI for 2009-2010. The formula for CPI calculation is given below:

Economics | Reference Book 2

 Cost of CPI basket
cp| at current-period prices Cost of CPI

basket at base-period prices /v /v /AUSHa

___________
/v
O OJ. baSket in
~L , RWe above, the cost of *e CPI basket in 2010 is PKR 28 7 pKr~2°6 c°tu 2009, derlved from the previous table'is year
prices/x®S°the Cost of the
CPI CPI in 2009 basket at
ba; e—find ove, we
For 2009, the CPI is:

CPI in 2009 PKR

28.7
PKR

125.
PK
R
26.5
PK
R
26.5
-X100 =100

„tnt
For 2010:

=r -X100 =108.3

Calculating the CPI for multiple 26.5 items

yviQn ofCEI for

------------ in the example

0
stores
 n
CPI ~ y^fCPIj* weight
fsl

Taxes are not included in CPI computation, using the formula given bdow be

eakulated

GDP deflator Nominal GOP

Real GDP

Economics | Reference Book 2

= = — ^ -------in inflation.
/\
method of changine CPT kthPn°eS m a penod of time. The levels oye/a fc^^^P^Pnge in price

The formula for calculating the Inflation Rate is given below:

 Inflation Rate = —CP> (n1)~ X100 CPI (n-1)
Thus if we want to know how much prices have increased over last 12 months we would subtract last year’s index
from the current indd and divide by last year's number and multiply the result by 100 and all a % sign.

Governments are concerned to keep the rate of inflation low for a m; of reasons.
The problems
Redistribution of income and wealth
inflation
Inflation leads to an arbitrary redistribution of income and wealth. Peofk on fixed incomes suffer because their
incomes buy less which can h | especially severe on those who retire on a fixed pension, notably tb with independent
private pensions. State SSg pensions and some com] pensions are increased to offset inflation. "-“>

Creditors also suffer because the money they receive on repayment bi less than when they lent it. On the other hand,
debtors gain. For examf in 1970 in Britain it . ? was possible to buy a modern three bedroom house in Glasgow,
Scotland for about *te, £5,000. A person who borrowed £5?0001 on an interest only loan would now have a
property worth at least tvvenqr] times that amount and a debt of £5,000. Of course, the person wouli have paid
interest over the years and needed to maintain the proper^ but he or she would have had the use of the house for all
that time. The lender would be left with a claim to £5,000 and would have received interest on that amount.

Inflation can change the nominal value of other physical assets such as land, property in general, jewelry, paintings,
etc. At the same time it may push down the real value of financial assets, particularly those with a fixed rate of return
such as debentures, and most government securities The real value of bank accounts would also fall unless the rate of
interest after tax was greater than the rate of inflation.

Production
A degree of inflation can be helpful to businesses because it builds in an added element of profit. Major supermarket
chains have complained that: lower levels of inflation have reduced their profits. Too much inflation, however, can
be costly and disruptive. It adds a further element of uncertainty to companies’ plans and makes predicting future
costs and revenues difficult. It also makes suppliers very wary of fixed price contracts.

Industrial relations
Inflation and expectations of inflation can lead to pay demands which are themselves inflationary. It can also lead to
poor industrial relations and a conflict between workers and employers.

The balance of payments

If a country’s prices rise faster than those of competing countries, export markets will decline and domestic markets
will be increasingly penetrated

Economics | Reference Book 2

by imports which can lead to a deterioration of the balance of payments and a deficit on the current account. If the
exchange rate is floating, the country’s currency may fall against other currencies. If the government is trying to
maintain a fixed exchange rate, this will be harder to achiev e.

Expectations

Expectations of rising prices can make inflation self-perpetuating. If people expect prices to rise, they will seek higher
wages to compensate, which

adds to costs and leads to further price rises. Investors will be reluctant to lend at fixed rates of interest, making it
difficult for firms to raise loans. Overseas investors will be less willing to hold the country’s currency for fear that it
will fall on foreign exchange markets.

The benefits of inflation

Some people benefit from inflation — those who are able to increase their income in line with, or ahead of, price
rises may gain. People with real assets such as their own home will also benefit, but people with financial assets such
as bank deposits stand to lose. Those who own shares may benefit because, although shares are financial assets, they
represent claims over the physical assets of companies.

Control of inflation

Control of inflation depends on the underlying causes. The cure for demand pull infl ation would depend on what
caused collective demand to rise in the first place. A likely cause is government spending more than its income.
Governments are always under pressure to increase the range of services provided for the public and have great
difficulty in cutting back public expenditure. At the same time, nobody likes paying the taxes needed to finance the
public sector. The result may be that the government spends more than it raises in taxes and borrows the difference.
The amount the government borrows is known as the Public Sector Borrowing Requirement (PSBR).

Thus the government is putting more demand into the economy through its spending than it is taking out through
taxation. The solution is to cut collective demand. The government could cut private sector spending by increasing
taxes (not very popular) and cut its own spending by reducing services and benefits (also not popular and difficult to
achieve). Increased taxes and lower government spending should reduce the PSBR. Private spending may also be
reduced by restricting credit and raising interest rates which should make it more expensive to borrow money and so
havean effect on total demand. The problem is that interest rate elasticity of demand may be fairly inelastic, at least as
far as consumers are concerned, and so require a fairly high rate of interest to achieve the desired cut in consumer
spending. High interest rates may have a much more pronounced effect on company borrowing for new equipment.
During the Second World War and for six years after, rationing was used as a way of keeping down demand. While
this was accepted during the war, it became increasingly unpopular in the post war years.

Cost push and demand pull inflation may occur together. Rising wages infl ate costs and at the same time add to the
spending power of workers.

93
If they are not matched by a rise in output, demand rises faster i output and prices are bid up (demand pull
inflation). Workers then! further wage increases to maintain their living standards adding to < (cost push
inflation) and, when they spend, their pay increases, add to demand as well. However, cost push inflation is not
the same as deio pull inflation and different solutions are required. With wages for such a large part of total costs,
much attention has centered on hcosts. One approach has been to link pay rises with productivity. Iff wages
increase in line with output, pay increases are not inflatioi During the 1960s and 1970s in Britain, governments of
both major j used incomes policies to slow down the growth of wages. These tei to be unpopular and met with
limited success. In the 1980s and IS the emphasis was on making the labor market more efficient Mone argue
that the real solution for inflation is to control the growth ofl money supply.

ublic Sector Net Borrowing (PSNB) financing

The impact of the PSNB on money suppiy growth and inflation in 1 economy depends on how it is financed. If
the government has a de then the private sector must have a surplus, the bulk of which will iup as bank deposits.
The PSNB will tend to increase money supply ^ thereby create more inflation in the economy. However, the ult
outcome depends on how it is financed. The most appropriate : is to sell an equivalent amount of long-term debt
to the non-bank pc sector which prevents any increase in bank deposits or money : taking place)

Debt sales by the Treasury include national savings instruments; government stocks (gilts). Unless there is a
budget surplus, the Tre knows the estimated PSNB each fiscal year and develops a financ funding programme of
debt sales to offset the potential inflatioi impact of the PSNB.

It will sometimes be necessary to adjust the interest rate on new gihsa national savings upwards in order to create
sufficient buyers for the i debt in the market. The task is eased by some of the tax privileges ac to public sector
debt, such as tax-free national savings certificates. A ] financing policy based on public sector debt sales to the
non-bank ] sector reduces the availability of liquid assets in the banking spand curtails its lending capacity. Bank
lending creates deposits and i money supply, so PSNB debt sales influence money supply. the economy. Tms is
important for controlling the rate or inflj

Anth inflationary policy

Cost push and demand pull inflation may occur together. The ! encourages workers to seek wage/salary increases
to maintain their 1s tandards. This adds to costs in industry and commerce which are lpassed on to consumers in
the form of higher prices, i.e. cost push iitfla The latter tends to develop a momentum of its own, with each
^workers asking for income increases to meet higher prices caused by i awards to other groups of employees.
Workers also seek awards to ] their relative income position in relation to other crafts and

Economics | Reference I
Demand pull inflation may cease to exist in the economy due to various government measures such as increased
taxation or higher interest rates, but cost push inflation may continue to exist in the economy as trade unions seek to
maintain the real income of their members via annual wage/salary awards. Cost push inflation requires different
action from that of solving demand pull inflation. One approach has been to linklwage/salary rises with productivity
increases. If wage increases are paid out of increased output, then costs will not rise per unit of output and prices will
remain stable. Such pay increases are non-infl ationary. The problem with this approach is that some types of output
cannot be measured; for example, nurses, teachers, etc. Such workers tend to experience a decline in their relative
income position in society. In the past in Britain this has led to major wage disputes and strikes in the public sector
wnich subsequently resulted in infl ationary wage/salary awards. Another approach used by governments in the
1970s was an incomes policy, i.e. a statutory limit on wage/salary increases each year. Such policies proved to be
unpopular and achieved only limited short-term success but had little impact on cost push inflation in the economy.

In the 1990s, the emphasis on tackling cost push inflation changed to making the labour market more efficient, along
with tight cash limits for all aspects of public expenditure. At the same time, the government pursued various policies
to cut the PSNB and thereby eliminate the perceived underlying cause of infl ation — excessive money supply
growth.

Price Indices in Pakistan

The economic managers of Pakistan rely on four different price indices that are calculated and published on a
monthly basis, to assess the direction of the economy and plan economic policy. The four indices are: the
ConsumerPrice Index (CPI), the Wholesale Price Index (WPI), the Sensitive Pric< x (SPI) arid the GDP deflator.
* Inde

The Consumer Price Index (CPI), as the name indicates, measures inflation based on the change in Consumer Prices
of a basket of goods and serves that are considered as basic needs in a country’s private households. T~- CPI in
Pakistan is calculated by the consu~e~rices of a basket o(92 /regularly consumed goods andservices across 35 major
cities of the country.
A monthly summary of the prices is collected and compiled to cakiilate the Index and it reflects a basic idea of the
change in the cost of living in the urban areas of the country. Key components of the CPI Ire Fuel, Rent, Electricity,
Wheat Flour, Rice, Milk, Sugar and various others; Weightages are assigned to each item based on calculating the
averageeonsumption of each item so that the impact of a price rise of an item m correctly reflected in the Index.
ayjpe

The Wholesale Price Index (WPI) measures the price changes in the daily consumed goods at primary and
secondary le^terThe WPI measurement ii^akistan is based on the wholesale price 106 commodities prevailing
iifiEjmajor cities of Pakistan. The wholesalepric^s are collected directly a m mills as well as at

The Senskme Price Index (SFf~a weekly index that is calculated on the prices of53 Selected items ir~l7 ~najor cities
from within the CPI basket which nave the most importance in terms of weightage or because they wholesale
markets.

J
 including the oil-producing countries and their neighbors. The turmoil in] Libya has sprfad fears that it
cmldresult in a sharp drop in supply Although the Saudi government has indicate^ its commitment to increase
fsupply from Libya is s
topped> the
fate of the region remains

Pakistan had traditionally been providing heavy subsidies, in the last ecade or so to fuel consumers in order to absorb
the inflationary pressures of global oil prices. However, in 2008 when fuel prices reached over $100 / barrel the
subsidies given out by the government proved too much for the budget to handle and the government started
borrowing heavily from *e banki
ng sector to finance the gap. Today, even as fuel subsidies have almost been
completely eradicated, the government is faced with a colossal debt of close to Rs 200 billion that has been taken
from the banking sector over the last 2-3 years. It should be noted here that public sector borrowing in itself is
inflationary in nature.

Prices of other commodities like cotton and wheat have also risen sharphji Today, much of Pakistan's textile sector is
faced with ~ competitive disadvantage as input prices have increased, and while competing countries have been able
to counter this inflation through currency appreciation j and reducing operating costs (e,g. lower cost power supply,
reduced taxes, etc.), the Pakistani currency has continued to depreciate and local inputs | such as electricity have also
been rising in cost. Due to the rising costs of both local and imported inputs and the depreciation of the Pakistani
Rupee, many small and medium sized textile manufacturers have beea forced to curtail production or shut down
altogether.

Cotton and wood form the inputs for the paper industry and this sec has also been forced to consistently raise
prices, with a 17% rise in FebruT and a further 22% in the following month. This rise in prices affecf
everyone from the packaging and retail goods industries to the educa“ sector.

Analysts believe that the country is in dire need of support programs protect industries from being crushed by
inflationary pressures as decline in produetion will only cause a drop in supply and a rise • unemployment,
which in turn will further spiral the inflationary e!
 Paft Four
Unemployment

Learning Outcome By the end of this chapter you should be able to: ■ List and explain the different types of
unemployment _ Recall the formula to calculate the unemployment rate _ Discuss the
causes of unemployment » Define Okun's Law i Define the concept of the Phillips Curve ■
Recall the short-run/long-run Phillips Curve K Explain the Phillips Curve concept
using aggregate supply/aggregate demand and the output gap H Explain the factors that
influence short-run/long-run aggregate supply and real GDP n Explain movement along the
long-run and short-run aggregate supply curves

Unenmloyment occmTMhen there are qualifier indiyiduals and skilled workers who are willing to work at the wage
rates prevailing in the labor market but are unable to find jobs. Unemployment has increased in Pakistan from about
Unemployment
1.40% in the 1970s to a peak of about 5.6% in 2010.

Types and causes of unemployment

Unemployment can occur and increase due to several reasons. The different types and causes of unemployment are
discussed below.

1. Frictional unemployment
Frictional unemployment refers to the temporary unemployment people may experience when changing jobs(If there is
a break between the end of one job and the start of another, person may register as unemployed in order to receive
unemployment^ enefit (if they are living in a country that operates a welfare state system). If people are moving from
work where they are not required to work where they are, frictional unemployment may be considered a sign of a
dynamic economy and an indication of increasing efficiency. Frictional unemployment may be reduced by shortening
the time people spend searching for work.This is

Unemployment
 often a matter of improving the flow of information through job cerass)

High levels of unemployment benefit reduce the incentive to find i—J and may add to search
unemploymentThe perc'tage of pay av; as unemployment benefit is called the replacement ratio. If pav is i 1000
and unemployment benefit PKR 80, the replacement ratio is I ''The higher the replacement ratio, the less is the
pressure to take a partL job. Some people advocate lower benefits as a way of reducing frkf1— unemployment.
Frictional unemployment is not regarded as a 5arr problem.

2. Structural unemploymenT

Structural unemployment is a much more serious form of unemplq and is th'esult of long- Causfis-of-
mtiatien term changes in the structure ofthe eco may be the result of a'fall in demand for the
products of tradi'— industries such as coal, iron, steel, shipbuilding and cotton, or it m|g be technological
unemployment, the result of technological innov' which allow industries to produce the same output with fewer
woi The problem may be made even worse, leading to regional unemploy if the declining industries are
concentrated in certain parts ofthe cor and the new alternative industries grow up elsewhei

3. Seasonal unemployment

Seasonal unemploympnt, as might be expected, refers to unemploy caused by the seasofis of the year. Some
industries, such as constxuc ' and tourism, are busiest during the summer and relatively quiet dm" the winter
months when seasonal unemployment incre

4. Residual unemployment

The residual unemployed are all those people who/on account ofphjr' or mental disability, are unable to
find employment) The gove may provide them with social security benefits and ma'also set up Wzr
initiatives to provide them with employment. Another type ofresi unemployment arises where some
members of society refuse to _ — and are content to live on unemployment/social security benefits for;
indefinite time period.

In recent years governments have attempted to reduce this tyuo voluntary unemployment by withdrawing or
reducing some state be '
This has only been partially successful as such people make them unemployable either by appearance
or attitude, while the state is relr to make any of its citizens completely destitute.

5. Demand-deficiency or cyclical unemployment

This type of unemployment is associated with the trade o'usiness q, m a market economy.Y)uring a recession,
the general deficiency in de affects nearly all industries. It is the most serious type of unemploy and if it persists
for a prolonged period of time it can cause extreme '
economic distress. At the depth of the Great Depression in 932,registered unemployment in the USA and UK reached 14 million =nd 3
million respectively. It is this type of unemployment that Keynesian demand management policies sought to avert in the British and other
advanced economies in the post-1945 era.

6. Classical unemployment

Classical-or, strictly speaking, neo-classical-economists of the 1920s and 1930s took the view that there was an automatic tendency for the
economy to move towards full employment. They assumed that prices and wages were free to fluctuate and if there was unemployment they
('would move downwards until eventually everybody seeking work would find it. If unemployment did occur, it was because the necessary
adjustments had not yet taken place or were being prevented from taking place, for example by trade union action, j

100

Economics | Reference (
Keynesian unemployment

During the 1920s and 1930s it was quite obvious that the foil employment of the classical theory was not being achieved. In his “General Theory
of Employment, Interestand Money” published in 1936, Keynes offered an alternative analysis and argued that the assumptions of the classical
theory were wrong and leading to the wrong policies. Unlike the classical economists, Keynes did not accept that the economy tended
automatically towards full employment. On the contrary, he argued that it was possible tor the economy to be in equilibrium with high rates of
unemployment. Keynes saw a link between the real and monetary worlds and identified an additional cause of unemployment - lack of demand?'
Here Keynes stressed the role of money as a store of wealth. If people decided not to sPend 311 their mcome but to save part of it and hold it in the form of
i, total spending would fall. This would lead to lcue money bala unemployment)

Keynes drew a distinction between the nominal wage(the wage in terms of money) and the real wage(what that wage would buy). If your salary
in terms of rupees (your nominal wage) doubles, but all prices also double, you can only afford the same goods and services as before, so your real
wage has remained the same. Classical economists assumed that the real wagi" was flexible and would fall, if necessary, to match supply and
demand m the labor market. Keynes did not accept this, but maintained that the nominal wage was inflexible downwards. No doubt workers
stzn
would resist Vfy Sy attempts to cut their nominal pay. Assuming prices do not change, if the nominal wage does not fall, neither will the real
wage.

~ven the wa§e am be reduced, this is not the end of the matter. Keynes believed that classical economists had made an error of aggregation, assuming
that what was true for one part of the economy was true for the economy as a whole. If a firm is able to cut wages, it can lower costs, reduce its
prices, sell more and afford to take on more workers. If there is a general fall in wages, then all firms can lower costs and reduce their prices but
they may not sell any more, so they may not need anv more
 cut]n
wages would mean 5BP t?^5 ftp PH n
spending. Thus if unemployment is (AA^^5 and a fai1 >nA3 cuttmg wages will make matters worse " ^SP O O Iack of JS®A

mshm
could do . this by increasiM its n Cryone Sto work. GoxtiimJ
f£neral PubIic to spend more. WsTould beAV01A ^ ““‘“W if people are left with
more of their : achleveC ^ cutting more. lr own mcome, they are likely to '

A
£3SI2a==a! 1 3
employment. Instead they argue thaT aUt°matlcally Produoef unemployment to
1
The monetarists' which it will keep retur~ 1 & “IMS 13tf
view of
unemployment

succeed. Output will rise and Tc ng taxes, at first it, money in circulation
However
will kL~rk H, ,
::iamngTntwlgTs1/NA
•••

ssiiips
iabiewo ^ 1 ^, . ...
_ 5^fflAA
Measurement of ______

zub
f>sdlH governments ofdiCS juS ~ ft®, that ft tf unemployment and constrU(J :
CmpIoyers arri worta
,eCentW
-W conditions

Unem
pAedA°" m_y statistics ofl

mpl°yment.ThlsmeLLsA

102

Economics | Reference (
 Labor Force Sample Survey is considered to be the most effective; hence the most preferred method of measuring unemployment. The total
population is divided into different segments on the basis of similar characteristics such as gender, race, age, etc and the survey is carried out in each
segment to measure the unemployment rate. This method gives the most comprehensive and accurate results for the calculation of unemployments
used across the world and allows comparison of unemployment rates internationally as well.

Official Estimates aredetermined by combining two or more than two methods of measuring unemployment. This method is not as popular as
labor force sample surveys.

Social Insurance Statistics rely heavily on the unemployment benefits given by the government. The statistics are computed by looking at the
number of individuals insured (the total labor force) and, out of this pool, the individuals who are collecting unemployment benefits. This gives the
ratio of unemployed persons; however, this method has faced serious criticism due to the reason that insurance may expire before the person finds a
job.

Unemployment Rate

People generally focus on the number of individuals unemployed in the economy. Economists, however, look at the unemployment rate to measure
unemployment as it also takes into account an increase in population and increase in the labor force relative to the population. The unemployment rate
is expressed as a percentage and is calculated using the following formula:

Unemployment Rate =

GDP and Unemployment

We have already discussed recessionary periods in which output and unemployment are high, whereas
booms are those periods in which GDP is at its peak, the economy is working at full capacity and
employment, and the
unemployment level is very low. These periods
Unemployed
explain the relationship Workers between economic growth
and unemployment, but Total labour the more ~ important link that
we need to study is forcebetween unemployment and .y inflation. The relationship between unemployment and inflatio
by Arthur Okunin what is now known as Okun, s law.
uKun s law

In economics, Okun’s law describe^a relationship between the change in the rate of
unemployment and the difference between the actual and potential real GDP. The law
states that, “For every 2% of GDP fall relative to potential GDP, the unemployment rate
raises by 196”.

Let’s assume the GDP begins at 100% of its potential and the unemployment rate prevailing in the market is
8%. Now if the GDP falls to 96% of its potential, the unemployment rate will rise to 10% (an increase of
2%).

Unemployme te
nt
 A typical recession occurs when aggregate demand starts declining relatiic to aggregate supply. As output falls,
firms need less labor, therefore laboos laid off. The reason for layoffs during recession is to cut high
administratiic costs. In either situation, unemployment increases with declining output. Figure 4-1 shows the
trend lines of GDP growth and unemployment for the past 10 years. The inverse relationship between GDP and
unemployment rate can be observed through from 2003 to 2004 (between point c and d), and 2009 to 2010
(between point i and fjl

Figure 4-1: GDP and unemployment in Pakistan (2001-2010)

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Economic Survey of Pakistan 2009-201®|

There are several reasons why GDP may increase or decrease at a j pace than the unemployment
rate. As unemployment incre

• Unemployed people may drop out of the labor force (stop seeking work), after
which they no are no longer counted in unemployment statistics

• Employed worker may work reduced hours

.Labor productivity may decrease, perhaps because emplc retain more workers than
needed.

One implication of Okun, s law is the phenomenon of “jobless L that an increase in labor
productivity, together with an increase i size of the labor force, can mean that real net output grows
withe unemployment rates falling.

Phillips's Curve
A.W.Phillips, an economist who quantified the determinants of i developed a useful way of
representing the process of inflation^ carefully observing the data on money wages and
unemployment i UK, Phillips found^an inverse relationship between unemploj the changes in
money wages) He stated that wages tend to unemployment is low and vice vers^The reason why
high unen lowers the growth of money wages is that workers will not press 3

104
Economics | Ref<
 for a rise in wages when a few alternative jobs are available, and also firms will resist the wage demands if they are not earning high
profits.

The Phillips curve is used to analyze the short-run movements in unemployment and inflation. A simple Phillips curve is shown below:

Annual wage rise

Unemployment rate
As we move leftward on the
Phillips curve, unemployment
reduces while the rate of price and wage increase depicted by the curve becomes higher. Moreover, the rate of inflation also depends on
the rate of productivity growth. The general formula for the calculation of rate of inflation is:

Rate of inflation =Rate of wage growth-Rate of productivity growth

The Phillips curve shows the tradeoff theory of inflation. According to this theory, the nation can lower its level of unemployment if it is
ready to pay the price of a higher rate of inflation. The terms of the trade off are given by the slope, or the gradient, of the Phillips curve.

Interpretation

A Phillips curve is best thought of as a short-run relationship between inflation and unemployment when aggregate demand shifts and the
aggregate supply continues to change at its inertial rate. The Phillips curve is just a short-run curve and might change in the long run.
Inflation will affect people’s expectations and eventually, wages and costs will change too. The aggregate supply will be affected by these
changes, and therefore a new rate of inertial inflation will emerge. This process will lead to a shift in the Phillips curve.

The natural rate of unemployment

The natural rate of unemployment is that rate at which th{upward and downward forces on price and wage inflation are in balanceUt this
rate, inflation is stable, showing no tendency towards acceleratingAor declining inflation. In countries which Aconcerned with the
prevention of high inflation, this rate lowest level that can beAstistained. It therefore represents the highest sustainable level of empfoyment
and corresponds with the nation’s potential output.

Unemployment

105
====2== has $Q same actual inflation as~ -supplyshock,Thi : ~p ;; demand and ifthe~
the same as the natural rate ofimpm 1 , rate ofunemploym
P oyment
anges in the w *LL there are no unm
changes in the costs ofthe key raw mato~ ~
3bOVe
* -rtial 0f inflation 4a
m
11 then ad rn
J reality, and thus, the Phillips curve shifts/
_ as the inertial rate changes th^PhWr ®{£5, the P“Ps curve will tend to stJ

The Shifting Phillips Curve

Themovement in Phillips curve due to shocks
Figure 4-3, in the

Unemployment rate

fT =2=" ; :=:in ^ natural rate.wi Wr short-run “

rate is at

cT=e=P==AAand more workers to increase outvut*=*"«:, frms ffi hre

leads to a rise in the capacity utilization and Wa e ° ° P tent

e
as prices, start to rise. In terms ofthe Phi I r markuPs. 8 s> FH _ to point B on its
bU====m,the -my
/ - V O - T A r * . 1 1

workers begin t o fwa § Prices, firms

SSSi
This bring :

Economics I Reference I
rate returns to the original one, which is the natural rate on unemployment. Thus inflation declines due to higher unemployment.

The outcome of this is that, in period 4, the rate of inflation at natural rate is more than that in period
l. This is because of the changes in the expected inflation rate. Although the aggregate demand and supply remain unchanged during the 4
periods, the expectations of the firms and workers cause a change in the expected rate of inflation. This means that, in period 4, the economy will be
experiencing the same level of Gross National Product and levels of unemployment as in period 1,even though the nominal magnitudes would be
rising rapidly.

The Vertical Long-Run Phillips Curve

When the unemployment rate deviates from the natural rate of unemployment, the inflation rate will tend to change. If the natural rate is 8% while
the actual rate is 6%, then because of the gap, inflation will rise from year to year. According to the natural-rate theory, this upward spiral will only
stop when the unemployment rate returns to the natural rate. As long as the unemployment rate is below the natural rate, inflation will keep rising.

The reciprocal behavior will be seen at a high level of unemployment. In this case, as long as the unemployment rate is above the natural rate,
inflation will tend to keep falling.

The inflation rate will stabilize only if the actual rate of unemployment is the same as the natural rate of unemployment. The long-run Phillips curve
must therefore be drawn as a vertical line, rising straight up at the natural rate of unemployment.

The two important implications that the natural-rate theory has for the economic policy are, firstly, that there is a minimum level of unemployment
that the economy can sustain in the long run. Secondly, a nation may be able to ride the short-run Phillips curve. The unemployment rate can be
driven below the natural rate and the nation can temporarily enjoy lower unemployment, but also will have to suffer the higher rate of inflation.

Although the natural rate of unemployment is an important macroeconomic aspect, precise numerical estimates are hard to pin down. Moreover,
estimates byone economist might not match with the estimates of other economists.

In addition to frictional unemployment, structural and involuntary unemployment exists. Even when the unemployment rate is low, a substantial
fraction of the unemployed consists of job losers and longterm unemployed.

Aggregate Supply
As we discussed earlier, aggregate supply is known as the total quantity that firms plan to produce during a given period of time. The dependence of
the production quantity is based on various factors or inputs such as capital, technology, raw materials, labor, etc.
Long-term decisions are the basis for capital and technology; these decisions are a part of the past, making it impossibie them in a
short span of time. Labor, however, can be the determining the aggregate supply that can be produced in a pciM regularly
fluctuates. Labor at any given time is considered fixed: total population does not change overnight.

At any point in time a labor market may have full emplc,™« full employment or below full employment (un-emplo

Potential GDP is defined as the quantity of real GDP at full tIl]i» which is dependent and based on the full-employment quantity ofl
the quantity of capital, and the state of technology. Employment I fluctuating around full employment and real GDP keeps flucu
around potential GDP over the span of the entire business (

There are two time periods for aggregate supply which need i considered to study it: —

•Long-run aggregate supply

• Short-run aggregate supply

Long-run aggregate supply is defined as the relationship be quantity of real GDP supplied and the long-run price level readHtf result
of real GDP equaling potential GDP. Figure 4-4 shows the 1 run aggregate supply curve which illustrates this relatioi
GDPjjeAtatoT
The graphical representation of the long-run aggregate supply cm the vertical line present at potential GDP labeled LAS. As the
piicel changes, next to the long-run aggregate supply curve, real GDP re at potential GDP, which in Figure 4-4 is PKR 6 trillion.
The Ioi 7'gate supply curve is always vertical and is always located at ]
 LAS

Price (PKR)

Potential GDP Real GDP (in trillion of rupees)

The long-run aggregate supply curve is vertical because potential^ is independent of the price level. It is independent because ofa
mova~ along the LAS curve, which is accompanied by a change in two sets* prices. Firstly, the prices of goods and services
called the price level , secondly, the prices of the factors of production which include, notably, the money wage rate. A total of 10%
increase in the pric
The problems of goods and services is matched by an equal increase in the money wage rate. Due
inflation to the equality of the price level and the money wage rate change, the real wage
rate remains constant at its full-employment equilibrium level. Therefore in a situation where the price level changes and
the real wage rate remains constant,employmentremains constant and real GDP remains constant at potential GDP.

Short-Run Aggregate Supply

The relationship between the quantity of real GDP supplied and the price level at the point where the money
wage rate, along with the prices of other resources and potential GDP remain constant, is called short-run
aggregate supply. All points on the SAS curve, independently, correspond to a row of the schedule. Figure 4-
5 depicts this relationship as the short- run aggregate supply curve SAS and the short-run aggregate supply
schedule.

For example, if the price level is PKR 90, the resultant quantity of real GDP supplied is PKR 6 trillion.
Considering the short run, a rise in the price level brings an increase in the quantity of real GDP supplied.
The short-run aggregate supply curve’s slope is upward.

For the real wage rate to be at its full-employment equilibrium level, with a given money wage rate, there is
only one price level. At this specific price level, the quantity of real GDP supplied equals potential GDP and
the SAS curve intersects the LAS curve. Now consider this example, where the price level is at PKR 95. If
the price level is higher than 95, the quantity of real GDP supplied exceeds potential GDP. Similarly, if the
price level is below 95, the quantity of real GDP supplied is less than potential GDP.
A Price
Real GDP 5.0
80

B 85 5.5

C 90 6.0

D 95 6.5

E 100 7.0

108
Economics | Reference I
Figure 4-5: Short-run aggregate supply
Movement along the LAS and SAS Curve

If you look at Figure 4-6, it summarizes what we have discussed j about the LAS and SAS curves. At the price level where the i rate and other
factor prices rise by the same percentage, relative | remain constant and the quantity of real GDP supplied equals ] GDP. A movement along the
LAS curve occurs.
At a point where the price level rises but the money wage rate andi factor prices remain the same, the quantity of real GDP supplied i and a
movement along the SAS curve occurs.

Figure 4-6: Movement along the aggregate supply curves

Price (PKR)

LAS
Price level rises and SAS
money wage rate rise
by theGDP
same Real GDP
Real
percentage
below above
Potential GDP Potente l Real GDP (in trillion of i
Price level rises
GDP
and money
Changes in Aggregate Supply wage rate is
unchanged
A movement along the aggregate supply curves can be seen
due toiprice level but it does not change aggregate supply. The chants i aggregate supply occurs only when there
are influences on proai plans other than the price level change. Discussed below are the 1 that change the
aggregate supply and move the curve in the upwa downward direction.
•Changes in potential GDP

When potential GDP changes, aggregate supply changes. An inc both long-run and short-run aggregate supplies
is a result of an i in potential GDP.
The effects of an increase in potential GDP are depicted in Figure 4-7-1 the figure shows, at first, the long-run
aggregate supply curve is LAS: the short-run aggregate supply curve is SAS. In the case of an inc in the full-
employment quantity of labor, an increase in the quant capital, or advancement in technology increases potential
GDP to ] 8 trillion, and the long-run aggregate supply curve shifts rightwaM^ LAS . Short-run aggregate supply
also increases, and the short-run j supply curve shifts rightwards to SAS' The two supply curves shift by ! same
amount only if the full-employment price level remains cor which we will assume to be the case.

Economics I Reference I
Potential GDP can increase for any three reasons:

•The full-employment quantity of labor increases

• The quantity of capital increases

• Technology advances

1- An increase in the full-employment quantity of labor

The relationship between quantity of labor and real GDP is such that if the quantity of labor employed is larger, the
real GDP is greater. With the passage of time, an increase in the labor force results in the increase of potential GDP.
The increase in potential GDP is possible only if the full-employment quantity of labor increases (with constant
capital and technology). The increase in the full-employment quantity of labor is the factor behind the increase of
potential GDP. Fluctuations in employment over the business cycle are the cause for fluctuations in real GDP. But
these changes in real GDP are fluctuations around potential GDP -they are not changes in potential GDP and long-
run aggregate supply.

2- An increase in quantity of capital

In any economy, a larger quantity of capital means a more productive labor force and greater potential GDP. Per
person potential GDP in any capital-rich country is hugely greater as compared to that of a capital- poor country.

Human capital is a part ofxapital. If the economy is considered as a whole, the larger the quantity of human capital,
which is defined as the skills that people have acquired in school and through on-the-job training, the greater is
potential GDP.

3- Advancement in technology
Increased production over the past two centuries has occurred due to one important source which is technological
advances. Potential GDP can be increased by improvements in technology with fixed labor and
capital. It is due to technological advancement that an a produce almost 14 cars and trucks in a year.

Changes in the money wage rate and other factor prices

The money wage rate has an impact on short-run aggregate it (or the money price of any other factor of
production sucfas changes: short-run aggregate supply changes but long-run W supply does not change.

The impact of the increase of money wage rate is shown in figunc.. first, the short-
l
run aggregate supply curve is SAS. A rise in tfaei wage rate decreases short-run aggregate supply and shifts
the aggregate supply curve leftward to SAS”.
 Figure 4-8: Change in the money wage rate ^

6 Real GDP (in trillion of ru|>ees)

The reason for the decrease in the short-run aggregate supply due rise in the money wage rate is the increase in firms,
costs. Due m increased costs, firms cut down the quantity that they are willing to at each price level and that quantity
decrease, which is shown by a 1 shift of the SAS curve.

There is no change in the long-run aggregate supply due to a ch the money as it is

on the LAS curve; the change in the money wage is accompanied by an equal
percentage change in the price level. As are no relative prices, it provides no
incentive to the firms to c, production and real GDP remains constant at potential
GDP. With change in potential GDP, the long-run aggregate supply curve remj at LAS.
By the end of this chapter you should be able to: _ Explain the purpose of
the balance of payment (BoP) account « List the payments included in the
BoP

Pa tFive _ Recall the reporting format liade Balance and ----- for calculating the BoP

Exchange Rate ■ Define and explain the

Chapter 1 Trade Balance concept of current accounts and
capital accounts and discuss the relationship between the two » Define and explain balance of trade, trade deficit,
trade surplus ■ Discuss Learning Outcome .. the BoP accounts of Pakistan Introduction
The balance of payments of a country shows the relationship between the total payments into and out of that country
in a given period, usually a year. Apart from imports and exports of goods and services, capital flows must also be
considered in order to have a complete balance of payments statement.

Most countries now use a currency flow and official financing statement to record such items. This avoids the
classification of capital flows into and out of a country according to degrees of alleged liquidity. Balance of payments
statements are not standardized on a global basis, so that slight national variations arise in the collation and
presentation of these statistics.

Key items and components of balance of payments statement

• Visible exports and imports

This includes payments made and received for visible or tangible goods such as food, oil, raw materials and
manufactured goods. The composition of exports and imports is influenced by the resource endowment, climatic
factors and the maturity of the economy; for example, a well developed industrial sector will tend to encourage
manufactured exports.

• Trade balance

If the payments received for exports exceed the payments made for imports, the trade balance is in surplus or said to
be “favorable”. In the opposite situation of imports exceeding exports, there is a trade balance deficit or trade gap.
Most countries publish monthly figures for visible exports and imports along with the trade balance. These are subject
to revision as new data become available.

Economics | Reference I
 nTisible ex
'i Ports and imports
, Y wvisi-a transactions. An invisible export take
T

The main types ofinvisible transactions are:

• Shipping/airline services

• interest and dividends

• Tourism

.Banking, insurance and financial market fees

th_ I q-^IieS t . -K i
IT ^ immigra*
A Iater covers
expenditure of the government for milit the maintenance of armed forces stationeH ^ 7PUrposes> such as the developing
countries in the form of grt ~------------------------------------------------------------------------------------------- i®J
given to

Current account
balance
s md
:Qmprises PaymentVmad^L^ivedfo ~ ^^balance and / ^Ports. It can be either positive
~ !, We and ^visible
(SUlplus, or £ Untry the Iatt
< The former adds to the net worth of f negative (deficit). coimtiy s net worth. A country’s current a, ° ; er diminishes a by
P endit
seasonal factors which^ffect iC tpositioncanb
0 influenced /=, ^$exports, tQ=

nt a c c Ar s h o AS A 1-the domestic currency depredates '

2. 3
domestic GDP decreases, or / - ^eign GDP increases.

'^c°SSnSn^J= ^^=a=:k:dde° msb goods relatively cheaper

QfP klS
a tan ind_s , O ------------- _ a c c o u n t

Trade Balance

0
XbTgS~ ImP° rtS)^mfe^e (v __________________ e

0 oZZTs °fS-ices (such as legal and

114

Econom | _ ^ Reference Book 2

• Net Factor Income from Abroad (such as interest and dividends)

• Net Unilateral Transfers from Abroad (such as foreign aid, grants, gifts etc.)

Capital account

This records the inflow and outflow of capital and incorporates capital movements by private individuals, institutions, corporations and governments.
Although overseas investment may boost the current account in the long run via interest/dividends or increased exports, the immediate effect is that capital is
leaving a country.

The capital account is also termed the financial ac~ount(xhe financial account includes the net change in foreign ownership of domestic asset~ If foreign
ownership of assets has increased more quickly than domestic ownership of foreign assets in a given year, then the domestic country has a financial account
surplus. On the other hand, if domestic ownership of foreign assets has increased more quickly than foreign ownership of domestic assets, then the domestic
country has a financial account deficit.

The accounting entries in the financial account record the purchase and sale of domestic andassets. These assets are dr^ided into categories
such as Foreign Direct Investment (FDI), PorJfc5lio Investment (which includes trade in stocks and bonds) and Other Investment (which includes
transactions in currency and bank deposits).

Financial Account = Increase in foreign ownership of domestic assets ■ increase of domestic ownership of
foreign assets Currency flow

This is the combined totals ofthe current and capital accounts together with a balancing item to take account of errors and omissions in the collection of
statistics. Assume the country has an overall currency outflow of PKR -100 million. This deficit (or surplus) necessitates official financing transactions in
order to achieve balance of payments equilibrium.

Official financing of currency flow

Everything bought abroad must be paid for in some way, such as from current earnings from exports of goods and services, by borrowing, or by drawing on
foreign reserve^. Official financing shows the net changes in the country’s gold, currency reserves and net balances with other countries, central banks and
the International Monetary FundTThese movements must match the currency flow deficit or surplus. In official financing accounting:
The transactions resulted in official financing should match the total currency flow position. Thus, for every country,
total currency flow equals total official financing but with an opposite sign:

Total currency flow + or- Total official financing -

or +
Balance of payments

Balance of payments equilibrium

From the above, it should be clear to you that the balance of payments must always balance, i.e. total receipts equal
total payments. Balance of payments statements are based on double-entry bookkeeping principles: for every debit
there is a credit for an equal amount. For example, an export is a credit (+) whereas the receipt of foreign currency is a
debit (—). If a foreign corporation acquires a firm, the payment for it will be a capital inflow (+) and the foreign
currency paid for it will be a debit (-)• The latter will be added to the country5s official reserves.

Thus, the “accounting” balance of payments is always in overall equilibrium. What politicians and economists concern
themselves about is any serious disequilibrium in one of the components, i.e. trade balance, current account balance or
capital flow position. Are disequilibria in these components sustainable over a prolonged time period and what is their
likely impact to be on official financing?

A series of annual currency flow deficits will cause reserves to decn alarmingly, and external official borrowing to
increase. Neither of tL could be allowed to go on for very long so that a government will n: to take other measures
to correct a persistently adverse balance of paymi currency flow. It is important to remember that an adverse
currency fl« position means there is a deficit on the combined current and car, accounts. It is essential for the
implementation of appropriate econ policies to identify the main components giving rise to any parti problem. On
the other hand, a currency flow surplus means that a co can strengthen its official reserves, provide loans to other
central and reduce its external debts. In this manner, the net external fin position of the country will be improved.

Capital flows Autonomous

capital flows

These are private capital flows which are a feature of market with no exchange
controls. Such flows result from the spontaneo1 of investors, institutions and
corporations etc, and are in most arelated to the existing currency flow structure
or position of a Private investment is made abroad because future income is er be
greater than that from investment at home. There is the] guarantee that a capital
inflow will offset a current account de~ capital outflow offset a current account
surplus for any coi hence the need for official financing.
Capital outflows occur when,

• Residents purchase foreign bonds and shares (portfolio investment) in anticipation of higher
returns, possible capital appreciation and a favorable exchange rate movement

• Resident firms extend credit to overseas customers

• Resident firms promote or acquire subsidiaries abroad (direct investment) with new capital or retain
profits abroad, such action being taken possibly to service an export market or exploit the growth/profit
potential in a foreign market(s)

• The government makes loans to developing countries

Capital inflows occur when:

• Foreign residents acquire bonds and securities (portfolio investment)

• Foreign firms invest in subsidiaries or acquire firms (foreign direct investment)

• Foreign residents participate in privatization share issues of former state enterprises (portfolio
investment)

• Foreign currency bank loans are made to the local residents and firms

Accommodating capital flows

These capital flows result from government attempts to “equalize” the current account and/or capital account position.
In order to set off the current surplus, lower interest rates might be used to encourage a capital outflow via portfolio
investment and repayment of foreign currency loans. Additions to international reserves or repayment of official
borrowings also fall into the category of accommodating capital flows. In the opposite situation, a country with a
current account deficit and inadequate international reserves might increase interest rates to encourage a capital inflow.
Obviously, higher interest rates have implications for the entire economy.

Financial and monetary transfers

Any value judgment on the capital account of a country requires a close examination of all capital flows. A capital
outflow might be “encouraged” by a government in order to utilize a current account surplus or excess international
reserves. A real (net) financial transfer occurs when a current account surplus is used to acquire foreign assets or repay
external debt and thus adds to the net worth of a country(A monetary transfer occurs when shortterm capital inflows
are used to finance long-term outflows and results in no initial alteration to a country’s net worth
CuAthfltgitcobllanSrrefcSayments currency flow position indicates the overall surplus or deficit in a country’s
external position each year, it is the current account balance which is regarded as the real barometer of a
country’s economic performance in the international economy. AI current account deficit is viewed as being a
more serious imbalance than a surplus; it arises when a country is absorbing more than it is producing. This
might be due to excessive consumption, investment or government expenditure which results in a savings
deficit in the economy which is mirrored by an import deficit. Such a deficit may be financed by capital inflows,
i.e. other countries, savings or by using official reserves. Howevei; such action might result in excessive external
debt which becomes difficult to service via interest payments and principal repayments together with reserve
exhaustion.

Both these outcomes can result in the collapse of a currency’s external value. Current account deficit countries
may face reserve exhaustion2 | increasing external debt and speculative pressures on their116
overvalued exchange
 rate. Sometimes current account deficits can be sustained over long periods of time by capital inflows and the
consequent accumulatkm of external financial liabilities (e.g. USA). In such a situation, capital inflows must be
wisely invested in expanding the productive capacity d the economy so that it can adequately service such debt
by subseque increases in its export revenues. However, many developing and emer economies are ~- unable to
finance current account deficits over a prolonged period of time -and so must take economic steps to deal witn
fundamental disequilibrium between (visible and invisible) exports ani imports.

When such a situation arises, most governments have two policy optic

• Expenditure adjustment policies, or

• Expenditure switching policies

Expenditure adjustment policies

Deflation is an attempt to reduce the level of import demand in . economy by fiscal and monetary measures,
i.e. higher taxation and int rates. It should also increase exports by making them more prk> competitive (via
lower inflation) and available in overseas markets. 1 pursued with sufficient vigor, deflationary measures
should reduce i eliminate a current account deficit in most economic^

However, such policy action can impose severe economic and social < on an economy:

• A reduction in economic activity will generally involve a rise i unemployment, the severity of which will
depend on the degree il deflation required to correct the current account defil

2 To reduce imports and expand exports, wage increases must be a to improve a country’s
competitive position which might nece further deflationary measures if voluntary wage restraint is reje
118
• Deflation will probably reduce investment and thereby damage future potential output and export
competitiveness. It might actually increase the economy’s reliance on imports in the future.

Such costs might encourage a government to look at alternative policies as a means of correcting a current
account deficit.

Expenditure switching policies

A current account deficit may be rectified by a country devaluing its cpfrency or allowing it to depreciate against
other countries, currencies, v^pevaluation of currency occurs under a fixed exchange rate system, while
^/depreciation is applicable to a floating exchange rate system.) Such action will reduce export prices in foreign
currencies and increase export volumes while increased import prices in domestic currency terms should reduce
import volumes.

If a country s external debt is mainly denominated in its own currency, then overseas holders of such debt will
suffer a financial loss in terms of their own currency. If the external debt is mainly in foreign currencies, then the
devaluing country will face increased external debt service costs in the future in domestic currency terms. The
effectiveness of currency devaluation/depreciation depends on a number of factors:

• Success or failure will depend on the price sensitivity of demand for exports and imports. If a small change in
price due to devaluation/depreciation results in a large change in import-export demand, then a country’s current
account should improve, but if export-import demand is not price sensitive, devaluation/depreciation is unlikely to
achieve its intended purpose. Surplus economic capacity (labor and capital resources) must exist in a country in
order to exploit successfully the export and import substitution opportunities offered by depreciation. Economic
resources may have to be diverted from non-export sectors to the export and import replacement sectors. If an
economy is at full employment, deflationary policies to release resources will have to be applied; otherwise, an
 influx of export orders may cause delivery dates to grow longer rather than increase foreign currency earnings.

; An increase in the price of imported goods and services is likely to be inflationary. Rising export volumes will
also generate additional purchasing power among export industry employees which in the absence of greater
output could prove to be inflationary.

Eco
nomics | Reference I
 So, for a country to obtain the maximum benefit from devaluation/depreciation:

• Demand for both exports and imports must be sufficiently price sensitiir

•Spare capacity must exist in export and import competing industries

• Inflationary pressure must be kept under control in the economjL

Alternative expenditure switching policies to currency depreciation air available to governments in the form of
direct controls on trade, i.e. tariife and quotas. Tariffs are taxes imposed on imports which artificially raise their
price and so discourage import expenditures. Through the use uff import licenses, quotas reduce the availability of
imported goods. Bodi actions should divert home demand to domestically produced goo'' Unfortunately, while
such trade policies might reduce imports, they iniiir the possibility of retaliation by trading partners which could
damage a country’s exports.

In the event of the latter happening, no improvement in the ciaccount will take place and the overall level of
world economic wel will be reduced. The World Trade Organization exists to prevent sudia outcome for the
global economy.

Pakistan's balance of payments statistics are compiled monthly, qi and annually, are derived mainly from
Balance of
exchange records and ; mainly to those transactions that are routed through authorized de (ADs). The data on
Payment
foreign economic assistance and commercial bor are collected from the Economic Affairs Division and the
Accounts of
Finance ]
Pakistan

Concepts used for the analysis of Balance of Payments in I

Trade Account
The narrowest definition of payments imbalance relates to the I balance, i.e. the difference between
total merchandise goods and imported on uniform f.o.b. basis. Exports are valued on f.o.hLa as c.i.f.
basis. In order to bring about uniformity in the data, adjustments for freight, coverage, valuation and
timing are also ] balance of payments purposes. The freight collected by for Pakistani shipping/air
1
companies is deducted from the c.i.f. exports; as such, certain estimates under this item are based i
proceeds of exports recorded by the FED.

For imports, exchange records cover only cash imports througjill channels.
Freight is estimated at a flat rate of 8 per cent of total! payments and the same is deducted from the exchange
record' imports to arrive at a uniform value of imports on f.o.b. adjustments are also made in exchange record
data, i.e. hby loans/grants and imports of capital goods by the branches or a operating in Pakistan by their
parent companies abroad. The iimports are collected from the annual survey of liabilities andj foreign
investment in Pakistan.

120 Eco
Services Account

Transactions under the services account consist of payments/receipts on account of Shipment, Transportation,
Travel, Investment Income and Other Services (official and private).

Services can be classified in two broad categories* i) factor services, and ii) nonfactor services. Non-factor
services involve receipts and payments on account of freight, transportation, travel and other services. Factor
services, on the other hand, include interest, interest on reserves, profit and dividends, etc.

Flows under the services account are real flows, such as goods, and in contrast with financial transactions or
changes in levels of financial assets and liabilities.

Current Transfers
Unrequited transfers are one-sided transactions across national borders. These are non-debt-creating flows. To
deal with such transactions, which involve no financial compensation, the balance of payments methodology
includes a category called "transfers". This convention allows one-sided transactions to be converted to standard
two-sided transactions. Most generally, all transfers with an economic value, when no quid pro quo is involved,
give rise to a counter-entry, either a current or a capital transfer.

Current transfers include cash transfers, gifts in kind (such as food and medicines), contributions to international
organizations, and remittances sent by workers residing abroad to families back home. Capital transfers may be in
cash (investment grants) or in kind (debt forgiveness). Current transfers are classified into the following two major
categories*

a) Private Transfers - These cover workers' remittances, residents' foreign currency accounts, SBP outright
purchases, philanthropic donations, pensions etc. and contra entries for imports under personal baggage, non-
repatriable investment (NRI) scheme and sale proceeds of Duty Free Shops.

b) Official Transfers - These are transactions between the official sectors of two economies. The credit entries
cover grants received by Pakistan from bilateral and multilateral sources and also includes external debt
cancellation. The debit entries relate to reverse grants such as release from counterpart rupee funds for payment
abroad and Pakistan's contribution to International Organizations for administrative expenses.

Current Account
The current account balance represents the net of earnings and expenditures of an economy on account of goods,
services, income, and current transfers. It shows the net change in financial assets arising from an economy's real
transactions. Transactions classified under "goods” relate to the movement of merchandise - exports and imports -
and generally involve a change of ownership. "Services" can be of many different types, "Income" may be
derived from labor (wages paid to employees living in neighboring countries) or from financial assets or liabilities
(for example interest payments on external debt).

121
The current account balance is derived by summing up net balances under trade, services and transfers account.

Most current account entries show gross debits or credits, but entries in the capital and financial account are
typically net. Net entries are shown only as credits or debits, according to the conventions.

Capital Account

The capital account of the balance of payments comprises transactions in the economy’s foreign financial assets
and liabilities.

Long-term Capital: This comprises foreign investment; foreign long-term loans/credits availed of by the official
and private sectors, and other longterm capital.

Foreign investment includes both direct foreign investment and portfolio investment. The direct investment is
further bifurcated into:

i) direct investment made abroad by Pakistani firms/companies and repatriation thereof, and

ii) direct investment in Pakistan which covers the investment made by foreign enterprises in the
form of cash brought-in, capital equipment brought-in and re-invested earnings.

Basic investment data are obtained from exchange records but non-cash flows data,
i. e. capital equipment and reinvested earnings, are derived from the annual survey of Assets and Liabilities
and Foreign Investment in Pakistan, from foreign companies/branches operating in Pakistan, Pakistani joint stock
companies, and partnership companies.

Portfolio investment relates to remittances received on account of bonds, national savings investments, Foreign
Exchange Bearer Certificates (FEBC), Foreign Currency Bearer Certificates, (VCBC), Special U.S. Dollar
Bonds, corporate equities, shares, debentures, etc. sold to foreigners by resident enterprises and remittances made
on account of purchase of foreign bonds and corporate equities.

Foreign Economic Assistance (net) covers disbursements made under official longterm capital on account of
project, food and program aids and repayments of principal amount (amortization). The remaining other long-
term loans/credits are clubbed together with other long-term capital which largely comprises non-contractual
flows from parent companies to MIVCs operating in Pakistan and supplier’s credit to finance imports.

Short-term Capital: It includes short-term loans/credits under the official sector, changes in short-term liabilities
and non-resident accounts maintained with State Bank of Pakistan, changes in exchange balances of Pakistan’s
diplomatic mission abroad and Pakistani shipping companies. It also covers changes in assets and liabilities on
account of transactions under bilateral commodity exchange agreements and non-resident rupee accounts with
deposit money banks and foreign currency accounts maintained with NBFIs in Pakistan under non-resident
accounts.

Economics | Reference Book 2

 Basic Balance

11
?ned by adding a long-term capital movements (flows/outflows) to the current account balance. This balance is
often ought ofas indicative ofthe long-term trend in the international account ZXt fdudes short-term capital flows,
which are likely to be reversed in exf-L°rt t, . p„ly, the items entering into the basic balance bit more stability
than those that do not and may therefore constitute a fairly reliable guide
for long-term policy planning.
Errors and Omissions (Net)

7 e entleswderths
? headingrelate mainly to leads and lags in reporting
1 t0 the
o transactions. It is in the nature of a balancing entry and is needed as f °ffset
overstatement/understatement ofthe recorded components. ^ a so includes 'Multilateral Settlements' in
geographical distribution.
unilateral Settlements relate to transactions settled in currencies of o It countries/territories. Thus if
payments are made in sterling to (sfy U~, the credlt entry appear in the capital account with UK j^le^he debit entry
appears in the merchandise account with US~ : The country statements of both will be balanced through debit and
crefit entries respectively of equal magnitude in the multilateral settlements which are not only self-balancing
but also balance total figures.
Overall Balance

overaI1 balance
^he ©# all transactions taking place under Current Account and Capital Account (both long-term
and short-term). In other words the sum of Current Account balance and the net capital inflow/outflow
under Capital Account yields the Overall Balance. This „ala"ce 1S commonly considered a measure of
balance of payments performance". Normally overall balance should match with changes in reserves but in
the case of exceptional financing, the overall balance is matched by adding exceptional finance with
changes in reserves.
Reserves - The official reserves account records changes in gold and foreign exchange balances held by the
monetary institutions. Reserve assets are available to meet immediate needs of the country's payments Despite
the name, reserves in the standard balance of payments accounts are not stocks but changes in gross external
assets. These include foreign exchange (currency, deposits, and securities), monetary gold, SDRs, and country’s
reserve position in the IMF. Reserve assets are under the effective control ofthe monetary authorities and can
be used either directly (to finance payment imbalances), or indirectly (to regulate imbalances by, for instance,
intervening in foreign exchange markets to support the value ofthe currency). Transactions with the IMF affect
both reserve assets and reserve liabilities.

Exceptional Financing/Gap - It covers the debt relief, roll over of SBP and NBP deposits, commercial banks
(medium and short term) deposits, commercial interest, rescheduling of bonds, possible financing of IMF,
World Bank and ADB, and other bridge/residual financing.,

balance
123
 (Million Rupees) forgiveness 1 -1 -2 Other
1.2 Other sectors 2-
Item Net

l.Current Account A.
Goods and services Acquisitions/disposal of non-
a. Goods produced non- financia! Assets FY
09
1. General -Debit
merchandise Credt
2. Goods for
processing 2775464 3502359 -726973 3195778 352&MS3 -3
3. Repairs on 1823280 3079802 -1256601 2086830 319S191-
goods 4- Goods 1500966 2492086 -991198 1648631 26153 7
procured in 1485031 2465632 -980601 1629608 2593327
ports by carriers
5. No monetary
gold
b. Services
1. Transport
ation 1.1 Passenger
1.2 Freight
1.3 Other
2. Travel
2.1 Business
2.2 Personal
3. Communications
services
4. Construction
services
5. Insurance services
6. Financial services
7. Computer and • Movements in exchange rates
information
services • Multilateral, bilateral and unilateral taxes or restrictions on
8. Royalties and
license fees 914251089
trade -347o4 '
9. Other business 45588 32096'
services 10. 6 70 18 2 6 8
Personal, cultural, • Non-tariff barriers such a s env i r o n m1 ental,
and
recreational health or safety standards
services 1V Government
services B. Income • The availability of adequate foreign exchange to pay for
I.Compensation of
employees 2.
imports
Investment income
2.1 Direct • Prices of goods manufactured at home (influenced by the
investment 2.1.1 responsiveness of supply)
income on equity
2.1.2 Income
Balance of Trade and Business Cycle
on debt
(interest) Countries focus on exporting more during a recessionary period in
2.2 Portfolio
investment order to curtail unemployment. This can be achieved by creating
2.2.1 Income on equity demand for local goods in other countries. During an
(dividends) expansionary phase (or boom period), when industries are
2.2.2 Income on debt
(interest) running at full capacity and demand is on a rise, countries tend to
2.3 Other investment import more to fulfill the supply gap. This encourages price
2.3.1. Monetary
competition between local and foreign goods which limits
authorities
2.3.2. General inflation and provides goods beyond the economy’s ability to
government meet supply. Trade deficit is considered healthy only in the case
2.3.3. Banks
2.3.4. Others when there is economic growth in the^ountry.
C. Current transfers
t' General government 2.
Other sectors
1.1.Saudi Oil Facility
2. Capital And Financial
Account A. Capital
account 13 Capital
transfers
Pakistan's Balance of Payments
1.1 General
government
Debt goods and other inputs
124
Economics I
 Pakistan's Balance of Payments 549 6437 -5887 335
6453
15386 20017 -4710 18688 *5517
32231 587717 -265403 438199 S79824
4
96631 285184 -188553 107182 2997S9
51259 42782 8478 60756 '
37292

9891 206137 -196246 9302 221991

35481 36266 -785 37124 40uiT’6i
24648 78655 -54007 23967 73662
1099 1727 -628 335 2346'
23549 76928 -53379 23632 713TH
15386 11304 4082 20615 13324 5
2433 5495 -3061 1341 2430
4631 10440 -5809 3520 12235
4945 13031 -8085 7542 7961
14444 9577 4867 15755
863 7300 -6437 503 9302
92433
38700 129365 -90666 44918
78 235 -157 419 1552'
11955 37130 8242 21243 5313©
3 3
41455 -345942 7 3220S
68608 0 47013 9
1256 157 67352
414393 3061
250567 -247505
3061 250567 -
247505

46863 78341 -3147B 36454 63TC3

235 13659 -13423 - 1642S

46628 64683 -18055 36454 4667H

17427 85485 -68058 8464 7517®?
6908 5338 1570 2095 124CB

78 56126 -56048 754 5313S0

9341 9734 -392 4944 I
1099 14287 -13188 670 2349
673K
883577 8007 875570 106193
1

16485 3689 12795 5

49

0
B

50784
883577 8007 875570 101115 5Q2ft
1
113995 422242 717710 947127 663458
2 392 1 35717 15336
36109 392 35560 15336 419
35952 33519 14749
33519
479
33519 392 33519 14749
2433 2041 587

157 157

125
Economics I
126
Economics I
Balance of Trade
Balance of trade is one of the largest and most important components of the country’s balance of payments.
It forms part of the current account in balance of payments. Balance of payments, or net exports, is the
difference between the monetary value of imports and exports over a period of time. The balance of trade is
similar to the difference between the goods and services produced by the country and the total domestic
demand. The difference between these two factors identifies how many goods a country has to purchase (or
import) from abroad. However, this does not account for the money reinvested in foreign stocks and the raw
materials imported to produce for the domestic market. The balance of trade is calculated as follows2
Balance of Trade (Monetary Value) = Net Exports = Total Exports + Re-Exports -
Total Imports-Re-Imports
The balance of trade is said to be in surplus if exports are higher than imports. This positive balance of trade
is called trade surplus. If the economy is in trade surplus, the country’s net international asset position
improves correspondingly, whereas the balance of trade is said to be in deficit if the country imports are more
than it is able to export. This negative balance of trade is known as trade deficit and, more commonly, trade
gap. Trade deficit tends to decrease the net international asset position.

Factors affecting Balance of Trade

There are several factors that can affect the balance of trade. Some of them are listed below*

2 The cost of production (land, labor, capital, taxes, incentives, etc.) in the
exporting economy in comparison with those in the importing economy
 Balance of Trade of Pakistan
TJie goods that Pakistan exports are rice, furniture, cotton fibo; tiles, marble, textiles, clothing,
leather goods, carpets and nig>. products. The major imports of Pakistan are petroleum anH p
products, machinery, plastics, transportation equipment, edibje and paperboard, iron and steel and
tea. The trading partners of. include the European Union, China, United Arab Emirates and the
States. The trade deficit of Pakistan in 2010 was -15 billiom

o\ iTade

( Millioa
Period Exports 67.1 10,309.4
FY 00 8,568.6 18.1 -1,69U
FY01 9,201.6 63.5 10,728.9 12.2 -1,476J»

FY 02 9,134.6 70.1 10,339.5 111 -1,145.9

FY 03 11,160.2 50.4 12,220.3 5.8 -1,015*5

FY 04 12,313.3 415.9 15,591.8 14.3 -2,876.9

FY OS 14,391.1 103.4 20,598.1 80.2 -6,183JI

FY 06 16,451.2 129.1 28,580.9 10.3 -12,010.9

FY 07 16,976.2 162.1 30,539.7 4.4 -13,40SJ

FY 08 19,052.3 727.4 39,965.5 10.9 -20,196.7 J

FY 09 17,688.0 263.3 34,822.1 20.4 -16,891*2

FY10 19,290.0 257.0 34,710.0 - -15,163 J»

Re-exports Imports Re-imports Baianoe nf

Source: Federal Bureau of Statistics
 Trade Balance
and Exchange
Part Five

Rate
Chapter 2 Exchange Rate

By the end of this chapter you should be able to: m Define the exchange rate system ®
Learning Outcome List and define the types of exchange rates ® Differentiate between

nominal and real exchange rates ■ Compare real interest rates to nominal interest

rates

■ Discuss the impact of change in interest rates to exchange rates - Define a closed economy and

an open economy

Exchange rate
systems
The exchange rate can be defined as the foreign currency price of a unit of the domestic currency. Assume for simplicity
that there are only two nations, the United States and Pakistan, with the rupee (PKR) as the domestic currency and the dollar ($) as the
foreign currency. The exchange rate between the rupee and the dollar is equal to the amount of rupees needed to purchase one dollar,
that is, R = PICR/$. For instance, ifR = PKR/$ is 85, this means that 85 rupees are required to purchase one dollar.
Under a flexible exchange rate system, the rupee price of the dollar (R) is determined, just like the price of any commodity, by
intersection of the market demand and supply curve for the dollar. Figure 5-1 shows the demand and supply for U.S. dollars in a
simplified example where we have a bilateral trade between two currencies.

Figure 5-1, Exchange rate equilibrium

Amount of foreign currency

2ffldiange Rates
 The demand for the dollar depends on the need of the people. People may purchase dollars to buy American
goods or dollar denominated financial instruments, whereas the supply of rupees comes from those individuals
who supply goods or services to the Americans or those who invest in U.S. dollars. The price of foreign
exchange settles at the price where supply and demand of the currencies are in equilibrium. Point E in Figure 5-
1 shows the balance between the two currencies and that one unit of dollar can be traded against 85 units of
rupee. If the rate is above E, there would be excessive supply of foreign currency; however, the market forces
would push the exchange rate back to point E, i.e. at the equilibrium level.

Figure5-2: Demand shifts

Foreign exchange rate

(PKR/USD)

Amount
of 1

FigureS-3: Supply shifts

Foreign exchange rate (PKR/USD)

Aiiwtl

Finally, while we have dealt with only two reality there are numerous
exchange rates, oof currencies. Thus, apart from the exchange rate ! rupee
and the U.S. dollar, there is an exchangt dollar and the British pound,
between the
VS.4

128
euro, between the Pakistani rupee and Japanese yen. between the GermaE euro and Saudi Riyal, and so on.
Once the exchange rate betv»een eacfc of the pair of currencies with respect to the dollar is established, fee
exchange rate between the two currencies, or the cross rates, can be determined.

For example, if the exchange rate (R) is 2 between the U.S. dollar and the British pound and 0.5 between the
dollar and the German euro (), then the exchange rate between the pound and the German euro is 4. It means
that it takes 4 Euros to purchase 1 pound. Numerically,

cXA=/£ = ($value of £)/ ($ value of) = 2/0.5 = 4

Since over time a currency can depreciate with respect to some currencies and appreciates against others, an
effective exchange rate is calculated. This is a weighted average of the exchange rates between the domestic
currency and the nation’s most important trade partners, with weights given by the relative importance of the
nation’s trade with each of these trade partners.

Fixed exchange rate system

The Bretton Woods Conference in 1944 established a fixed exchange rate system in the post-war world. Each
currency was given a fixed parity (value) in relation to the U.S. dollar. The devaluation or revaluation of a
currency against the dollar was permitted only when a country faced a severe economic crisis due to a
misaligned currency value in relation to the dollar. A number of factors, such as high inflation and large current
account imbalances, resulted in the collapse of the fixed exchange rate system in March 1973. Since then the
world’s major currencies have floated in relation to each other.

Some developing and emerging economies continue to fix the external value of their currencies to one specific
currency such as the dollar or euro. In the European Union, seventeen countries have irrevocably fixed their
exchange rates to the euro, thereby creating a single currency area known as the Euro zone. (This is currently in
trouble with some member countries, notably Greece, effectively bankrupt and in default of euro currency
loans and many questions are being raised as to the future sustainability of such a single currency area.)

Operational aspects

Under a fixed exchange rate system, a country adopts an official par value for its currency against a major
reserve currency such as the dollar or A euro. The actual forex market rate of the currency is allowed to
fluctuate Cjvithin a narrow band set by the central bank around the central parity rate) If the market rate
threatens to move outside the permitted band, then the country will take appropriate domestic economic
measures to correct the current and/or capital account flows causing the divergence. The country’s central bank
might intervene in the forex market to influence the exchange rate via alterations in its international reserves.
Sometimes a country will apply for an International Monetary Fnnd loan to assist it in

The problem with a fixed exchange rate is that the limit sign exchange stabilizing its exchange rate until

corrective economic measures take effect.

reserve position of most central banks creates a specurators, paradise ® a bet against a country’s currency can
result in huge profits if devaluatkn occurs. If enough speculators sell a currency “short, , , they will tend
validate their devaluation expectations. Such speculative capital outflow4 from a country can quickly exhaust
the foreign currency reserves of most central banks. Official financing in effect becomes a non option;
devalualiaii or the adoption of a floating exchange rate become the only realistic options.
7
The fixed exchange rate system helped post-1945 economic recoven. ani growth, encouraged international
trade and investment and preventeJ competitive currency depreciations. However, with the benefit of
hindsisfcit fixed exchange rates proved to be an unrealistic proposition over m prolonged time period for the
main industrial countries. Cost/prkcJ disparities due to differing country wage bargaining systems resulted i—
J misaligned exchange rates. Technological advances and innovatiomi resulted in structural changes in
economies with consequential eflfecnl on export and import values. Economies also experienced differing
economic growth rates which affected per capita income levels and resuiail in changing consumer preferences
for domestic and imported goods services. The rise of new industr shifted the shares and pattern ofW
ial and emerging economies has zistl
All these factors and others resu V o r k l I t J i k ' exchange rates at
regular intervals
exch
ange rate system by an inc i;,.J :n i i ; J .u ■, J
devel
°pmg and emergmg ec°n°m i( ,, ,,, , 11: j , ,,, A , , , . , ; , , , , , ,
fixed rate system where its percei
n u n ! , : : ,.! - -
costs of its use A gover
. ent c
nm an: i, bu
!t. h, „ ,,
not
botii totter A fixed ex to be i,,U|I.. 1|t, .
flexible
in order t o control caj activity. : i i ! l k i ; ! , . i i v : .

... . . change rate will require interest raH

Floating exchange rates ,
)ital ln/outfl ows and domestic econovi

Under a free float (no central ban to fluctuate freely

according to de foreign exchange market. Tradi
export i port of goods d servio e
/m an th i/jntervention) currencies are alkji
exter al values of currencies i
n l! , !i;ijj! . |l| ., !ni ) N ,
| i ; k .
| l ;

est b shes an equi ibri m or natu

ak l u ng transactions associated wi t h *
decision or i terference
n . l(, ml ; i , n , -

™ ... t n relation to one another. The

The following diagram illustrates ,
, i ii ral exchange rate without any potti
sterling and the dollar.

At E2 the lower exchange rate ii

t^ebuctugungngxc^ggeinfliteswhd ^Itheufceirtairaies aotofMeigre Itrade an
resiidfiSSs^As a result, the current
• A fall in an exchange rate may increase infl ation which, if not controlled, may lead to farther currency
depreHation.lFikfed exchange cr&tesrdo rimpose discipline on a country’s monetary authdTtiesp
asreBonoipiBrtS cheaper fbl^B
account disequilibrium is elimin^|

Economics | Reference taM

 Under a free float, the exchange rate is always changing to a new equilibrium rate(El to E2) to take account of
internal and external factors influencing the demand and supply of sterling in relation to other currencies.
Figure 5-4: Floating exchange rate - Sterling and USD

0 Quantity of (Sterling)
Point E,: Demand and supply of sterling on the foreigii exdiange market
establish a rate of ©xchangs of S1,60 per pound.
Point E2: Tht supply of staring inaeasAs to S} (tan SJ dye to
increased domastic demand for Imports (UK residents sell £ for $);
ynder a floating exchange rate sAtem this establishes a new exohartgB
rale al $1.20 «f poyml.

A number of general comments can be made about floating exchange rates:

• The degree of depreciation/appreciation required to correct current account disequilibrium is determined by

the market and not politicians.
• In theory, the government can concentrate on attaining internal equilibrium (economic growth; full
employment) as external equilibrium is automatically assured via the foreign exchange market.
• Governments do not require to hold large international reserves for exchange rate intervention needs as there
is no need to defend a declared parity.
• Floating rates may lessen the need for import controls and thereby encourage world trade growth. Such
controls are generally used to partially correct acurrent account deficit and avoid devaluation or deflation.

Risks

Although we have just identified the advantages of floating exchange rates, there arealso some associated risks:
mismanagement could result in the exhaustion of a count
• Without any central bank intervention, speculation may resuk I an inappropriate exchange rate which
could destabilize the econon ~"d rfsdt in misallocation of national economic resouic .Speculative capital fl
ows might result in an overvalued (or under

Types of floating Free (or clean) float rates ~

With this type of exchange rate system there is no official fina accommodating capital flows. The
exchange rate is free Unfortunately, a free float can result in an exchange rate oversfioM (t* appreciation or
depreciation) which might lead to a misallocatiaw resources m an economy. It is questionable whether a
government i actually abdicate totally responsibility for its own currency’s e] rate. Also, internal economic
policies/statements will influence the i perception of what is the “correct” exchange rate.

Managed (or dirty) float . . . \ \ ’ \ A k . o

]
Wit) this type of float, official financing and/or interest rate policva used to influence the exchange rate at
certain points of time to en] it is consistent with domestic economic objectives. A dirty float presupm that
the government knows what the correct exchange rate is

131
 Floating exchange rates in practice

Floating has provided no real freedom (or autonomy) for dom

economic policy actions. Current account adjustment still requires ai
,eairesource h to economy and changes in relative real wa] make a country
competitive in world markets.

It has provided no quick panacea for any underlying economic pr m a country. On a positive note, floating
did increase the shock absoni capacity of individual countries and the international economiLl
ffSt£m /x —ed weli with large oil price fluctuations, recessiores boo^ns, the external debt problems of many
countries and various ma= crises. It is unlikely that fixed exchange rates could have~

Floating has not lessened the degree of international financial a m the world. The IMF continues to carry
out surveillance o L exchange rates and provides loans, if required, to those nations n balance of payments
assistance.

HenTional trade and investment has expanded over the years, do4 eiped by the dismantlement of
import and exchange controls. Hoh perverse exchange rate movements have sometimes been expe^
when currency rates did not reflect the underlying economic ftmda and/or current account position
of a country. Occasionally, countr a current account deficit and high inflation have raised interest i
deflate the economy, only to witness capital inflows causing exchange rate appreciation. The latter has
reduced exports and increased imports thus swelling the current account deficit. In other words, the exchange
rate movement, rather than correcting an imbalance, has exacerbated the situation. Ultimately, correction
does take place but only after a misallocation of resources in an economy. The factors which can influence a
countr/s exchange rate are trade flows, capital account flows interest rates, investment portfolio adjustments,
official financing and psychological factors.

Nominal and real exchange rates

The nominal exchange rate (NER) is defined as the number of units of the domestic currency that can
purchase a unit of a given foreign currency.
A decrease in this variable is termed npminal appreciation of the currency. (Under the fixed exchange
raj^regime, a downward adjustment of the rate is termed reydiMtion.) An increase m this variable is termed
nominal deprecito of the currency. (Under the fixedpxchange rate regime, an upward adjustment of the rate is
called devaluation.)

f The "real exchange rate" (RER) is the purchasing power of two currencies L^- relative to one another)lt is
based on the GDP deflator measurement of the
price level in the Wstic and foreign countries (P,Pf), which is arbitrarily set equal to 1 in a given base year.
Therefore, the level o e RER is arbitrarily set depending on which year is chosen as the base year for the
GDP deflator of two countries. The changes m the RER instead informative on the evolution over time of
thJrelative price of a unit o GDP in the foreign country in terms of GDP units of the domestic country, j

The nature of interest rates

A definition of interest might be that it is a sum, usually expressed as a rate or percentage per annum, and
paid for the use of financial capital. Interest is therefore derived from the use of capital. An interest rate is the
price paid for borrowing money - capital- and is determined by the interaction of supply and demand.
Interest rate theories mcorpora e different concepts on the supply of, and demand for, funds.

The market rate of interest

The market rate of interest is determined by the supply a^d demand for credit in an economy. Net savers, or
net lenders, will supply funds to the credit market (or to the net investors who borrow money andmvestm
different avenues). Net borrowers will demand funds from the credit market.

Classical interest rate theory

Classical theory combines the investment demand curve with the supply of savings curve. It is referred to as
a real or non-monetary theory of interest rates. If the interest rate increases, it is assumed that people wi save

132
Economics I Refe
 more, and vice versa if it falls.

The equilibrium interest rate is the rate at which savings and investment are equal for a particular time period.

Exchange Rates

133
 SJperfaeperM

In this diagram the demand for, and supply of, capital are equal equilibrium interest rate that equates demand and supp

In this diagram investment demand declines from I1I1 to a result, interest rates decline from 6%to 4%. The lower interest iair
in fewer savings being made available for investment

Classical theory assumes that people have a time preference for and prefer a given sum now to the same sum in the future? paid to
compensate them for the loss of current purchasing powe and investment are brought into equilibrium by changes in int If the
economy experiences a recession due to a collapse in ex investment may decline. The net effect of this would be lower Irates,
savings and investment in the economy.

S,Iptrf_ p

LThe classical theory regards savings as being influenced by whereas modem theory believes that savings depend more on
income?)rhe classical version is also concerned with flows of investment over a period ot time.

Economics j
Nominal and real interest rates

A nominal interest rate is one expressed in money terms, as advertised, w ereas a real interest rate is the nominal rate stated minus the
inflation
5
,f°oro/XamP ain°minal lnterest rate of 5% adjusted for an inflation rate of 2/o is equivalent to a real interest rate of 3%. If the inflation rate
was 7/o, then the real interest rate is - 2%. In other words, it represents a negative return on your money or capital.

Equation relating real and nominal interest rates

x 100
NR

RIR,
Where
RIR= Real Interest Rate,
NIR= Nominal Interest Rate effect on initial investment and '= M ationary effect on initial investment

Term structure of interest rates

t0the pattem of inte

SuXfe/YCtUre referS on similar I W ^a^- t » generally the case that interest
Figure 5-7, The Yield Curve ▲

Yield %
yield
curve

inm to maturity

11 80the
^ yMo cu : v£ ^(2)ws ^because the lon8er term to maturity, , f. " and uncertamA lender looks for compensation though a
higher return rate. The lender also seeks
compensation for lack
sho t A ------- a claim than a short-term claim. The
borrower is willing to pay more for longer-term
[imds because they provide certainty of cash and cost, unlike short-term borrowing which has to be
constantly reviewed at uncertain interest rates

135
 The pattern of interest rates is the result of such factors as risk, maturity and competition. A bank’s interest rate
structure is influenced by the competition for funds in the savings/money markets. On the lending side it must offer
Interest rate overdrafts, loans and mortgages on competitive interest rate terms in order to win business. Obviously, the interest
pattern rate charged will also be influenced by the creditworthiness of the borrower and the facility’s repayment date. All
other things being equal, the longer the maturity, the higher the rate of interest. L

Interest rate levels are determined by the govemmenfs economic policies. The size of the budget deficit and the
technique of funding can have a profound effect on interest rates. Overall monetary policy can influence interest
rates, particularly short-term rates, which are influenced by daily intervention in the repo money markets by the
central bank, which can control the marginal cost of funds to the banking system and thereby control the speed and
direction of interest rate changes it desires. In the case of longer-term interest rates, a change in short-term rates may
influence expectations on long-term interest rates, although the latter are also influenced by inflation expectations.

Interest rates change and exchange rates

Interest rates change when the central bank changes the discount rate. These interest rate effects occur quickly and
relatively predictably. The exchange rate responds to changes in the interest rate in the country relative to the interp^t
rates in other countries. This phenomenon is known as interest rate differential.

When the central bank raises the discount rate; the country’s interest rale differential rises. Keeping other factors
constant,; a rise in the interest rate differential results in the appreciation of the currency. An appreciatkm of currency
is defined as an increase in its value with respect to one or multiple foreign currencies. For example, the exchange
J
rate between PKR and USD is 1USD = 85PKR, now, and if the interest rate rises in Pakistani the value of PKR will
increase and the exchange rate may look like t 1 USD = 84 PKR (we now have to pay less to purchase one unit of
dol

An appreciation in the rupee makes the country’s exports more expenswej and reduces the volume of exports and
aggregate demand. It also proWi the local firms with an incentive to keep the costs down in order to rer competitive
in the international trade market. A stronger rupee reduces import prices, making firms, raw materials and
components cheaper and therefore helping them to control production cost. The appreciation in the value of currency
also attracts foreign investors and encourages them to invest in the currency.

On the contrary, a fall in the interest rate differential results in the depreciation of currency. The results of currency
depreciation are cheaper exports and expensive imports.

An economy in which international trade isMlowed and individuals and | businesses trade goods and services
Open economy
with the individuals and businesses in other countries is termed an open economy. An open economy allc flow
and closed
of funds as investment across borders.
economy

136
Economics | Reference Bo«k2
 When individuals ana businesses sell goods and services to a foreign country, they are engaged in “exporting, , ,
whereas when they buy goods and services from a foreign country, they are “importing”. This process of importing
from and exporting to international markets is called international trade.
Open economies provide consumers and suppliers with a larger variety of goods and services to choose from. Tms
is the primary advantage of an open economy. People have a choice or both local and foreign goods. Also, if
products are not available in the host country, people have the option of importing them from another country or
countries. This is not the case with exports. Goods that are produced to excess in the country can be exported to
otherxountries where the demand for such gooas is high. Exporters of goods and services often target
those countries
where such goods are not availaole due to lack of resources.
Moreover, consumers have an opportunity to invest their savings in foreign markets. If the country in which the
person is residing has a low return on investment, he/she can invest in a foreign country that provides a better return.
In an open economy, the country’s spending may not necessarily be equal to its output of goods and services in any
given year. A country may borrow from abroad and increase the money supply or it can cut down on the money
supply and lend it to foreign countries.

at
A closed economy exists when a country can continue to su
external assistance. Such economies are rarely existent in today’s world. A closed economy reflects the quality of
being self-sufficient. Generally, a closed economy is applicable to political states or the economic policies of the
country.
Exchange rate This article has been taken from the SBP website Source:
Stabilization &
State Bank of Pakistan
Liberalization
Of the regime As a matter of policy and with a view to improving the confidence of the market and reducing the risk of the system
to speculation, State Bank has been vigorously implementing the strategy to both liberalize the entire foreign
exchange rate regime and to provide stability to the exchange rate itself. The post September 11 events, the ensuing
global recession and other exogenous shocks, although they initially lowered export earnings, the impact of these
events on the exchange rate remained limited. The Rupee has remained stable, thus enabling exporters to correctly
price their products and benefit from the increased opportunities created in the European Union, where the benefits
of increased quotas were negotiated with reduced or eliminated tariffs. Some of the steps taken and policy measures
introduced by the State Bank of Pakistan towards this end include:

The Foreign Exchange Manual has been updated, revised, and brought into line with tne market needs and realities.
This has removed the longstanding anomalies that existed between the move towards liberalization and the rules
that were conceived for the control regime.

Exchange
Rates
Formation of Exchange Companies was a vital part of SBP’s i developing a sound and documented foreign
exchange markzfltl country on sound governance principles. The work on formi proper regulatory and legislative
framework has been compft nine licenses already issued for formation of exchange con

As a result, five companies are already in operation and pr , facilitation of retail foreign exchange business through
these cxn would phase out the moneychangers within the next year. This i not only lead to better regulation and
supervision ofthe acthi market, but also allow for better service provision to the

Home remittances have started to be channeled through the i system for a variety of reasons including the curb on
hawala aTid i | and the elimination of differential between the open and market. Also, the five big Pakistani banks
have also streamlinai | remittance mobilization and processing, making it possible for j in Pakistan to receive
remittances within 24-48 hours in the la of Pakistan.

Authorized Dealers have been delegated the powers to allow ] of surplus passage/freight collection of
Foreign Airlines of Foreign Airlines subject to certain limitations on their

NOSTRO Limits, imposed on the Authorized Dealers for bala abroad on account of their trading activities, have
been wit

Subject to certain conditions and State Bank’s prior approval, of Pakistan, including firms and companies, are
allowed to make op based investments, other than portfolio investment, in incorpoi unincorporated companies
and Joint Ventures abi

Authorized Dealers were allowed to freely buy and sell foreign • from and to other Authorized Dealers in
Pakistan within the j permissible exposure limits.

To introduce the needed flexibility and widen the scope of the Scheme, it was decided that while computing the
20% cap on deposits against local currency deposits, the foreign currency de | mobilized under FE-25 and utilized
for financing of trade-related; will be netted off

Authorized Dealers were allowed to issue foreign currency travi cheques, for restricted amounts, to foreign and
Pakistani nationals (re and non-resident) against surrender of foreign exchange in

Shipping Companies were allowed to open and operate foreign i accounts in Pakistan for both receipt and
payment of foreign exd

Relevant rules were revised to allow Authorized Dealers to hold am the incremental foreign exchange deposits
mobilized by them as ag the earlier requirement of surrendering the same to State Bank FE-31 Scheme.

Economics | Reference I
Establishment of Swap Desk to ensure two-way liquidity in the foreign exchange forward market not only gave
support to the inter-bank market but also to importers and exporters by rationalizing forward premiums. On the other
hand, the desk also provided ample support to the money market through this mechanism. Introduction of Karachi
Interbank Offer Rate (KBOR) which has grown in stature as the bench mark for borrowing and lending in the
interbank market for maturities up to six months. The benchmark is becoming increasingly popular for pricing
customer loans.
Part Six
Money
Evolution of Money

Chapter 1

By the end of this chapter you should be able to: ■ Define and explain
Learning Outcome the basic characteristics of money _ Discuss why credit cards and
cheques cannot be categorized « Define the liquidity preference theory _
Define the portfolio management theory

Money is anything that can be traded for goods and/or servkes a this characteristic of it makes the
exchange of goods and: easy, it promotes specialization. For instance, the owner of a car < can focus
on the production of cars, which he can exchange fan and the money obtained can be used to purchase
any other j services he likes. This practice for using money as a medium oft for goods and services is
absolutely necessary in the modem | economy for the smooth operation of businesses and transac
Introduction absence of it, people would have to rely on the barter system j exchange of one good or service for
another.

Why Credit Cards and Cheques cannot be counted as

Simply writing a cheque or carrying out a credit card transactkn^ not increase the money supply. It is when the
money has been: does the transaction fully occur.

Outstanding cheques mean that the transaction was not fully < and for this reason cheques cannot be
counted as money. Credit a the other hand are, in actuality, a short-term loan that the card I takes from
the issuer which is repaid when the bill has been re Thus, credit cards also cannot be counted as money.

Functions of Money
1. The first and most important function of money is that of a ] of exchange. This function of money
recognizes that money is the ] which a purchaser would use in order to buy a good or service and i the seller
will accept in exchange for that good or sei

2. Another function of Money is that of a valuF measure. Just as i measure length in meters, weight in grams
and time in seconds we I to have a measure of the value of money. This is why a common i account is used as
this measure.

3. Money can also be used as a store oivalue. This function recog that money can be stored and accumulated
over time. Money also (not have the risks associated with assets like jewellery, property and d: and the owner
can be confident that it will realize its monetary value i the future.

140 Eco
4. Another function of money is to serve as a means of deferred payments.
Most ofthe transactions are made on credit in this modem world. In this case, sellers are unlikely to accept
promises to pay in the future which are expressed m terms of goods other than money. They cannot estimate how
much ofthe product they will require in exchange and if they would face the risk involved m selling them. Sellers
usually accept promises to pay expressed in terms of money because they know they can use money to buy the
goods or service the want. Hence, money makes it easier to borrow and lend as it is a convenient way of
measuring debt and repaying debt.

The quantity theory of money

Tjie quantity theory of money suggests that if in the long run, the quantity ~money is subjected to an increase; the
price lev^Twll increase by the ,f percentage- The money supply is directly proportional to the price !evf! prevailin§m the
economy. While economists agree that this theory hoi J true m long run, there is still disagreement about its
applicability X? short run. However, he monetarism’s belief is that the money supply determines short-run
movements in nominal GDP and long-run in prices.

the movement of money varies from time to time. Sometimes the money turnover
is very slow, whereas, during high inflation, the turnover of 1S very high. This concept of
money turnover is explained with help ofhe concept Velocity of Money. The velocity of money measures the speed at
which money circulates in the economy. When the money suPP | y~is higher relative to the flow of expenditures,
the velocity of

We can precisely define the income velocity of money as the ration of total GDp to the Money supply. Thus
velocity is the measure ofthe rate at which money turns over relative to the total income or output of economy.
Mathematically,

V=GDP/M ...c
Here V is the velocity of money and M is the stock of money.
~ tare studied eariier> ^ GDP is equal to the price level(p) multiplied by the real GDP (q). Therefore:

GDP=p x q... (ii)

Equation (i) can be written as

V=GDP/M = (piqi + p2q2 +... pnqn)/M =PQ/M

the veIocit 5
Y of circulation is the number of times money changes an we see that this equation always has to be true.
This equation a so tells us that m the long run, the quantity of money determines the

P= (V/Q) M = kM .. (iii)
(V/Y) is independent of M therefore M and P is directly proportional to each other. The k is a variable substituted
in place of (V/Q).
 The same equation can be expressed in terms of growth I

1
STcLrmrney + ~ 0fVd0dty ^Qngp^ n^Q From this equation we see that:

Wth rate Of mOney ^ Rate vel ch

Since the long run negates effects of the rate of velocity change Inflation rate = Growth rate of money —Real

GDP Gnmtfc

JothfT/CVKent that m the lon§ ! the rate ofinflatioo $=h=rnCe m gr°Wth rate of _ey and the

Implications of the Quantity Theory I

Looking at equation (iii) if k is held constant, the prices wiD
c ^ temo ney supply A STABLE _
SC f . -;P ;
W ~ —, so wiH thepocrJ
Th£
~~theory is evident during the period of h “ when money supply grows with the multiple of about 10
0A3 rises with the same multiplier. ’toe "I

goods3com!nt0/remuer that »<—fundamentally dite] ^

core of hi d:d of good rises, the prices will automatTS The liquidity preference

theory

(llufdTvTZTM LiqUidity Preference rstothe demand teJ (liquidity). John Maynard Keynes, in his book,The General uJ
an Mone 1936
f y( ), talked about this con'l : ^ : : SPPY d£mand for determnSAl e. He stated that merely saving money does not
yield interest 3
n ereTA f r.» - 5 doeAS
with S ~ ^ —, is ™ as a result ofS

rSac, s »o * since income is _ always availably J

transactions The
incomeTf W °T . higher thtSMmcomeof a person, the higher will be his demand for lj3

cumstances that require expenditure. Again, the higher del

Economics | RefnoHA!A!
 3. The speculative motive: People prefer liquidity when they are speculating that there will be a decrease in the
price of a bond. People demand more money as interest rate falls because this pushes down an existing bonds price
so that the interest rate is in line with this existing bonds yield. Therefore, the lower the interest rate, the more the
money demanded.

Keynes stated that there is an inverse relation between the speculative demand for money and the rate of interest.

Keynes expressed the speculative demand for money as follows:

M2E= LsE(r)

Where L2 is the speculative demand for money, and r is the rate of interest. If a graph is plotted, it will give a
smooth curve sloping downward from left to right. He also expressed that:

M = M1E+ M2

Where total liquid money is denoted by M, Ml denotes the transactions plus precautionary motives and M2
denotes the speculative motive.

Supply of Money

The supply of money in a country is the total quantity of money it has. Although interest rates affect money supply
to certain level, the monetary authorities fix it. The supply curve of money is therefore a vertical straight line (it is
perfectly inelastic)

Determination of Interest Rates

The rate of interest of money is determined at the level where the demand curve and supply curve of money
interact. This is illustrated below:
\ Q
Interest rate

\Ei
Ri

***»• wmmmmrnam
immm.ammm
wH»lll E :
R
!!ll!
L
1
R
*1 --------------- 1
1
1 1
1
0
Mi M M; Amount of Money
The line QM is the supply curve. L is the demand interaction at E2 determines an interest rate of R- Any
dequilibrium interest rate will result in the rate of interest
- to reoccur at the equilibrium. For instance, when at the demand for money Mi is less than the supply
which is at Mj in order to achieve the equilibrium rate of interest R the rafir fl will decline from Ri to this
point. In the same way, when thtiis at R2, the supply of money is at M which is less than tbti money which
is now at

of Money
 M2. In this case, in order to achieve tbri interest rate of R, the rate of interest will start rising from St.1 point.

The Portfolio Management Theory

The modern portfolio theory is an investment theory v amount of portfolio risk, aims at maximizing
portfolio and similarly, for a given amount of portfolio expected rea minimizing portfolio risk by selecting
the proportions or u assets. Despite the fact that this theory is widely practiced in d industry, many fields such
as behavioral economics have c basic assumptions.

As fluctuations of prices in the stock market are completely i of fluctuations of prices in the bond market,
both assets coll a lower risk factor than either ofthem individually do. In Ireturns are negatively correlated
and even if this is not diversification helps lower risks. The modern portfolio mathematical formulation of
this kind of diversification in

In rather technical terms, this theory suggests the returns of 2be a normally distributed fiinction where the
standard devi denotes the risk and expresses a portfolio as the weighted > of the assets. The modern
portfolio theory aims at reducing 1 variance of the portfolio return. Its assumptions are that all i rational ones
and all markets are efficient ones.

Since there are adequate statistics suggesting that investors are DOK~ and all markets, not efficient. This
theory has suffered mudii including the fact that financial returns do not follow any I symmetric pattern.

The theory suggests that it is important to compare price cha asset with the other assets in the portfolio,
rather than sek individually from the investment portfolio. It also assumes that i are risk-averse which means
that if there are two portfolios withi expected return, an investor would tend to choose the one wiii risk
factor. Thus, suggesting that only if a higher amount of l return is offered will the investor take a higher risk
to get it' that if the investor is rational, he will invest in the portfolio, the more favorable risk-expected return
profile.

144
 ^1! D e m a n d and Supply of Moy
apter 1
Demand and Suppy of Money

Learning Outcome By the end of this chapter you should be able to,
Explain the demand for nrioney in an e<:onomy

" (ustrate the four main that influence the demand foi Interpret r money the creation of

money

Illustrate the expansion of credit through 9 system measures the bankin Explain the

of m
composition of °ney

Ml, M2 and M3
Describe the
components of Reserve Money (MO) and Money Multiplier

■^ ybehaViCf of PoLcy
tHe ;

The Demand for

Money

TM _ a fall in the d

We _ *
ady know t

mA
PPy of Money

145
 are paid to workers for their services. Money balances that are held to finance such flows are called
transaction balances. The average money balances which are held by people over a particular period is
relevant for macroeconomics, but we need to Imow how money demand relates to GDP rather than to
total transactions.

2* The precautionary motive Many reasons for spending arise out of the blue,such as car repairs if
it breaks down unexpectedly, or if you need to make an unplanned trip to visit a sick relative. As a
precaution against cash crises, when receipts are abnormally low or disbursements are abnormally high,
firms and individuals carry money balances. The precautionary money balances provide a safety net
against uncertainty about the timing of cash flows. If the number of such balances is larger, the protection
against running out of money is greater because of temporary fluctuations in cash flows.

3. The speculative motive The characteristics ofmoney mean that it can be heldas an asset. A
certain amount of money can be held by firms and individuals to provide a “cushion” against the
uncertainty inherent in fluctuating prices of other financial assets. Money balances held for this purpose are
called speculative balances.

Factors affecting demand for money

There are four factors that influence the quantity of money demanded by people:

1. The price level

Before we discuss how the price level affects the demand for tht\ money, let us first look at the difference
between nominal me and real money. As discussed earlier,nominal GDP is equal to t product of nominal
price of goods and services and their qua Nominal price level is the quantity of money measured in ]
whereas real money is the quantity of money measured in own rupees. Real money is:

Real money = nominal money price

level

If at any interest rate, the nominal price of the goods and-------------------------------- increase,
the demand for money will also increase, or vicn Therefore the quantity of nominal money in
demand is i proportional to the price level. For instance, if the price of f rises by 10%, the
consumers will need 10% more money to j the flour, thus the quantity of nominal money demaa
also increase by 10%. However, note that the change in pi_ changes the demand for the nominal
quantity of monef ~ does not have an impact on the real quantity of money | plan to hold. For
instance if you hold PKR 100 to buy will increase money holding by PICRllO if the price for f
your “wage rate” increase by 10%. Your PKR 110 buys 1 quantity of flour and is the same
quantity of real money 2 PKR 100 at the original price level.
2.Real GDP
The increase in the total output results in real GDP growth;this in turn increases the demand for money in
the economy. The relationship between real GDP and quantity of money demanded is simple. When the
economy is growing, people get better incomes, thus at the same price level they can consume more goods
and services for which they require higher volume money, thus the demand for money increases. Note that
it is the real GDP growth that will increase the quantity of real money people plan to hold.

3.The nominal interest rate

The rise in the nominal interest rate decreases the quantity of money demanded. Higher interest rates
indicate higher return on the savings (on bank deposits, bonds, t-bills etc.). Thus the higher the opportunity
cost of earning interest incomes and forgoing expenditures on goods and services, the smaller is the
quantity of real money demanded. There is a zero interest on the currency we hold, so the opportunity cost

146
Economics |
 of keeping the currency is the nominal interest on savings accounts or saving bonds, t-bills or any interest
bearing security. By holding money you forgo the interest that you would have earned otherwise.

Inflation depreciates the value of money. If other things are held constant, the higher the expected inflation
rate, the higher is the nominal interest rate.

4.Financial innovation
Technological advancements in banking and introduction of new financial products have changed the
quantity of money held by people. Money transactions have become convenient now with the introduction
of new facilities such as ATMs, credit and debit cards, online banking, automatic transfers, etc. — the fact
that people can now hold currency electronically, they tend to demand agreater quantity of money. Thus
financial innovation has a shortterm influence on the demand for money.

The demand for money is explained by the relationship between the nominal interest rate and the quantity of money
demanded. As discussed earlier, there is an inverse relationship between nominal interest rates and the demand for
money when all other factors remain the same.

Figure 74 shows this relationship in the form of a curve.

There is an inverse relationship between the demand for money and interest rates when all other influences on the
amount of money that people wish to hold remain the same. The increase in the interest rate causes the demand for
real money to fall. This causes the movement along the curve. For example at point A, the interest rate is at its high
whereas the quantity demanded is low. Now when the interest rates fall to point B, quantity demanded increases.

lesisand and Suppy of Money

Figure 7-1, Relationship between interest rate and quantity of money

Quality money

.I
The change in price level, GDP or financial innovation has a direct relationship with the quantity demanded. When there is
a change in any one of the factors mentioned above, the entire demand curve shifts accordingly (either rightward or
leftward).

For example, in Figure 7-2, the increase in real GDP increases the demand for money,
thus the demand curves shift to the right handside.
Figure 7-2: Real GDP and the (Wuantity of moneY demanded

147
 ©
fa
L_

7
7
5
i
V
c

The supply of money

I in: an t r,i I [m [ik controls the supply of money (using mon( apter . discussed in ch,8). The
money supply determined by ident of the ^ i 'j n k i s indcpLiinterest rate. Figure 1-3 shows [S.
The straight , s i i p p K 'i . i i i a c \ vertical line shows the perfec oney supply. ,
nature of the m
Figure 7-3: Money Supply M S Interest Rate %

6.0 Real Money (PKR trillions)

t0
V ow fwe measure the money supply in nominal currency units, it will sensi ve the price level. As inflation
increases, households and usinesses need more money to buy costlier goods and services. If prices double,
firms and households would need approximately twice the amount ofmoney to fund their purchases and to
meet their needs for money in [eserve. Ifwe divide the nominal supply of money by the price level, we have
the money supply in real terms. We can think ofthe real money supply as the money supply in terms of
constant purchasing power.

Measures of Money
Ml measures the following:

1 <1 Currency (coins and paper money) which is present outside

the Treasury, Federal Reserve banks, and the vaults of depository
institutions. (In depository institutions, currency is reserves for deposits and hence is
not considered to be in public hands. The same is true for currency held by the Treasury and The
Central Bank.)

2. Demand deposits or checking accounts in commercial banks. The depositor can withdraw these
deposits or transfer the funds to someone else at any time (usually by cheque) without any prior
notice to the banks and these deposits are generally interest (ree. These are called demand deposits by
banks. Commercial banks, until recently, were the only financial institutions allowed to have
checking accounts,but changes have pervaded the financial environment that effectively granted this
 right to other financial

3. Traveler s cheques of non-bank issuers.

4. It measures OCD, Other Checkable Deposits, consisting of negotiable order of withdrawal

(NOW) and automatic transfer service (ATS) accounts at depository institutions, demand deposits at
thrift institutions, and credit union share draft accounts. These share draft accounts cane be described
as checking accounts at federally insured credit unions that function like NOW accounts.
Both NOW and ATS accounts are very similar. These two accounts fiinctim checking accounts and this is the
reason for the central bank to mrimif this , forme of money in the Ml category. The funds in a NOW account
c | be withdrawn b^ the holder by writing what is essentially, but not Ieai | a cheque. NOWs, which aril
interest-bearing, are currently availaHel commercial banks, saving and loansc associations, and mutual furniil

A relatively lower level of liquidity is reflected by M2. It is thou^t nq the kej economic indicator which is used
to forecast inflation. As a fonul it measures th^ following:

1 .Ml

2.Interest-earning savings deposits and small-denominatioii deposits. The pass book deposits and
many other depositsfl varyin; terms and periods of maturity are a part of this. Inkefl is earned
one these time and savings deposits, but their redetiyuj is subject to specified waiting period.

3. Balances in both taxable and tax-exempt general purpose broker/dealer money market
mutual funds.

4. Resident foreign currency deposits with the scheduled faal

5. Overnight (and continuing contract) repurchase agreeniai (repos, issued by all commercial
banks. Business entities wlftfl are mostly larg< firms can use these agreements to keep smplj
funds at commerci; banks. Repos allow a firm to sell secmifl to a creditor and at the same time
agree to buy them back tsMat the same price plus interest for the _ use of the funds fbrH period of
the contract. Repos are considered secured shoitlH loans to the firm.

6. Money market deposit accounts. These are the special accounts that allow S&Ls
and mutual funds to be more comp witl other financial institutions.

Ml and M2 are both different from each other in way that saving currency^! and checkable deposits are
included in M2. The empha Ml is on the medium-of-exchange function of money, whereas the of-value
function of ;; moneyis also measured inM2.

M3 comprises the following components:

1.M2

2. Large denomination time deposits and term repo lial issuec by financial
institutions

3. Balances in both taxable and tax-exempt institution-only l market mutual funds

 1. M3

2. Non-bank public holdings of saving bonds.

3. Short-term treasury securities.

4. Bankers’ acceptances and commercial paper. The time draft bills of exchange which are
cosigned by a bank which promises to pay a specified amount at a specified time period (30 to
180 days, with 90 days common) are called Bankers, acceptances. Exports and Imports are
financed using these bankers’acceptances whichare discounted promissory notesissued by
highly rated credit borrowers (big financial and non-financial corporations) and are generally
Includes the following components: called commercial paper. A bankrupt line of credit with a
commercial bank is present with most issuers.
5. Last but certainly not the least measure of money stock L is quite broad and encapsulates
nearly all liquid assets.
Money market equilibrium

Just like AD-AS equilibrium, money market equilibrium occurs when the quantity of money demanded
equals the supply of money. Figure 7- 4 shows the equilibrium interest rate. This interest rate occurs at the
point where the demand curve intersects the supply curve or, in other words, the point where the quantity of
money demanded is equal to the quantity of money supplied.

Figure 7-4: Money Market Equilibrium

MS

Interest Rate %

MD

6.0 Real Money (PKR trillions)

12
 In the short run, the actions of banks and the central bank detc the quantity of money supplied. The
central bank adjusts the supply in order to conform to the interest rate target. For instance i Figure 7-4, the
central bank decides to maintain the interest rate ai hence in order to achieve the target the quantity of
money suj 4 PKR 6 trillion. In the short run, if the interest rate is 13%, peopjet invest in interest-bearing
securities rather than holding money. Oil I contrary, if the interest rate falls to 11%, the situation will be
the op | The investors would disinvest by selling securities, bid down their Wandraise the interest rate.

In the long run, the interest rate is determined by the demand and 3 in the loanable funds market. In the long
run, real GDP (whiciil direct influence on the quantity demanded for money) is equal to j GDP. The price
level adjusts to make the quantity of money equal to the quantity of money supplied. In the long run, the t
change is in direct proportion to the change in the quantity etiTherefore if the central bank changes the
nominal quantity ofl supply by one percent, the price level will also change by one

Creation of money
Banks create money by creating deposits for savers and by: to the borrowers. When a bank makes a loan,
the borrower money. The sellers who receive the cash may deposit it The deposits which are in excess
ofthe reserves (fractional deposits to be held by banks in the central bank as required by additional funds
which can be lent out. This cycle or dej and spending may continue until the amount of excess re for
lending are exhausted and become zero.

Three factors limit the quantity of deposits that the banking i create:

1. The monetary base

As we discussed earlier, banks are bound by law to W____________________

level of money as reserves in the central bank, henxl the monetary base restricts the
total quantity of moog supply. Furthermore, individuals and firms also haiic j level
of currency holding from the monetary base, of the monetary base depend on the
quantity i

2. Desired reserves

Reserves are calculated in ratio to the deposits portion of a bank’s total deposits
held in reserves i reserve ratio.

The monetary base which includes notes and vault and the deposits it has in the
central bani ‘actual reserves. These reserves are used at the time i has to meet
depositors demands and to make banks.
As per central bank regulations, banks are required to maintain a specified percentage of total
deposits as reserves. Since banks are required to hold a certain level of reserves in order to
maintain the percentage set by the central bank, this percentage is termed the required reserve ratio.

Banks also wish to hold a certain level of reserves against the deposits. The percentage of holding
the deposits as reserves that banks set themselves is called the desired reserve ratio. The desired
reserve ratio exceeds the required reserve ratio by an amount determined by the banks in order to
be prudent on the basis of their daily business practices and requirements.

A bank’s excess reserves are its actual reserves minus its desired reserves. Whenever the banking
system as a whole has excess reserves, the banks are able to create money. Banks increase their
loans and deposits when they have excess reserves and they decrease their loans and deposits
when they are short of reserves ^ when desired reserves exceed actual reserves.

A bank is said to be holding excess reserves when its actual reserves are higher than its desired
reserves (excess reserves = actual reserves - desired reserves). The excess reserves help the banks
in creating money as there is a surplus amount of money which can be either lent out or invested.
Banks also have room to increase deposits. On the contrary, when banks are short of reserves, they
decrease their loans and deposits. This is the case when desired reserves exceed actual reserves.

The bank’s reserve ratio increases when the customer makes a deposit as the reserves and deposits
increase by the same amount. Similarly, if a customer withdraws money from the banks, reserves
and deposits decrease by the same amount; this causes the reserve ratio to decrease.

However higher the desired reserve ratio maintained by the banks, the smaller is the quantity of
152
 deposits and money that the banking system can create from a given amount of monetary base.

3. Desired currency holding

Another factor that limits the money supply is the desire of maividuals to hold money in the
form of currency. When the total quantity of deposits increases, the amount of currency
people wish to hold also increases.

The money creation process through credit expansion

As we discussed earlier, money can be created when the monetary base increases and there are excess
reserves in the banking system. The excess reserves are created when the central banks purchases short-term
securities mostly t-bills) from the banks (the process of central bank borrowing,called open-market operations,
discussed in Part Eight of the book). The purchase of securities increases the banks, reserves but it does not
change the total quantity of deposits. Therefore banks have excess reserves that can be lent out to the investors
and borrowers.

When the central bank buys securities from a bank, the bank’s reserves increase but its deposits do not change.
So the bank has excess reserves and it lends those excess reserves. A sequence of events then plays out.

The banks do not keep 100 percent cash reserves against all deposits; else there

153
 will be no creation of money in the system. The banks hold certain percentage of deposits while the rest of the
reserves are circulated in the system in the form of loans.

We can explain the creation of money process by taking an example of a bank that has a required reserve ratio
of 10 percent and currency drain ratio of 20 percent. The underlying assumption is that the banking system as
a whole - public and private borrowers and depositors - creates money in ratio 10:1 for each new rupee of
reserves created by the central bank and deposited in the banking system.Lefs assume the banks have excess
reserves of PKR 1 million.

When the banks lend out 1 million of excess reserves, PKR 333,330 drains off and is held outside the banks as
currency. The remaining PKR 666,6710 remains in the banks as deposits. The sum of money has now
increased by PKR 1 million (the increase in deposits + the increase in currency holdings). The increased bank
deposits of PKR 666,670 generate an increase in desired reserves of 10 percent amounting to PKR 66,670. Tbt
actual reserves have also increased by the same amount as the increase in deposits which is PKR 666,670. So
the banks have excess reserves of PKR 600,000.

Now this excess reserve of PKR 600,000 will follow the same cycle. — of the currency will leak out of
the system (currency drain). The rema' amount, after excluding the money to be held as reserve, will be
lent fThis cyclical process will continue as long as the excess reserves re positive. This cycle is illustrated
in the table given be I

Table 7-1: The money creation process

In summary, once the banks lend money, the quantity of money increases; new deposits or money are used
to make payments. New money is used to make payments. Some of the new money remains in the deposits
while some of it leaves the banks in a currency drain. The increased bank deposits generate an increase in the
desired reserves. The actual reserves also increase by the same amount as the increase in the deposits; hence
the excess reserves remain positive.

The money multiplier

If we look at Table 7-1 closely, we will see how the amount ofmoney has increased each time it has been
circulated in the system. Let us compute how this has happened. Let’s name the initial increase in reserves as
A(PKR 1 million). The proportion of loan at each stage is 60% ofthe previous loan, similarly, the quantity of
money has also increased by 60% from the previous amount, therefore, L =
60%. Numerically, the cyclical process can be written as follows:

s = a+al2+al3+al4+...aln
Since L is a fraction of money, the amount of new loans and money will keep getting smaller at each stage.
The total value of loans and the quantity of money generated at the end ofthe sequence is the sum of the
sequence, which is:

S = A/(1-L)
Using the figures from Table 7-1 and inserting them in the equation given above, we can calculate thetotal
increase in the quantity of money:

PKR 1,000,000 + 600,000 + 360,000 + ...

= 1,000,000(1+ 0.6 + 0.36 + ...)

 2
=1,000,000 (1 + 0.6 + 0.6 + • • • )

= 1 , 0 0 0 , 0 0 0 x 1 (1 -0 . 6 ) = 1 , 0 0 0 , 0 0 0 x 1 / (0 . 4 ) = 1,000,000
x 2.5 = PKR2/500,000
The money introduced into the system increases as it is circulated around. The ratio in which the change in the
quantity of money occurs with respect to the change in the monetary base is called the money multiplier. In our
example, the monetary base was increased by PKR 1 million, whereas the quantity of money increased by PKR 2.5
million, hence the money multiplier is 2.5.

The magnitude of the money multiplier depends on the desired reserve ratio and the currency drain ratio. As we
discussed earlier, the monetary base comprises desired currency holding and desired reserves:

Monetary base (Mo) = Desired currency holding + Desired reserves

When there are no reserves in the banking system, the quantity ofmoney is the sum of deposits and desired currency
holding:

Quantity of Money (M) = Deposits + Desired currency holding Desired

currency holding = Drain ratio (a) x Deposits Desired reserves = Desired reserve

ratio (b) x Deposits

Thus,

Mo = (a+b) x Deposits M =(1 +

a) x Deposits
The change in monetary base (A Mo) and change in the quantity of money (A M) can be calculated as follows:

AMo = (a+b) x change in deposits AM = (1 + a ) x change in deposits

Recall the definition of money multiplier. It is the ratio of change in the monetary base to the change in the quantity of
money. Hence, by dividing the above equation for AM for AMo, we will get the equation for the

Money Multiplier =(1 + a) / (a+b) Monetary Policy

and Money Multiplier
When the central bank uses open market operations to expand the monetary base, the quantity of money increases with a
multiplier effect because the increase (or decrease) in bank deposits when the federal reserve buys or sells securities
creates excess reserves. The magnitude of i the expansion ofthe money supply is reduced by the portion of securities j
proceeds and bank loans that are held in cash, the effect of people holding I part ofthe increase in the money supply as
currency, rather than depositing ] it so that it can be used to create more loans.

The money multiplier for a change in the monetary base thus depen* I on both the required reserve ratio and the currency
drain.

The relation between the monetary base, the money multiplier, and tlvJ quantity ofmoney can be stated as: '

Change in quantity of money = Change in monetary base x money multipfiv ]

Additionally,
Fiscal Policy Multipliers Government Expenditure Multiplier
The government expenditure multiplier is the magnification effect« change
in government expenditure in goods and services on a^ demand. Since
government expenditure is a component of ag expenditure, a change in
government expenditurewill change demand. This results in a change in Real
GDPwhich in turn indi change in consumption expenditure, which brings a
farther char aggregate expenditure. Hence, multiplier effect comes into The Autonomous Tax Multiplier

au
The autonomous tax multiplier is the magnification effect of a change tonomoustaxesonaggregatedemandAdecreasemtaeshreasss
Oisposa6(e income, wAicA increases consumption expenditure. A decrease in taxes wotks like an iivcxease m govemme^
expeTvdituxe. But tWve magnitude of the autonomous tax multiplier is smaller than the government expenditure multiplier. The
reason is that a rupee tax cut generates less than a rupee of additional expenditure. The marginal propensity to consume determines
the increase in consumption expenditure induced by a tax cut. For example, if the marginal propensity to consume is 0.75, then a
 rupee tax cut affects consumption expenditure by only 75 paisa. In this case, the tax multiplier is 0.75 times the magnitude of the
government expenditure multiplier.

The Balanced Budget Multiplier

The balanced budget multiplier is the magnification effect on a^pregate demand ofa simultaneous change in government
expenditure and taxes !hat leaves the budget balance unchanged. The balanced budget multiplier is positive because a rupee
increase in government expenditure increases aggregate demand by more than a rupee increase in taxes decreases aggregate
demand. So when both government expenditure and taxes increase by a rupee, aggregate demand increases.

156
Economics I Refer I
 Monetary Policy
Part Eight

Objectives of Monetary Policy

Chapter 1

Learning Outcome By the end of this chapter you should be able to: ■ Summarize the objectives of a
Monetary Policy ■ Discuss the monetary policy tools undertaken by the
Central Bank to stabilize inflation m Discuss the concept of contractionary
monetary policy w Discuss the concept of expansionary monetary policy

Introduction Monetary policy is the use of interest rates and the level of money supply to manage the economy. Interest
rates used to be set by the central bank. The operational independence of the central bank means that it can
se: targets for inflation and set interest rates at the level most appropriate to achieve those targets. Monetary
policy may be used either to expand (or reflate) the economy or contract (or deflate) the economy.
Monetaiy policy is usually set by the Central Bank.

Objectives of monetary (economic) policy

Monetary policy has four main objectives:

1. The maintenance of high and stable employment

2. Reasonable stability of the price level

3. Balance of payments (currency flow) equilibrium

4. Economic growth
As we have already seen, these objectives have proved difficult to simultaneously in any economy.
Attempts to foster economic ^- full employment often lead to balance of payments difficulties. Tl attempts
to reduce inflation in the economy are often acco] a substantial increase in unemployment.

In theory, there is no reason why an economy should not growth, full employment,
price stability and balance ai equilibrium. The reality is that few economies achieve
all at the same time. This may be due to poor economic m the part of the government
or internal/external factors o
 The role ofmoney

£rm yne aiut

demand increases and prices remain stable, it follows that output and ‘ Q r' increase, or fhe ktter remain
unaffectedthenprices
_sit Th^Urrefint political/economic view is that changes in monetary
demand mainly influence prices and thevalueofmoney,mdhavelitleimpact on output and employment over the
long term. The objective of monetary policy has therefore been to create a stable financial environment WIth!n
”nomic agents - consumers and compames - a make market-based decisions which determine the level of
F
output and employment.

Target variables

Jhe controls selected to achieve a particular economic objective take the form ofa monetary variable which is
of importance, such as bank lending growth or money supply growth. This is referred to as a target variable
To achieve a target, the Central Bank will not control it directly, but will use various monetary instruments or
techniques such as altering interest rates, open market operations, reserve ratios and directives These
instruments influence the target variable and may contribute to the
A
oWWcA t^Qcxivsj Q Ns, Q ® fE
AA
Ttvsctv^ ^
has an impact on the country’s inflation rate, output and employment.

~eTary ~Is
The central bank is responsible for setting short-term interest rates in order to keep inflation within 1% either
way of the governments inflation target. If there is a danger of inflation overshooting this target, interest rates
will be raised and, conversely, if there is a risk of a short fall they will be lowered. It is the central bank’s task
to bring short-term interest rates in the money markets into line by providing financial assistance to members
of the banking community who are short of funds.

Alternatively, the central bank may grant loans secured on first class bills at rates which it determines. In this
way the bank’s short-term interest rate is passed on to the rest of the economy. The bank provides this
support through banks and other financial institutions, known collectively as the bank’s counterparties. For
this process to be effective, banks must be short of liquidity and in need of assistance.

Open market operations (0M0)

The central bank uses open market operations - the purchase and sale of treasury bills - to influence the price
of gilts and interest rates. As gilt prices rise, interest rates fall and vice versa. This in turn influences money supply
growth and overall demand in the economy. For OMO to be effective there must be an efficient deep and liquid
market in government securities.

Open market operations affect the cost and supply of money in two ways:

1. The central bank through its operations in the repo market is in a

lins at Monetary Policy position to influence security prices and interest rates. iq9
If it wishes to prevent interest rates from rising, it must prevent t-bill prices from falling. To achieve this it must purchase t-bills at the
appropriate price in any amount and thereby prevent a rise in interest rates. The Bank’s actions pump additional money into the financial
markets and add to money supply in the economy. The opposite approach of selling gilts will depress their price, raise interest rates and
take money out of the financial markets and economy. As well as impacting on current interest rates, the Bank uses its OMO to influence
expectations about future interest rates.

2. The Bank's OMO have an additional effect on the cash reserves, operational balances at the Bank and overall liquidity position of the
country’s banks. If the Bank is buying securities, it pays the sellers by cheque; the cheques are paid into the sellers‘ accounts at the banks
and in due course are presented through the clearing system to the Bank foi payment. The Bank makes settlement by crediting the banks’
 accounts at the Bank, increasing their operational balances. The banks can use this increase in their liquid assets as a basis for
credit/deposit creation via the bank deposit multiplier. If the Bank sells securities to the public, it has the opposite effect and leads to a
contraction in bank credit in the economy.
Short term interest rates

Fortnightly, the Central Bank raises short-term loans for the government by selling Treasury bills (t-bill), short-term IOUs issued by the Treasury,
which reduces the Bank’s liquidity. The counterparties are able to restore liquidity by borrowing from the Bank but on its terms. The most
important way this is done is through the sale of repos which are sale and purchase agreements. A seller sells securities with a legal commitment to
buy back the equivalent security on a specified date at an agreed price. This is in effect a form of secured loan. The difference between the selling
price and the buyback price represents the interest.

Daily operations in the money markets

The central bank estimates the flows of funds through the money market for the day and the likely level of liquidity. These estimates are passed to
the counterparties and the Bank offers to smooth out any shortages or surpluses at rates which it determines.

In the event of a shortage of liquidity, the Bank provides assistance and again with the counterparties by buying repos of repos and eligible hills
and/or by the outright purchase of eligible bills.
The Bank publishes an update and if there is still significant shortage of liquidity, may offer further assistance. In the
event of surplus in the market, the Bank can reverse the process and take funds out ofthe market by selling repos
and bills to the counterparties.

When the Bank buys repos and bills this puts money into the market and produces downward pressure on interest
rates. When the Bank sells repos and bills this takes money out of the market and puts an upward pressure on
interest rates. These open market operations in the money markets are therefore an important way of implementing
interest rate policy.

Long-term interest rates

The Central Baijk^also influences long-term interest rates by buying and selling longterm government securities (t-
bill edged) on the Stock Exchange.

The Bank uses these open market operations to influence the price of securities and interest rates (as security prices
rise, interest rates fall and vice versa) and to influence the money supply. The rate of interest is the price which
matches the supply of money with the demand for money. If the authorities wish to keep interest rates low and there
is a high demand for money then they will have to accept an increase in the money supply to meet the demand
Alternatively,iftheauthoritieswishtorestrict the money supply, they may be forced to accept a high rate of interest to cut
ofsomeofthedemandformoney.

Through its open market operations, the central bank attempts to influence either the moneysupplyortherateofinterest
- it cannotcontrolbothat the same time. The Bank’s open market operations affect the money supply in two ways:

1. The Central Bank is the largest dealer in the market for t-bill edged securities on the Stock
Exchange. The Bank therefore is in a strong position to influence the price and, since security prices and
interest rates move in opposite directions, the rate of return of any security traded on the Stock Exchange.
If the Bank wishes to prevent a certain rate from rising, it must prevent the corresponding security price
from falling. The Bank can achieve this by always being willing to buy the security at the appropriate
price in any amount. With the Bank a willing buyer, sellers would not accept less elsewhere so the price
is maintained and the rate of interest is kept from rising. The Bank is able to keep pumping money into
the market. The Bank can also take the opposite approach. If the Bank sells securities it can depress their
price, raise the rate of interest and take money out of the market. As well as having an effect on current
interest rates, the Bank uses its open market operations to influence expectations about future rates of
interest.

2. The Bank’s open market operations have the additional effect of altering the cash reserves (or their
equivalent, the operational

Economics | Reference Book 1

fflifectives of Monetary Policy
 balances kept at the Central Bank) of the clearing banks. If the Bank is buying securities, it pays the sellers by cheque, the cheques are
paid into the sellers, accounts at the clearing banks and in due course are presented through the clearing system to the Bank for payment.
The Bank pays by crediting the clearing banks, accounts at the Bank, thus increasing their operational balances. The clearing banks treat
this as an increase in their cash reserves and can use it as a basis for credit creation. If the Bank sells securities to the public there will be a
movement of cash from the clearing banks to the Bank for the securities they have bought which reduces the cash reserves of the
clearing banks and so restricts their ability to lend.

The t-bill (Treasury bill) repo market

There are no official restrictions on anyone repoing: lending or borrowing t-bills for any purpose, either directly or indirectly through an
intcrmediary- This reform has extended choice and thereby has increased the demand for t-bills which has enhanced the liquidity and efficiency of
the t-bill market.

What is a repo?

A repo is a sale and repurchase” agreement: Party A sells securities loj Party B with a legally binding agreement to purchase equivalentseciiritioj
from Party B for an agreed price at a specified future date, or at calljPsm P has unfettered title to the securities and may use or dispose of them -
it pleases; but it has an obligation to deliver equivalentsecurities to Pr A at the end of the repo.

The interest rate implied by the difference between the sale price repurchase price is the repo rate. If Party A is selling securities to ,T B in order
to raise finance, the repo rate, in effect, is the cost to P? of raising secured funds. Party B can “lend” money to Party A for 2.rate” of interest, and
take in exchange a “bundle “of t-bills.
This is • collateral repo.

The t-bill repo market has developed to such an extent that it has a modem form of secured money and therefore is an appropriate —
instrument for the Bank, s open market operations.

pays for stock

A A
Party A now £l00orc Hs aphstv ich it has mmmd£1 Second leg of the
mm

seii
 Directives

Treasury Thf ^ _cns to a banker as so authorized by the Treasury. This power has never been formally invoked, but the bankdoes give directives
which are of two kinds: bankdoes

*Antltaj67 drectiveS _ concerned with the amount of lending banks abandoned “ ceiings”. Quantitative directives were
abandoned with the introduction of Competition and Credit Control.

• Qualitative directives _ concerned with the type of lending banks do. Expansionary Monetary Policy

and FIH eXpanSi°naiy monetary p— to increase investment and consumption m an economy by increasing money supply which in
"etum reduce mtere^ rates. TMs will encourage people and firms to borrow more money. It will also give people who have mortgages more money to
spend each month as their mortgage payments fell The
£ffeCtS
— _ |— * ^ofconsumpdon^d . n e e consumption and investment are two of
the kev components of aggregate
demand, cutting interest rates should result in
A A A A Invest
X=n=rft Educed ^—ent. As the business aSs aSL W^e in financial

SF*LPv0l11—°r Central bank Considers that inflation tgandthey will easily meet their inflation
target, then they mav
c
o~s toutingmterest rates down.if *ere is a danger ofthe economy suffermg a downturn this will help reinforce this decision. The governmem or central
bank could also allow the money supply to increase in order

XThnh " r1,1^ :Tthat this ft®1 -HS high

; ™ pre e Quantity Theory of Money. Therefore expansionary
policies are about:

'Cutting interest rates

• Allowing money supply to increase

f owin
di g fig^e shows how cutting interest rates increases the supply t°fn?°”ey m th5ueC°nomy_ When the interest rates are lowered ftoTi J / E, the cost of
borrowing decreases, which in turn increases the demand

in^sTe^Xhe Nommal Rate

money
6 lag of the repo:
pays £ 100 <s: h plus repo rate of inlerast say, 6V2%
Party A "" —A
•I Monetary Is £100 worth of
Policy stock

163
Contractionary Monetary Policy
The central bank uses contractionary monetary policy to decrease consumption by reducing money supply in the economy, which results in higher
interest rates. This results in a fall in investment and consumption due to the high cost of borrowing and inflation. The net exports also fall due to
rising interest rates.
If the central bank considers that inflation is in danger of rising and perhaps going over its inflation target, then it may consider increasing interest
rates. Increasing interest rates will discourage people and firms from borrowing money and will also give people who are indebted with mortgages
less money to spend each month as their mortgage payments rise. The combination of these effects will reduce the levels of consumption and
investment. Since consumption and investment are two key components of aggregate demand, increasing interest rates should resul: in reduced
economic growth and increased unemployment.
The government or central bank can also try to cut the level of mor.~ supply growth to cut inflation. Therefore a contractionary policy with:
• Increasing interest rates

• Reducing money supply

Consider the figure given below. When the interest rates are incr~ from io to i, Ihe cost of borrowing increases, which in turn reducs demand for
money. The supply of money therefore falls from S
 Fiscal Policy
Part Nine
Objectives of Fiscal Policv
Chapter 1

By the end of this chapter you should be able to.

Learning Outcome
* Sh<W=:yt0°S — the government to

■ Explain the concept of the crowding out effect Explain discretionary

fiscal policy and its limitations » Explain automatic stabilizers •■Hy PC,icy and automatic

* betWeen
diSCret
'oduction
When the g.^ payments Ogives out -gaging in Iscal ~ : = in the government
budget is felt bv Dartf ? TMpaCt of Jjgp change families with children for , Y partlcular
t h a
Sroups-a tax cut for t
n*1 • T'\* • r” i i• i £S '/'dlSp> Sable incomeo ni ri
families. Discussions cn fiscal pclicv ho ^ f such of bu
changes
to in
the gov
emment bx l& foCUS W an economy, '
c on the
macroeconomic variables -s GDPanJ°V' ec°nomy - on such 'cts, the transfe, Phases, it is
£S aS GDP
and unemployment and inflation
federal _

1
' T o Ml \fy.\Kl ) government activities 2' To

macroeconomic objectives

the
governments outlay exceeds its tax revenue . nrfrn T hx

Revenues include:

1. Perso

n a l income tax A Social

security taxes J. Corporate

income taxes
Indirect taxes
Outlays are classified into three categories:
1. Transfer payments (payments to individuals, businesses, other levels of government and the rest of
the world)

2. Expenditure on goods and services

3. Debt interest (interest on government loan)

Surplus or deficit is calculated using the formula given below Budget balance =

Tax revenues - outlays

Budget deficit can be categorized as follows:
• Actual budget - the actual budget records the actual rupee expenditures, revenues and deficits in a
specific time period.

.Structural budget - the structural budget calculates the government expenditures, revenues and deficits
if the econom> is operating at potential output.

■ Cyclical budget - calculates the impact of business cycle on the budget. It measures the
changes in revenues, expenditures a. . — deficits that arise when the economy is either in
boom or recession. It can also be obtained by measuring the different between the actual and
structural budget.

The making of fiscal policy

Fiscal policy plays a vital role in shaping government expenditure taxation in order to alter the
business cycle and to maintain ecor. growth, keeping stable employment and inflation rate. Fiscal said
to be tight or contractionary when revenue is higher than s (the government budget is in surplus) and
expansionary when s is higher than revenue (the budget is in deficit). Suppose the. in a particular year
is heading toward prolonged recession. The bank may try to use expansionary fiscal policy to
encourage in'

Often the focus is not on the level of the deficit, but on the ch deficit. Thus, a reduction of deficit from USD
200 billion to billion is said to be contractionary fiscal policy, even though :he is still in deficit.

The ability of fiscal policy to affect output by affecting aggr ~ makes it a potential tool for
economic stabilization. In a r : government c an run an expansionary fiscal policy, thus help
output to its normal level and to put unemployed worker?
During boom, when inflation is perceived to be a greater unemployment, the government can
run a budget surh. slow down the economy. Such a countercyclical policy budget that was
balanced on average.

Fiscal policy can be used in various forms. It may be , the level of economic activity when the
economy is fl
 case i1:is ca t00
A [ led reflationary policy. Alternatively the economy may domg a llttle well and in need of slowing
down. In this case, deflationary policy is called for. The fiscal
policy can be used as a: ,
• Supply-side tool

• Demand-side tool

Fiscal policy as a Supply-side policies are policies that aim to increase the capacity of the eg€Kgmy to produce. Fiscal policy has
supply-side tool
important effects on employment p° tenlialGDP’ and aggregate supply. These effects are known as supply- side effects.
Supply-side fiscal policies include:

.Cutting the lower and basic rates of tax to open up the gap between earnings in and out of work and
ensure people have an incentive to work

.Increasing the level of personal allowances for the

• Re d u ci n g t h e t op r at e of t a x t o e n cou r a ge e n t e r pr i s e, r i s k -t a ki n g and the incentive to work hard

Let us look m detail at the effects of income tax on the labor market and potential GDP.

The effects of income tax

InAne tax will always have an effect on people’ s incentive to work This
1 true at most i
f ’COme levels. If tax at low income levels is too high p«>ple may ch°°se not
to work but to remain on benefits instead. If tax
on j g ] evfls of mcome is too high, people may choose not to work so
and tata nsfe- TMS drives a wedge between the take-home wage of workers and their cost to firms.

FSure 1-1 shows this outcome. In the labor market, income tax has no A ecton demand for labor,
which remains at LD. This is primarily due to the reason that the quantity of labor that firms plan
to hire depends on the productivity and cost of the labor which is regarded as the real wage rate.
same reason

:f Fiscal Policy
 Figure 9-1, Income tax and the labor market

:f Fiscal Policy
 But the supply of the labor can change. In the absence of income tax, the real wage rate is PKR 75 an hour and 250 billion hours of labor are employed annually. As we already discussed, income tax reduces the incentive to work and

decreases the labor supply as well. This is due to the reason that for each rupee of earnings before tax, every worker has to pay tax to the government as per the income tax code. Therefore * workers consider the after-tax wage rate while

deciding on the quantityof labor to be supplied. The income tax shifts the supplycurve on the left-hand side to LSI. The distance between the two curves (LS and LSI) measures the amount of income tax. With the minute supplyof labor, the

before-tax wage rate rises to PKR 80 an hour but the after-tax wage rate falls to PKR 70. At this level, the new equilibrium of labor is 200 billions hours a year which is less than the non-tax case. The potential GDP will also fall due to a fall in

employment which will result in a fall in aggregate supply.

The most immediate impact of fiscal policyis to change the aggregate demand for goods and services. A fiscal expansion, for example, raises aggregate demand through one of two channels. First, if the governmerr. increases purchases but

keeps taxation the same, it directlyincrease? demand. Second, if the government cuts taxation or increases transfer payments, individuals ’ disposable income rises, and they will spend more on consumption. This rise in consumption will, in

turn, raise aggregate demand.

Fiscal policy as
demand-side tool i
Fiscal policyalso changes the composition of aggregate demand. Wh*3 the government runsat a deficit, it meets some of its expenses by bonds. In doing so, the government competes with private borrowers moneylent

55
bysavers. Thisraises interest rates and “crowds out f private investment. Thus, expansionaryfiscal policyreduces the fra. of output that is used for private investment.

Tohelp understandhow the policies work, think of the econom> balloon. Theair in the balloon is the level of demand or economic Ifthe balloon is low on air, you would want toreflate it,but if i: s stretched due to excessive

air and is on the verge of bursting, you want to deflate it. The same is true for anyeconomy, though uh over-expanded instead of bursting we get other problems such asinflationandalarger balanceofpaymentsdeficit.
Fiscal policyhas an influence on both aggregate demand and - supply. Those policies that are used to stabilize business cycle bychangingaggregate demandare:

1. Automatic stabilizers

2. Discretionaryfiscal policy
 Automatic stabilizers

=form of countercyclical fiscal policy is known as automatic stabilizers a r e

p r ogr a ms t h a t a ut oma t i ca l l y e x p a n d fi s ca l p ol i c y d u r i n g r e ce s s i on

315
stabiHzAA Unn§ ^ ° mS' F° nowing samples of automatic Unemployment insurance, welfare and other

transfers

SesTonXhlnT , ' spends more during

i§ Wgh is an
automatk Ti' ), 'Mple of an
if ft c ' UnemPIoyment insurance serves this ftmction even
f the government does not extend the duration of benefits Emlvees start receiving
unemployment insurance as soon as they are laid off the

Automatic changes in tax receipts

Simil because taxes are roughly proportionally to wages and profits

Sy p
== ' f ------------------ ft P ------------ d co 4 =

As the economy enters into recession, the income of = === begins to fall. Even though the central bank does
not make LilLSTfVhe' thC g0Veppent tax receiPts automatically decline

fr
Slow the upward spiral of prices and wages. In previL times stabmtv of ZnUCWaS COnsidered good and it was
U n0t Vary Wlth
believed W° —ness conditions. Fortunately at present the tax y tern possesses a high degree of
flexibility, with receipts tending to rise

Discretionary fiscal policy

whe/thire areTalS T M?iWPBfy heard d™g recessions, economy going again" . U P ft ^ pr°W ms ° “ W the
r
A discretionary fiscal policy is one in which the government changes tax ;P —
? .In contrast to auto=t?c s»bT£* dlSCre‘l°"ay P*S ™lve passing
legislation to change the
structure of the fiscal system. The primary tools of discretionary fiscal policy are explained below.

Public Work
In previous times, governments often relied on creating jobs by introducing public investment projects to counteract
recessionary periods. Big projects such as rural electrification were considered successful as such projects did not only
create employment but also benefited the community. On the other hand, projects such as raking leaves were considered
“make work” projects and resulted in little value to the community.

planners now realize that it can take considerable time to start big projects such as the construction of a park or a bridge or
any other engineering and construction project. Also, it may be years before a significant part of the funds is available
forspending and people can be employed. Considering the difficulty of forecasting future business cycles, we migh - find
the public works project only coming on stream as the econom> recovers from recession. Therefore, today, the economic
impact of suc.. programs is well understood and is often not relied upon to fight recession-

Public Employment Projects ?

V
Such programs are designed to hire unemployed workers on contra^tJ say for a year or more. Once the recession starts
fading away and privai~ sectors start hiring again, these workers can move to regular jobs. P L ‘ employment projects
are more practical as they can be initiated and ca off very quickly as these projects are of shorter duration and are
extremely capital-intensive. However, critics find them unimport^n. wasteful as the transition from such jobs to regular
ones is tougr.. studies indicate that finding a public employment job does not ir the chances of getting a regular private
sector job

Variation of Tax Rates

Income tax rates can be temporarily reduced to prevent disposable from falling and avoiding“snow-balling” into deep
recession- TJU can vary for two purposes: either to contract or expand the rc

Varying tax rates is considered an ideal weapon by the suppo discretionary fiscal policy primarily because its gives
instant Consumers respond immediately to tax rate cuts. A tax cu widely over the population, stimulating consumption
of inducing an economic upturn.

However, practically this tool has serious shortcomings. The generally takes time to decide on the tax rates.
Additionally, on tax rates is controversial due to the involvement ot ]

Limitations of discretionary fiscal policy

Unfortunately, discretionary fiscal policy is rarely able to promise. Fiscal policy is especially difficult to
use for stabf2- ofthe “inside lag,,- the gap between the time when th; policy arises and when it is actually
implemented. If eco? well, then the lag will not matter. They could tell govern
what the appropriate fiscal policy is. But economists may not forecast well. In the absence of accurate forecasts, attempts
to use discretionary fiscal policy to counteract business cycle fluctuations are as likely to do harm as good.

The case for using discretionary policy is further weakened by the fact that another tool, monetary policy, is far more agile
than fiscal policy. Even here, though, many economists argue that monetary policy is too prone to lags to be effective, and
that the best countercyclical policy is to leave well enough alone.

Whether for better or for worse, fiscal policy's ability to affect the level of output via aggregate demand wears off over time.
Higher aggregate demand due to a fiscal stimulus, for example, eventually shows up only in higher prices and does not
increase output at all. That is because,in the long run, the level of output is determined not by demand, but by the supply of
factors of production. These factors of production determine a natural rate of output, around which business cycles and
macroeconomic policies can cause only temporary fluctuations.

Government Saving and Government Debt

Fiscal policy affects the level of output in the long run because it effects the country’s saving rate. The country’s total
saving is composed of two parts:

i. Private saving (by individuals and corporations)

ii. Government saving (similar to budget surplus)

If the government saving is negative, the government has a budget deficit. Negative government saving means that
government has higher expenditures against the revenue earned. In order to fill this deficit, government borrows short_term
or long-term debt. Hence, the increase in government debt over a specific period of time is equal to the budget deficit.

Most of the government debt is in the form of short_term interest-bearing securities, which include T_Bills and notes. The
government generally borrows from financial institutions such as mutual funds, banks and insurance companies. These
companies lend money to the government against securities (mostly T_Bills) at discount rate.

In order to understand the effect of government debt on the economy, it is important to analyze the short_run and long_run
impact independently.

In the long run, government debt varies with changes in fiscal and monetary goals, and output moves toward its full
potential. Long_run issues related to fiscal policies involve the impact of government debt on capital formation and future
consumption. In the longrun,debt can be considered as a burden as the repayments and increasing interest rates in future
may result in a bigger budget deficit.

In the sort run, the stock of government debt is given, and we can allow variations of output around its potential. The
short_run impact of budget deficit upon the economy is known as the “crowding out” effect.
The crowding out effect is said to take place when there is a fall in private investment due to an increase in government
expenditure on other activities such as on goods and services or on public_work projects and health programs.Political and
business leaders often argue that government spending undermines the economy. The funds that government spends on
various activities simply crowd out private investment. This argument that government spending reduces private
investment invokes the crowding out hypothesis. In an extreme case, the hypothesis suggests that private investment falls
by the same amount that government additionally spends on goods and services.

Mechanism of crowding out

Assume that government increases its expenditure by starting a power plant project. In the short run, if there is no change in
financial conditions. GDP will rise by 2 to 3 times the increase in expenditure (this increase will be due to the multiplier
effect discussed in Part 7). This concept is also applicable when taxes are reduced.

Now, since the GDP is higher, the transactions demand for money Wvi— also rise. The higher level of GDP will force the
central bank to go for monetary tightening. The demand
for money will increase the interes: rates; therefore the rising interest rates and tightening of credit will likely choke off or
“crowd out” interest rates and other interest-sensitive spendiu

Here, we are assuming that there is a discretionary increase in gove expenditure or cut in tax rates, implying that the
structural deficit K increased. This analysis shows that budget deficits may crowd investment through the working
of monetary policy and financial m

In summary, crowding out occurs in the short run when market reacr' reduce the effectiveness of fiscal policy. The
growing structural d will result in an increase in interest rates and thus lowering inve Thus a portion of the induced
increase in GDP may be offset increase in structural deficit crowds out investment.

Complete Crowding out Let’s assume an extreme situation w monetary reaction is powerful. In this case,
government expe completely crowds out investment from the economy. Now athe Federal Reserve determines that
a rise in output will be infl ~
The Fed therefore increases the interest rate level and brings in\ down. If the Fed has set an output target, then it will
completelv out investment (100% crowding out).

This can be seen in Figure 9-2. The straight line of C+1+ G+ X is before government expenditure was
increased, with equilibrium E. The government then increases spending from G to G, . The 1' upward,
named C+1+ G’+ X. Assuming there is no monetary r this change, GDP will rise from Q to QW

However, because of the monetary reaction, interest rates rise investment and net
exports. The reaction is so strong that expenditure line is
C+I, , +G, +X , , wh a new equilibrium E” w at the old equilibrium (E).

171
 Figure 9-2: Complete Crowding out

Total Spending
Real Output

G'+X
’at exactly happened
here is that the fiscal
policy stimulated the
G+X=
Fomy’ monetary
policy tightened and V+X"
rates rose; buAess interest cut
Capltal ects mcthe ri • °n
P_ sing
exchange
rate on the rupee
reduced
mCreaSed
the
im
P°rts_Knally interest
rates had to enough
In

£XPOr
MM>A ^
tS .
* 3BPn^nofhe incret
 Transmission Mechanism of
Part Ten
Monetary Policy and the Impact of
Banking Sector Credit
Chapter 1 Monetary Policy Transmission Channels

By the end of this chapter you should be able to: » Define a credit channel and explain the
implications that an increase/decrease in the policy rates has on economic growth, inflation
and lending * Explain the impact of an increase/decrease in the policy rates under the
Learning Outcome money or interest rate channel on consumption, investment inflation and economic qrowth
» Explain the impact of an increase/decrease in the policy rates under the exchange rate
channel on currency, imports, exports, economic growth and inflation m Demonstrate the
impact of the increase/decrease in the policy rates under the asset price channel on wealth,
assets, economic growth and inflation

What does Monetary The transmission mechanism of monetary policy refers to the pres through which change(s) in
Policy Transmission
monetary policy tools influence the econcx variables, particularly inflation. Central banks around the
Mechanism mean?
world monetary policy to target domestic price level while at the same striking a balance between
inflation and aggregate output level(GI Like any other economic policy (e.g. fiscal policy, investment
po j monetary policy decisions affect the targeted variables in a variety of ~ and through different
channels. Identifying these transmission ds necessary to establish an understanding of monetary
policy effec as well as to identify the best set of monetary policy tools, transmission channels are
elaborated below.

Channels of Monetary Policy Transmission

Economic theory identifies four main channels through which i policy affects economic variables,
particularly aggregate output •
These channels are (a) Credit (b) Market Interest Rates (c)
Rate, and (d) Asset Prices or Wealth. Chart 10.1 draws the basic 1 framework. In the following discussion,
we will take Pakistansi bank,
State Bank of Pakistan’s (SBP) key policy rate “Discount I the monetary policy tool.
Moreover, for simplicity, we will the impact of an increase in the Discount Rate.

173
 Chart 10.1 : Monetary Policy Transmission Mechanism

z
i

(A) Credit

i'dit refers to the level of loans required by firms and individuals Firms may need loans to finance their consumption demand (i e daily
operations), investment demand (e.g. purchase ofland, purchase of machinery) or sometimes to pay off The Central Bank's their
existing debt that is about to mature. Indivzduals, in most ofthe cases, may Monetary Tools need loans to si ia^Thdr mves’t demand. For
the purpose of our analysis, we will moXocus
oTndrynd ty fims m ----------------------------------------------□ pHmm
s

^ o _ ~ if Lending

Bank Lendina Channel

banfeSiT referS t0'h£ SUpply ofIoanable f~nds available to banks deposits). deposits form a major portion of funds Consumer
vailable to banks for their lending operations. Therefore, any change in he supply and
availability of deposits affects banks’ lending ability ^gmficandy. For instance, an
expansionary monetary

of loS Zd ~ kadS t0 Wgher bankln§ posits. As the supply f r.°PMi?nds mcrlf, come down and induce borrowers rates
o^atite tag **- This leads to higher credit off-

,(?n.e]lmp0r,tant underlYing assumption behind bank lending channel is ks d° n0t have a close
substitute of deposits available and almost

Transmission Channels
entirely rely on deposits for their supply of loanable funds. Therefore, a monetary policy change that directly affects deposits also has an
immediate impacton bank lending.

Nevertheless, despite the fact that deposits are usually a more favored source for banks due to their low cost (Currently, interest rates that
banks offer on consumer deposits are between 7% and 10%), what makes bank lending channel less effective is the availability of other
avenues whereb> banks can raise funds. For instance, a scheduled bank in Pakistan car issue Term Finance Certificates (TFCs) to raise
long term funds fro— corporate and other financial institutions.

Balance Sheet Channel

Balance Sheet Channel refers to the impact monetary policy can through the balance sheets of corporate entities. In other words, it deaii with
the impact of monetary policy given the leverage position and or networthof borrower. In most of the cases, banks lend to firms a floating-
rate basis, which means setting the loanrate equal to KIBOH KIBOR,or Karachi Inter-Bank Offer Rate, isan indicative inters: which
commercial banks and other
e
financial institutions make benchmark when lending to firm plus a premium. When SBP the Discount Rate, the benchmark rate also goes
up and so does at which firms acquire loans. If a firm that has already taken a ha previously, an increase in the Discount Rate means an
increase ral fm s cost of servicing the debt (interest expense or finance cosj means that firms planning to set up new plant through borrov. r:
will have to abandon such plans. More adversely, a highly le\ e may seek to cut down its operating cost, which means trimmin£ and/or
reducing employment.

On the other hand, an increase in the Discount Rate is not for every firm. For instance, cash-rich firms find it attract^ ~ their
excess cash with banks or to invest in money mar, : S leading to better cash flows for them. Such firms may seek their
productionand/or to reward their shareholders throi dividend payments.

Of course, the net effect on the production (supply) side of i depends on how leveraged the firms are, or whether they
to expand their businesses through debt. In such a scer-~n~ find it difficult to finance their operations when the
increases, economic activities decline, thereby leading to i i demand. This will ultimately lead to a decline in the

However, this might not always be the case, as much demand elasticity of goods that firms produce. For irA:
hike in the Discount Rate, firms that produce goods hr.i demand will immediately increase the sale price,
and 1 are necessities, consumers cannot avoid their consi a contractionary monetary policy seeking to arrest
completely opposite outcome. This is the reason why the world take special care of the production prc~ ‘ in
order to make a change in monetar; *

ratefro, SBP increasing when the latter

f^AAAA
. cb............... drmxlA " ConSUmptiQn ’
-*=9
(C) Exchange Rate

(B) Market Interest Rates

-----

S-~

• * ••• • iA5iii = i
for firms, since they will now receive less PKR for every USD of export. As a result, net exports fall (also because a stronger PKR makes our goods relativelyless affordable overseas). Finally, the fall in net exports decreases the aggregate level of output, leading to a

cool down in inflation.

Transmission via Imports: Keeping other things constant, appreciation of the exchange rate mayeither increase or decrease imports. Exchange rate appreciation maylead to a stronger consumption demand for foreign goods. In such a scenario, the country’ s import

bill rises, which then leads toa fall in net exports. On the other hand, exchangerate appreciation mayalsotend toreduce the cost of sales for those firms that are using imported inputs, which ultimatelyleads tothereduction in their domestic selling prices (see Chart 10.1)

andthe fall in aggregate import value for the country. The final impact on inflation andaggregate output level will be the same.
(D) Asset Prices or Wealth
Asset, here, refers to both financial assets (e.g. bonds and shares) and physical assets (e.g. housing). An increase in SBP5s Discount Rate affects financial assets. With other things being equal,a hike in the Discount Rate increases the market interest rates, therebyincreasing the opportunity

cost of investment in shares. Higher market interest rates alsomean higher finance cost for firms and this is thereason whythe share prices ofhighlyleveraged firms tend tofall more sharplythan those ofthe othc : firms when SBP increases the Discount Rate. Furthermore, the price t"
: Government Bondshas an inverserelationship with interest rate-

A rise in interest rates tends tolower bondand share prices, which to firms with sizeable bond investment portfolios suffering significirAT capital losses. As a result, such firms witness a steep dropin their fina wealth, leading to decline in both production and consumpt

There is another wayof explaining the effect of monetarypolicy< economyvia changes in financial asset prices. James Tobin o: University(Winner of 1981 Nobel Prize in Economics) hypothesizeJj q ratiO(also calledTobin’ sq) equalsthemarketvalueofa
firm bythe replacement cost of firm’ s capital:

q = Market Value of Firms Replacement Cost of Capital

Aq greater than one means that a firm’ s market value is high its replacement cost of capital. Thus if the firm in question issue new shares, it can fetch a better market price for its : to the investment spending it is going to make (for instance,. new
machinery, setting up a plant etc.). Conversely, qless thar. i that the firm’ s market value islow relative toits replace* capital. In such a scenario, the firm will reduce its inves and/or will refrain from an early-planned capex.

Now where does monetarypolicycome into play? We that an increase in the Discount Rate leadsto a decline in i

of a firm. This will result in a lower qand therebylower investment spending bythe firm. This lower investment spending will leadto a decline in overall aggregate demand (recall that Y=C+I+G).

While Tobin,s q explains the monetary transmission through investment decisions, wealth channel explains it through consumption decisions. It theorizes that consumers hold a significant portion of their wealth in the form of common stocks of
companies. Arise in Discount Rate decreases the prices of common stock, therebyreducing consumers * wealth. Moreover, consumption decisionsarenot onlybased on current income but alsoon lifetime income (or wealth). Therefore, a monetarypolicydecision leading todecline in

consumers’ wealth will also lead todeclinein their current consumption.

Future Expectations

Apart from these four basic channels ofmonetarypolicytransmission, economictheoryalsoidentifies a fifth channel-future expectations. In the practical world, economic agentstend toreact not just tothe material changes, but alsotointuition, suspicion and expectations. Nevertheless * it

is important to understand that an expectations channel does not work separately, as with the other four, but instead, it brings change via the other four channels. Consider a simple case where an official from SBP hints that the Discount Rate is going to be increased in future. As a result,

without anychange in SBP, s current stance, thisleak or disinformation will change the market expectations, thus triggeringthe changes in interest rates or asset prices and ultimatelyleading tochange in aggregate output and inflation. Hence, thecredibility(and anonymity) ofa monetary

policyannouncement is equallyimportant.

Sources:

Monetary Policy, Rules and Transmission Mechanisms, edited by Norman Loavza and Klaus Schmidt-Hebbel, Central
Bank of Chile, Santiago, Chile. The Transmission Mechanism of Monetary Policy, the Monetary Policy Committee,
Bank of England The Channels of Monetary Transmission, Lessons for Monetary Policy, Frederick S. Mishkin,
Banque de France Bulletin Digest No. 2/, March 1996 Contractionary Monetary Policy

The central bank uses contractionarymonetarypolicyto decrease consumption byreducing moneysupplyin the economy, which results in higher interest rates. This results in a fall in investment and consumption due to thehigh cost of borrowing and inflation. The net exports also fall

due torising interest rates.

If the central bank considers that inflation is in danger of rising and perhaps going over its inflation target, then it may consider increasing interest rates. Increasing interest rates will discourage people and firms from borrowing money and will also give people who are indebted

withmortgages less moneyto spend each month as their mortgage payments rise. The combination of these effects will reduce the levels of consumption and investment. Since consumption and investment are two key components of aggregate demand, increasing interest rates shou

result in reduced economic growth and increased unemployment.

The government or central bank can alsotryto cut the level of moneysupplygrowth to cut inflation. Therefore a contractionarypolicydeals

with:

.Increasing interest rates

• Reducingmoneysupply
Consider the figure given below. When theinterest rates are increased from i0 to ii, the cost of borrowingincreases, which in turn reduces the demand for money. The supplyof moneytherefore falls from So toSI.

Economics | Reference I
 xmmy

Currently, interest rates that banks offer on consumer deposits are between 70/0 and 10%, KIBOR, or Karachi Inter-
Bank Offer Rate, is an indicative intere rate which commercial banks and other financial institutions make their
benchmark when lending to firms

Transmission Channels
Port Eleven
Central Banks and Monetary
Policy Regimes

Learning Outcome By the end of this chapter you should be able to, ■ Define Monetary targeting
■ Define Inflation targeting
■ Discuss the various choices of policy anchor o Volume of money o Interest
rate o Exchange rate

■ ifiustrate the relationship between exchange rate and monetary

■ Comfre the effects of the monetary policy under a fixed and a flexible exchange rate
regime ■ Provide a brief overview of the monetary policy and the role of the State Bank of
Pakistan

Formulating the As discussed earlier, the primary goal of monetary policy is to Policy, Choice
°f target general
Mone y Policy
price levels while at the same time try to maintain a sustainable level of tar employment and aggregate output level. In the
preceding chapter we learned about the Anch°r channels through which monetary policy affects inflation and aggregate output.
Here, we
will discuss how monetary policy strategy is formed and implemented.

One important element of a monetary policy strategy is to set economic targets via focusing on different
variables. An anchor is a variable that central bank uses to control the ultimate target of monetary policy. 7 More
specifically, a monetary poHcy anchor can be exchange rate, money Aupply, rate of inflation or interest rate
that the central bank intermediately focuses on m order to achieve the desired general price level in the
country.

During the early 1970s, many central banks thought that a change in monetary policy strategies is necessary
to control inflation and unemployment more effectively. This led to a more focused approach by the central
banks to target inflation and aggregate output level. As a result, central banks around the world
experimented, broadly stating, with two alternative strategies: monetary targeting and inflation targeting For
a detailed discussion of these two strategies, see Bemanke and Mishkin, "Central Bank Behavior and the
Strategy of Monetary Policy: Observations from Six Industrialized Countries”, NBER Macroeconomics
Annual, 1992. Before we delve into defining these strategies more comprehensively, it is important to
understand that both these strategies target inflation with fomer targeting it indirectly and the latter directly. In
addition, given the importance of international trade and finance and their impact on
domestic price level, exchange rate targeting also has a long history.
I Monetary Policy Regimes
 Monetarytargetingrefers tothe setting ofa rate of growth ofmoneysupply(usuallyM2) bythe central bank for thenext year. This targeted growth rate ofmoneysupplyis the primarytarget ofthe central bankand isannounced publically. Moreover, the target level ofmoneysupplygrowth,

Monetary Targeting in principal, needs to be consistent with the central bank’ s desired level of inflation. The keyelement ofmonetarytargeting isto adjust interest rates more freelyin order toachieve the desired outcome ofmoneysupplygrowth.

During the 1970s, major central banksadoptedmonetarytargetingas themonetarypolicystrategy; the first toadopt this being the central bank of Germany, Bundesbank, in 1975.

After Fed (Federal Reserve System; the central banking system of the United States) adopted monetarytargeting in late 1970s, it set growth targets for three different monetaryaggregates, namelyMl * M2 and M3. Abel and Bernanice (1998) argue that because Fed onlyhad control of the

monetarybase (high powered money) at its disposal, trying to contro: all three measures of moneysupplywas unrealistic. As a result, Fed missec its monetarygrowth targets three years in a row (1979-1982). Similarly in theUK, theBank ofEnglandannouncedits M3target
in 1976. Howev er the targets were not met andthe Bank of Englandalsokept revising t hetargets on an interim basis, making the monetarypolicystrategyambiguous.

Due to financial innovations, financial systems around the world chani r:rapidlyduringthe1970sand1980s. Newinstrumentswereintroduce^^inthebankingsector andregulationschangedaccordingly. Thisled»centralbankschangingmoneysupplyrapidlyin order tostabilize
aggreAas demand. However, abrupt changes in moneydemandmade r predictabilityvague and thus targeting monetarygrowth became effective.

The Central Bank's

Monetary Tools Despite the fact that theultimate goal ofmonetarytargeting \s3m control inflation, most of the countries found it difficult toadcrrd inflation. For instance in the UK, inflation began toincrease in 19”Atouchedthe 20%mark by1980, playing down the

effectiveness of monfiJ targeting.

Having said that, not all countries who adopted monetarytargeting toachieve their desiredtargets. Most notably, the central banks of GeAlH and Switzerland were often able to keepmoneydemandmore szM/primarilybecause their monetary growth targeting was moreandtransparent

andtheyhave a relativelytighter regulatorycontra

•their financial markets.

Can a Central Bank target interest rates as well?

The answer is yes. Often in the past, central banks targeting variableshad todeal with the choice between whether totarget

182
 aggregates (such as M2) or interest rates to achieve the desired goals. These two anchors are mutuallyexclusive; a central bank can onlytarget either monetaryaggregates or interest rates but not both. Suppose for instance that

the central bank is targeting interest rates. Due to a change in the public consumption pattern, demand for money changes and this leads to fluctuation in interest rates. To keep interest rates at the targeted level, the central bank

has toincrease or decrease moneysupply(e.g. through sale or purchase of government securities in the open market).

Alternatively, if the central bank is aim ing to keep the money supply at a certain level, a similar shock (i.e. change in consumption pattern) will bring about changes in money demand and thereby in interest rates. Here, the

central bank cannot address interest rate fluctuations bychangingmoneysupply.

Inflation Targeting As stated earlier, inflation targeting refers to the public announcement of inflation targets for the coming year(s).
Mishkin (2001) Inflation Targeting by Frederic S. Mishkin, in Howard Vane and Brian
Snowdon, Encyclopedia of Macroeconomics (Edward Elgar: Cheltenham U.K., 2002):
identifies five key elements of inflation targeting as a monetary policy strategy. These are (1)public
announcement of quantitative targets for inflation; (2) dedication to price stability as the main goal of
monetary policy; (3) choice and setting of monetary policy instruments using many variables instead of
only focusing on monetary aggregates; (4) transparency of monetary policy strategy; and (5)
accountability of the central bank for achieving its inflation targets. One important thing to
note about inflation targeting is its emphasis on transparency and accountability;
something that was not present (or at least vague) when central banks were by and

large practicingmonetarytargeting. The central bank of New Zealand was the first bank topublicallyannounce a set of inflation targets in 1990andis the prime example of the success of inflation targeting (see Chart 11.1).

Chart 11.1 : NewZealand CPS inflation (year-on-yearchange) %

Source: Reserve Bank of New Zealand

For a detailed discussion of these two strategies, see Bemanke and Mishkin, "Centra! Bank
Behavior and the Strategy of Monetary Policy: Observations from Six Industrialized
Countries", NBER Macroeconomics Annual, 1992

and Monetary Policy Regimes 183

 In inflation targeting, the central bank directly targets the ulti A (inflation), instead ofirst setting targets for intermediate goakMoreoverA inflation targeting
gives central banks more mdependence and Aexi in adjusting money supply whenever money demand
A
nges.Anoth
eas A to
advantage is that the targets of inflation are much ''
to the general publicthan monetarytargets, since people can understand

theArdativelymore easUyandthusact

monetary policy relatively more transparent. In addition with the pa g of time the quality of central banks , communication alsoimproved as they shifted from releasing dry and formal reports to
and easy-to-understand reports. Some of the examples a England’s Inflation Report and SBP’s Inflation Monitor. Mishkm (200 ) argues that these
publications have been used by the centra : communicate the following to the general public, politicians and fi
s

participants: (1) monetary policy’s goals and UmitaUons; (2) quantitative inflation targets including their
rationale; (3)=s

central banksin fine-tuningtheir policies.

Another qualityof inflation targetingis its flexibility. Inflation A does not require central banks to follow simple and mechanical .

to conduct monetarypolicy, nor does it reqmre

centcal
=== solelyon one variable. Usually, central banks aroundthe world. inflation via the use of a key Policy Interest Rate to curb excess
However, before changing the PolicyRate, a central bank inflation targeting uses all available information. One good such information is SBP ’ s MonetaryPolicyInformation Con Athat is releasedalong with a monetarypolicystatement. This mfo. helps SBP in devising the

monetarypolicy.

Furthermore, the central bank becomes more accountable for as transparency increases, though the level of accounts 1 a - economies. The strongest case of central bank
accounta i.r - New Zealand. Under the law passed by New Zealand, the a > has the right to fire the governor of Reserve Bank ofNew Za fails to meet the inflation target,
even for one quarter. De^ f - inflation targeting as a monetary policy anchor is net n t criticism. Recently, after the global

financial crisis began prominent economist Joseph Stiglitz (winner of 2001 Nc Economics) came with a strong criticism.

Inflation Targeting by Frederic S. Mishkin, in Howard VaneA Encyclopedia of

Macroeconomics (Edward Elgar:
Chelte
In his words:

"••Developingcountriescurrentlyfacehigherratesofinflation,notbecauseofpoorermacro-managementbutbecauseoilandfoodpricesare
soaring,andtheseitemsrepresentamuchlargershareoftheaveragehouseholdbudgetthaninrichcountries..Inflationinthesecountriesis,forthe
most part, imported. Raising interest rates won't have much effect on the international price of grains or fuel... Raising interest rates can reduce
aggregate demand, which can... tame increases in prices ofsome goods and services... But, unless taken to an intolerable level, these measures by
themselvescannotbringinflationdowntothetargetedlevels.Forexample,evenifglobalenergyandfoodpricesincreaseatamoremoderaterate
thannow—forexample,20%peryear— andgetreflectedindomesticprices,bringingtheoverallinflationrateto,say,3%wouldrequiremarkedly
fallingpriceselsewhere.ThatwouldalmostsurelyentailamarkedeconomicslowdownandhighunemploymentThecurewouldbeworsethanthe
disease... Both developing and developed countries need to abandon inflation targeting. The struggle to meetrising food and energy prices is hard
enough.Theweakereconomyandhigherunemploymentthatinflationtargetingbringswon’thavemucheffectoninflation;itwilonlymakethetaskof
survivingintheseconditionsmore

This particular article appeared in many sources. For example, refer to "Inflated Claims", The Guardian, May 9
2008 and "The Failure of Inflation Targeting", Project-Syndicate, May 6,2008 .
 Exchange Rate Targeting

Exchange rate targeting refers to a policy where the central bank focuses on exchange rate as the monetary policy anchor in order to target
imported inflation. By imported inflation, we mean pressures on domestic prices that come with the change in prices of foreign goods that a
domestic economy consumes.

Exchange rate targeting can take multiple forms, which are discussed below:

Fixed Exchange Rate Regime

The government/central bank may choose to tie the value of domestic currency with a commodity such as gold. Another form is to tie the
value of domestic currency to the currency of another country and maintain that value by continuously buying or selling the currency of the
other country. These two types of exchange rate targeting are called currency peggngorfXed exchange rate regime. In addition,
sometimes a central bank following a fixed exchange rate regime may allow its currency to appreciate or depreciate gradually. This type of
fixed exchange rate regime is called crawlingpeg.
Floating Exchange Rate Regime

In thisregime, the value ofthe domestic currencyis allowed to fluctuate when itsvalue

relativetothevalueofothercurrency(s) changes in the foreign

exchange market. Trading transactions associated with the export/import of goods and services and capital account flows determine the external values of currencies in relation to one another. The market establishes an equilibrium or

natural exchange rate without anypolitical decision or interference.

A floating exchange rate regime can also take the form of managedffoat (also called dirtyfloat) if the central bank
occasionally intervenes in the foreign exchange market to buy or sell its own currency in order to prevent it from
excessively appreciating or depreciating. Moreover, in this type of float, official financing and/or interest rate
policy are also used in order to influence the exchange rate at certain points of time to ensure it is consistent with domestic economic
objectives.

Advantages of Exchange Rate Targeting

The most important advantage of exchange rate targeting is its con:r^' over imported inflation. In particular, developing countries with he reliance on the import of capital goods and raw materials immedia face high

inflation when the value of their currencydepreciates in foreign exchange market. In this case, the central bank can use the. of exchange
rate to control the extent of inflationary pressure cor from costly imports. In emerging or developing
countries wl institutional capacities are not as strong as in developed economies j where duration of business cycles is short (e.g. quick spells
of inflation), exchangeratetargeting can be used effectii

Moreover, like inflation targeting, an exchange rate target has the ac ofclarityand simplicity. Financial market participants, aswel :
general public, can easily understand what it means for their oj ifa central bankannouncesan exchangeratetarget.

Disadvantages of One clear disadvantage of exchange rate targeting is that when ‘A’ ties Exchange Rate its currencytoCountry B, eamric shocks in
Country transmit to Country Targetmg A • Therefore, the monetary policy of ( loses itsabilitytorespondto
domestic shocks that are indef those hitting Country t, . Another problem with exchange rate I particularlywitha fixed exchangerate,isthatthe
country: foreign exchangereserves to support its depreciating currency, 'wthis situation is verytough in practice for a countryand foreign exchange reserve position of
most central banks ~ speculators paradiseasa bet againsta country’ s currencyhuge profits if devaluation occurs. If enough
5

speculators scD i “snot,, , feywill tendtovalidatetheir devaluation expectat disparitiesduetodifferingcountrywage bargainingsystei misaligned exchangerates. Technologicaladvancesani
resultedin structural changes in economies with

effects on export and import values. Economies also experienced differing economic growth rates which affected per capita income levels and resulted m changing consumer preferences for domestic and imported goods and services. The rise of

newindustrial and emerging economieshas alsoshifted the shares and pattern ofworld trade. All these factors and others resultedin overvalued and undervaluedexchangerates at regular intervals, forcing the abandonment ofthe fixed exchange rate

system byan increasing number of countries.

How are they inter-connected?

Exchange rate targeting also influences interest rates. To understand this more easily, consider a simple example. Suppose SBP is following a fixed exchange rate regime wherebyPKR is tied to USD. In order to maintain a fixed exchange rate, say

PKR 60 against every USD, SBP has a large quantity of USD reserves that it sells (buys) in the foreign exchange market when PKR depreciates (appreciates) too much. Now let’ s assume that, since PKR looks set to depreciate to PKR 61 per

USD, SBP sells some of its USD reserves in the foreign exchange market in order to keep PKR from depreciating. However, selling USD means contracting moneysupply from the interbank market (i.e. buying PKR), which ultimately leads to

Monetary Policy Regimes

 tighter liquidityin themarket and an increase in market interest rates.

Interest Rate and Exchange Rate,

Moreover, recall from Chapter 10 that central banks can adjust their key policy rate to influence exchange rate. Often central banks take on multiple policy roles whereby they change policy interest rates on the one hand and buy/sell domestic

currency in the foreign exchange market on the other, while keeping the ultimate target in sight - inflation or price level (see Box 11.1 for the UK’ s experience with interest rate adjustment under exchange rate targeting). Nevertheless, it is not

necessarythat central bank simultaneouslycommunicate inflation and exchange rate targets.

Chart 11.1: New Zealand CPI Inflation (ye ar-on-year change)

%
j Startof BollalkMi fFTargsBit-

Source: Reserve Bank of New Zealand

Another important thing tonote is that a government can fix either interest rate or exchange rate, but not both together. A fixed exchange rate will require interest rates to be flexible in order to control capital inflows/outflows and domestic economic

activity.

•iooetary Policy Regimes 187

Conduct of One analysis of monetary policy conduct is based upon the Mundell- Fleming model
Monetary Policy in (named after economists Robert Mundell and Marcus Fleming). The Mundel-Fleming an open economy model is an
extension of the IS-LM framework IS (Investment-Saving relationship) refers to the equilibrium in goods market while LM (Money
Demand-Money Supply relationship) refers to the money market equilibrium. IS-LM framework is used to study the relationship
between interest rate and real output in goods and money markets. The intersection of IS and LM curves is often called General
Equilibrium, i.e. a state when both goods and money markets are in equilibrium simultaneously with an open economy. In this section,
we will analyze how monetary policy adjustments affect interest rates and aggregate output in a small open economy. For the following
discussion, help is mainly taken from Macro Economics, Rudiger Dornbusch and Stanely Fischer, Macgraw-Hill International Editions,
1990.

Consider chart 11.2 that plots familiar IS-LM curves Standard text books on monetary economics introduce another curve on this graph
- Balance of Payment curve (refer to Monetary Economics: Policy and its Theoretical Basis, Keith Bain and Peter Howells, Palgrave Macmillan,
2003). We have omitted this curve for the sake of simplicity.. Point Eo is our starting point where goods and money markets are in equilibrium.
Moreover. 2: this point, domestic interest rate id equals foreign interest rate if. New assume that the central bank
Monetary Policy in an increases nominal money supply, which I at a given price level, leads to the increase in real money balances
Open Economy with RNL j Increase in RM pushes the LM curve rightward from LM1 to LM2. NfWj equilibrium is at El where
Flexible Exch ange goods and money markets are in equilibr
Rate
Chart 11.2: Effects of Monetary Policy in Floating Exchange Rate
R^ime Interest

A
7
IS (Investment-Saving relationship) refers to the equilibrium in while LM (Money Demand-
Money Supply relationship) refers 1 market equilibrium. IS-LM framework is used to study the
between interest rate and real output in goods and mone> intersection of IS and LM curves is often
called General Equilib when both goods and money markets are in equilibrium 8For the following
discussion, help is mainly taken from Rudiger Dornbusch and Stanely Fischer, Macgraw-Hill Intc
1990.
Standard text books on monetary economics introduce ar graph - Balance of Payment
curve (refer to, for example,
Policy and its Theoretical Basis , Keith Bain and Peter Macmillan, 2003).
We have omitted this curve for the
 foreign mter ; st it , 'd — COme down below
and will cause exchange rate ho : WI^°W °Ut ofthe country -change rate depredftln
The
w*makeT H *
more competitive and thus outm]t in 0mestlc country’s exports from ISi to IS2 and
exchange keeps & IS Curve shfs
P
of domestic goods falls cZ^tn T* *rdatlve £[fe Now, at E2, we have gLs to E,

depreciation does not always lead tn ^.mstance, exchange rate domestic economy is highly im non A lmfOVed extsmaI account if the in the case ofa •
Moreover,
rates alone cannot induce foreL caniLl a 7> £11 [ MSS^in ---------------------------- n^n into account
other C= S* a f"1^ Nestor also market risk premium. mcludmg sovereign rating and

Monetary Policy in
an Open Economy
with Fsxed
Rate Crease its foreign exchange re*esTt —Cy, aso has *
Exchange

equilibrium from EH to E2 in CharUl 2°h A : shft of

—sells foreign
SmCe he Central bank
currency in the market'to J
ultimately, the equilibrium returns to F 1,exchange ® intact, in output. £tUrnS
° El
Wlth 0I
% a short-lived increase

M
°netafy po,ky and the ro,e 4; m State Bank of Pakistan (SBP)

- — = — - tn
"'stfb* Policy in

count Rate
instrument to signal contractiomn, n as the key
POlky In
1997, SEP s central board was empowered—-* . independent monetary policy and at thA conductand
implement an Fiscal Coordination Board was set un to fefflfrrr a^p, k Monetary and remained in line
with those taken hv
fiscal ^oIic .♦ -, - '/Vlrlitinn 9RP

P y actions -worked extensively to improve was necessary because the financial 1 tre^piatms,
which
mone
policy changes everywhere in the world ^DT

-^-*cs and Monetary Policy Regimes

189
 Over the years, SBP has also improved monetary policy communicatxo with therelease ofdetailedpolicystatementsand supportingdatAAft themid1990s, thequality
of SBP publicationshas improved both m terms of coverage and depth. SBP ’ s Research Bulletin, the early2000s, also provides academicians, as well as S #□

with a platform to expresstheir independent views and to bring contemporaryeconomic issues intothe limelight.

Today, SBP follows a monetarypolicyregime that focuses on monetarytargeting (with broad money- M2 -as anchor)m accordance with th targets of inflation andreal GDP growth envisaged by*e governmeAA of Pakistan - recall from the

preceding discussion that Ganges level ofmoneysupplyhave significant impact over both level in the economy. SBP signals a monetarypolicystance pnm through changes in the Discount Rate (also calledreverse repo mteA addition SBP may
Cash Reserve Requirement(CRR) ar: the Statutory Liquidity Requirement (SLR) to complement rts moneta.:
alsoadjust the

policy stance.
In order to understand the SBP ’ s monetarypolicystance, it is to understand what makes upmoneysupply. From theasse s i - - money equals net foreign assets (NFA) and net
domestic assets (ND X ^ thebankingsystem.

M2 = NFA +

More specifically, NFA is the difference between foreign exchange i and outflows arising from foreign trade, foreign investment and m debt-relatedactivities. Conversely, NFA reflects Pakistan s payment
A
position. On the other hand, NDA consists of dome a to the private sector and government. In order to undersun- monetarypolicyis conducted and what trade-offs SBP canAA a
simple example. Suppose that, due to some exogenous de-.,A outside the control of SBP, PKR depredates against UbD . a g deterioration inthe
balance of payments. This will tngger----------------------------------------------------------------------------------------^ and M2 growth will fall below what SBP
has been targets cannot directly influence the exchange rate (Pakistan regimeisFloating.), one wayofachievingthetargetedV-reducetheDiscount Rate,
which will increase credit NDA. However, such a policy can also initiate a vxi L L: —- interestrates canalsobringabout domestic currencyder*to such
A
inter-linkages, SBP considers development 0 economic variablesrangingfrominternational conur government’s tax collection, and
from private sector growth in sub-sectors of the economy, before formula
policy.

Since 2005, in response to increasing inflation, SBP has adopted a contractionary SBP s recent monetary policy
stance (see Chart 11.3). Before 2005, monetary policy was relatively
monetary polfcy easy, which ensured availability of cheap credit. This led to increasing demand pressures expenence and inflation started
rising. SBP responded to this demand-pull infl ation by increasing the
Discount Rate in 2005.2008 was the year when on the one hand global commodity prices started escalating and on the other,
government started borrowing excessively from SBP. These developments not only triggered cost-push inflation but also
fueled demand-pull inflationary pressures. As a result, inflation abruptly rose to levels never seen in decades. Monetary policy
was further tightened and the Discount Rate was increased from 9% in July 2007 to 15% in November 2008. Some easing in
monetary policy was seen after a cool-down in inflation that started in January 2009 and continued till October 2009.
Nevertheless, a second phase of contractionary monetary policy started in September 2010 and has continued to this date.
Whether the SBP,s stance was more reactive than proactive is still a hot topic in academic debates
Chart 11.3: Inflation and SBP's Monetary Policy Response
30% 1 • • ® cp| inflation, YoY Chanp (LHS) ■_ SBP's Discount Rate (RHS)
 +
3‘ i§h
-
Source: SBP

«cal and Monetary Policies on Equilibrium

C

191
PartTwelve
Impact of Fiscal and Monetary
Policies on Equilibrium
By the end of this chapter you should be able to: m Define policy mix ■ Explain
what aspects of the economy the mix of fiscal and monetary policy aims to influence »
Illustrate the impact of fiscal policy on AD-AS equilibrium ■ Illustrate the impact
Learning Outcome of monetary policy on AD-AS equilibrium w Analyze the impact of fiscal and monetary
policies in the short vs the long run m Compare the effects of the fiscal policy under a
fixed and a fk exchange rate regime mInterpret the fiscal and monetary policy
relationship as ap; Pakistan's economy

In chapters 8 and 9, we discussed the objectives of monetary policies and how they work separately. We
learned that monf aims to control interest rates and level of money supply in ne twhile fiscal policy
manages government spending and the 1 Since both policies affect goods and money markets anc
Fiscal and monetary demand, they need to be devised in line with each other.I the name given to using both these policies
policies together: the togetrifrj macroeconomic goals.
policy mix
How does the policy mix work?

In the real world, economies use policy mix to adcre inflation and
aggregate demand. As we have seer — all these variables
are affected by both monetary So, why use both these
v. and i
policies simultaneous-; /to make life easier? The most
important rations ! mix is the different intensity of fiscal and monc they affect target variables. For
instance, consider iPakistan’s economy is at initial equilibrium government is looking to boost aggregate
ou:r ~ ; government spending (expansionary fiscal supply (expansionary monetary policy). If fiscal
policy, it will shift IS curve righnvarc ••<!.! output increases to Y2 and interest rate : other hand, if the
SBP uses expansionir- the LM curve to the right to E2 where : ’ t I lower interest rates.
 ==w, hr government faces a complex issue. Too much spending pleases * W t H l n k
g° vemment should spend on infrastructure but displeases tbusmess communitywho

donot like high rates of interest. On the

Chart 12.1: Effects of Monetary and Fiscal Policies on aggregate output

Panel fa)

IS
2

LM Y, Output(Y)

LM
?
#
✓

Y2 Output (Y)

n order to satisfyall three, i.e. those who love to spend in a big waythe busmess

Panel
Tb]—
communityand depositors, both the SBP and government can usemonetaryand fiscal policies simultaneouslyin order toattain the arreted output level with the same level of interest rates as before This

e shyn m ^ait ^ (t>). simultaneous use of expansionary fiscal and AuAetarjAoliaes will increase the output from YO to Y2 (new equilibrium at E3)
without altering the level of interest rates.

Effects of fiscal and monetary policies, general equilibrium analysis

=have just seen how fiscal and monetary policies work in a simple IS- LM framework. It is also important
to understand how general equilibrium conditions(aggregatedemand,aggregate supply) areaffected bya policy
nge
' * be covered m the following discussion. We will also discuss how the policies work in the short run and beyond, in a closed economy. We will
consider fiscal policyfirst.

Effects of fiscal policy

Let us assume that Pakistan's economyis at equilibrium as shown bypomt Eom panels (a)and (b) of Chart 12.2. Moreover, r0 and P0 arerespectivelyequilibrium real interest rate and general price level while

WS tJf equmbrmm output This output level is the °

economy's natural ,eve o P > i-e. the level which the economy is able to sustain
in the
ng mn mdat whlch the level of
° unemployment is natural. Now suppose the government of Pakistan wants to _
,A , increase government spending

IS e UC YWIUmcrease
syatfi* economy. We have just seen that an expansionarypi. yshfte t* ow rightward; thisis shown in Chart 12.2 (a) f A j aggregate demand and will shift ADI curve to AD • Consequently, the economy

«cal and Monetary Policies on Equilibrium

C

193
 extends from Eo toEi in both panel

(a) and (b) and output is increased from Yo to Yi.Nevertheless, this is not the end of the story. Since higher output means more demand for
employees, nominal wages will increase. An increase in nominal wages will jack up producers^ costs which will, in turn, increase their
product prices, resulting in the level of general prices rising from Po to Pi. This price increase will also cause the real money supply to decline
(recall that real money supply equals nominal money supply divided by general price level, i.e. )• This will shift LM curve from LMi to LM2
and increase interest rate to rl.Output will decline from Yi to Y2. So, in the short run, an expansionary fiscal policy leads to a slightly higher
level of output with a higher interest rate and higher price levels.

Chart 12.2: Effects of expansionary fiscal policy (Short run)

General price
level(P)
Pi

Output(Y)

Let us see what happens beyond the short term. We have

just in the short run, producers increase prices to meet their his
expenditure. Nevertheless, employees expect prices to rise future. Thinking that it will ultimately decrease their real •' again
demand a higher nominal wage. Since current output: changed, increase in the expected price level will shift the A AS1 to AS2
in Chart 12.3 (b) and producers will have to iiK further from Pi to P2 to address employees, concerns. As a ] output will
eventually fall to its original position Yo. MoreoW ; in price levels will again shift the LM curve from LM2 to: in the interest
rate rising to T2

This output level is the economy's natural level of output, i.e. 1 the economy is able to sustain in the long
run and at which the leve* 1 is natural.
 Chart 12.3: Effects of expansionary fiscal policy (Overtime)

Y
0 Y2 Output (Y)

Why did output fall to Yo? Why not a little higher or lower? Recall the identity • Also recall that
consumption £C, equals income CY? minus taxes T • In our analysis neither £Y, nor‘T, has changed.
However, since the interest rate has risen, an initial increase in £G, will have to be met by exactly the same
amount of decline in investment T for the identity to hold (recall the negative relationship between interest
rate and investment).

Effects of monetary policy

Let us turn our focus to monetary policy and assume that, this time, SBP pursues an expansionary monetary
policy. In Chart 12.4 (a), expansionary money supply will shift the LM curve down from LMI to LM2 and
goods- money markets equilibrium from Eo to Ei.Since prices are not yet affected, a shift of equilibrium in
the goods-money market will shift the general equilibrium too; and output rises from Yo to Yi in Chart 12.4
(b). While discussing Chart 12.2 above, we saw that the rise in output from its natural level causes
employment and thus nominal wages to rise, which has to be compensated by an increase in price level.
Therefore, the general price level will rise from Po to Pi, causing the aggregate output to decline from Yi to
Y2. Also, a rise in the general price level will reduce real money supply; thus the LM curve will shift
backward from LM2 to LM3 with equilibrium interest rate now ti.

• -seal and Monetary Policies on Equilibrium

Chart 12.4: BTectsof expansionary monetary policy (Short run)
Panel (a)

Y
o Y2 Yi Output (Y)
Panel (b)
General price
level(P)

Pi

Y
n Y2 Yt Output (Y)

Having discussed the effects of fiscal policy in Chart 12.3 (b), it is easy to interpret what will happen beyond
the short run in the case of monetary expansion. This is shown in Chart 12.5 (b). Thanks to the similarir*
between Chart 12.3 (b) and 12.5
(b) , we know that the increase in the expected general price level will increase the actual general price \c\ti
from Pi to P2 and aggregate output will settle at its original position Y . Now, looking at Chart 12.5 (a), an
interesting observation is that the f.~al rise in price level will push back the LM curve to its initial position '
LM3 to LM1) and the interest rate is also back to ro (increase in p— level leads to decrease in real money
supply). So, beyond the short an expansionary monetary policy will not cause any change in gf goods-money
market equilibrium and aggregate output level will remain the same. The only ultimate outcome is the
increase in the g price level.
 Chart 12.5: Effects of expansionary monetary policy (Overtime)
Panel fa)

2 Output (Y)
Panel (b)
General price 'AS2
level(P)

P*
Pt

Y0 Y2
Output (Y)
Effects of fiscal policy in an open economy
previous section we discussed how macroeconomic policies affect equilibrium conditions in a closed
economy. Let us now open our economy to foreign trade and capital in/outflow. We have already seen in
Chapter
11 how monetary policy affects goods-money market equilibrium. Now this is the fiscal policy’s turn. We
will stick to the basic framework of goods-money market equilibrium and also assume that capital flows are
perfectly mobile in and out of Pakistan. First, let us discuss the effects of fiscal policy if Pakistan is
(hypothetically speaking) following a floating exchange rate regime.

We know that the governmenfs expansionary fiscal policy increases the demand for goods and services and
pushes the IS curve to the right (shown in Chart 12.6). Consequently, the level of production will adjust to
higher demand and thus output will rise and equilibrium will shift from EO to El. Since the economy is now
open, higher demand will also lead to higher imports, resulting in a fall in net exports (exports minus imports)
and depreciation of the exchange rate. Moreover, a rise in aggregate output/income will also increase
transaction demand for money - i.e. people want more money in hand to satiate their demand ^ which will
cause the interest rate to rise. A rise in the interest rate will bring about a reduction in investment (this is the
crowdingouteffect,refer to chapter 9). As a result, goods-money market equilibrium will shift In fact, the

of Fiscal and Monetary Policies on Equilibrium

transition from Eo to Ei to E2 will be rapid (or you can say, too fast to notice). This is the reason why we have
not signified equilibrium output ‘Y’ corresponding to point Eo from Ei to E2 and aggregate output will
finally settle at Yi.

Chart 12.6: Effects of expansionary fiscal policy in open economy (Floating Exchange Rate)

Real interest Rate (r)

rir0

Y
°

Despite the fact that this analysis is complete per sey there is one important complexity to note here. Above,
we have only discussed one effect on the exchange rate and that is of higher imports (leading to exchange
rate depreciation). The exchange rate will witness another effect, which will come from increasing interest
rates. We know that if capital is perfectly mobile, an increase in the interest rate will make bonds
denominated in the Pak Rupee more attractive to foreign investors. The inflow of foreign capital will
improve Pakistan’s balance of payments, causing the Pak Rupee to appreciate. To conclude, the effect of
fiscal expansion on Pakistan net exports is not ambiguous. However, whether fiscal expansion u — finally
lead to appreciation or depreciation of the exchange rate is noc clear due to the counterbalancing effects of
higher imports and mgher capital flows.

Chart 12.7, Effects of expansionary fiscal policy in open economy (Fixed Exchange Rate)
IS2
Real interAt ■ SI % LM1

LM2
Rate (r)
 7An
~ US wiD happen under a exchange rate regime the Tr"%r ^ f'
mCr£ase in
spending will shift "V" ; " th£nft0152 ---------------------- ^ 0P^±i and interest rates
. n rsspecUveiy-An mcisase A interest rate will attract foreign captai to move m. However, since the economy
is under a fixed exchange rate regime SBP cannot allow appreciation ofthe exchange rate Thus f
f/^x=Aforeign currency by mcreasmg the noLal maney supply r d that will shift the LM curve from
LMI to LM2. The interest rate will keep declining until it returns to its original level and there is
fiAUyTeA 1 " ™ f°rei8n CUrrmCy t0 fl°W in- AAe-g^e will

Fiscal- Pakistan represents a unique case of policy mix. In fact, it is arguable if any fiscal-monetary
monetary policy coordination really exists. Although studies on s,t from Pakistan's perspective are few, most
mix: of these studies >ify£lther no c°ordmation, for
Case of Pakistan instance, MonetaryandFiscalPoliciesoordinatwn-Pakistan's
Experience, Muhammad F arooq Arby and
==T « 1e e m sbp ReSearch Bulletin Volume 6, No.1,
/ :ydommanCe oVer .^etay policy, for example,

S FISm ^ an „ Monetar
I J y , Sakib Sherani, The Lahore

Journa of Economics, Vol. 11-SE, 2006.

Throughout history, Pakistan's fiscal policy remained highly tilted towards ex ravagant
spending with often limited focus on bridging the budgetary gap through tax revenue
mobilization. As Chart 12.8 shows, Pakistan's
Vai7ing d£greeS of budget deficit wWch
Wdl ab e 6/0 0fGDP m
°! most cases. On the other hand, tax revenue has remained stagnant at around 11% of GDP
throughout history. Over the year , high ei budget deficits have mostly been financed either
through p ernal funding or domestic borrowing from central and commercial

= ^ t thY°le of policy has not only remained

relatively weak since it has to chase government spending, but also the
• !fe. of
m°ney supply have remained less meaningful in controlling inflation. Even after the
inception of the Monetary and Fiscal Policies

signStT B°ard (MFPCB) " W, thC sitUation has K "proved

rv~\
116
TOaSi? r?e lmo"etary po]icy Was Partimlarly evident during f - ^when government heavily financed the deficit
through borrowmg from SBP (currency printing, in laymans language) and from
Chart 12C9 d „ aUCti°ning of EHf^Bjnfrrr debt instruments), thp nr f end-of-month borrowing positions of
government and
1 V a £ Se< 0r ls not
• . f' difficult to see how government continued r creasmg its borrowing from the
banking system, which made SBP's
m netar
A y ^fflbult (i.e. controlling money supply to control
f ation). Moreover, such hefty borrowing also restricted availability of

„ T7T4rr i ♦ gaP en gOVemment and private _ *

wafpKRTs 1 i, K u P sector borrowing was PKR
1.5 billion, which reduced to PKR 507 million by May 2011.

• -seal and Monetary Policies on Equilibrium

Chart 1Z8: Budc let Def kit and Tax Mobilization sn Pakttan
Sit fr0m Eo t0 E110 E2 wili be
2/rWthe. trrt" " (or you can say, too
A A A ^ Si9n!i ^f^^^-tput
f ed
 Chart 1Z8: Budget Def kit and Tax Mobilization sn Pakistan
Budget Deficit as % of GDP (LHS) —— Tax RevenueasK of 6DP (RIB)
8

]
IA W 1/1
'
3
S
T
' ■ ' i ^
r M N r x r J N f M r M N f M N
ey,
F
i
Mini i

Chart 12*9: Trend in Govemmentand Prrvate Sector Borrowings

PKRBiHion
3.500
3.000
Private
2.500 Sector
Borrawir^
2. 000 {end-rf
month stock)
1.500
Governme
1.0 nt E from
Banking
500 jend-of-
o tj S u < £L I 3 monrt
smM
v* Q — n
Source:
SBP Pakistan’s example is an excellent case to show how theor* 2iai can be different. What we
have learned from previous seer^""] increase in government borrowing increases aggregate
outp~ during 2007 and beyond, an expansionary fiscal policy did hsiq aggregate output, but
contributed significantly in creanr~ t pressures. Of course, expansionary fiscal policy was r.o-
: dEir behind inflation. Increase in international oil price an j prices also passed on what we
call 'imported inflation. Tbi~ forced the SBP to use a contractionary monetary po r* $ period
under review (refer to chapter 11,Chart 11.5

13
See, for instance. Monetary and Fiscal Pakistan's Experience, Muhammad
Farooq Arby and SBP Research Bulletin Volume 6, No.1,May, 2010
14
See Pakistan's Rscal and Monetary System ,
Sakib of Economics, Vol. 11-SE, 2006
 Moreover, in order to improve government debt management and improve fiscal responsibility, the
government enacted the Fiscal Responsibility and Debt Limitation Act in 2005, which sets a number of targets
regarding the reduction of public debt and budget deficit. However, there remain many slippages in
achievement of the target. Unless such rules are designed realistically and then strictly adhered to, the policy
mix will remain weak in Pakistan and monetary policy will continue to play an obligatory role.

:s0f course, expansionary fiscal policy was not the only factor behind inflation, increase in
international oil and other commodity prices also passed on what we call imported inflation 7. See
Debt Policy Statement 2010-11, Ministry of Finance, Government of Pakistan

Monetary Policies on Equilibrium 20

 Learning Outcome
PartThirteen
The World Economy:
International Monetary
Institutions
By the end of this chapter you should be able to, m Provide a brief history of the International

Monetary Institutions

■ Discuss the objectives of IMF, Worid Bank, Asian Development Bank and Bank for International
Settlements

m Recall the world crisis of 2008 and its impact on the banking industry

» Explain the role of international lenders in debt management and poverty reduction of Pakistan
® Identify the performance criteria of the IMF program

History of The modern history of international monetary institutions can be traced back to 1944, with
International the formation of the Bretton Woods System. Durir : the 1930s, two of the biggest flaws in Monetary economic policies
were exchange controls and trade protectionism. Countries used
Institutions exchange rate devaluatior. to boost exports and to substitute import demand at the
expense of oth er nations (referred to as Beggar-Thy-Neighbor policies in economics), \vh:, i led to the drying up of
international trade, a fall in national income, unemployment and concentration of power among a few nations.
Moreover, the international flow of foreign capital was also severely affected by these policies. All these events
culminated in what is toiaj known as the Great Depression, though the list of causes of the Gr; Depression is longer
than this.

After the end of the Great Depression and World War II, the coun affected felt the need to harmonize their
economic policies with a re: focus on international monetary management, the role of gove and exchange
rate policies. Representatives of 44 nations met at the U: Nations Monetary and Financial Conference in
Bretton Wood^ Hampshire during July 1944 to reach a consensus of overhauling economic systems. The
Bretton Woods System set the internatior.il for exchanging currencies and laid down the plan to form
global institutions. The main brain behind the Bretton Woods System British economist John Maynard
Keynes. Briefly stated, 44 Allied agreed on the following:

1. Pegging of major currencies to US Dollar, with a vie^ adjusting the exchange rate as and
when

rconomy : Internationa I Monetary institutions

 Formation of International Bank for Reconstruction and Development (IBRD) — now known as a part of The World Bank Group ^ to lend
needed capital to underdeveloped nations.

Prominent monetary International Monetary Fund

institutions in today's
world The IMF (usually referred to simply as “the Fund”) was established in 1945 and became operational in March 1947. The IMF’s role is outlined in
Article 1 of its Articles of Agreement which constitute an international treaty between the member countries of the IMF. Some of the IMFs roles
or objectives are to:

1. Promote monetary cooperation

2. Facilitate the expansion and growth of international trade
3. Promote exchange rate stability and to avoid competitive currency depreciations

4. Assist in the establishment of a multilateral system of payments

5. Elimination of foreign exchange restrictions (controls on trade and capital flows)
6. Shorten the duration and extent of disequilibrium in international balance of Davments

In order to carry out its monetary operations (i.e. lending) with member countries, IMF uses a special composite (artificial) currencycalled Special Drawing Rights (SDR). SDR is made
up of a basket of four currencies which are weighted as follows:

• US Dollar 44%

• Euro 34%

• Japanese Yen 11%

• UK Pound 11%
The basic function of the IMF is to provide loans to enable countries to meet short and medium term balance of payments problems. Its resources
supplement each member’s gold and foreign currency reserves and can be used to finance a balance of payments currency flow deficit. The extent
of the IMF’s assistance is limited to the size of the borrowing member’s quota. Each country’s quota is based on its GNP size, degree of
industrialization, participation in foreign trade and international reserves. A country’s IMF quota (or contribution) determines its voting power and
drawing rights (borrowing power) within the IMF. Each country pays 25% of its quota in reserve currencies (SDRs, $, ¥, £, , etc) and the
remaining 75% in its own domestic currency. These quotas provide the IMF with financial resources for its balance of payments assistance
programs; it is not authorized to make long term loans or investments in member countries.
 There are several schemes to help countries borrow from the IMF. There are normal borrowing/tranche (slice) borrowings where each tranche
equals 25% of a country, s quota; successive tranche borrowings result in increased IMF supervision of the borrowing member’s economic
policies; and there are also concessionary borrowing facilities. Following are the types of financing facilities extended by IMF:

Reserve tranche (25% of member's quota): No conditions are set on its use
except balance of payments needs. No interest is payable when a member country uses its reserve tranche.

Credit Tranche Facility (Standby Agreements): Use of the Standby

Agreement must be associated with reasonable efforts to overcome balance of payments problems. Interest is charged on the use of credit
tranche facilities. This facility includes performance criteria. The performance criteria are to allow both the IMF and the member country to
assess progress in implementing policies during the period of the standby arrangement. Failure to observe the performance criteria results in
an examination of farther measures to achieve the program’s objectives. Non-performance results in a withdrawal of committed funds.

Extended Fund (or Arrangement) Facility: This medium term facility was established to provide members with financial assistance to
overcome structural, deep rooted balance of payments problems. It requires a detailed statement of policies and measures for the first and
subsequent years when the facility is being used. Financial resources (drawings) are provided over three years (100% quota per annum) in
the form of extended arrangements which include performance criteria and drawings by instalments. Interest is also charged on the use of
this facility. By means of this facility, the IMF is able to provide assistance to members for longer periods and in larger amounts in relation to
quotas than is the practice under normal credit tranche drawings.

Compensatory Financing Facility (CFF): This facility was establishes mainly to help primary producers confronted by temporary
expor. shortfalls for reasons beyond their control. Assistance is provided a;>? where a country has exceptional import expenditures due
fluctuations in cereal prices or a shortfall in domestic cereal production (wheat, maize, etc). Borrowing under the CFF is in addition to thosr
drawings permitted under the credit tranche policies. This facilrn3 permits a member to exceed 200% of its quota being held by the INI? in
the borrower’s own currency. Repurchases of drawings are siir.iJr to the credit tranche facility. As for other IMF facilities, interes: » charged.

Supplemental Reserve Facility (SRF): SRF is provided to me., countries experiencing exceptional balance of payments probL
owing to a large short term financing need resulting from a su > and disruptive loss of market confidence reflected in pressure cn capital
account and the member’s reserves. Financing under the available in the form of additional resources under a star <1 : ~ extended
arrangement, is committed for up to one year and is generally available in two or more drawings. Interest rate is charged under SRF.

Emergency assistance, In addition to balance of payments assistance under its tranche policies and special facilities, the Fund provides
emergency assistance to help members meet balance of payments problems arising from sudden and unforeseeable natural disasters. Such
assistance does not involve performance criteria but basic interest rate is charged.

3 Transfer risk - implementation of exchange controls which prevent capital repayment.

The World Economy : International Monetary Institutions

 Poverty Reduction and Growth Facility (PRGF): Low income member countries are eligible for
assistance under the PRGF on the basis of per capita income and criteria that reflect closely eligibility under the
World Bank’s concessional lending facility - the International Development Association. An eligible country
may borrow up to 140% of its IMF quota under a three-year arrangement, although this limit may be increased
under exceptional circumstances to 185% of quota. PRGF carries a small interest rate.

The World Bank

The World Bank became operational in December 1945 with thirty-eight member country shareholders. Its former
name (IBRD) confirmed its initial concern with postwar reconstruction in Europe. Since the demise of the European
empires in Africa and Asia (decolonialisation) in the 1960s, its prime concern has been to assist in the development
of LDCs (lesser developed countries). The World Bank makes loans to member nations where private capital is not
available to finance productive investment. Loans are made direct to lesser developed countries, governments or to
private enterprise with the guarantee ofthe respective government. Membership of the World Bank is conditional
L
upon IMF membership.

The Bank operates not as a single entity. Instead, it is made up of five institutions given below:

International Bank for Reconstruction and Development (IBRD): The original task of IBRD was to finance the
countries devastated by World War II. Now the role of IBRD is fighting poverty through promoting sustainable
development in poor countries. IBRD raises its funds on the world’s financial markets through the issuance of
bonds.

International Development Association (IDA): The IDA was established to make loans to low income LDCs at
a concessionary interest rate. IDA membership is open to all World Bank members. It is administered by the
same staff although it is legally and financially distinct from the World Bank. By being the largest provider of
“soft” loans to low income countries, the IDA indirectly helps to maintain the high quality level of the Bank's
own loan portfolio which lends mainly to middle income LDCs. The IDA, s loans are known as development
credits.
International Finance Corporation (IFC): IFC was established to supplement the World Bank’ s activities by encouraging private enterprise and investment in lesser developed countries. The IFC acts essentially as a

multilateral investment bank that grants loans, provides guarantees and acquires equitystakes in private enterprises.

However, it does not provide all the capital for a particular venture in which a stake is taken. Equityand loan participations arenot guaranteed bygovernments asthe IFC deals directlywith private borrowers. Instead ofinterest-

onlyloanslike the Bai, the IFCis prepared toaccept a return in the form of interest with theright toparticipate in the enterprise’ s future profits.

Multilateral Insurance Guarantee Agency (MIGA): The MIGA works as a billion dollar insurance agency aimed at encouraging investment in LDCs. It insures foreign investment in these countries against political risk but

not commercial risk. Investors seeking insurance protection must be nationals of MIGA member countries. MIGA provides insurance against four specific types of risk:

• Legislative risk ~ nationalization without any compensation to foreign shareholders.

• Repudiation - a legal judgment in favor of the investor(s) that cannot be enforcedduetotheaction ofa sovereign government.

• Armed conflict/civil war ^ destruction of the investment project or facilities.

International Centre for Settlement of Investment Disputes (ICSID): The primarypurpose of ICSIDis toprovide facilities for conciliation and arbitration of international investment disputes.

The World Bankaims topromote long term economic growth via increased

investment in LDC infrastructure (roads, docks, power stations) so as to enable them to exploit their mineral and
agricultural resources. If no private capital or an insufficient amount is available, then the Bank will assess the
economic and financial viability of various schemes and, if J satisfied, will provide five totwenty- five yearloanstomeet theforeign exchangecost oftheproject.

The overall aim ofThe World Bank istoraise LDC per capita income in particular to make poor people more productive and encourage the :r integration and
participation in their own domestic economy. Up to 1mid-1980s, three-fifths ofthe Bank’ s cumulative lendinghad been devc to energy, agricultural and rural development, andtransport. For indivi LDCs the Bank encourages their increased

participation in intematio: trade to strengthen export earnings and international investment to, innatural resourcedevelopment. TheoperationsoftheBankthusi from the
IMF which is committedto providing onlytemporaryfinan assistance to countries with balance of payments problems. Long capital fromthe Bankandother sources isused
to finance improver in industry, agriculture, transport and health over a prolonged period. Many LDCs are politically unstable
which discourages p:
foreign investment. It is the purpose of the Bank to step into this breach by providing either direct loans or guarantees to
promote private foreign
 The Bank charges interest rates on its loans. Most loans provide for a frace penod offve years and are repayable over twenty
years or less. Loans are made available in various currencies with no restriction on country procurement for required
materials and personnel. Following are the types of loan facilities extended by The World Bank:

project Loans: Most Bank loans are for specific projects which must be viable in technical and economic terms
and must contribute to the borrower’s economic development. The loan must not impose an undue strain on the
borrower’s economy in debt service costs. If :his is likely, then part of it might be financed by concessional
funds from the International Development Association.

Program Loans: These loans are aimed at supporting existing projects, geTral economic development programs
or meeting foreign’ exchange needs. Such funding is not provided with any one specific project in mind.

Asian Development Bank

^ Development Bank (ADB) was established in 1966. It is a multilateral development bank that aims to reduce poverty in
Asia and the Pacific r e^,n tough medusa economic growth and regional integration. ADT s operations are by
and large based on The World Bank's operational model. They key areas where ADB focuses include (but
not limited to) goverty reduction, gender, governance, anti-corruption, private sector development and anti-
money laundering.

i'B’s loan facilities can be generally sub-divided into two main categories- CaPltaI Resources (OCR) and
Special Funds (most notably Asian Development Fund). OCR offers loans on commercial interest rates and
vvers a wide range of activities including agriculture, natural resources, e ucation, energy, finance, health,
social protection, industry and trade public sector management, transport, information and communication
technology, water supply and other municipal infrastructure and services.

!?eSfte~apid ec_mic growth the Asia Pacific region observed during the last fifteen years or so, ADB estimates
that there are still 900 million
Efop e survMng °n d°se ^ one dollar a day. The purpose ofthe Asian Development Fund (ADF) was to enable
sustainable and equitable evelopment m Asia through concessional financing, ADF offers loans at very
reasonable interest rates to poor countries in the Asia Pacific

The Bank for International Settlements (BIS)

~ ~as the probbms c^ted by German war reparations and inter-allied debt payments
after the First World War (1914-18) that finally provided the motive for central
bank cooperation and the establishment ofthe ■orid
Economy: International Monetary Institutions
Bank for International Settlements (BIS). German reparations initially were paid in
physical goods, but this reduced Germany’s economic growth and its capacity to
make financial reparations. In order to ease the strain on the German economy and
create a more stable economic environment in Europe, various plans were
proposed to deal with these financial payments.

In 1929, the Young Plan proposed a new loan and institution to handle German reparations, suggesting that
German payments be reinvested in Germany by the new bank, while receiving countries, such as the UK
and France, would have equivalent deposits recorded in the bak s books. These were to be regarded as an
asset by countries but they were not expected to spend or cash in their deposits.
The new bank, known as the Bank for International Settlements, was set up in Basel, Switzerland in 1930 to
handle the recycling of reparation payments. The objectives of the BIS were to promote central bank
cooperation and act as a trustee for international financial settlements. Post-1945 the BIS task list extended to
include distribution of financial assistance made available under the Marshall Aid program to war-torn
economies of Western Europe. Also between 1950 and 1958, when European currencies were not fully
convertible, the BIS facilitated settlement arrangements for the successful European Payments Union.

For central banks, the BIS assists reserve management by providing access to immediate liquidity, if
required, at any time of day. The BIS does not issue any form of bank notes nor does it act as a lender of last
resort to banks or banking systems, but it does lend to central banks to help then: deal with financial

The World Economy : International Monetary Institutions

emergencies. It has participated in the granting of ] credits, under the auspices of the IMF, to some countries
such as Mexico j and Russia to assist in their economic and financial restructuring. Both j these activities are
only undertaken by the BIS in conjunction with t~r IMF and/or member central banks. The original role
ofthe BIS, provid:.-s? a means of settlement between central banks, still continues

Today, the BIS is best known for its banking supervisory activities via.t Basel Committee on Banking
Supervision which was set up in Deceml 1974. In December 1975 it approved the Basel Concordat
which develc guidelines for
the division of responsibilities between national supervi authorities. The Concordat laid down key
principles on the super\i>i of foreign banks which was regarded as a joint responsibility betnc home
and host country regulatory authorities.

In July 1988 the Basel Committee announced the phased introduct of a Capital Convergence Accord
which represented a shift towj harmonization and the creation of a level playing field in intemat
banking, thereby allowing banks to compete on an equal basis. Va in required capital ratios had meant
that banks from high capital: countries were less able to compete with banks from low capital!
countries. This had tended to depress interest margins on loaniw \ diminishing returns for all banks.
As a result, some banks indulf riskier lending in order to boost their earnings, while banks supervisors
in any given country found it difficult to raise their , adequacy ratios in isolation. In 1988 the central
banks often maiori
economies/countries, including the United Kingdom, signed an agreement which standardized the criteria to
be used when assessing a bank, s capital adequacy. The Basel Capital Accord, which took account of bank
domestic and international operations, incorporates:

1. A definition of what constitutes the capital of a bank — equity capital, reserves, general
provision and certain types of loan capital.

2. A specification of the minimum capital requirement.

Overall the Basel Capital Accord equalises the impact of supervision on the competitive positions of banks in
different countries in terms of capital adequacy. It has also strengthened the international banking system by
making it more able to deal with global economic/financial shocks. In January 2001, the BIS issued Basel
Capital Accord 2 which became effective in 2006-07. The aim of Basel II was to further strengthen the
solvency of the world’s banking system. A broad framework for Basel
III was developed in 2009 and approved in 2010 by the Basel Committee on Banking Supervision, to
strengthen the regulation, supervision and risk management of the banking sector. Specifically, Basel III aims
to:

* Improve the banking sector’s ability to absorb shocks arising from

financial and economic stress, whatever the source » Improve risk
management and governance
♦ Strengthen banks’ transparency and disclosures.

Global Financial Crisis The global financial crisis of 2008 was a severe economic downturn and its impact on the characterized by
an acute liquidity shortfall in the US and European banking banking system system. Often referred to as the worst financial crisis after
the Great
Depression, the 2008 financial crisis began in late 2007 with its roots in the securitization of real estate
mortgages in the United States. Long before the crisis began, mortgage-backed securities had found a strong
foothold in the US financial market and around the world. Real estate prices peaked in 2006 and so did the
values of mortgage-backed securities. However, the real estate bubble burst with the rise in sub-prime loan
losses during 2007. The situation was further intensified by a sharp increase in global commodity prices,
especially oil. As the crisis unfolded, US and European financial markets faced severe liquidity shortfalls and
major financial institutions suffered huge losses due to the drop in housing and share prices. The height of the
financial crisis was arguably September 2008 when Lehman Brothers filed for bankruptcy (see Box 13.1 for a
timeline of the 2008 financial crisis).

The crisis was not limited to financial markets only. Trade activities around the world dropped sharply;
unemployment levels rose and economic growth slowed down considerably, especially in developed
countries.

Impact on the global banking system

 According to one estimate, between 2007 and 2009, the US and European banks lost more than USD 1 trillion
due to loan defaults and asset

The World Economy : International Monetary Institutions

 depletion. More than 100 institutions that were involved in mortgage lending were forced to shut down their businesses during 2007-08
while the crisis had not fully subsided even in 2010.

The first notable victim of the crisis was a mid-size but prominent UK bank, Northern Rock. This bank’s operations were highly leveraged
and as the crisis started unfolding, it was forced to send SOS calls to the Bank of England. This event panicked the investors and during
September 2007 resulted in massive queues outside the bank’s branches of people eager to withdraw their money. Finally, the Bank of
England rescued Northern Rock by taking it into government hands in February 2008. Initially, those companies who had direct exposure
in home mortgage business took the hit, but then came the chain reaction which saw prominent financial institutions with indirect exposures
beginning to fail. September 2008 was the time when the financial crisis hit its peak. First, the US government had to bail out the biggest US
home mortgage lenders ^ Federal National Mortgage Association (FNMA), known as 'Fannie Mae, and Federal Home Loan Mortgage
Corporation (FHLMC), known as 'Freddie Mac, - and then Lehman Brothers went bankrupt. These events triggered further failures while
the full recovery did not start until early 2010.

-Key Events

22 February 2007: HSBC’s losses reached USD 10.5 billion. Bank fired the head mortgage lending
p
r
Box 13.1:
The Unfolding of Global il 2007: New Century Financial, one ofthe biggest sub-prime lenders in the US, filed for Chapter 11
Financial Crisis 20072009 bankruptcy protection after it was forced to repurchase bad loans

3 May 2007: UBS closes its US sub-prime lending arm, Dillon Read Capital Management

22 June 2007: Bear Stearns revealed it had spent $3.2bn bailing out two of its funds exposed to the sub-prime market. It further told
investors that they will get little money back from the two hedge funds that the lender was forced to rescue. The trouble spreads to major
firms such as Merrill Lynch, JPMorgan Chase, Citigroup and Goldman Sachs which had loaned the firms money

6 August 2007: American Home Mortgage, one of the largest US independent home loan providers, filed for bankruptcy after firing
majority of its staff.

9 August 2007: French bank BNP Paribas suspended three investment funds worth Euro 2 billion, citing problems in the US sub-prime
mortgage sector. Shortterm credit markets froze up

10 August 2007: The ECB provided Euro 61 billion for banks and further pumped Euro 47.7 billion into the money markets two days
latter.

210 Economics | Reference Book 2

 17 August 2007: The US Federal ResavecultfaeiDiciainieJridh it lends to banks (the discount nie)
to

28 August 2007: The German regional bank SadnaiLaBiEAflakw

sold to Germany’s biggest regional bank, Landesbank BaicB- Wuerttemberg. It came close to collapsing owing to itsesqiosaietoab- prime debt

4 September 2007: Bank of China revealed USD 9 billion in sub-prime losses. Overnight bank lending dried up as banks feared interbank
defaults. Libor rate hit 6.7975%, way above the Bank of England’s base rate of 5.75%

6
September 2007: As credit fears intensified, ECB injected fresh cash into markets. Total intervention reached Euro 250 billion

13 September 2007: Northern Rock asked for and was granted emergency financial support from the Bank of England. A day later, depositors
withdraw £lbn from Northern Rock in what was the biggest run on a British bank for more than a 100 years

18 September 2007: The US Federal Reserve cut interest rates to 4.75% from 5.25%

I October 2007: Swiss bank UBS announced losses - USD 3.4 billion - from sub-prime related investments. Investment bank Merrill Lynch
also revealed $5.6bn sub-prime losses a couple of days later.

6
December 2007: The Bank of England cut interest rates by a quarter of one percentage point to 5.5%.

17 December 2007: The central banks continued to inject money. There was a USD 20 billion auction from the US Federal Reserve and, the
following day, USD 500 billion from the European Central Bank to help commercial banks

21 January 2008: Global stock markets suffered their biggest falls since
II September 2001

22 January 2008: The US Fed cut rates by three quarters of a percentage point to 3.5% - its biggest cut in 25 years

7
February 2008: Bank of England cut interest rates by a quarter of one percent to 5.25%. After two weeks, British government nationalized
Northern Rock.

7 March 2008: Federal Reserve injected $200bn of funds in the banking system to improve liquidity

The World Economy : International Monetary Institutions 211

16 March 2008: Bear Stearns was bought by J.P. Morgan Chase in a deal arranged and backed up by the U.S. government

8 April 2008: The International Monetary Fund (IMF), warned that potential losses from the credit crunch could reach $1 trillion and may be even
higher

10 April 2008: Bank of England further cut interest rates to 5%.

19 June 2008: FBI arrested 406 people in a crackdown on alleged mortgage frauds worth USD 1 billion. Two former Bear Stearns workers faced
criminal charges related to the collapse of two hedge funds linked to subprime mortgages. It was alleged that their non-disclosure of critical
information led to investors losing a total of USD 1.4 billion.

31 July 2008: UK house prices showed their biggest annual fall 1991, a decline of 8.1%.

7 September 2008: Mortgage lenders Fannie Mae and Freddie Mac - which accounted for nearly half of the outstanding mortgages in the US
■were rescued by the US government in one of the largest bailouts in US history

15 September 2008: Bank of America agreed to a USD $50 billion rescue package for Merril Lynch. Lehman Brothers filed for bankruptcy -
the largest bankruptcy filing in US history (USD 639 billion)

25 September 2008: Ireland became the first state in the Euro-zone to fall into recession.

2 October 2008: The U.S. Senate approved the USD 700 billion bailout

8 October 2008: The Federal Reserve, the Bank of England and the European Central Bank all cut their interest rates by half a point. That was
the first unscheduled rate move since the aftermath of 9/11.

19 October 2008: It was revealed that Dutch savings bank ING was to get a Euro 10 billion capital injection from Dutch authorities. South
Korea announced a USD 130 billion financial rescue package to stabilize its markets.

24 October 2008: Stock markets and the pound slumped as official government figures confirmed that the U.K. economy was shrinking the
biggest drop in GDP since 1990.

9 November 2008: China announced a two-year USD 586 billion economc stimulus package
23 November 2008: Citigroup was bailed out in an asset-relief package worth USD 306 billion

1 December 2008: National Bureau of Economic Research (NBER), a US think tank well known for keeping track of business cycles,
announced that US economy has been in recession since December 2007.

16 December 2008: Federal Reserve slashed its key interest rate from 1% to 0.25%

8
January 2009: Bank of England decreased interest rate to 1.5% -lowest in its 315 years history. Official data showed that jobless rate hit 7.2%.

Economics | Reference Book 2

 15 January 2009: European Central Bank cut Eurozone interest rates by half a percent to 2%.

28 January 2009: IMF warned that World GDP growth may fall to 0.5% in 2009 -lowest since World War II.

17 February 2009: US President Barack Obama signed his USD 787 billion economic stimulus plan into law.

2 March 2009: Insurance giant AIG reported USD 61.7 billion loss - largest quarterly loss is the US corporate history

2 April 2009: At the G20 summit in London, world’s largest economies reached an agreement to deal with the financial crisis with measures
worth USD 1.1 trillion

1 May 2009: Chrysler - one of the “big three” carmakers - entered bankruptcy protection and majority of its assets were to be sold to Fiat.

1 June 2009: World’s biggest carmakers GM also entered bankruptcy protection. The deal meant that bondholders were to lose 90% of their
money.

10 June 2009: World oil consumption fell for the first time since 1993. According to BP energy outlook, it was another sign of the depth of
recession.

15 July 2009: UK jobless rate increased to 7.6% - the highest in more than 10 years.

Sources:
http://news.bbc.co.Uk/2/hi/business/7521250.stm
http://www.foxbusiness.com/story/markets/economy/timeline-financial-crisis/
http://www.guardian.co.uk/business/2008/oct/08/creditcrunch.marketturmoil
http://www.iht.com/artides/ap/2008/09/19/america/Financial-Meltdown-Timeline.php Did Pakistan remain immune to the
financial crisis?

Financial institutions in Pakistan mostly remained immune to the direct impact ofthe global financial crisis. There are many reasons behind why
Pakistani banks were not caught up in the global financial crisis. First, Pakistan’s financial market remained, and still at the nascent stage of
development. In a global perspective, the products our banks offer are limited and the financial engineering behind the development of these
products is relatively more simple. Second, the housing market in Pakistan is mostly unregulated and undocumented and there are virtually no or
very limited financially engineered products such as Real Estate Investment Trusts (REITS), Mortgage Back Securities or Collateralized Debt
Obligations (CDOs). Third, domestic banks in Pakistan are even less exposed to international markets. Very few have international operations,
and those that have, did not venture into sub-prime lending. Fourth, the role of the regulator - the SBP - has been to be vigilant for quite some
time and banks and other financial institutions are not encouraged to undertake investments in risky ventures.

Pakistan’s financial institutions did experience a liquidity crunch during late 2008; just before the Pakistani government applied for financial
assistance from the IMF. Nevertheless, that crunch was triggered primari]> through the imports channel. An unprecedented hike in internation t
11 and food prices led to huge twin deficits. These effects trickled dovl— which resulted in exchange rate depreciation and steep rise in banks
nor> performing loans. In addition, the government started monetizing tnc fiscal deficit that led to the private sector being crowded out and a
declare in banking sector profitability.

Role of international lenders in Pakistani development

Foreign aid has often been a subject of controversy in terms of its • on the recipient country" development and economic studies are on this issue.
Some studies points towards a positive relationship foreign aid and economic growth See for instance, Counting CH When They Hatch: The
Short-Term Effect of Aid on Growth. Clemens, S. Radelet, and R. Bhavnani, Working Paper No.44, Ce Global Development, 2004 while others
highlight the negative of aid For instance, Aid and Growth: What Does the Cros Evidence Really Show?, Raghuram Raj an and Arvind Sub
Review of Economics and Statistics, Vol.90, No. 4, 2008. In the Pakistan, the effectiveness of external financing is sporadic and Javid and
Qayyum (2011) Foreign Aid-Growth Nexus in Pak of Macroeconomic Policies, Muhammad Javid and Abdul Qa> Paper No. 29498, provide a
comprehensive survey of stu emphasize ineffective, or sometimes adverse, effects of

A profile of Pakistan’s poverty and income inequality is g^ 13.1. After falling until the early 1990s, poverty has gene the rise in Pakistan.

—<j Economy : International Monetary Institutions

Moreover, distribution of income has more skewed towards the wealthy population.

Economks |
 Chart 13.1; Poverty and Income Inequaility in Pakfetar

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 It is important to understand what determines the success or failure of aid. Multiple reasons can be cited
behind the ineffectiveness of foreign development lending. First, policies developed by donors sometimes
neglect key concerns, shortcomings and need of stakeholders and fail to justify the conditions that are
attached with the grant. Such grants often fail to successfully implement the project for which the grant is
provided. Second, limited institutional capacity of the recipient country is also a big problem. The aid-
receiving countries are often poor with a weak institutional infrastructure and lack of human capital. If the
grant is unconditional, these shortcomings prove to be a big hurdle in effective utilization of foreign money.
Third, corruption and political vested interests also lead to the failures of foreign aid programs. Fifth, foreign
aid often misses the proper channels of targeting poverty or social development (e.g. aid for military
expenditure instead of targeting education and health). One way or the other, these arguments are true in the
case of Pakistan as well.
20
Chapter 9: External and Domestic Debt, Pakistan Economic Survey 2010-11, Ministry of Finance,
Government of Pakistan
21
Asian Development Bank and Pakistan: Fact Sheet,
http://www.adb.org/Documents/Fact_Sheets/PAK.pdf
Pakistan and IMF: Latest arrangement

As stated earlier, during 2008, Pakistan was among the countries affected by the steep rise in commodity
prices the most. The country suffered unprecedented exchange rate depreciation and a serious balance of
payments crisis. These events took Pakistan to IMF’s doorstep and the country requested financial assistance
from the Fund in October 2008. On November 15, 2008, IMF informed through a press release that Pakistan
and IMF had reached an agreement on a SDR 5.17 billion 23- month Stand-by Arrangement (SBA). The
core objectives ofthe SBA were (a) removing macroeconomic imbalances through pursuing contractionary
fiscal and monetary policies, and (b) programming a well-targeted social safety net for the protection of the
most vulnerable of society. Tables 13.1 and 13.2 highlight the performance criteria associated with the
original SBA.
Table 13.1: IMF Performance Criteria (Quantitative Targets)
Floor on net foreign assets of the SBP* (stock, in millions of Ui. dollars)
Jun-09 Sep-09 Dec-09 Mar-1C

2,782 3,200 5/100 “

Ceiling on net government borrowing from SBP" (stock, in billions of Pakistani rupees) —
1,314 1,300 1,270
1,18 1,130 1,130
Ceiling on net domestic assets of the SBP* (stock, in billions of Pakistani rupees) 1

Ceiling on overall budget deficif (cumulative flow, in billions of Pakistani rupees) 562 194 400

Ceiling on outstanding stock of short-term public and publicly guaranteed external debt 7 (in millions of U.S. dollars)
1,50 1,500 1,500
0
Cumulative ceiling on contracting of non-concessional medium- and long-term public and
publicly guaranteed external debt (in millions of U.S. dollars) _______________________________________________________
9,50 9,500 9,500 ■
Accumulation of external payments arrears (continuous performance criterion during the 0
program period, in millions of U.S. dollars) _______________________________________________
Continuous ceiling on SBP's foreign currency swaps and forward sales" (In millions of U.S, dollars) 0 0 I

2,500 m

Source: Fourth Review under SBA, Country Report 10/133, June 2010, IMF

2,750 2,500
—bUDrmsaon ot Federal VAT act to parliament and consistent Provincial VAI acts to provincial assemblies. A contingency plan for
handling problem private
s wil I f/FPerd.r mance Criteria - Structural Targets

Tar
get da
te Status as at June 2010
A full description of required reforms in the area of tax \ the GST and income tax administration will be finalized 2UU-D>ecember Met 2008

Trie SBP's provision of foreign exchange for furnace oi! will be eliminated
end-December Met ' 2008

The government wiii prepare a plan for eliminating the inter-corporate circular debt, rne transition to a treasury single end-December Met1
2008
account"will be completed
1-Feb-09Met end-March,
2009 Met _

end-March, 2009 Met with a delay

>0 . -ent >u I v-We tax and G S 1 — a end-june 2010 Underway2 end-August

Submission ot the VAT law to Parliament. 2009 Met with a delay

e
n
5-Sep-09 Met with a delay ' d
....................................................................................................... -December Met with a delay" 2009

__y5
_
- unitS to ensuredfredinplTrf

irr
A MU 8p!o^ntitrn nf the

5y,eder-al in commercial bankaccounts. The target date has been revisArom end 11
,bout

8 - '■^^subm'tt®d to provincial assemblies by

fourth Review under SBA, Country Report 10/133. hmp ?nm »MC

Pakistan’s performance remained on track and the country met most of t e targets set initially. Moreover, upon
government request, IMF increased total disbursement to be made under the SBA to SDR 7.2 billion and a/°4wed a
Portio" of SBA to be used for fiscal deficit financing At tJje tune of SBA signing in November 2008, IMF
financing was for balance of payments support only. At the time ofthe second review in August 5 009, IMF
allowed SDR 951 million to be used for deficit financing (to made available in three tranches). See also Table
13.3.. Afterwards despite missing some quantitative targets, disbursements remained on track albeit with some
lag until May 2010 (Table 13 . 3 ) .

4 A further complicating factor is that most employees will realize that, although nominal incomes remain

*r1d Economy: International Monetary Institutions

217
 During mid-2010, massive floods hit the country and put an excessive fiscal burden on the country. As a result,
Pakistan requested financial assistance under the Fund’s policy for Emergency Natural Disaster Assistance (ENDA)
and subsequently was granted ENDA of USD 451 million. In addition, IMF also rephased the remaining tranches to
allow Pakistan to achieve the remaining targets. Nevertheless, as the economic turmoil kept unwinding, especially at the
forefront of keeping the fiscal deficit below the targeted level, the government found it more difficult to achieve the
targets. During December 2010, Pakistan requested the IMF for a 9 month extension of the SBA in order to have more
time to

Jf.'tk',: n>>m
Tranche No. Original SBA Funding Total Remarks
Disbursement Funding for Fundin
Date Budgetary g
Support
Nov-08 2,067 2,067 Disbursed on time

1 Mar~09 569 569 Delayed, disbursed in April 2009

2 Jun-09 767 476 1,242 Delayed, disbursed in August 2009

3 Nov-09 767 238 1,004 Delayed, disbursed in December 2009

4 Feb-10 767 238 1,004 Delayed, disbursed in May 2010

5 initially rephased into two tranches of SDR 1,150

May-10 767 767 million each; was to be disbursed In
57 August-10 and November-10. Second rephasing
Aug-10 767 767 was done in December-10, which allowed the
SDR 1,150 million to be disbursed in August-11.
Nov-10 766 766 Actual disbursements have, however, not taken
place as yet

Total SBA 7,236 951 8,187

SBA 4,936 951 5,887
Debused
2,300 2300
SBA
Remaning

Source: Authors computation based on IMF SBA Reviews

(http://www.imf.org/external/country/pak/index.htm)

=At the time of SBA signing in November 2008, IMF financing was for _ of payments support
only. At the time of the second review in Auaust IMF allowed SDR 951 million to be used for
deficit financing (to be available in three tranches). See also Table 13.3.
unchanged, higher import prices will reduce real incomes, thus pressure for higher wages/salaries could prove to be inflationary. In due course,
such inflation could increase export production costs and erode the benefits of depreciation. For the latter to be successful, it may need the support
of mild deflationary policies to prevent inflationary pressures in the economy.
2
' = w/ is in casesofUnfij

218
Economics | RefefeHr
 of income of, the higher the demand for liquidity.
General collateral repo (in non-specific stock)
First i gg of the repo;
sells £100:=worth of stock
—j». .T ~A
Party A

I £100 cf sft)ck to whicti Par%l

2. Formation of the International Monetary Fund (IM? order to monitor global exchange rates and to lend currencies
to help nations with trade deficits.
par, o. the VAT law package was submitted «o theparliA'ent on February25, 2O10. The provincial laws

1Minus sign = addition to reserves

• Plus sign = deduction from reserves
3 The cost and availability of
raw materials, intermediate

219
Economics | RefefeHr