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Solutions for all Economics Learner’s Book has been developed
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Economics.
Economics
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The Economics Solutions for all Learner’s Book is supported by the
Economics Solutions for all Teacher’s Guide. This course provides
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11: a complete solution for the classroom.
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Also available in this series for the Further Education and Training
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ISBN 978 143100 000 0
Also available in Afrikaans.
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Grade 12 Learner’s Book
The Economics Solutions for all Learner’s Book is supported by the
Economics Solutions for all Teacher’s Guide. This course provides
everything the teacher and learners need to master Economics in Grade
11: a complete solution for the classroom.
Also available in this series for the Further Education and Training
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or all
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The Economics Solutions for all Learner’s Book is supported by the
Economics Solutions for all Teacher’s Guide. This course provides
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10: a complete solution for the classroom.
Also available in this series for the Further Education and Training
Phase:
lution
Economics
In addition, learners are provided with:
• Additionalhomeworkactivities
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enrichment
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The Economics Solutions for all Learner’s Book is supported by the
Economics Solutions for all Teacher’s Guide. This course provides
everything the teacher and learners need to master Economics in Grade
10: a complete solution for the classroom.
Also available in Afrikaans.
solutions for all
Economics
In addition, learners are provided with:
• Additionalhomeworkactivities
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• Asummaryofacycleofwork.Acyclemayconsistofoneormore
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lution
Economics Solutions for all Learner’s Book has been developed to
support the content (knowledge, concepts and skills) contained in
the National Curriculum Statement (NCS), as organised in the new
Curriculum and Assessment Policy Statement (CAPS) for Economics.
The Economics Solutions for all Learner’s Book has been organised
to support teaching and learning in the Economics classroom by
presenting the material to be taught and practised in the classroom in
30-60 minute lessons. In each lesson the learners will:
• Establishwhattheyalreadyknowaboutatopic
• Learnnewfactsaboutatopic
• Practiseusingthenewknowledge,conceptsandskillstheyhave
acquired in the lesson.
or all
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solutions for all
or all
sf
The Economics Solutions for all Learner’s Book has been organised
to support teaching and learning in the Economics classroom by
presenting the material to be taught and practised in the classroom in
30-60 minute lessons. In each lesson the learners will:
• Establishwhattheyalreadyknowaboutatopic
• Learnnewfactsaboutatopic
• Practiseusingthenewknowledge,conceptsandskillstheyhave
acquired in the lesson.
Economics
In addition, learners are provided with:
• Additionalhomeworkactivities
• Extrapracticeactivitiesthatcaterforbothremediationand
enrichment
• Asummaryofacycleofwork.Acyclemayconsistofoneormore
weeks’ work.
lution
Economics Solutions for all Learner’s Book has been developed to
support the content (knowledge, concepts and skills) contained in
the National Curriculum Statement (NCS), as organised in the new
Curriculum and Assessment Policy Statement (CAPS) for Economics.
solutions for all
or all
sf
The Economics Solutions for all Learner’s Book has been organised
to support teaching and learning in the Economics classroom by
presenting the material to be taught and practised in the classroom in
30-60 minute lessons. In each lesson the learners will:
• Establishwhattheyalreadyknowaboutatopic
• Learnnewfactsaboutatopic
• Practiseusingthenewknowledge,conceptsandskillstheyhave
acquired in the lesson.
Economics
In addition, learners are provided with:
• Additionalhomeworkactivities
• Extrapracticeactivitiesthatcaterforbothremediationand
enrichment
• Asummaryofacycleofwork.Acyclemayconsistofoneormore
weeks’ work.
lution
Economics Solutions for all Learner’s Book has been developed to
support the content (knowledge, concepts and skills) contained in
the National Curriculum Statement (NCS), as organised in the new
Curriculum and Assessment Policy Statement (CAPS) for Economics.
solutions for all
Economics Solutions for all Learner’s Book has been developed to
support the content (knowledge, concepts and skills) contained in
the National Curriculum Statement (NCS), as organised in the new
Curriculum and Assessment Policy Statement (CAPS) for Economics.
The Economics Solutions for all Learner’s Book has been organised
to support teaching and learning in the Economics classroom by
presenting the material to be taught and practised in the classroom in
30-60 minute lessons. In each lesson the learners will:
• Establishwhattheyalreadyknowaboutatopic
• Learnnewfactsaboutatopic
• Practiseusingthenewknowledge,conceptsandskillstheyhave
acquired in the lesson.
so
Also available in this series for the Further Education and Training
Phase:
www.macmillan.co.za
Teacher’s
Guide
ISBN 978 143100 000 0
Also available in Afrikaans.
www.macmillan.co.za
ISBN 978 143101 375 3
C Chaplin
B Serfontein
C van Zyl
Learner’s
Book
12
CAP
S
Solutions for all
Economics
Grade 12
Learner’s Book
C Chaplin
B Serfontein
C van Zyl
Solutions for all Economics Grade 12 Learner’s Book
© C Chaplin, B Serfontein, C van Zyl, 2013
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Contents
ContentsContents
Understanding the icons used in this book ....................................................................................... xiii
Topic 1 Circular flow .............................................................................................................. 1
1. The open economy circular flow model ............................................................................................4
1.1 The components of an open circular flow model ......................................................................4
1.1.1 The participants in an open circular flow model ....................................................................4
1.1.2 The markets in an open circular flow model ..........................................................................5
1.1.3 The flows in an open circular flow model ...............................................................................6
1.2 The open economy circular flow model .....................................................................................7
1.2.1 A two-sector model ................................................................................................................7
1.2.2 A three-sector model ............................................................................................................10
1.2.3 The four-sector model (open circular flow) ..........................................................................12
1.3 From the circular flow model to a theory of the determination of output .......................... 14
2. Markets .................................................................................................................................................15
2.1 Factor market .............................................................................................................................. 15
2.2 Goods market ............................................................................................................................. 16
2.3 Financial market ......................................................................................................................... 17
3. National account aggregates and conversions ............................................................................... 18
3.1 Gross domestic product (GDP) ................................................................................................. 18
3.2 Gross domestic expenditure (GDE) ......................................................................................... 19
3.3 Gross domestic income (GDI) ................................................................................................... 19
3.4 Measuring gross domestic product ......................................................................................... 19
3.4.1 Factor prices to basic prices ................................................................................................ 20
3.4.2 Basic prices to market prices ............................................................................................... 21
3.5 Expenditure method .................................................................................................................. 21
3.5.1 National and domestic figures ............................................................................................ 22
3.5.2 Net figures .......................................................................................................................... 23
4. The multiplier ..................................................................................................................................... 24
4.1 Defining the multiplier effect ................................................................................................... 24
4.2 The multiplier in the circular flow model ............................................................................... 25
4.3 The multiplier in a model with a government sector ............................................................ 28
4.4 The multiplier in an open economy ......................................................................................... 29
4.5 The multiplier effect in a graph ................................................................................................ 30
Summary .................................................................................................................................................. 35
Topic 2 Business cycles ......................................................................................................... 37
1. Composition and features of business cycles ................................................................................. 40
1.1 Composition of business cycles ................................................................................................ 40
1.2 Features of business cycles ....................................................................................................... 40
1.2.1 Four phases of the business cycle ........................................................................................ 40
1.2.2 Peaks and troughs ............................................................................................................... 41
1.2.3 The trend line ..................................................................................................................... 41
1.2.4 The amplitude of the business cycle .....................................................................................41
1.2.5 Duration of a business cycle ................................................................................................42
Contents
•
iii
1.3 Explanation of the different phases ...........................................................................................42
1.3.1 Recession phase ....................................................................................................................42
1.3.2 Depression phase .................................................................................................................42
1.3.3 Recovery phase ....................................................................................................................43
1.3.4 Prosperity phase ..................................................................................................................44
1.4 Actual business cycles in South Africa ................................................................................... 44
2. Explaining the business cycle .......................................................................................................... 45
2.1 Exogenous (monetarist) approach ............................................................................................ 45
2.2 Endogenous (Keynesian) approach ......................................................................................... 46
2.3 Kinds of business cycles ............................................................................................................ 47
2.3.1 Supply-driven business cycle .............................................................................................. 47
2.3.2 Demand-driven business cycle (Keynesian view) ............................................................... 48
2.3.3 Political business cycle ........................................................................................................ 49
2.3.4 Kitchin business cycle ......................................................................................................... 49
2.3.5 Juglar business cycle ........................................................................................................... 49
2.3.6 Kuznets business cycle ........................................................................................................ 50
2.3.7 Kondratieff business cycle ................................................................................................... 50
3. Government policy and the business cycle .................................................................................... 50
3.1 Using expansionary policy ....................................................................................................... 51
3.2 Using contractionary policy ...................................................................................................... 51
4. The new economic paradigm ........................................................................................................... 51
5. Features of forecasting in business cycles ...................................................................................... 52
5.1 Leading indicators ..................................................................................................................... 52
5.2 Coincident indicators ................................................................................................................. 53
5.3 Lagging indicators ..................................................................................................................... 54
5.4 Extrapolation ............................................................................................................................... 54
5.5 Moving averages ........................................................................................................................ 55
Summary .................................................................................................................................................. 59
Topic 3 The public sector ..................................................................................................... 60
1. The composition and necessity of the public sector ...................................................................... 62
1.1 The composition of the public sector ...................................................................................... 62
1.2 The necessity of the public sector ............................................................................................ 62
1.3 The South African Constitution and the public sector ......................................................... 63
1.4 Reasons for government intervention ..................................................................................... 63
1.4.1 To provide public goods and services .................................................................................. 63
1.4.2 To provide merit goods ........................................................................................................ 64
1.4.3 To protect natural resources ................................................................................................ 65
1.4.4 To redistribute wealth and income ...................................................................................... 65
1.4.5 To manage the economy ...................................................................................................... 65
1.4.6 To encourage competition ................................................................................................... 66
2. Problems of public sector provisioning .......................................................................................... 66
2.1 Accountability ............................................................................................................................ 66
2.2 Efficiency ..................................................................................................................................... 67
2.3 Assessing needs and correct planning .................................................................................... 67
2.4 Correct pricing ............................................................................................................................ 67
iv
• Contents
Contents
2.5 State-owned enterprises (parastatals) ...................................................................................... 68
2.6 Privatisation ................................................................................................................................ 69
2.7 Nationalisation ........................................................................................................................... 69
3. Objectives and budgets ..................................................................................................................... 71
3.1 The objectives of the public sector ........................................................................................... 71
3.1.1 Economic growth ................................................................................................................ 71
3.1.2 Full employment ................................................................................................................. 71
3.1.3 Price stability ...................................................................................................................... 71
3.1.4 Exchange rate stability ........................................................................................................ 72
3.1.5 Economic equity .................................................................................................................. 72
3.2 The budgets ................................................................................................................................. 72
3.2.1 The medium-term expenditure framework (MTEF) ........................................................... 72
3.2.2 The main budget ................................................................................................................. 73
3.2.3 The allocation of state income ............................................................................................. 73
3.3 The budget cycle ......................................................................................................................... 75
4. Fiscal policy ........................................................................................................................................ 76
4.1 The composition of government income ................................................................................. 76
4.2 Government expenditure .......................................................................................................... 77
4.3 Types of taxation ........................................................................................................................ 79
4.3.1 Direct taxation .................................................................................................................... 79
4.3.2 Indirect taxation ................................................................................................................. 79
4.3.3 What makes a good tax? ..................................................................................................... 80
4.3.4 The effects of taxation ......................................................................................................... 80
4.3.5 The advantages and disadvantages of direct taxation ......................................................... 80
4.3.6 The advantages and disadvantages of indirect taxation ...................................................... 81
4.3.7 The effects of fiscal policy .................................................................................................... 81
4.4 The Laffer curve ......................................................................................................................... 82
5. Reasons for public sector failures .................................................................................................... 84
Summary .................................................................................................................................................. 88
Topic 4 Economic growth and development: Foreign exchange market
(globalisation) ......................................................................................................... 90
1. The main reasons for international trade ....................................................................................... 93
1.1 Factors of production ................................................................................................................. 94
1.2 Climate ........................................................................................................................................ 94
1.3 Availability of technology ......................................................................................................... 94
1.4 Labour force ................................................................................................................................ 95
1.5 Absolute advantage .................................................................................................................... 95
1.6 Comparative advantage ............................................................................................................. 98
2. Balance of payments ........................................................................................................................ 101
2.1 The current account ................................................................................................................. 103
2.2 The capital transfer account .................................................................................................... 106
2.3 The financial account ............................................................................................................... 107
2.4 Unrecorded transactions ......................................................................................................... 108
2.5 Changes in foreign reserves ................................................................................................... 108
Contents
•
v
3. Foreign exchange markets .............................................................................................................. 111
3.1 A floating or flexible exchange rate system .......................................................................... 112
3.2 A fixed exchange rate system ................................................................................................. 113
3.2.1 Revaluation ....................................................................................................................... 113
3.2.2 Devaluation ...................................................................................................................... 113
3.3 A managed floating exchange rate system ........................................................................... 113
3.3.1 Appreciation ..................................................................................................................... 114
3.3.2 Depreciation ..................................................................................................................... 114
4. The establishment of foreign exchange rates ............................................................................... 114
4.1 Equilibrium exchange rate ...................................................................................................... 117
4.2 Changes in the exchange rate ................................................................................................. 118
5. Corrections of balance of payments surpluses and deficits (disequilibria) .............................. 121
5.1 Causes of disequilibria ............................................................................................................ 122
5.2 Flexible exchange rate and balance of payments disequilibria .......................................... 122
5.2.1 Deficit on the balance of payments ................................................................................... 122
5.2.2 Surplus on the balance of payments .................................................................................. 122
Summary ................................................................................................................................................ 127
Term 1 Revision .................................................................................................................................... 129
Topic 5 Economic systems: Protection and free trade (globalisation) ............................. 131
1. Export promotion ............................................................................................................................ 134
1.1 Export Marketing and Investment Assistance ..................................................................... 134
1.2 Export credit incentives ........................................................................................................... 135
1.3 Export credit insurance ........................................................................................................... 135
1.4 Customs and excise duty refunds .......................................................................................... 135
2. Import substitution .......................................................................................................................... 137
2.1 Tariffs and trade barriers ........................................................................................................ 137
2.1.1 Specific tariffs ................................................................................................................... 137
2.1.2 Ad valorem tariffs ........................................................................................................... 137
2.1.3 Licences ............................................................................................................................. 138
2.1.4 Import quotas .................................................................................................................... 138
2.1.5 Voluntary export restraints (VERs) .................................................................................. 138
2.1.6 Local content requirement ................................................................................................ 138
2.2 Who benefits from tariffs? ...................................................................................................... 138
2.3 The effects of tariffs on prices ................................................................................................ 139
2.4 Tariffs and modern trade ........................................................................................................ 140
2.5 Proudly South African ............................................................................................................. 140
3. Protectionism ................................................................................................................................... 141
3.1 The arguments for protectionism .......................................................................................... 141
3.2 The arguments against protectionism ................................................................................... 142
4. Free trade .......................................................................................................................................... 143
4.1 The arguments for free trade .................................................................................................. 143
4.2 The arguments against free trade .......................................................................................... 144
5. A desirable mix ................................................................................................................................ 147
5.1 Free trade areas (FTAs) ............................................................................................................ 148
5.2 Customs unions ........................................................................................................................ 148
vi
• Contents
Contents
5.3 Common markets ..................................................................................................................... 148
5.4 Economic unions ...................................................................................................................... 148
6. Evaluation of South African international trade policies ........................................................... 150
6.1 South Africa’s trade policies ................................................................................................... 150
6.1.1 The Southern African Customs Union (SACU) ............................................................... 150
6.1.2 The Southern African Development Community (SADC) .............................................. 150
6.1.3 The African Union (AU) .................................................................................................. 150
6.1.4 The European Union (EU) ............................................................................................... 151
6.1.5 Mercosur ........................................................................................................................... 151
6.2 Other negotiations ................................................................................................................... 151
6.3 The BRICS countries ................................................................................................................ 151
Summary ................................................................................................................................................ 156
Topic 6 Dynamics of markets: Perfect markets ................................................................. 158
1. Perfect competition .......................................................................................................................... 161
1.1 Introduction .............................................................................................................................. 161
1.2 Characteristics of perfect competition ................................................................................... 161
1.2.1 Many buyers and sellers ................................................................................................... 161
1.2.2 Homogeneous product ...................................................................................................... 162
1.2.3 Perfect information ........................................................................................................... 162
1.2.4 No collusion ...................................................................................................................... 162
1.2.5 Freedom of entry and exit ................................................................................................. 163
1.2.6 Mobility of the factors of production ................................................................................. 163
1.2.7 Unregulated market .......................................................................................................... 163
2. Individual business and industry .................................................................................................. 163
3. Market structure .............................................................................................................................. 167
4. Output ............................................................................................................................................... 168
4.1 Demand, marginal revenue and average revenue ............................................................... 169
4.2 Cost of production and marginal cost ................................................................................... 170
4.3 Profit maximisation ................................................................................................................. 172
4.4 The output (supply) decisions of the individual producer under perfect competition ... 173
5. Profits ................................................................................................................................................. 174
5.1 Normal profit ............................................................................................................................ 174
5.2 Economic profit ......................................................................................................................... 175
6. Losses and supply ............................................................................................................................ 177
7. Competition policies ........................................................................................................................ 179
7.1 The aims of competition policies ........................................................................................... 179
7.2 Requirements of competition policy in South Africa .......................................................... 180
7.3 The instruments of competition policy in South Africa ..................................................... 180
Summary ................................................................................................................................................ 185
Topic 7 Dynamics of markets: Imperfect markets ............................................................. 186
1. Dynamics of imperfect markets .................................................................................................... 188
2. Monopolies ....................................................................................................................................... 189
2.1 Characteristics of a monopoly ................................................................................................ 189
2.2 The demand curve of a monopolist ....................................................................................... 190
2.3 The marginal revenue curve of a monopolist ...................................................................... 190
Contents
•
vii
2.4 Cost of production of a monopolist ....................................................................................... 192
2.5 Profit maximisation of the monopolist .................................................................................. 192
2.6 Short-run profits and losses .................................................................................................... 193
2.7 Long-run equilibrium and economic profit .......................................................................... 194
2.8 Comparison with perfect competition .................................................................................. 194
3. Oligopolies ........................................................................................................................................ 196
3.1 Characteristics of an oligopoly ............................................................................................... 196
3.2 Non-price competition ............................................................................................................. 198
3.3 Collusion ................................................................................................................................... 198
3.4 Prices and production levels ................................................................................................... 199
3.5 Comparison with perfect competition .................................................................................. 199
4. Monopolistic competition ............................................................................................................... 200
4.1 Characteristics of monopolistic competition ........................................................................ 200
4.2 The demand curve for monopolistic competition ............................................................... 201
4.3 Profit maximisation for monopolistic competition .............................................................. 202
4.3.1 Short run .......................................................................................................................... 202
4.3.2 Long run ........................................................................................................................... 203
4.3.3 Compared with perfect competition .................................................................................. 203
Summary ................................................................................................................................................ 207
Topic 8 Dynamics of markets: Market failures .................................................................. 209
1. The causes of market failures ......................................................................................................... 211
1.1 Externalities .............................................................................................................................. 211
1.2 Public goods .............................................................................................................................. 212
1.3 Merit and demerit goods ......................................................................................................... 214
1.4 Imperfect competition increases inefficiencies ..................................................................... 215
1.5 Lack of information ................................................................................................................. 215
1.6 Immobility of the factors of production ................................................................................ 215
1.7 Imperfect distribution of income and wealth ....................................................................... 215
1.8 Pareto efficiency ....................................................................................................................... 216
2. Consequences of market failures ................................................................................................... 216
2.1 Dealing with market failure ................................................................................................... 217
2.2 Methods of public sector intervention in market failure .................................................... 217
2.2.1 Dealing with externalities ................................................................................................. 217
2.2.2 Dealing with merit and demerit goods ............................................................................. 217
2.2.3 Providing public goods ..................................................................................................... 217
2.2.4 Dealing with the effects of imperfect competition ............................................................. 218
2.2.5 The problem of lack of information ................................................................................... 218
2.2.6 Distribution of income and wealth ................................................................................... 218
3. Cost–benefit analysis (CBA) ............................................................................................................ 220
Summary ................................................................................................................................................ 224
Term 2 Revision .................................................................................................................................... 225
Topic 9 Economic growth and development .................................................................... 227
1. The demand-side approach ............................................................................................................ 230
viii
• Contents
Contents
1.1 Government expenditure ........................................................................................................ 230
1.2 Redistribution of income ......................................................................................................... 231
1.3 Promoting exports ................................................................................................................... 231
1.4 Import substitution .................................................................................................................. 232
1.5 Keynesian economics ............................................................................................................... 232
2. The supply-side approach ............................................................................................................... 233
2.1 Natural resources ..................................................................................................................... 233
2.2 Labour force .............................................................................................................................. 234
2.3 Capital ........................................................................................................................................ 234
2.4 Entrepreneurs ........................................................................................................................... 235
3. Evaluation of approaches used in South Africa ........................................................................... 236
3.1 The New Growth Path ............................................................................................................. 236
3.1.1 Trade-offs in the New Growth Path .................................................................................. 236
3.1.2 Strategies to ensure adequate demand .............................................................................. 237
3.1.3 Macroeconomic strategy ................................................................................................... 237
3.1.4 Microeconomic programmes ............................................................................................. 237
3.2 Previous plans and strategies aimed at growth and development ................................... 239
3.2.1 The Reconstruction and Development Programme (RDP) .............................................. 239
3.2.2 The Growth, Employment and Redistribution Programme (GEAR) ............................... 239
3.2.3 The Accelerated and Shared Growth Initiative for South Africa Programme (AsgiSA) ... 240
3.3 Evaluation of growth and development in South Africa using different indicators ....... 241
3.3.1 Gross domestic product (GDP) at market prices and at constant prices ........................... 241
3.3.2 Gross domestic product per capita .................................................................................... 242
3.3.3 Distribution of income ...................................................................................................... 243
3.3.4 Standard of living ............................................................................................................. 244
3.4 Comparison with international benchmarks ....................................................................... 244
4. The North–South divide ................................................................................................................. 246
Summary ................................................................................................................................................ 253
Topic 10 Economic growth and development: Industrial development policies ............. 254
1. Industrial development ................................................................................................................... 257
2. Regional development ..................................................................................................................... 259
3. South Africa’s endeavours .............................................................................................................. 262
3.1 Industrial development policy ............................................................................................... 262
3.1.1 The Industrial Policy Action Plan 2 (IPAP 2) .................................................................. 263
3.1.2 The Industrial Development Corporation (IDC) .............................................................. 264
3.2 Regional development policy ................................................................................................. 264
3.2.1 Spatial development initiatives (SDIs) .............................................................................. 264
3.2.2 Industrial development zones (IDZs) ............................................................................... 265
3.2.3 Integrated Sustainable Rural Development Programme (ISRDP) .................................... 266
4. South African strategies .................................................................................................................. 267
4.1 Appropriateness to South Africa ............................................................................................ 267
4.2 Suitability for international best practice .............................................................................. 269
Summary ................................................................................................................................................ 273
Contents
•
ix
Topic 11 Basic concepts and quantitative elements:
Economic and social performance indicators ..................................................... 275
1. The performance of an economy ................................................................................................... 278
2. Economic indicators ........................................................................................................................ 280
2.1 Inflation rate .............................................................................................................................. 280
2.2 Foreign trade ............................................................................................................................. 283
2.2.1 Balance of payments ......................................................................................................... 283
2.2.2 Exchange rates .................................................................................................................. 285
2.2.3 Interest rate differential ..................................................................................................... 286
2.3 Employment .............................................................................................................................. 286
2.4 Productivity .............................................................................................................................. 287
2.5 Interest rates .............................................................................................................................. 290
2.6 Money supply ........................................................................................................................... 292
3. Social indicators ............................................................................................................................... 294
3.1 Demographics ........................................................................................................................... 294
3.2 Health and nutrition ................................................................................................................ 295
3.2.1 Health indicators ............................................................................................................... 296
3.2.2 Nutrition indicators .......................................................................................................... 296
3.3 Education ................................................................................................................................... 297
3.4 Services ...................................................................................................................................... 298
3.5 Housing and urbanisation ...................................................................................................... 300
4. International comparisons .............................................................................................................. 303
Summary ................................................................................................................................................ 310
Topic 12 Economic issues of the day: Inflations ................................................................ 312
1. Definition of inflation ...................................................................................................................... 314
2. Analysis and investigation of inflation ......................................................................................... 315
3. Types of inflation ............................................................................................................................. 318
3.1 Demand-pull inflation ............................................................................................................. 318
3.2 Cost-push inflation ................................................................................................................... 318
3.3 Stagflation .................................................................................................................................. 318
3.4 Hyperinflation .......................................................................................................................... 318
3.5 Deflation .................................................................................................................................... 319
3.6 Core inflation ............................................................................................................................ 319
3.7 Consumer price inflation ........................................................................................................ 319
3.8 Producer price inflation ........................................................................................................... 319
3.9 Administered price inflation .................................................................................................. 319
4. Characteristics of inflation .............................................................................................................. 320
5. Causes of inflation ........................................................................................................................... 321
5.1 Demand-pull inflation ............................................................................................................. 321
5.2 Cost-push inflation ................................................................................................................... 322
6. Consequences of inflation ............................................................................................................... 323
6.1 Distributional effects ............................................................................................................... 323
6.2 Economic effects ....................................................................................................................... 323
6.3 Social and political effects ....................................................................................................... 324
x
• Contents
Contents
7. Inflation problem in South Africa ..................................................................................................
8. Measures to combat inflation .........................................................................................................
8.1 Dealing with demand-pull inflation .....................................................................................
8.2 Dealing with cost-push inflation ............................................................................................
8.3 Inflation targeting ....................................................................................................................
Summary ................................................................................................................................................
324
326
326
326
327
331
Topic 13 Tourism and economic redress: Environmental sustainability ........................... 332
1. Introduction to tourism ................................................................................................................... 334
1.1 Impact of tourism ..................................................................................................................... 334
1.2 Tourism policy .......................................................................................................................... 335
2. Reasons for growth in tourism ...................................................................................................... 336
2.1 Effect of income level and economic growth on tourism ................................................... 336
2.2 Effect of exchange rates and fuel and oil prices ................................................................... 337
2.3 Effect of the internet ................................................................................................................ 337
2.4 Travelling is becoming a necessity ........................................................................................ 337
2.5 The changing national profile of tourists .............................................................................. 337
2.6 Government expenditure on promoting tourism ................................................................ 338
3. Effects of tourism ............................................................................................................................. 338
3.1 Preserving culture and heritage ............................................................................................. 339
3.2 Establishing the character of our society .............................................................................. 339
3.3 Contribution to GDP ................................................................................................................ 339
3.4 Impact on the environment .................................................................................................... 340
3.5 Impact on infrastructure ......................................................................................................... 340
4. Benefits of tourism ........................................................................................................................... 341
4.1 An increase in expenditure and income ............................................................................... 341
4.2 A decrease in unemployment and an increase in capital formation ................................. 341
4.3 Low entry barriers ................................................................................................................... 342
5. South Africa’s profile ....................................................................................................................... 342
5.1 Tourism in South Africa .......................................................................................................... 342
5.1.1 Approach to rural tourism ................................................................................................ 343
5.1.2 Encouraging tourism of all population groups ................................................................. 344
5.1.3 Niche tourism ................................................................................................................... 344
5.1.4 Problems with advancing tourism in South Africa ........................................................... 344
5.2 Indigenous knowledge systems ............................................................................................. 345
5.3 World Heritage Sites ................................................................................................................ 346
6. Policy suggestions ............................................................................................................................ 349
6.1 Policy suggestions .................................................................................................................... 349
6.2 Sustainable Tourism–Eliminating Poverty (ST–EP) ............................................................. 350
6.3 Objectives of tourism policy in South Africa ....................................................................... 351
Summary ................................................................................................................................................ 356
Topic 14 Basic economic problem: Environmental sustainability ..................................... 359
1. The state of the environment .......................................................................................................... 361
1.1 Millennium Development Goal 7: Ensure environmental sustainability ......................... 361
1.2 Climate change and environmental sustainability ............................................................. 362
Contents
•
xi
2. Measures to ensure sustainability ................................................................................................. 366
2.1 Sustaining biodiversity ............................................................................................................ 367
2.2 Climate change policy ............................................................................................................. 368
2.2.1 United Nations Framework Convention on Climate Change (UNFCCC) and the
Kyoto Protocol .................................................................................................................. 369
2.2.2 Adaptation and mitigation ................................................................................................ 369
2.2.3 Policies aimed at decreasing carbon emissions .................................................................. 370
2.2.4 The Clean Development Mechanism ................................................................................ 272
3. Major international agreements ..................................................................................................... 372
3.1 Rio de Janeiro summit ............................................................................................................. 373
3.2 Johannesburg summit ............................................................................................................. 374
3.3 The Rio+20 summit .................................................................................................................. 374
Summary ................................................................................................................................................ 377
Term 3 Revision .................................................................................................................................... 379
Term 4 Revision .................................................................................................................................... 380
Word list ............................................................................................................................. 385
Bibliography ....................................................................................................................... 388
Note to the teacher:
Please refer to the Teacher’s Guide for possible formal assessment tasks, sample tests and exam
papers, as well as their memoranda.
xii
• Contents
Understanding the icons used in this book
Understanding the icons used in this book
What you know already
This is a brief summary of what you have already learnt about this topic in
earlier grades.
ck
Che elf
mys
This will be a short exercise you will do in a group or with your
whole class to discuss the topic and check your prior knowledge.
Word bank A B C
These are new words which appear in the topic. They each have a brief but
clear definition to explain what they mean.
What you still need to know
This includes all the new material as part of the Grade 12 content that you
will learn about in the topic.
Issues
S
This icon will alert you to current economic
issues covered in the topic.
of the day
Understanding the icons used in this book
•
xiii
xiv
Topic
1 Circular flow
Topic 1
What you will learn about in this topic
•
•
•
•
Theopeneconomycircularflowmodel.
Themarkets.
Nationalaccountaggregatesandconversions.
Themultiplier:
– definitionofmultipliereffect
– e xplanationofthemultiplierprocessaidedwitha
circularflowandexamples.
Let’s talk about this topic
• Whyisinvestmentspendingimportantfortheeconomy?
• Whyareexportsimportantforoureconomy?
• H
owdoweknowhowmanygoodsandserviceswe
produceinSouthAfrica?
••
Circular
Circularflow
flow
11
What you know already
Itistheinteractionbetweentheimportantdecision-makers(households,firms,
governmentandtheforeignsector)thatdeterminesthelevelofeconomic
activityinacountry.Theseinteractionstakeplaceinthedifferentmarkets
(goodsmarket,factormarket,financialmarketandforeignexchangemarket).
Achangeinthebehaviourofoneofthedecision-makersimpactsonthe
behaviourofanotherdecision-maker,sowearecollectivelyresponsiblefor
whatishappeningintheeconomy.
Animportantmeasureofthelevelofeconomicactivityandtheeconomic
well-beingofacountryistherealgrossdomesticproduct.
ck
Che elf
mys
1. Whoaretheimportantdecision-makersintheeconomy?
2. Whatarefinalgoodsandservices?
3. Whatismeantbyrealgrossdomesticproduct?
Word bank A B C
Autonomous spendingisspendingthatisnotinfluencedbythelevelof
outputandincome.
Basic prices areusedwhenGDPiscalculatedaccordingtotheproduction
methodandrepresenttheproductioncosts(includingprofits)offirms.
Capital goodsincludeallmanufacturedresources,suchasmachines,
toolsandbuildings,whichareusedintheproductionofothergoodsand
services.
Circular flow modeldescribesthecontinuousflowofspending,
productionandincomebetweenthedifferentsectorsinaneconomy.
Expenditure on gross domestic product isthetotalspendingonthe
goodsandservicesproducedinsidethebordersofacountry.Itincludes
exportsbutexcludesimports,sinceimportsareproducedoutsidethe
bordersofthecountry.
Factor market isthemarketwheretheservicesofthefactorsofproduction
arepurchasedandsold.Thistakesplaceinmanydifferentmarkets.
Thesemarketsarecollectivelycalledthefactormarket.Thefactormarket
includesthelabourmarket,wheretheservicesoflabourareboughtand
sold,andthemarketsforcapitalgoods.Thefactormarketisalsoknown
astheresourcemarket.
Factor pricesarethepricespaidfortheservicesoffactorsofproduction
(labour,capital,landandentrepreneurship)whentheseareexchanged
throughthefactormarket.
Financial marketisthemarketwherebothshort-termandlong-term
financialassetsaretraded.
2
Topic 1
Firmsaredefinedastheunitsthatemployfactorsofproductionto
producegoodsandservicesthataresoldonthegoodsmarket.
Foreign exchange marketisthemarketinwhichonecurrencycanbe
tradedforanothercurrency.Thepriceatwhichonecurrencyistradedfor
anotherinthismarketistheexchangerate.
Foreign sector consistsofallthecountriesintherestoftheworldaswell
asinternationalinstitutionsthatregulatetheflowofgoodsandservices
andtheflowoffundsbetweendifferentcountries.
Goods marketiswheregoodsandservicesareexchangedformoney.
Governmentincludesalllevelsofgovernment(local,provincialand
national)aswellasthedifferentdepartmentsandgovernment-owned
businessenterprises.
Gross domestic expenditure(GDE)isthetotalvalueofspendinginside
thebordersofacountrybythevariouseconomicparticipants(sectors).
Itincludesspendingonimportsbutexcludesspendingonexports,since
spendingonexportsoccursintherestoftheworld.
Gross domestic income(GDI)istheincomereceivedbythefactorsof
productionforproducingthegrossdomesticproduct.
Gross domestic product(GDP)isthetotalvalueofallfinalgoodsand
servicesproducedwithintheboundariesofacountryinaparticular
period(usuallyoneyear).
Householdsaretheownersofthefactorsofproduction.Householdssell
thefactorsofproductiontofirmsandreceiveanincomeinreturn.From
theincometheyreceivetheybuygoodsandservices.Thisisreferredtoas
consumptionspendingbyhouseholds.
Injectionsareanyfactorthatincreasestheflowofincomeandspending.
Examplesofinjectionsareinvestment,governmentspendingandexports.
Leakagesareanyfactorthatdecreasesthecircularflowofincomeand
spending.Examplesofleakagesaresavings,taxesandimports.
Marginal propensity to consume istheproportionofanincreasein
incomethathouseholdsspendonconsumption.
Marginal propensity to saveistheproportionofanincreaseinincome
thathouseholdssave.
Market prices arethepricesthatarepaidforgoodsandservicesinthe
market.Thepricesincludeanyindirecttaxesontheproductsandservices.
Money flowistheflowofmoneybetweenthedifferentsectorsand
throughthedifferentmarkets.Alongsidemoneyflow,intheopposite
direction,istherealflowofgoodsandservices.
Multiplieristheratioofthechangeinincometothechangeinspending.
Behindthemultiplieristheideathatthespendingofonepersonbecomes
theincomeofanotherperson.Itisbecauseofthisinterdependenceof
spendingandincomethatanincreaseinspendingeventuallycauses
productionandincometoincreasebymorethantheinitialincreasein
spending.
Circular flow
•
3
Real flowsarethephysicalsideoftheflowofgoodsandservicesinthe
economy.Alongsidearealflowisamoneyflow,movingintheopposite
directiontotherealflow.
Total income (or aggregate income) istheincomereceivedbytheowners
ofthefactorsofproductionformakingthesefactorsofproduction
availabletofirmstobeusedintheproductionofgoodsandservices.The
mainsourcesofincomearewagesandsalaries,interest,rentandprofits.
Total production (or aggregate production) istheproductionofall
goodsandservicesintheeconomy.Thedeterminationoftheleveloftotal
productionisanimportantissueinmacroeconomics.
Total spending (or aggregate spending)isthespendingbyhouseholds,
firms,thegovernmentandtheforeignsectorondomesticallyproduced
goodsandservices.Theformulafortotalspendingis:
TS=C+I+G+(X–M).
What you still need to know
1. The open economy circular flow model
Acountrythattradeswithothercountrieshasanopeneconomy.Theselinks
betweenacountryandtherestoftheworldhaveacrucialimpactonthe
country’seconomicdevelopmentandthelevelofeconomicactivity.Togeta
betterunderstandingofhowtheselinksimpactonaneconomywewillbuilda
circular flow modelforanopeneconomy.
1.1 The components of an open circular flow model
Anopencircularflowmodelconsistsofdifferentcomponents:
• p
articipants(alsoknownasdecision-makersorsectors)
• m
arkets
• fl
ows(whichareinfluencedbyeconomicleakagesandinjections).
1.1.1 The participants in an open circular flow model
Theparticipantsinanopencircularflowmodelaregroupedintofoursectors
asfollows:
• H
ouseholds–Ahouseholdisanindividualoragroupofpeoplewho
livetogetherandwhomakejointeconomicdecisions.Householdsare
alsotheownersofthefactorsofproduction(land,labour,capitaland
entrepreneurship).Householdsofferthesefactorsofproductiontofirms
inthefactormarket.Firmsthenusethesefactorstoproducegoodsand
services.Householdsreceiveincomefromfirmsinexchangeforthefactors
ofproduction.Thisincomeisintheformofrent,wagesandsalaries,
interestandprofit.Householdsusethisincometobuysgoodsandservices
inthegoodsmarket.
4
Topic 1
• F
irms–Alsocalledbusinessenterprises,theseareentitiesthatusethe
factorsofproduction(labour,capital,landandentrepreneurship)toproduce
goodsorservicestobesoldonthegoodsmarket.Firmsareresponsible
fortheproductionofgoodsandservices,aswellasforinvestinginthe
economy.Firmsneedthefactorsofproductiontoproducegoodsand
services.Firmsbuythesefactorsofproductionfromhouseholdsin
exchangeforincome(intheformofrent,wagesandsalaries,interestand
profit).Asproductionincreases,firmsbuymorefactorsofproductionfrom
households,therebyincreasinghouseholdincome.
• Government–Governmentconsistsofthedifferentlevelsofgovernment
(national,provincialandlocal),thedifferentgovernmentdepartments
(housing,health,education,etc.)andthegovernment-ownedenterprises.
Thegovernmentplaysanimportantroleintheeconomybecauseitsupplies
goodsandservicestohouseholdsandalsotaxeshouseholdsandfirms.
• Foreignsector– Theforeignsectorconsistsofallthecountriesintherestof
theworldaswellasinternationalinstitutionsthatgoverntheflowofgoods
andservicesandtheflowoffundsbetweendifferentcountries.Theforeign
sectorplaysanimportantroleintheeconomybecausethisiswherewebuy
(import)andsell(export)goodsandservicestoandfromforeigncountries.
Important decision makers
Households
Firms
Government
Foreign sector
1.1.2 The markets in an open circular flow model
Therearethreemainmarketsinthecircularflowmodelforanopeneconomy:
• F
actormarket– Theservicesofthefactorsofproduction(labour,capital,
land,entrepreneurship)areexchangedforincome(salariesandwages,
interest,rent,profits)inthefactormarket.Thisisanimportantmarket
becauseitisthemarketwherehouseholdsoffertheirfactorsofproduction
tofirmsandearnincomefromfirmsinexchangeforthesefactors.
• Goodsmarket– Goodsandservicesareboughtandsoldinthegoods
market.Firmsoffertheirgoodsandservicesforsaletohouseholds,other
firmsandtheforeignsectorinthegoodsmarket.Therefore,thisisthe
marketwherefirmsearntheirincome.
• Financialmarket– Thefinancialmarketconsistsofthemoneyandcapital
markets.Surplusfundsaredepositedandloansaremadeinthefinancial
market.Thesavingsintheeconomyflowtothismarket.Decisionsabout
offeringloanstoapplicantsarealsomadeinthismarket.
Circular flow
•
5
Markets
Factor market
Goods market
Financial market
1.1.3 The flows in an open circular flow model
Inthecircularflowmodelwecandistinguishbetweendifferenttypesofflows.
Thethreemajorflowsareasfollows:
• Production flow–Thisistheflowofgoodsandservicesproducedin
theeconomy.Firmsproducegoodsandservicesandthenselltheseto
households,thegovernmentandtheforeignsector.Theproductionflow
beginswhenfirmsproducegoodsandservices,andcontinuesthroughthe
goodsmarketwherethesegoodsandservicesarethensoldinexchangefor
income.
• Income flow–Thisistheflowofincometotheownersofthefactorsof
productionfortheuseofthefactorsofproduction.Thereisaflowofincome
fromfirmstohouseholdsinexchangeforthefactorsofproduction.This
flowtakesplacethroughthefactormarket.
• Spending flow–Thisistheflowofspendingongoodsandservices
bythedifferentparticipants(sectors).Householdsareresponsiblefor
consumerspending,firmsareresponsibleforinvestmentspendingandthe
governmentisresponsibleforgovernmentspending.Theforeignsectoris
responsibleforspendingonexports.
Inacircularflowmodelwecanalsodistinguishbetweenrealflowsand
moneyflows:
• R
eal flows – Thesearetheflowsofphysicalthings,suchasgoodsand
servicesandfactorsofproduction.
• Money flows – Thesearealsoknownasnominalflowsandconsistofthe
flowofmoney.
Flows
Real flows
Money flows
Inthecircularflowmodeltherealflowsandthemoneyflowsareinopposite
directions.
6
Topic 1
Leakages and injections
Itisalsopossibletodistinguishbetweenleakages(withdrawals)and
injectionsinthecircularflowmodel:
• L
eakages – Thesearefactorsthatcauseadeclineintheflowofspending,
incomeandproduction.Asyouwillseelaterinouropeneconomiccircular
flowmodeltheleakagesaresavings(S),taxes(T)andimports(M).These
factorsdecreasetheflowofmoneyandthetotalspendingintheeconomy.
Theleakagesintheeconomyconsistofsavings,taxationandimports.These
leakagesreducetheflowofspendingintheeconomy.
• Injections – Thesearefactorsthatcauseanincreaseintheflowof
spending,incomeandproduction.Inouropeneconomiccircularflow
modeltheinjectionsareinvestment(I),governmentspending(G)and
exports(X).
Leakages and injections
Leakages
Injections
Theinterestingthingtonoticeabouttheseleakagesandinjectionsisthatwhen
thesystemisinequilibriumleakagesareequaltoinjections.Inotherwords,
S+T+M=I+G+X.
1.2 The open economy circular flow model
Theopeneconomycircularflowmodelforanopeneconomyisalsoknown
asthefour-sectormodel.Tobuildthisopencircularflowmodelwewillstart
withatwo-sectormodel(consistingofhouseholdsandfirms),thenbuildon
tocreateathree-sectormodel(addingthegovernmenttothemodel).Finally
wewillarriveatthefour-sectormodel(consistingofhouseholds,firms,
governmentandtheforeignsector).
1.2.1 A two-sector model
Thetwo-sectormodelisalsoknownasacircularflowmodelforaclosed
economywithoutgovernment.Itisatwo-sectormodelbecausethereareonly
twosectors,namelyhouseholdsandfirms.Itisacircularflowmodelbecause
itshowstherelationshipbetweentheincome,spendingandproductionflows
betweenhouseholdsandfirms.Theseflowstakeplacethroughthreemarkets,
namelythefactormarket,thegoodsmarketandthefinancialmarket.
Flows through the factor market
Householdsaretheownersofthefactorsofproduction(land,labour,capital
andentrepreneurship)andtheymakethesefactorsofproductionavailableto
Circular flow
•
7
firmsthroughthefactormarket.Thisrepresentsarealflowfromhouseholdsto
firms.
Firmsthenusethesefactorsofproductiontoproduce
goodsandservices.Inreturnfortheuseofthe
factorsofproductionownedbyhouseholds,firms
payhouseholdsrent,wagesandsalaries,interestand
profits.Thisisamoneyflowfromfirmstohouseholds.
Thismoneyflowalsorepresentstheincomeflowin
ourmodelandisdenotedbythesymbolY.
Factors of production
Factors of production
Income (Y)
Payment for
factors of
production
Factor
market
Income (Y)
Payment for
factors of
production
Households
Firms
Notethattherealflowandthemoneyflowarein
oppositedirections.
Flows through the goods market
Households(H)usetheirincometobuygoodsand
servicesproducedbyfirms(F)onthegoodsmarket.
Thisiscalledconsumptionspendingbyhouseholds
andisdenotedbythesymbolC.Thisspendingflow
byhouseholdsongoodsandservicespresentsa
moneyflowfromhouseholdstothefirms.
Intheoppositedirectionisarealflowofgoodsand
servicesfromfirms,throughthegoodsmarket,to
households.
Spending by
households
Consumption (C)
Flow of goods and services
Savings (S)
Leakage
Financial
market
Spending by
households
Goods
market
Injection
Real flow
Money flow
Figure 1.1 A two-sector model: Circular flow
between households and firms
Inthisparticularcircularflowmodel,thesavingsbyhouseholdsarethen
channelledthroughthefinancialmarkettofirmsintheformofloans.There
isthenamoneyflowfromhouseholdstothefinancialmarketandfromthe
financialmarkettofirms.
Firmsthenusethesefundstofinancetheirinvestmentspending(I).Firmsspend
moneyonbuildingfactoriesandmanufacturingmachines.So,thisinvestment
spendingbyfirmsrepresentsarealflowtothegoodsmarketandamoneyflow
fromthefinancialmarkettofirms.
Leakage and injection
Inthistwo-sectorcircularflowmodel,thereisoneleakageandoneinjection.
Theleakageisthesavingsbyhouseholds,becauseitdecreasesspendinginthe
economy.Investmentistheinjection,becauseitincreasesspendinginthemodel.
Whenthesystemisinequilibriumleakagesareequaltoinjections.Inthismodel
itiswhenS=I.
• Circular flow
Flow of
goods and services
Loans for investment (I)
Flows through the financial market
Households,however,donotspendalltheirincomeongoodsandservices–
theyalsosavepartoftheirincome.Thisiscalledasavingsflow.Itisdenotedby
thesymbolSandrepresentsamoneyflowtothefinancialmarket.
8
Consump
tion (C)
Topic 1
Spending, production and income flows
Inthistwo-sectormodelwecanidentifytheflowoftotal spending(TS),total
production(TP)andtotal income(TI).
Thespendingflowconsistsofthespendingbyhouseholdsandfirms.This
spendingisrepresentedbyconsumptionspendingbyhouseholds(C)and
investmentspendingbyfirms(I).Insymbols,wecanwritetotalspendingas:
TS=C+I
Theproductionflowistheflowofgoodsandservicesproducedbyfirmsto
thegoodsmarket.Itconsistsoftheconsumergoodsandservicesandcapital
goodsproducedbyfirms.Theincomeflowistheflowofincomeintheformof
rent,wagesandsalaries,interestandprofitstohouseholdsfromfirms.
Thesethreeflowstakeplacesimultaneouslyandareequal.Whatisspenton
goodsandservices(TS)isequaltowhatisbeingproduced(TP),whichisequal
towhatispaidoutasincome(TI)tothefactorsofproductionthatwereusedto
producethegoodsandservices.
Production
Income
Spending
Figure 1.2 The three flows: Total spending, total production and total income
Factor
market
Y = 1 000
A numerical example
Anumericalexampleofthedifferentmoneyflowsina
two-sectormodelisgiveninFigure1.3.
Thetotalspendinginthemodelisequalto:
TS=C+I=800+200=1000
Households
Firms
C = 800
S = 200
Financial
market
SinceTS=TP=TI,itfollowsthattotalproductionand
totalincomearealsoequalto1 000.
Y=1000
Giventheconsumption(C)of800andanincome(Y)of
1 000,itfollowsthatthesavings(S)inthemodelis:
S=Y–C=1000–800=200
Goods
market
I = 200
Figure 1.3 A numerical example of the
different money flows
Circular flow
•
9
Savings(S)isaleakageandinvestment(I)isan
injection:
Valueofleakage=savings=S=200
Valueofinjection=investment=I=200
Factors of production
Payment for
factors of
production
Payment for factors
of production
Asyoucanseethereisanequilibriumsince
S=I.
Spending by
households
Consumption (C)
Goods and services
Addinggovernmenttoourcircularflowchangesit
asshowninFigure1.4.
Savings
Financial
market
Firms
Government
Goods and
services
Goods and
services
Byaddingtheimpactofthegovernmenttoour
model,itbecomesathree-sectormodel.
Thegovernmentimpactsthecircularflowthrough
governmentspending(G)andtaxation(T).
Tax on profits
Value–added tax
Goods and
services
1.2.2 A three-sector model
Payment for
factors of
production
Factors of production
Income taxes
Households
Factors of production
Income (Y)
Factor
market
Income (Y)
Payment for goods
and services
Goods
market
Spending by
households
Consumption (C)
Goods and services
Loans for investment (I)
money flow
real flow
Figure 1.4 The government spends on goods
Thegovernmentprovidesgoodsandservicestoboth
and services (G) and collects income taxes (T).
householdsandfirms.Itprovidesuswithroads,dams,
schools,books,hospitals,medicines,lawandorderand
variousothergovernmentservices.
Itisonthegoodsmarketthatthegovernmentbuysgoodsandservices.From
thegovernmenttothegoodsmarketthereisthereforeaflowofmoney(amoney
flow),asthegovernmentpaysforthesegoodsandservices.Andthereisa real
flowasthesegoodsandservicesflowtothegovernment.Asthegovernment
providesthesegoodsandservicestohouseholdsandfirms,thereisarealflow
ofgoodsandservicestohouseholdsandfirms.
Governmentalsobuysfactorsofproduction,mainlylabour(servicesofteachers
andgovernmentofficials),fromhouseholdsonthefactormarket.Thereis
thereforearealflowoffactorsofproductionfromhouseholdstothegovernment
throughthefactormarket.Governmentpaysfortheseservicesandthereis
thereforeamoneyflowfromgovernmenttohouseholdsthroughthefactor
market.
ThisspendingbygovernmentisdenotedbythesymbolG.Thisrepresentsan
injectionintoourcircularflowsinceitispartofthespendingthatisinjectedinto
thesystem.Themorethegovernmentspendsongoodsandservicesandfactors
ofproduction,thehigherthespending,productionandincomeinthesystem.
Tofinanceitsspending,thegovernmentusesdifferentkindsoftaxation,which
isdenotedbythesymbolT.Themainformsoftaxationforgovernmentare
incometaxes,value-addedtax(VAT)andtaxonprofits.
10
Topic 1
Incometaxisataxleviedontheincomeofhouseholdsandhasanimportant
impactontheconsumptionspendingbyhouseholds.Incometaxdecreasesthe
incomeavailabletohouseholds.Theconsumptionspendingbyhouseholds
nowdependsontheirdisposableincome(Yd)thatis,theirincomeafter
payingincometax.Inourcircularflowmodel,somepartofincomepaidto
householdsflowstothegovernmentasamoneyflowintheformofincome
taxes.
Anothertaxpaidbyhouseholdsisvalue-addedtax(VAT).Thistaxispaid
whenhouseholdsspendtheirincomeandthereisthereforeamoneyflowin
theformofvalue-addedtaxfromthehouseholdstothegovernment.
Ataxonprofitsisleviedontheprofitsoffirms.Fromfirmstothegovernment
thereisthereforeamoneyflowintheformoftaxonprofits.
Sincetaxation(T)decreasesthespendingflowintheeconomy,itisregardedas
aleakage.
Whatwecanlearnfromthisthree-sectorcircularflowmodelisthefollowing:
• Thedemandforgoodsandservicesinoureconomyconsistsofthe
spendingbytheparticipantsandisequaltoconsumptionspendingby
householdsplusinvestmentspendingbyfirmsplusgovernmentspending.
Insymbols:
TS=C+I+G
• Thethreeflowsofspending,productionandincomeareequal.
• Therearetwoleakages,namelysavings(S)andtaxation(T).
• Therearetwoinjections,namelyinvestment
spending(I)andgovernmentspending(G).
Y = 1 200
Factor
market
• Inequilibriumleakagesareequaltoinjections.
InotherwordsS+T=I+G.
Income tax = 50
Households
Government
= Y-T
=
= 1 150
Firms
G = 100
C = 900
S = 250
Financial
market
Goods
market
= 200
A numerical example
Figure1.5givesasimplifiednumericalexample
ofthedifferentmoneyflows.Inthisexamplewe
ignorevalue-addedtax,taxonprofitsandthe
buyingoffactorsofproductionbythegovernment.
Thetotalspendinginthemodelisequalto:
TS=C+I+G=900+200+100=1200
SinceTS=TP=TI,itfollowsthattotalproduction
andtotalincomearealsoequalto1200.
Y=1200
Figure 1.5 Numerical example with government
added to the circular flow
Circular flow
•
11
Given an income (Y) of 1 200 and taxes (T) of 50, it follows that:
Yd = Y – T = 1 200 – 50 = 1 150
Given a consumption spending (C) of 900, savings is therefore:
S = Yd – C = 1 150 – 900 = 250
The leakages are savings (S) and taxation (T):
S + T = 250 + 50 = 300
The injections are investment (I) and government spending (G):
I + G = 200 + 100 = 300
1.2.3 The four-sector model (open circular flow)
By adding the foreign sector to our three-sector model we have a circular flow
model of an open economy.
The foreign sector has an important impact on the factor, goods and financial
markets and strong links exist between the foreign sector and the other
participants, namely households, firms and government.
In our circular flow model, we simplify things and
concentrate only on the flow of exports (denoted by
the symbol X) and imports (denoted by the symbol M)
through the goods market.
Factor
market
Y
Y
G
T
T
Government
Households
Firms
G
C
Payments for exports (X)
Financial
Goods
market
Payments for imports (M)
Households, firms and government buy goods and
services from the foreign sector. These goods and
services are called imports. Domestic firms sell goods
and services to the foreign sector. These are called
exports. The foreign exchange market is located in
the financial market and it is on this market that the
exchange rate is determined. There are also flows of
funds between the foreign sector, firms and government
as borrowing and lending takes place.
C
I
Imports
What we can learn from this four-sector circular flow model is the following:
• Thedemandforgoodsandservicesproducedinoureconomyconsistsof
12
• Circular flow
Exports
S
market
From the goods market to the foreign sector there is
therefore a money flow that represents the payment for
imports. In the opposite direction there is a real flow of
the imported goods and services. From the foreign sector
Foreign
money flow
sector
to the goods market there is a money flow of spending
real flow
that represents the payment for exports. In the opposite
direction there is a real flow of the exported goods and Figure 1.6 Circular flow of an open economy
services from the goods market to the foreign sector.
Topic 1
Households
Y d =Y-T
Income tax (T)
=1 130-50
=1 080
50
C = 850
S = 230
Financial
market
the spending by the participants and is equal to consumption spending by
households plus investment spending by firms plus government spending
plus exports minus imports. Imports are subtracted because these are
spending by domestic participants on goods and services we have not
produced. In our model, part of the spending by households, firms and
government is on imported goods and services and this must be subtracted.
In symbols, the total spending on domestic goods is:
TS = C + I + G + (X – M)
• Thethreeflowsofspending(TS),production
(TP) and income (TI) are equal.
Y
1
130
Factor
=
market
• Therearenowthreeleakages,namelysavings
(S), taxation (T) and imports (M). Imports are
aleakagebecausethemorethatisspenton
imports, the less is spent on locally produced
goods and the lower the total spending on
Government
Firms
goods produced domestically.
• Therearethreeinjections,namelyinvestment
(I), government spending (G) and exports (X).
G = 100
Exportsareaninjectionbecausethemorewe
export, the more goods and services we produce
Goods
and the higher the spending, production and
market
income.
•
Inequilibriumleakagesareequaltoinjections.
1 = 200
In other words S + T + M = I + G + X.
A numerical example
Figure 1.7 gives a simplified numerical example of
Foreign
thedifferentmoneyflowsinacircularflowmodel
market
for an open economy. In this example we ignore
value-added tax, tax on profits and the buying of
Figure 1.7 Numerical example of an open economy
factors of production by the government.
M = 120
X = 100
The total spending in the model is equal to:
TS = C + I + G + (X – M)
= 850 + 200 + 100 + (100 – 120)
= 1 130
Since TS = TP = TI, it follows that total production and total income are also
equal to 1 130.
Y = 1 130
Given an income (Y) of 1 130, and taxes (T) of 50, disposable income (Yd) is:
Yd = Y – T
= 1 130 – 50
= 1 080
Circular flow
•
13
Giventheconsumption(C)of850anddisposableincome(Yd)of1 080,it
followsthatthesavingsinthemodelis:
S=Yd–C
=1080–850
=230
Theleakagesaresavings(S),taxation(T)andimports(M):
L
eakages=S+T+M
=230+50+120
=400
Theinjectionsareinvestment(I),governmentspending(G)andexports(X):
Injections=I+G+X
=200+100+100
=400
1.3 From the circular flow model to a theory of the
determination of output
Howthelevelofproductionisdeterminedintheeconomyisanimportant
issueinmacroeconomics.Ourcircularmodelcanhelpustofindthisout.
Inthistopic,weassumethatthedrivingforceofproductionisthetotal
spendingondomesticallyproducedgoods.Thisisbecausespending
determinesproduction,whichinturndeterminesincome,whichinturn
determinesspending,andsoon.Achangeinthelevelofproductionoccursif
thelevelofspendingincreasesordecreases.Anincreaseinspendingcauses
anincreaseinproduction,whileadecreaseinspendingcausesadecreasein
production.
So,tounderstandchangesinthelevelofdomesticproduction,weneedto
understandthechangesinspendingondomesticproduction.
Whenwelookatthedifferentflows,weseethatspendingondomesticgoods
consistsofconsumptionspendingbyhouseholds(C)+investmentspendingby
firms(I)+governmentspending(G)+(exports(X)–imports(M)).Importsare
subtractedbecausethisitemisincludedintheconsumptionandinvestment
figures.
Wecanusethefollowingequationtoexpresstotalspending(TS)on
domesticallyproducedgoodsandservices:
TS=C+I+G+(X–M)
14
Topic 1
Classroom activity 1.1 (21 marks)
1
Identify the different flows a, b, c, d, e, f, g, h and i.
=
c
Factor
market
(9)
a
b = 100
H
G
F
g = 150
Goods
market
e = 350
f = 250
Financial
market
h = 250
i = 300
Foreign
market
2
3
Calculate the missing values for flows d and a in the diagram
in Question 1.
(4)
Identify and calculate the leakages and injections.
(8)
2. Markets
There are three main markets in the circular flow model, namely the:
1. factor market
2. goods market
3. financial market.
2.1 Factor market
The main purpose or role of the factor market in the circular flow model is
to channel the services of the factors of production from the owners of these
factors of production to the firms. The owners of the factors of production are
the households. The factors of production are natural resources, labour, capital
and entrepreneurship. It is through this factor market that households make
the services of the factors of production they own available to firms. Firms then
use these to produce goods and services. The flow represents a real flow.
Circular flow
•
15
Firmspaythehouseholdsfortheuseofthefactorsofproduction.Thereisa
flowofincomeintheformofrent(fornaturalresources),wagesandsalaries(for
labour),interest(forcapital)andprofits(forentrepreneurship).Thisisamoney,or
nominal,flow.
Thepricesofthefactorsofproductionaredeterminedinthismarket.In
microeconomics,thisentailsthestudyofthefactorsthatdeterminethesupplyof
anddemandforthesefactorsofproduction.Forexample,itisthesupplyofand
demandforlabourthatdetermineswagesandsalaries.Behindthissupplyof
anddemandforlabourarefactorssuchasthequantityandqualityoflabour.
Government,throughitspoliciesineducationandtrainingandthroughlabour
lawsandregulations,hasanimportantinfluenceoneventsinthismarket.
Similarly,policiesforthedistributionoflandandtheuseofwaterwillalsohave
animportantinfluenceontherealandmoneyflowsthroughthismarket.
2.2 Goods market
Goodsandservicesareexchangedformoneyinthegoodsmarket.Firmsand
theforeignsectorsupplygoodsandservices(arealflow),andhouseholds,firms,
governmentandtheforeignsectorbuythesegoodsandservices(amoneyflow).
Therearethousandsofdifferentproducersofgoodsandservices,andmillions
ofdifferentconsumersofthesegoodsandservices,intheeconomy.In
macroeconomics,allofthesedifferentmarketsforgoodsandservices,which
includebothproducersandconsumers,aregroupedtogetherundertheheading
of‘thegoodsmarket’.Ineconomics,this‘groupingtogether’iscalledaggregation.
Inmicroeconomics,thesemarketsarestudiedindividually,suchasthemarket
forchicken,themarketforpetrol,themarketformedicalsuppliesandsoon.
Onceagain,thisimpliesthestudyoftheforcesofsupplyanddemandthat
determinethepriceandquantitysuppliedanddemandedofthesegoods.
Inthecircularflowwearemoreinterestedintheaggregateflowofthesegoods
andservicesandthefactorsthatdeterminetheseaggregateflows.Animportant
macrofactorthatdeterminestheflowthroughthismarketisthetotalspending
byhouseholds,firms,governmentandtheforeignsector.
Thespendingbythesesectorsisthemoneyflow,whiletheflowofgoodsand
servicestothesesectorsistherealflow.
Government,throughitstaxationandspendingpolicies,hasanimportant
impactontheflowsthroughthegoodsmarket.If,forinstance,government
increasesitsspending,itincreasesthedemandforgoodsandservicesandmore
goodsandserviceswillflowthroughthismarket.Itcanalsousetaxationto
influencethismarket.Anincreaseintaxationdecreasesthedisposableincome
ofhouseholds,resultinginlowerconsumptionspending,whichdecreasesthe
flowsthroughthismarket.Theuseofspendingandtaxationbygovernmentto
influencetheflowsthroughthegoodsmarketiscalledfiscalpolicy.
16
Topic 1
2.3 Financial market
Inthefinancialmarket,whichconsistsofthemoneyandcapitalmarkets,funds
fromsurplusunitsarechannelledtodeficitunitsinaneconomy.
Surplusunitsarethosehouseholdsandfirmsinaneconomythatdonotspend
alloftheirincome.Theyarealsocalledthesaversinaneconomy.Deficitunits
arethosehouseholds,firmsandthegovernmentinaneconomythatarelooking
formorefunds,forinstancebecausetheyhaveoverspentorbecausetheyneed
moremoneytoinvest.Theyarealsocalledtheborrowersinaneconomy.
Financial sector
Surplus units
Savers
Deficit units
Borrowers
Households
Deposits
Financial
institutions
Firms
Figure 1.8 In the financial market, funds are channelled
via financial institutions from surplus units to deficit
units in the economy.
Households
Loans
Government
Firms
Surplusunitsorsaversdeposittheirsurplusfundswithfinancialinstitutions,
suchasbanks.Theinstitutionsthenusethissurplustolendmoneytodeficit
unitsthatqualifyforcreditoraloan.
Inacircularflowdiagram,savingsisaleakagefromthespendingandincome
flows–householdsaresaving(leaking)ratherthanspending(injecting).But
loanstakenoutbydeficitunitsareaninjection–firmsareexpandingtheir
productioncapabilitiesandthusbuyingmorefactorsofproduction.This
increasestheincomesofhouseholds,whocanthenbuymoregoodsand
servicesfromotherfirms.
Animportantinstitutioninthefinancialmarketisthecentralbankofacountry.
Throughitsregulationsandmonetarypolicy,ithasanimportantimpactonthe
flows.
Inthefinancialmarket,wealsofindtheforeignexchangemarket.Inanopen
economy,foreigncurrenciesareneededtofinancetransactionsbetweencountries.
Itisontheforeignexchangemarketthatonecurrencycanbeexchangedforother
currencies.Pulasareexchangedforrands,randsfordollars,dollarsforeuros,
Circular flow
•
17
eurosforyen,yenforroubles,andsoon.Itisthroughtheforcesofsupplyand
demandthattheexchangeratefortherandisthendeterminedinthismarket.
Classroom activity 1.2 (12 marks)
Identifytherealflowsandthemoneyflowsthroughthefactormarket,the
goodsmarketandthefinancialmarket.
Market
Factormarket
Goodsmarket
Financialmarket
Money flow
Real flow
3. National account aggregates and conversions
Households,firmsandgovernmentneedaccurateandup-to-dateinformation
tomakeinformeddecisions.Animportantsourceofinformationisournational
incomeaccounts.StatisticsSouthAfricaandtheSouthAfricanReserveBank
areresponsibleforcompilingournationalincomeaccounts,whichcoverawide
rangeofareas.Inthissection,wewilllookatsomeoftheimportantmeasures,
suchasgross domestic product,gross domestic expenditureandgross
domestic income.
3.1 Gross domestic product (GDP)
Youhavealreadylearntaboutthegrossdomesticproduct(GDP)inGrades10and
11.TheGDPisthemostimportantconceptinournationalaccounts.Itisthetotal
marketvalueofallfinalgoodsandservicesproducedwithintheboundariesof
acountryinaparticularperiod(usuallyayear).TheGDPprovidesameasureof
thelevelofproductioninaneconomyandofeconomicgrowth.Itisarelatively
simpleconcepttounderstandbutacomplexonetocalculate.
Hereisasummaryoftheimportantthingstotakenoteofwhenyoudealwith
thegrossdomesticproductofacountry:
• GDPisagrossmeasurement,becauseitincludesthetotalamountofgoods
andservicesproduced.Themeasurementincludesgoodsthatreplacegoods
thathavedepreciatedorhavewornout.
• G
DPmeasuresthegoodsandservicesproducedinsidethebordersofa
countrybybothitscitizensandforeigners.So,itreflectsthelevelofeconomic
activitythatistakingplaceinthecountry.
• G
DPincludesonlyfinalgoodsandservices.
• GDPmeasurestheproductionofnewgoodsandservices(alsocalledcurrent
production)duringaspecifiedperiod.Itisanannualflow,asitmeasures
thevalueofgoodsandservicesproducedoverayear.AGDPofR60billion
impliesthattheSouthAfricaneconomyproducedR60billionworthoffinal
goodsandservicesduringaspecificyear.
18
Topic 1
• T
otalvalueismeasuredbyexpressingthevalueofproductioninterms
ofthepricesofthevariousgoodsandservices.GDPisusuallyvaluedat
market prices,butitisalsopossibletovalueGDPbyusingbasic pricesor
factor prices(alsocalledfactorincome).
• RealGDP,orGDPatconstantprices,isameasureofGDPinwhichthe
quantitiesproducedarevaluedatthepricesinabaseyearratherthanat
currentprices.Thisisdonetotaketheeffectofinflationintoaccount.Real
GDPmeasurestheactualphysicalvolumeofproduction.
3.2 Gross domestic expenditure (GDE)
Grossdomesticexpenditure(GDE)isthetotalvalueofspendingonfinal
goodsandserviceswithinthebordersofacountry.GDEinvolvesspendingby
households,firmsandgovernmentongoodsandservices.
Partofthespendingbyhouseholds,firmsandgovernmentwithintheborders
ofacountryisongoodsandservicesthatareimportedfromtherestofthe
world(suchascomputersandDVDplayers).So,figuresforGDEinclude
spendingonimports.
SpendingonexportsareexcludedfromthefiguresforGDEbecauseexports
representexpenditurethatoccursoutsideofthebordersofthecountry.
Grossdomesticexpenditureisdividedintothefollowingthreeexpenditure
components:
• finalconsumptionexpenditurebyhouseholds(C)
• grossfixedcapitalformation(I)
• consumptionexpenditurebygeneralgovernment(G).
Grossdomesticexpenditure(GDE)=C+I+G
3.3 Gross domestic income (GDI)
Grossdomesticincome(GDI)measurestheincomeearnedbythefactorsof
productionintheproductionoftheGDPofacountry.Itincludesincomesuch
asrent,wagesandsalaries,interestandprofits.Thisfigureiscalculatedby
usingtheincomemethodformeasuringgrossdomesticproduct.
Grossdomesticincomediffersfromgrossnationalincomebecauseitmeasures
whatishappeningtotheincomeandlivingstandardsofallthepeople(both
citizensandforeigners)withinthebordersofacountry.
3.4 Measuring gross domestic product
LookatFigure1.9.ThethreewaysinwhichGDPcanbemeasuredare:
• incomemethod
• productionmethod
• expendituremethod.
Circular flow
•
19
Factor market
Factors of production
Income
Income
method uses
factor prices
Firms
Households
Goods market
Expenditure
method uses
market prices
Spending on goods and services
Supply of goods and services
Production
method uses
basic prices
Figure 1.9 Different methods of calculating gross domestic product
Theincome,productionandexpendituremethodsofcalculatingthegross
domesticproductwillonlygivethesameresultifthepricesthatareusedinthe
calculationsarethesame.
Therearethreesetsofpricesintheworld.Thesepricesdiffermainlybecauseof
taxesandsubsidies.Thesedifferentpricesare:
• f actorprices
• b
asicprices
• m
arketprices.
3.4.1 Factor prices to basic prices
FactorpricestobasicpricesareusedwhenGDPiscalculatedaccordingtofactor
cost.Inthenationalaccounts,itconsistsofcompensationofemployees,net
operatingsurplusandconsumptionoffixedcapital(depreciationofthevalueof
fixedassets).Byaddingthesethreeitemswegetthefigureforgrossvalueaddedat
factorcost.
Measuringoutputintermsoffactorcostdiffersfromusingtheproduction
approachbecauseoftaxesandsubsidies.Taxesthatarepaidbyproducers(suchas
payrolltaxesandassessmentrates)andsubsidiesthatarepaidtofirms(suchasa
payrolloremploymentsubsidy)arenotreflectedinthefactorprices.Toensurethat
GDPaccordingtofactorcostisinlinewithGDPaccordingtoproduction,these
20
Topic 1
taxesmustbeaddedandsubsidiessubtracted.Thisgivesusgrossvalueadded
atbasicprices.
LookatTable1.1.Thistableshowsthecalculationsthatappearinthenational
accounts.
Table 1.1
Compensationofemployees
Netoperatingsurplus
Consumptionoffixedcapital
Gross value added at factor cost
Othertaxesonproduction
Less:Othersubsidiesonproduction
Gross value added at basic prices
Taxesonproducts
Less:Subsidiesonproducts
Gross domestic product at market prices
R millions 2010
1 201 990
821783
350982
2 374 755
46213
8478
2 412 490
263988
15044
2 661 434
(Source:SouthAfricanReserveBank.(2012).Quarterly Bulletin,March.)
3.4.2 Basic prices to market prices
Basicpricestomarketpricesareusedwhenthegrossdomesticproductis
calculatedaccordingtotheproductionapproach.Thebasicpriceofaproduct,
however,differsfromthepricetheuserpaysforit(themarketprice)ifthereisa
taxorsubsidyontheproduct.
Ataxontheproductwillcausethemarketpricetobehigherthanthebasic
price.Forexample,VATonaproductsuchasacanofcolddrinkimpliesthatthe
priceyoupayforthecolddrinkishigherthanthebasicpriceofthecolddrink.
Accordingtotheaccountsoftheproducer,thebasicpriceofthecanofcold
drink(includingtheprofitonit)mightbeR6,00whilethemarketprice,which
includestheVAT,isR6,84.So,thefigureforGDPatmarketpriceswillbehigher
thanthefigureforGDPatbasicprices.Taxesonproductsmustthereforebe
addedtobasicpricestoreachmarketprices.Seethecalculationsinthenational
accountsinTable1.1.
Subsidiesthatarepaidonproductscausethebasicpricetobehigherthanthe
marketprice.Asubsidypaidbygovernmentonaloafofbreadmeansthatthe
consumerpaysapricethatislowerthanthebasicpriceintheaccountsofthe
producers.IfthebasicpriceofbreadisR7andthegovernmentsubsidisesthis
breadby50cents,themarketpriceisR6,50.So,thefigureforGDPatmarket
priceswillbelowerthanthefigureforGDPatbasicprices.Subsidiesona
productmustthereforebesubtractedfromGDPatbasicpricestobringthemin
linewithmarketprices.SeethecalculationsinthenationalaccountsinTable1.1.
Circular flow
•
21
3.5 Expenditure method
Theexpendituremethodusesmarketpricesandthespendingbythedifferent
sectors(households,firms,governmentandtheforeignsector)tocalculategross
domesticproductatmarketprices.
Finalconsumptionexpenditurebyhouseholds
Finalconsumptionexpenditurebygeneralgovernment
Grosscapitalformation
Residualitem
Gross domestic expenditure
Exportsofgoodsandservices
Less:Importsofgoodsandservices
Expenditure on gross domestic product (GDP at market prices)
Primaryincomefromtherestoftheworld
Less:Primaryincometotherestoftheworld
Gross national income at market prices
R millions 2010
1575930
573470
517009
298
2 666 707
727721
732994
2 661 434
34099
87022
2 608 511
Thesefiguresthenreflecttotalspendingondomesticgoods:
TS=C+I+G+(X–M)
3.5.1 National and domestic figures
Whiledomesticfigurestelluswhatishappeninginsidethebordersofacountry,
nationalfiguresgiveusinformationaboutthepositionofthecitizensofacountry,
nomatterwheretheyareintheworld.
Nationalfiguresareimportantifwewanttoknowwhatishappeningtothe
economicwelfareofourcitizens.
• Gross domestic product(GDP)isthemeasureofthevalueoftheproduction
thatistakingplacewithinthebordersofacountry.
• Gross national product(GNP)isthemeasureofthevalueofgoodsand
servicesproducedbythecitizensofacountry.
Whilethesetwomeasuresareverysimilar,thereisanimportantdistinction.
TheGDPgivesusameasureofwhathappenstophysicalproductionwithina
country,nomatterwhoproducesit.Forexample,Zimbabweans,Germans,and
AmericanswhoarelivingandworkinginSouthAfricaalsocontributetowards
SouthAfrica’sGDP.
Grossnationalproduct(GNP)tellsussomethingaboutthevalueofthegoodsand
servicesproducedbythecitizensofacountry,regardlessofwhereintheworld
theproductionhappens.Grossnationalincome(GNI)givesusameasureofthe
incomeearnedbySouthAfricancitizensinSouthAfricaandelsewhereinthe
worldfromtheownershipofthefactorsofproduction.
22
(Source:SouthAfricanReserveBank.(2012).
Quarterly Bulletin,March)
Table 1.2
Topic 1
Tomovefromgrossdomesticproducttogrossnationalincome,wemust:
• subtractincomeearnedbyforeign-ownedfactorsofproduction
• addallincomeearnedbyfactorsofproductionownedbySouthAfricain
therestoftheworld.
Inthenationalaccounts,thisisdoneasfollows:
Table 1.3
Expenditure on gross domestic product (GDP at market prices)
Primaryincomefromtherestoftheworld
Less:Primaryincometotherestoftheworld
Gross national income at market prices
2 661 434
34099
87022
2 608 511
3.5.2 Net figures
ThefiguresinTable1.3aregrossfigures.Thedifferencebetweengrossfigures
andnetfiguresisthatinnetfigures,wemakeprovisionfordepreciation.
Depreciationreflectsthewearandtearofcapitalgoods.Anadjustmentismade
togrossfiguresforthedecreaseinthevalueofcapitalgoodsthatneedtobe
replaced.Thisgivesusamorerealisticpictureoftheeconomicperformanceof
thecountry.
Classroom activity 1.3 (9 marks)
1 2 hoosethecorrectanswerinbracketstomakethestatement
C
true:TheGDPatmarketpricesisequaltotheGDPatbasic
prices(plus subsidies minus taxes on products/minus taxes plus
subsidies on products).
(2)
tudythefollowingtableofthenationalaccountsof
S
SouthAfricaandanswerthequestions:
Compensationofemployees
Netoperatingsurplus
Consumptionoffixedcapital
Gross value added at ____(a)____
Othertaxesonproduction
Less:Othersubsidiesonproduction
Gross value added at ____(b)____
Taxesonproducts
Less:Subsidiesonproducts
Gross domestic product at ____(c)____
R millions 2009
1 077833
731204
332584
2 141 621
42101
9210
2 174 512
238557
14914
2 398 155
(Source:SouthAfricanReserveBank.(2012).Quarterly Bulletin,March)
Circular flow
•
23
a) Providethemissingwordsfora,bandc.
b) UsethefiguresinthetabletocalculatetheGNIatmarket
pricesifthefactorpaymentsfromtherestoftheworldwere
R34075millionandthefactorpaymentstotherestofthe
worldwereR87 593million.
(3)
(4)
4. The multiplier
4.1 Defining the multiplier effect
Themultiplieristheprocesswherebyaninitialchangeinspendingchanges
thelevelofoutputandincomebymorethantheinitialchangeinspending.
Behindthemultiplieristheprocesswherebyoneperson’sspendingbecomes
anotherperson’sincome.Thisincomethenbecomesthatperson’sspending,
whichbecomessomeoneelse’sincome,andsoon.
Spending
Income
Spending
Income
Figure 1.10 The multiplier: Spending turns into income turns into spending turns into income
If,forexample,ABManufacturersbuildsanewclothingfactoryinatown(in
economicswerefertothisasinvestmentspending)somehouseholdsliving
inthetownwillsupplythefirmwithlabourtobuildthefactory.Inreturn
fortheirlabour,thehouseholdswillreceivewagesandsalaries.Partofthe
investmentspendingbyABManufacturersisnowtheincomeofhouseholds.
Thesehouseholdsthenusesomeofthisincometobuygoodsandservices
fromTJStores.TheirspendingisnowtheincomeofTJStores.TJStoresthen
usethisincometobuyvegetablesfromthevegetablefarmers.Theirspending
isnowtheincomeofthevegetablefarmers.Duetothehigherdemandfor
vegetables,farmersemploymorelabourtoworkonthefarmsandmore
householdsreceiveanincome.Thisincreaseinincomethenleadstomore
spending.
Someoftheincreasedincomethathouseholdsreceivemightgotowards
spendingontaxifarestogettothefactorybuildingsiteandthevegetable
24
Topic 1
plots.Thisspendingbecomestheincomeoftaxiownersand,becausethereis
ahigherdemandfortaxitransport,taxiownerswillemploymoredriverswho
arepaidfortheirservices.Morehouseholdsinthetownarenowemployed.
Whatthisexampledemonstratesishowaninitialincreaseinspending–
buildingafactory–leadstoamultipliereffectonoutputandincomeinthis
town.TheincomenotonlyofhouseholdswhosupplyABManufacturers
withlabourhasincreased,butalsotheincomeoftheshopkeepers,vegetable
farmers,taxiownersandthehouseholdsthatthesebusinessesemploy.
4.2 The multiplier in the circular flow model
Wecanusethecircularflowmodeltodemonstratetheworkingofthe
multiplierinaneconomy.Forthispurpose,wewilluseatwo-sectormodel
consistingofhouseholdsandfirms.
Income, Y = 512
Income, Y = 640
Income, Y = 800
Income, Y = 1 000
cY
Households
0,8
128 160 200
Firms
Consumption, C = 800
Consumption, C = 640
Consumntion C = 512
Savings (S)
0,2
I = R1 000
Figure 1.11 The multiplier process
Themultiplierprocessstartswithaninjectionintothespendingflow.In
Figure1.11,thisisduetoanincreaseininvestmentspending.Intheopen
circularflowmodel,thiscanbetheresultofanincreaseinanyofthe
injections,namelyinvestmentspending,governmentspendingorexports.
Let’sassumethatdomesticfirmsincreasetheirinvestmentspendingbyR1000.
TheydothisbyorderingcapitalgoodstothevalueofR1 000fromdomestic
firmsthatspecialiseintheproductionofcapitalgoods.Inthiscase,weassume
therearenocapitalimports.
Circular flow
•
25
OurtotalspendingintheeconomyhasincreasedbyR1000.Totalproduction
hasincreasedbyR1000(becausethecapitalgoodsorderedbyfirmswere
producedbyfirms),whichalsoleadstoanincreaseofR1000inincome.Note
thattheincreaseinspendingisequaltotheincreaseinproduction,whichis
equaltotheincreaseinincome.
HouseholdsthenusethisincreaseofR1 000inincometoincreasetheir
consumptionspending(C).Households,however,donotincreasetheir
consumptionspendingbythewholeamount–theysavesomepartofit.
Assumingthathouseholdssave20%oftheirincome,outofanincreasein
incomeofR1 000theywillsaveR200andincreasetheirconsumptionspending
byR800.So,theincreaseinconsumptionspendingis80%oftheincreasein
income.
Ineconomics,werefertothe20%asthemarginal propensity to save(denoted
byalowercases)andthe80%asthemarginal propensity to consume
(denotedbyalowercasec).
What do you think domestic firms are going to do if households spend R800 more on
domestic consumer goods?Theywillincreasetheirproductionequaltothevalue
ofR800.Astheyproducemore,theyemploymorefactorsofproductionand
theincomeofhouseholdsincreasesbyR800.
ItisimportanttorealisethatfromaninitialincreaseinspendingofR1 000,
totalspending,totalproductionandtotalincomehaveincreasedbyR1 000(the
initialspending)+R800(increaseinconsumptionspending)=R1 800.Thisis
themultiplierprocessinaction.
Theprocessdoesnotstophere.TheincreaseofR800inincomeleadstoa
furtherincreaseinconsumptionspendingof80%×R800=R640.Thisincrease
inconsumptionspendingofR640leadstoafurtherincreaseinproductionand
incomeofR640.Theincreaseintotalspending,productionandincomeisnow
R2440andismadeupasfollows:
R 1000 (theinitialspending)
+ R 800 (increaseinconsumptionspendinginthefirstround)
+ R 640 (increaseinconsumptionspendinginthesecondround)
R 2440
Andtheprocesscontinues.Inthethirdround,theincreaseinincomeof
R640leadstoafurtherincreaseof80%×R640=R512inconsumption
spending.Thisincreaseinconsumptionspendingincreasestotalspending,
totalproductionandtotalincomebyR512.Theincreaseintotalspending,
productionandincomeisnowR2952andismadeupasfollows:
26
Topic 1
R 1000
+ R 800
+ R 640
+ R 512
R 2952
(theinitialspending)
(increaseinconsumptionspendinginthefirstround)
(increaseinconsumptionspendinginthesecondround)
(increaseinconsumptionspendinginthethirdround)
Andtheprocesscontinues,butnotindefinitely,duetotheleakagethat
occurs.Inthiscase,theleakagethatoccursisthesavingsbyhouseholds.
Duetothesavingsbyhouseholds,thesubsequentincreaseintotalspending
becomessmallereachtime.TheprocessstartedoffwithanincreaseofR1
000ininvestmentspending,followedbyanincreaseofR800inconsumption
spending,whichwasfollowedbyanincreaseofR640andthenanincreaseof
R512.Aftereveryround,theincreaseintotalspendingbecomesless.
Itispossibletocalculatetheincreaseinspending,productionandincomethat
takesplaceifaninjectionoccursintheeconomy.Inotherwords,itispossible
tocalculatethevalueofthemultiplier.
Whatwehavehereisageometricseries:
1000+(0,8×1000)+0,8×(0,8×1000)+0,8×(0,8×0,8×1000)+...
Theformulaforthesumofthisgeometricseriesis: 1 =5whichgivesus
1–0,8
thevalueofthemultiplier.
Thefigure0,8inourexampleisthemarginalpropensitytoconsume(c),sowe
canwritetheformulaforthevalueofthemultiplieras 1 .
1–c
1
Inourexample,thevalueofthemultiplieristherefore 1–0,8 =5.What
thisvaluetellsusisthatiftheincreaseininitialspendingisR1,thentotal
spending,totaloutputandtotalincomewilleventuallyincreasebyR5.Inour
example,theinitialincreaseofR1 000willeventuallyleadtoanincreaseof
R5 000intotaloutput,spendingandincome.
Anotherwaytoconsiderthevalueofthemultiplieristolookattheleakage
thatoccurs.Itisclearfromthemodelthatthereasonwhythemultiplierdoes
notcontinueindefinitelyistheleakageintheformofsavings.Thisleakageis
capturedbythemarginalpropensitytosave(s),andinourexampleitis20%,
ors=0,2.So,thevalueofthemultipliercanbewrittenas:
1
leakagerate
1
= 1s = 0,2
=5
Fromthis,wecanalsoconcludethatthehighertheleakagerate(orthemore
leakagesthereareintheeconomy),thelowerthemultiplierandthesmallerthe
impactofaninitialchangeinspendingonthelevelofoutputandincome.
Circular flow
•
27
Table1.4comparestwoscenarios.
Scenario 1: Marginalpropensitytosave=s=20%=0,2
Marginalpropensitytoconsume=c=80%=0,8
Scenario 2: M
arginalpropensitytosave=s=40%=0,4
Marginalpropensitytoconsume=c=60%=0,6
Table 1.4 A comparison of two multiplier scenarios
Scenario 1
Scenario 2
R 1000
+ R 800
R 1800
R 1000
+ R 600
R 1600
Scenario 1
Scenario 2
Second round
+ R 640
R 2440
+ R 360
R 1960
Third round
+ R 512
R 2952
+ R 216
R 2176
1
= 1 =5
1–c 1–0,8
1
= 1 =2,5
1–c 1–0,6
1
= 1 =5
s
0,2
1
= 1 =2,5
s
0,4
First round
Value of the multiplier
or
Final change
or
5×R1000=R5000 2,5×R1000=R2500
Whatthescenariosshowisthatthehighertheleakage,thelowerthevalueof
themultiplierandthesmallertheimpactofaninitialchangeinspendingon
outputandincome.
4.3 The multiplier in a model with a government sector
Whenagovernmentsectorisaddedtothecircularflowmodel,moreleakages
andinjectionsoccur.
• T
heleakagesaresavings(S)andtaxation(T).
• T
heinjectionsareinvestmentspending(I)andgovernmentspending(G).
Theimpactoftheadditionalleakage(taxation)tothemodelisthatitlowersthe
valueofthemultiplier.Figure1.12demonstratesthereasonforthis.
TheinitialincreaseininvestmentspendingofR1 000increasestheincome
ofhouseholdsbyR1 000.Beforethehouseholdscanspendthisincreasein
incomeonconsumption,theymustfirstpaytheirincometaxes.Assuming
thatthetaxrate(t)is10%oftheirincome,theymustpayR100togovernment,
whichleavesthemwithanincreaseindisposableincomeofR900.Assuming
28
Topic 1
furtherthattheirmarginalpropensitytoconsumeis0,8,theywillincrease
theirconsumptionspendingby0,8×900=R720,whichislessthaninthecase
wheretherewasnotaxation.
Disposable income = 900
cY
10% tax= 100
0,8
Households
Government
Firms
180
Consumption, (C) = 720
Savings 20%
I = R1 000
Figure 1.12 Taxation and the multiplier
Thevalueofthemultiplierisnow:
1
1
1–c(l–t)
=
=3,6
1–0,8(1–0,1)
Taxationdecreasesthevalueofthemultiplierandaninitialchangein
spendingwillhaveasmallerimpactonthelevelofoutputandincome.For
everyR1increaseinadditionalspending,outputandincomeincreasebyR3,60.
4.4 The multiplier in an open economy
Whenaforeignsectorisaddedtothecircularflowmodel,thenumberof
leakagesandinjectionsincreases.
• Theleakagesaresavings(S),taxation(T)andimports(M).
• Theinjectionsareinvestment(I),governmentspending(G)andexports(X).
Theimpactoftheadditionalleakageimports(marginalpropensitytoimport
(m))tothemodelisthatitlowersthevalueofthemultiplier.
1
Thevalueofthemultiplierisnow: 1–c(l–t)
+m
Giventhefollowingvalues:
Marginalpropensitytoconsume(c)=0,8
Taxrate(t)=0,1
Marginalpropensitytoimport(m)=0,2
1
Thevalueofthemultiplieris: 1–0,8(l–0,1)
+0,2=3,8
ForeveryR1increaseinadditionalspending,outputandincomeincreaseby
R3,80.
Circular flow
•
29
4.5 The multiplier effect in a graph
Themultipliereffectcanalsobedemonstratedusingagraph.InFigure1.13,
thelevelofoutputandincomeintheeconomyismeasuredonthehorizontal
axis.Ontheverticalaxiswemeasurethetotalspendingintheeconomy.
TheverticalinterceptofthetotalspendingcurveTS1representsourinitial
spendingintheeconomy,calledautonomous spending.Autonomous
spendingismadeupofthespendingintheeconomythatisnotinfluenced
bythelevelofoutputandincome.Inathree-sectormodelitconsistsof
autonomousspendingbyhouseholds,autonomousinvestmentspendingby
firmsandautonomousgovernmentspending.
Thistotalspendingcurveslopesupwards,indicatingthatasthelevelof
productionandincomeincreases,householdsincreasetheirconsumption
spending,whichincreasestotalspendingintheeconomy.So,theslopeof
thislinecapturesthebehaviourofhouseholdstoincreasetheirconsumption
spendingastheirincomeincreases.Theslopethereforeindicatesthemarginal
propensitytoconsume(c).
TS
Todemonstratetheimpactofthemultiplier,westartwitha
giventotalspendingcurve(TS1).Giventhistotalspending
curve,thereisacorrespondinglevelofoutputandincome,Y1.
Anincreaseinautonomousspending,forinstanceanincrease
ininvestmentspendingorgovernmentspending,willshift
thecurveupwards,equaltotheincreaseinautonomous
spending.Forexample,ifinvestmentspendingincreasesby
R1 000,thecurveshiftsupwardsbyR1000.Wethenhavea
newtotalspendingcurve(TS2)andanewlevelofincomeand
output,Y2.
1
1 000
5 000
0
45°
Y1
Y2
Output and income
Figure 1.13 The multiplier
IfinvestmentspendingincreasesbyR1 000,theupwardsshiftisequalto
R1 000.Givenamarginalpropensitytoconsumeof0,8,theincreaseinthelevel
ofoutputandincomeonthehorizontalaxisisequaltothemultiplier:
=5×R1000
=R5000
30
TS 1
0,8
1
Themultipliereffectisdemonstratedbycomparingthechangeinautonomous
spending–theupwardsshiftontheverticalaxis–withthechangeinoutput
andincome–thechangeonthehorizontalaxis.Fromthiscomparison,wecan
seethattheverticalupwardsshiftissmallerthanthechangeonthehorizontal
axisfromY1toY2.Thisdemonstratesthatanincreaseinautonomousspending
hasamultiplierimpactonthelevelofoutputandincome.
1
1
(1–c
)×increaseininvestmentspending=( 1–0,8
)×R1000
TS 2
0,8
Y
Topic 1
Whatthismultiplierdemonstratesisthatitispossibletousefiscalpolicyin
theformofanincreaseingovernmentspendingtoincreasethelevelofoutput
andincomeintheeconomy.Anincreaseingovernmentspending,whichisan
injection,willhaveamultipliereffectonthelevelofoutputandincome.The
sameistrueforanincreaseinexports.So,wecanconcludethataninjection
willhaveamultipliereffectonthelevelofoutputandincome.
Classroom activity 1.4 (14 marks)
1 I llustratetheimpactofthemultiplierbyaddingthemissing
valuesinthefollowingcircularflowmodel:
(10)
Income , Y =
Income , Y =
Income , Y =
Income , Y =
cY
Households
0,8
Firms
Consumption, C =
Consumption. C =
Consumption, C =
I = R2 000
Savings (S)
s = 0,2
2 sethefollowingdiagramtoshowthemultipliereffectin
U
Question1:
(4)
TS
1
0
45°
Y1
TS
c = 0,8
Y
Output and income
Circular flow
•
31
Issues
Householdsareimportantdecision-makersintheeconomy.Thewaythey
behavewillhaveanimportantimpactontheeconomy,sotheirbehaviouris
closelymonitored.
ThefollowingisanextractfromtheAnnualEconomicReportof2011bythe
SouthAfricanReserveBank.
‘Fromanaggregatedemandperspective,themajordrivingforcebehind
therecoveryhasbeenfinalconsumptionexpenditurebyhouseholds.Real
spendingbyhouseholdscamefromalowbase,havingcontracteduptothe
middleof2009,buthassincerisenatannualisedratesofaround5percent.
Therecoveryinhouseholds’expenditurewasespeciallystronginthearea
ofdurablegoodssuchasmotorvehicles.Whilelowerinterestrateshave
givenindebtedconsumersareprieve,risingrealdisposableincomehas
beendrivingtheexpenditure,asopposedtoarapidincreaseindebtlevels.
Householddebthasbeenrisingmoderatelybutdisposableincomehas
beenincreasingmoreforcefully,resultinginadeclininghouseholddebt
ratio.Whilethedebtratioremainshigh,itsdownwardtrendsuggestsmore
sustainablebehavioursofarinthecurrentphaseofeconomicexpansion.
(Source:SouthAfricanReserveBank.(2011).Annual Economic Report. Availablefrom:http://
www.resbank.co.za/Lists/News%20and%20Publications/Attachments/4688/AER%202011.
pdf(Accessed:1August2012).)
Homework activity 1 (97 marks)
32
1 Indicatewhetherthefollowingstatementsaretrueorfalse:
a) Thefoursectorsthatinfluencetheopencircularflowofproduction,
incomeandspendingarethefactormarket,thegoodsmarket,the
financialmarketandtheforeignexchangemarket.
b) Inthefactormarket,fundsfromsurplusunitsarechannelledto
deficitunits.
c) Anincreaseintheflowofgoodsandservicesfromfirmsto
householdsalsoimpliesanincreaseintheflowofspendingon
goodsandservicesfromhouseholdstofirms.
d) Anincreaseininjectionsincreasestheflowofspending,production
andincome.
e) Thegrossdomesticproductprovidesameasureofthetotalvalueof
finalgoodsandservicesthatareconsumedwithinthebordersofa
country.
f) IftherealGDPofacountryincreasesitmeansthatthecountry
producesmoregoodsandservices.
g) Grossdomesticexpenditureincludesthespendingonimported
goodsandservices.
h) Expenditureongrossdomesticproductexcludesexportsand
includesimports.
S
of the day
Topic 1
i) Value-addedtaxcausesbasicpricestobehigherthanmarket
prices.
(9)
2 nswerthefollowingquestions:
A
a) Giventhefollowingvalues,constructacircularflowmodelof
production,incomeandspendingforanopeneconomy:
Totalproduction=1000 000
Incometaxes=200000
Savings=100 000
Imports=250000
Governmentspending=150 000
Investmentspending=200 000
Exports=200000 (14)
b) Identifyandcalculatetheleakagesandtheinjections.
(8)
3 Studythefollowingtableandanswerthequestions:
Compensationofemployees
Netoperatingsurplus
Consumptionoffixedcapital
Gross value added at factor cost
Othertaxesonproduction
Less:Othersubsidiesonproduction
Gross value added at basic prices
Taxesonproducts
Less:Subsidiesonproducts
Gross domestic product at market prices
Finalconsumptionexpenditurebyhouseholds
Finalconsumptionexpenditurebygeneralgovernment
Gross capital formation
Residualitem
Gross domestic expenditure
Exportsofgoodsandservices
Expenditure on gross domestic product
(GDP at market prices)
Primaryincomefromtherestoftheworld
Less:Primaryincometotherestoftheworld
Gross national income at market prices
Less:Importsofgoodsandservices
2009
R millions
1 077833
731204
332584
2 141 621
42101
9210
2 174 512
238557
14914
2 398 155
1 460 911
502492
470 963
–15095
2 419 271
657192
2 398 155
34075
87593
2 344 637
678308
(Source:SouthAfricanReserveBank.(2012).Quarterly Bulletin,March)
Circular flow
•
33
a) Whatisthedifferencebetweengrossdomesticexpenditureand
expenditureongrossdomesticproduct?
b) Whatismeantbygrosscapitalformation?
c) In2009householdsreceivedR_______fortheprovisionof
labourtotheeconomy.
d) Iffactorpricesareusedtocalculatethegrossdomesticproduct,
thenthegrossdomesticproductwasequaltoR_______in2009.
e) In2009thesubsidiesreceivedbyfirmsonproductionwere
R_____.
f) In2009thetaxesonproducts,forinstanceVAT,wereR______.
g) In2009consumptionspendingbyhouseholdswasR______.
h) In2009theprimaryincomeSouthAfricansearnedfromthe
restoftheworldwas(more/less)thantheprimaryincomewe
paidtotherestoftheworld.
i) Explainwhytheexpenditureongrossdomesticproductin
2009waslessthanthegrossdomesticexpenditure.
(4)
(2)
(1)
(1)
(1)
(1)
(1)
(1)
(2)
4 Explainwhyanincreaseinexportshasamultipliereffect
onthedomesticlevelofproductionandincome.
(7)
5 xplainwhathappenstothemultipliereffectifthereare
E
moreleakages.
(5)
6 Discussthethreemainmarketsinthecircularflowmodel.
(40)
Extra practice activity 1 (32 marks)
1 I ndicateandexplainwhetherthefollowingvariablesareleakagesor
injections:
Variable
Leakage or injection
Reason
Savings
Investment
Taxation
Governmentspending
Imports
Exports
(18)
34
Topic 1
2 UsethefollowingdataforSouthAfricatoconstructacircularflow
modelofanopeneconomy:
Finalconsumptionexpenditurebyhouseholds
1575930
Finalconsumptionexpenditurebygeneralgovernment
573470
Grosscapitalformation
517009
Residualitem
298
Gross domestic expenditure
2 666 707
Exportsofgoodsandservices
727721
Less:Importsofgoodsandservices
732994
Expenditure on gross domestic product
(GDP at market prices)
2 661 434
(Source:SouthAfricanReserveBank.(2012).Quarterly Bulletin,March)
(14)
Summary
• A
nopencircularflowmodelshowstheflowsofspending,production
andincomeinaneconomyconsistingofhouseholds,firms,government
andaforeignsector.
• Therearethreeleakagesinanopencircularflowmodel,namely
savings,taxationandimports.
• Therearethreeinjectionsinanopencircularflowmodel,namely
investment,governmentspendingandexports.
• Usingthecircularflowmodel,wecanshowhowthedifferent
aggregateconcepts,suchasgrossdomesticproduct,grossdomestic
expenditureandgrossnationalincome,aremeasuredandwhatthey
mean.
• Grossdomesticproducttellsussomethingaboutthelevelof
productionwithinthebordersofacountry.Wecanmeasuregross
domesticproductinthreedifferentways:asspending,asproductionor
asincome.Intherealworld,however,wemusttaketaxesandsubsidies
intoaccount,whichcausemarketprices,basicpricesandfactorprices
todiffer.
• Grossdomesticexpendituretellsussomethingaboutthespending
patternsofhouseholds,firmsandgovernmentinacountry.Itincludes
spendingonimportsbutexcludesspendingonexports.
Circular flow
•
35
• G
rossnationalincometellsuswhatishappeningwiththeincome
ofthecitizensofacountry.Itisanimportantmeasurementofthe
economicwelfareofthecitizensofacountry.
• T
hemultiplieristheprocesswherebyaninitialchangeinspending
changesthelevelofoutputandincomebymorethantheinitialchange
inspending.
• T
hesizeofthemultiplierdependsonthenumberofleakagesinthe
system.Themoretheleakagesinthesystem,thesmallerthemultiplier
willbe.
36
Topic
2 Business cycles
Topic 2
What you will learn about in this topic
•
•
•
•
•
T
hecompositionandfeaturesofbusinesscycles.
Explanations.
Governmentpolicy.
Theneweconomicparadigm(smoothingofcycles).
F
eaturesunderpinningforecastingwithregardto
businesscycles.
Let’s talk about this topic
• H
aveyoueverwonderedwhythelevelofeconomicactivity
goesupanddown?
• Howdoesaneconomicrecessionimpactonyour
household?
• Whatcanwedoabouttheupsanddownsofeconomic
activity?
Business cycles
•
37
What you know already
Oureconomyischaracterisedbyfluctuations(upsanddowns)inthelevelof
economicactivity.Thiscanbetheresultofachangeinconsumerspending,
investmentspending,governmentspendingandspendingbytheforeign
sector.Thisresultsinchangesinourrealgrossdomesticproductand
sometimesthesechangescanbequitedramatic.
Todealwiththisinstability,policy-makerscanmakeuseoffiscaland
monetarypolicy.
ck
Che elf
mys
1. W
hatistheimpactofanincreaseinexportsontotalspending,
totalproductionandtotalincome?
2. Distinguishbetweenfiscalpolicyandmonetarypolicy.
Word bank A B C
Business cycleistherecurringfluctuations(upsanddowns)ineconomic
activity,relativetotheeconomictrendvalue.
Coincident indicatorsareindicatorsthatprovideuswithapictureofthe
currentstateoftheeconomy.Examplesarethegrossdomesticproduct,
valueofwholesale,retailandnewvehiclesales,utilisationofproduction
capacityandemploymentincertainsectors.Theseindicatorschangeatthe
sametimeandinthesamedirectionastheeconomy.
Contraction phaseisthedownwardphaseofthebusinesscycle.During
thisphase,spendingdeclines,grossdomesticproductfalls,employment
decreases,businessconfidencedeclinesandincomefalls.
Demand-driven business cycle iscausedbyachangeinthespending
components(C+I+G+(X–M)).Changesinanyofthesecomponents
causechangesinthedemandforgoods.Asaresult,productionand
incomeintheeconomychange.
Depressionreferstoasustained,long-termeconomicdownturninthe
businesscyclethatismoreseverethanarecession.
Endogenous approach(alsocalledtheKeynesianapproach)statesthat
businesscyclescausetheinherentlyunstablenatureofmarketeconomies.
Endogenous factorsareaninherentpartoftheeconomy,unlikefactors
thatimpactfromoutsidetheeconomy.
Exogenous approach(alsocalledtheclassicalapproach)statesthatthe
causesofbusinesscyclesareexogenousforces,notforcesinherentina
marketsystem,andinappropriategovernmentpolicies.
Exogenous factors occurfromoutside,andthenimpactontheeconomy.
Expansion phaseoccurswheneconomicactivityrises.Thisisreflectedin
anincreaseinspending,grossdomesticproductandemployment.
38
• Business cycles
Topic 2
Fiscal policyreferstothegovernmentspendingandtaxationusedto
influencethedemandforgoodsandservicesintheeconomy.
Investment-driven business cyclesarecausedbytheinvestment
behaviourofbusinessesintheeconomyandbytheexpectationsof
businesspeople.
Juglar business cycles arecyclesof8–11yearswhereprosperityisusually
followedbyacrisis,whichcausestheliquidationofbusinessesand
eventuallyarecessionfollows.
Kitchin business cycles areshortcyclesof3–5years,alsoknownas
inventorycycles.
Kondratieff business cyclesareverylongbusinesscyclesof40–60years
thatarecharacterisedbyperiodsofhighsectoralgrowth,followedby
periodsofslowgrowth.
Kuznets business cyclesarelongbusinesscyclesof15–25years,also
knownasinfrastructuralinvestmentcycles.
Lagging indicators areindicatorsthatlagbehindthebusinesscycle,for
examplehoursworkedintheconstructionsector,employmentinthenonagriculturalsectorandlabourcostsinthemanufacturingsector.
Leading indicatorsareindicatorsthatprecedethebusinesscycle,for
examplebuildingplanspassed,opinionsurveysandjobadvertisements.
Monetary policyreferstothepolicyofthecentralbanktoinfluencethe
demandforgoods,bychangingtheavailabilityandcostofmoney,and
creditintheeconomy,throughchangingtheinterestrate.
Peakisthepointwheretheeconomicexpansionisatitshighest.Itis
followedbyacontraction.
Political business cycleiscausedbythebehaviourofpoliticianswhotry
towinvotesthroughmanipulatingtheeconomy.
Prosperity phase referstotheportionoftheexpansionphaseofthe
businesscycleduringwhichthelevelofeconomicupswingaccelerates.
Recessionreferstoadeclineinthelevelofeconomicoutput(adownturn
inthebusinesscycle)thatlastsforsixmonthsorlonger.
Recovery phasereferstotheportionoftheexpansionphaseofthe
businesscyclethatoccursdirectlyafterthebusinesscyclereachesa
troughandthelevelofeconomicactivitystartstograduallyincrease.
Supply-driven business cycle iscausedbyachangeinoneofthe
determinantsoftheaggregatesupplyofgoodsandservices(suchas
naturalresources,labour,technologyandcapital).
Trend lineisalineonagraphthatindicatesastatisticaltrend.Inthe
caseofthebusinesscycle,thetrendlinerepresentsthelong-termgrowth
potentialoftheeconomy.
Troughisthepointwheretheeconomiccontractionisatitslowest.Itis
followedbyanexpansion.
Business cycles
•
39
What you still need to know
1. Composition and features of business cycles
Fluctuationsinthelevelofeconomicactivityarepartofourlivesandinfluenceall
ofusinsomewayoranother:
• A
nincreaseinthelevelofeconomicactivitymakesiteasierforpeopletofind
jobsandgiveshouseholdsmoremoneytospend.
• Ontheotherhand,adeclineineconomicactivitymakesithardertofindajob
andcanevencausepeopletolosetheirjobs.
Economistshavebeenstudyingtheseupsanddownsinthelevelofeconomic
activityforcenturies.Someoftheissuesaroundeconomicactivitythateconomists
havebeentryingtoexplainrequirethemtoaskquestionssuchas:
• Whatarethecausesoftheseupsanddowns?
• Whatcanbedonetosmooththeseupsanddowns?
• W
hatisinstoreforusinthefuture?
Inthistopic,youwilllearnaboutthenatureandcausesofbusiness cycles.Youwill
lookatwhatcanbedoneaboutbusinesscyclesandyouwilldiscovertheproblems
involvedinforecastingthem.
1.1 Composition of business cycles
ThedataoneconomicactivityforSouthAfricashowsthatitisnotasmoothprocess.
Anincreaseineconomicactivityisusuallyfollowedbyadecreaseineconomic
activity,whichisinturnfollowedbyanincreaseineconomicactivity.
Theserecurringups(expansions)anddowns(contractions)ofeconomicactivityare
knownasthebusinesscycle.
Thebusinesscycletrendsarelong-termtrends.Onecompletecycletypicallylasts
fromthreetofiveyears,butcouldlasttenyearsorevenlonger.
1.2 Features of business cycles
Letustakeacloserlookatthedifferentfeaturesofabusinesscycleandathowone
phasefollowsanother.
1.2.1 Four phases of the business cycle
ThebusinesscycleisdividedintofourphasesasillustratedinFigure2.1:
Recession phase
ThisisindicatedfrompointatopointbinFigure2.1.
Depression phase
ThisisindicatedfrompointbtopointcinFigure2.1.
Duringtherecessionphaseandthedepressionphasethelevelofeconomicactivity
contractsanditisalsoreferredtoasthecontractionperiod(pointatopointc).
40
• Business cycles
Topic 2
Recovery phase
ThisisindicatedfrompointctopointdinFigure2.1.
Prosperity phase
ThisisindicatedfrompointdtopointeinFigure2.1.
Duringtherecoveryphaseandtheprosperityphaseeconomicactivity
expandsanditisalsoreferredtoastheexpansionperiod(pointctopointe).
1.2.2 Peaks and troughs
Wecanalsodistinguishbetweenpoints,namelypeaksandtroughs.
Peaks
Theprosperityphaseandexpansionperiodcometoanendonceapeakisreached.
Atthepeakofthebusinesscycletheeconomyusesmost,ifnotall,ofitsresources,
suchasskilledlabourandcapital.Followingapeakistherecessionphaseand
contractionperiod.InFigure2.1the
peaksareindicatedaspointsaande.
peak
a
omp
c
tren
d
prosperity
b
recession
c
depression recovery
contraction
0
e
d lin
cle
cy
lete
g
amplitude
Economic activity
peak
e
f
trough
expansion
Time
Figure 2.1 A business cycle, showing the four phases: recession,
depression, recovery, prosperity
Troughs
Thedepressionphaseandcontraction
periodcometoanendonceatrough
isreached.Atthetroughofthe
businesscyclethelevelofeconomic
activityislowandresourcesare
underutilised.Thetroughisa
turningpointafterwhichthe
economybeginstorecoverasthe
recoveryphaseandexpansionperiod
start.InFigure2.1thetroughsare
indicatedaspointscandf.
1.2.3 The trend line
Ingeneralterms,thetrendlinerepresentsthelong-termeconomicgrowth
potentialoftheeconomyofacountry.Thereareanumberofstatistical
techniquesavailablethatcanbeusedtodrawatrendline.Thetrendlineisthe
dottedlineshowninFigure2.1.Inthiscaseitisupwardslopingindicatingthat
theproductionpotentialoftheeconomyisgrowingovertime.
1.2.4 The amplitude of the business cycle
Theamplitudeofthebusinesscycleisthemaximumdeviationfromitstrend.
InFigure2.1thiscanbeindicatedbythedistancebetweenthepeakortrough
andthetrendline.Forinstance,thedeviationfromthetrendisgivenbythe
distancebetweenpointfandpointg.Ifyoucomparethisdistancewiththe
distancebetweenpointcandthetrendline,youcanseethattheamplitude
differs.Thisisduetothechangeintheunderlyingforces,andthesizeofthe
changesexperienced.
Business cycles
•
41
1.2.5 Duration of a business cycle
Acompletebusinesscycleconsistsofthetwoperiods,namelythecontractionperiod
andtheexpansionperiod.Itcaneitherbemeasuredfrompeaktopeak(pointato
pointe)ortroughtotrough(pointctopointf).Thedurationofthiscycledepends
onhowlongtheseperiodslastandcaneitherbelongorshort.
1.3 Explanation of the different phases
1.3.1 Recession phase
Figure 2.2 The level of economic activity decreases and spending by firms decreases during a
recession phase.
Oncethepeakisreached,therecessionphasestarts.Duringtherecessionphaseof
thebusinesscyclethelevelofeconomicactivitystartstodecreaseandthelevelof
realGDPfalls.
Thisdeclineineconomicactivityimpliesthatfewergoodsandservicesare
producedandconsequentlyfirmsemployfewerfactorsofproduction.Asfirms
employfewerfactorsofproduction,theincomeofhouseholdsfallsandtheir
spendingongoodsandservicesdeclines.Thedeclineinspendingbyhouseholds
leadstoafurtherdeclineinproductionandtherecessiongetsworse.
Duringtherecessionphasefirmsretrenchworkersandunemploymentrises.Firms
alsofinditmoredifficulttoselltheirgoodsandservicesandinventoriesrise.Dueto
this,unemploymentincreasesinthelabourmarketandwagestendtoriseatalower
rateortheymayevenfall.Inthegoodsmarketpricesofgoodsandserviceswillalso
riseatalowerrateandinflationwillbelower.
Thelevelofbusinessconfidencedeclinesanditismoredifficultforfirmstofind
thenecessaryfundstofinancetheirbusinesses.Consequently,firmsdecreasetheir
investmentspending.Thisleadstoafurtherdeclineineconomicactivity.Theriskof
bankruptcyalsoincreasesduringtherecessionphase.
Duetothelowerincomeofhouseholdsandhigherunemployment,households
loseconfidenceandconsequentlydecreasetheirspending,therebyworseningthe
economicsituation.
1.3.2 Depression phase
Astherecessionphasecontinuesandthesituationbecomesmoresevere,it
42
• Business cycles
Topic 2
mightresultinadepression.Asignificantfallofabout25%oftherealGDPis
experiencedandunemploymentrisessharply.Thisisasustained,long-term
economicdownturninthebusinesscycle.
Duetothis,depressedconditionsinthelabourandthegoodsmarketsprevail,
andwagesandpricesfall.Inflationnotonlydeclinesbutdeflation,thatisa
decreaseinthepricelevel,isalsoapossibility.
Moreandmorefirmsclosetheirdoorsandbankruptcyrises.Business
expectationsandconfidenceturnverynegativeandverylittle,ifany,investment
takesplaceintheeconomy.
Theincomeofhouseholdscontinuestodeclineandtheyexperienceanincreasein
unemployment.Thisinturnleadstoheightenedpessimismandlowerspending.
Thisdepressionphasecomestoanendonceatroughisreached.
Fortunately,economicdepressionsarearareoccurrenceandthelasttimeSouth
Africaandthemajoreconomiesoftheworldexperiencedaneconomicdepression
wasinthe1930s.Sincethenwehavebeenabletostaveoffeconomicdepressions
bytheuseoffiscalandmonetarypolicies.
1.3.3 Recovery phase
Therecoveryphasestartsonceatrough(alowerturningpoint)inthebusiness
cycleisreached.Duringtherecoveryphasethelevelofeconomicactivity
graduallyincreases.Inotherwords,moregoodsandservicesareproduced,
whichresultsinanincreaseinrealGDP.
Figure 2.3 The level of business confidence rises and investment spending by firms increases during
a recovery phase.
Asthelevelofeconomicactivityincreasesmoregoodsandservicesare
produced.Consequently,morefactorsofproductionareemployedbyfirmsand
unemploymentwillstarttodecrease.
Householdswillfindthattheirincomeincreasesandtheywillincreasetheir
spendingongoodsandservices.Thiscausesafurtherincreaseinproduction,
spendingandincome.Confidencelevelsofhouseholdsincreaseandpessimism
turnsintooptimism.
Business cycles
•
43
Duetothisincreaseineconomicactivityandincreasedspending,thesalesof
firmsincreaseandtheirlevelsofconfidencealsorise.Itisalsoeasierforfirms
tosecurebankcreditandincreasetheirinvestmentspending.
1.3.4 Prosperity phase
Duringtheprosperityphasethelevelofeconomicactivityincreasesandeven
accelerates.Theproductionofgoodsandservicescontinuestoriseandthereal
GDPincreases.
Astheprosperityphasegetsunderwaythelevelsofconfidencebyhouseholds
andfirmscontinuetoincrease,causinganincreaseinspending,production
andincome.Householdsincreasetheirconsumptionspendingwhilefirms
increasetheirinvestmentspending.
Duringtheprosperityphaseunemploymentcontinuestodecreaseandfirms
experienceanincreaseinsales.Pressuresnowbuildupinthelabourand
goodsmarkets.Inthelabourmarketthesepressuresleadtoanincreasein
wages,whileinthegoodsmarketpricesriseandinflationistheresult.
Duringtheprosperityphasewealsofindthatimportsincreasesubstantially,
causingchangesintheexchangerate.Theprosperityphasecomestoanend
onceapeakisreached(theupperturningpointofthebusinesscycle).
1.4 Actual business cycles in South Africa
99
35
Figure 2.4 Business cycles in South Africa
44
• Business cycles
42
Key
= expansion phase
= contraction phase
33
Dec 1996–Aug 1999
Sept 1999–Nov 2007
June 1993–Nov 1996
21
March 1989–May 1993
Sept 1981–March 1983
Jan 1978–Aug 1981
Sept 1974–Dec 1977
Sept 1972–Aug 1974
Jan 1971– Aug 1972
Jan 1968–Dec 1970
7
15
April 1986–Feb 1989
19
July 1984–March 1986
20 24
June 1967–Dec 1967
Jan 1966–May 1967
8
17
51
44
April 1983–June 1984
40
36
May 1965–Dec 1965
100
90
80
70
60
50 44
40
30
20
10
0
Sept 1961–April 1965
Number of months
months
Number
LookatFigure2.4.FromthedataonpastbusinesscyclesinSouthAfrica,we
seethattherearenosimplepatterns.Somecyclesarelongandothersareshort,
somecyclesaremildandothersaresevere.
(Source:SouthAfricanReserve
Bank.(2012).Quarterly Bulletin.
March)
Topic 2
ThelongestbusinesscycleinSouthAfrica,ifmeasuredfromtroughtotrough,
startedinMarch1986,reachedapeakinFebruary1989,andendedinatrough
inMay1993–atotalperiodof86months.
Theshortestcontractionphaselastedsevenmonths,startinginJune1967and
endinginDecember1967,whilethelongestcontractionphaselasted51months,
startinginMarch1989andendinginMay1993.
Theshortestexpansionphaselasted15months,startinginApril1983
andendinginJune1984,whilethelongestexpansionphaselastedfor99
months,startinginSeptember1999andendinginNovember2007.Theend
ofthatexpansionphasewascausedbytheinternationalfinancialcrisisthat
originatedintheUSA.
Classroom activity 2.1 (16 marks)
Discusshowyouthinkyourhouseholdwillbeaffectedbythe
following:
a) theexpansionphaseofthebusinesscycle
b) thecontractionphaseofthebusinesscycle.
(3)
(3)
2
Whatisthepurposeofatrendlineinabusinesscycle?
(2)
3
Whatcancausetheexpansionphasetoreachapeak?Explain.
(4)
Discusstheimpactthatahugeinvestmentprojectcanhave
onthebusinesscycle.
(4)
1
4
2. Explaining the business cycle
Itisnoteasytoidentifythecausesofbusinesscycles.Oneproblemisthatthe
businesscycleisalsoinfluencedbyhumandecisionsandactions.Thesecannot
beexplainedonthegroundsofasinglemodelortheory.However,modelsand
theoriesdohelptogiveussomeunderstandingofthecausesofbusinesscycles.
2.1 Exogenous (monetarist) approach
Oneviewisthatbusinesscyclesarecausedby
exogenous factorsandnotbyfactorsthatare
inherentinthemarketsystem.Exogenousfactors
arefactorsthatoriginatefromoutsidethedomestic
economicsystem.
Figure 2.5 A drought caused by a change in
weather patterns is an exogenous factor that can
have a negative impact on certain sectors of the
economy.
Examplesare:
• technologyshocks
• weatherandnaturaldisasters
• politicalshocks
• tasteshocks.
Business cycles
•
45
Theseexogenousfactorscanactasatriggermechanismforacontractionor
expansion.
Technologyshocks,whichchangetheprocessofproduction,mightbringabout
changesinproductivityandcouldcausesomedisruptiontotheprocessof
production.
Manysectors,suchasagricultureandtourism,areinfluencedbytheweather.
Achangeinweatherpatternsmighthavenegativeconsequencesforthese
sectors,whichcanspilloverintoothersectorsoftheeconomy.
Changesinfashions,tastesandpreferencesofconsumerscanhaveanimpact
ontheclothingandentertainmentindustries.
Theclassicalandmonetaristschoolssupporttheexogenous approachtothe
businesscycle.Theyworkfromthebasisthatthemarketeconomyisinherently
stableandthatifmarketsareallowedtodowhattheyaresupposedtodo,then
thebusinesscyclewillnotbeaprominentfeatureoftheeconomy.
Theyarguethatwhenexogenousfactorsoccur,theydocauseinstabilityand
marketswillrespondinanappropriatewaytoensurethateconomicstabilityis
reachedfairlysoon.This,however,dependsonhowfreemarketsare.
Animportantcauseofbusinesscycles,accordingtothemonetaristapproach,is
inappropriatepoliciesbythegovernmentandmonetaryauthorities.Theyview
thecauseofmostoftheeconomicinstabilityastheincorrectuseofmonetary
policies–byincreasingthemoneysupplytoofastortoolittle.
2.2 Endogenous (Keynesian) approach
Anotherviewisthatbusinesscyclesarecausedbyendogenous factors.These
arefactorsthatareinherentintheeconomy.Theexpansionphasealsocontains
theseedsthateventuallycauseacontractionofeconomicactivity.
Accordingtothisview,amarketsystemisinherentlyunstable
andthelevelofeconomicactivitytendstofluctuatequite
dramaticallysometimes.So,thelevelofeconomicactivitytends
tobeeitheraboveorbelowthepotentialoftheeconomy.
Thisistheresultofafailureofthepricemechanisminamarket
economytoensurestability.Thismightbeduetheinflexibility
ofmarketswherepricesarenotflexibleenoughtoensurethat
demandequalssupply.Marketfailurethereforeoccurs.Another
contributingfactormightbefundamentaluncertaintythatmakes
decision-makingverydifficultintheeconomy.
Accordingtothe endogenous approach,asthelevelofeconomic
activityincreases,thetotalspendingintheeconomyincreases
aswell.Thiscausesanincreaseinimports,whichnegatively
46
• Business cycles
Figure 2.6 An increase in imports
is an endogenous factor.
Topic 2
affectsthebalanceofpaymentsandleadstoadepreciationoftheexchangerate
andanincreaseintheinterestrate.Thesefactorsthenimpactnegativelyon
theeconomyandaslow-downoccurs.Oritmightbethattheincreaseintotal
spendingleadstoanincreaseininflation,whichnegativelyimpactsonthe
levelofeconomicactivity.
Ourperceptionsaboutthefuturealsoplayanimportantroleininfluencingthe
businesscycle.Ifconsumersandbusinesspeoplehavepositiveexpectations
aboutthefuture,theytendtospendmore.Theincreasedspendinginfluences
thebusinesscycle.Ontheotherhand,ifconsumersandbusinesspeoplehave
negativeperceptions,theytendtospendless.Thismightcauseacontractionor
adelayintheexpansionphase.Theexpectationswehaveofthefuturemight
notbebasedonfactsbutonoursubjectiveperceptionsofthings.
Sincethecauseofthebusinesscycleistheinherentinstabilityofthemarket
system,peoplewhofollowthisapproachseethegovernmentashavingan
importantroleinsmoothingthecyclesthroughfiscal policyandmonetary
policy.
2.3 Kinds of business cycles
Therearesevenkindsofbusinesscycles:
• supply-drivenbusinesscycles
• demand-drivenbusinesscycles
• politicalbusinesscycles
• Kitchinbusinesscycles
• Juglarbusinesscycles
• Kuznetsbusinesscycles
• Kondratieffbusinesscycles.
2.3.1 Supply-driven business cycle
Inasupply-driven business cycle,thecauseofthebusinesscycle
liesinsuddenchangesinmacroeconomicsupplyfactors.Theseare
factorssuchasnaturalresources,labour,technologyandcapital.
Inthelongterm,changesintheavailabilityandpricesofthese
factorsaretobeexpected.Itispossibletodealwiththeselongtermchanges.However,ifthereisasuddenchangeinoneormore
ofthesefactors,thismightcauseafairamountofinstabilityinthe
shortrun.
Figure 2.7 An increase in the
price of oil signals a decrease
in supply, which can ultimately
cause an economic contraction.
Forexample,thinkaboutasuddenlargedecreaseinthequantity
ofoilandasharpincreaseinitsprice:
• Thedecreaseinthesupplyofoilwillcauseaneconomic
contractiontosetin.
• Anincreaseinthepriceofoil(causedbythedecreasein
supply)causesanincreaseinthecostofproduction.
• A
sthecostofproductionincreasesthefollowingoccurs:
Business cycles
•
47
Inflationstartstorise.

Householdsareunabletobuythesameamountofgoodsand
servicesandtheyreducetheirtotalspendingintheeconomy.

Firmsreacttothisdeclineintotalspendingbyproducingfewer
goodsandservices.

Asaresult,unemploymentrisesandincomeintheeconomy
decreasesfurther.

Businesssentimentdeclinesandmanyfirmsdecidetopostponetheir
investmentplans,whichcausesafurtherdeclineintotalspending.

Asaresultofthelowerincomeintheeconomy,thegovernment
receiveslessrevenueintheformoftaxesandmightdecideto
decreaseitsspendingaccordingly.

Theeconomyisnowheadingforarecession.
2.3.2 Demand-driven business cycle (Keynesian view)
Ademand-driven business cycleoccursmorefrequentlythanasupply-driven
businesscycle.Inademand-drivenbusinesscyclethecauseofthebusiness
cycleisfoundinchangesintotalspending.Thiscanbeasaresultofachangein
consumptionspendingbyhouseholds,investmentspendingbyfirms,government
spendingorforeignsectorspending.
Figure 2.8 Demand-driven business cycle
Atypicaldemand-drivenbusinesscycleinSouthAfricamight,forinstance,start
whentheeconomicgrowthratesofourmainforeigntradingpartnersrise.An
increaseintheireconomicgrowthratesincreasesourexportstothemandthetotal
spendingonourgoodsthenincreases.Thismeansthataninjectionintothecircular
flowhasoccurred.Asthedemandforourexportsincreases,domesticfirmsproduce
moregoods.Theythereforeemploymorefactorsofproductionandtheincomeof
householdsincreases.Thisleadstoariseinconsumptionspendingandafurtherrise
inproductionandincome.Themultipliereffectisinoperationandtheexpansion
phaseofthebusinesscycleisonitsway.
48
• Business cycles
Topic 2
Manyeconomistsseechangesininvestmentspendingasanimportantcause
ofbusinesscycles.Theyarguethatinvestment-driven business cyclescanbe
classifiedasaseparatecategory.
Thedecisiontoinvestisacomplicatedaffairandhasmuchtodowiththe
profitsthatcanbemadeinanuncertainfuture.Asentrepreneurs’expectations
ofthefuturechange,theirinvestmentbehaviourwillchange:
• Asuddensurgeinoptimismfromentrepreneurswillcauseanoticeable
increaseininvestmentspendingintheeconomy:
Aninjectiontakesplaceinthecircularflowofspending,productionand
income.Thisincreasesthelevelofeconomicactivity.Anupswingwill
occurinthebusinesscycle.
• Amorepessimisticattitudefromtheentrepreneurshastheoppositeeffect:
Investmentspendingdrops(leakagefromcircularflow).Thisdecreases
thelevelofeconomicactivity.Acontractionphasewillbegininthe
businesscycle.
2.3.3 Political business cycle
Thepolitical business cycleoccurswhengovernmenttriesto
manipulatetheeconomyinordertowinvotesduringanelection
year.Accordingtothisview,duringanelectionyeargovernments
willtrytostimulatetheeconomythroughexpansionaryfiscaland
monetarypolicies.Intheshortrun,itispossibletoimplementtax
cutsthatbenefittaxpayers,increasegovernmentspendingforspecial
interestgroupsanddecreasetheinterestrate.
Figure 2.9
Political business
cycle
Theseactionswillcauseanincreaseintotalspendingintheeconomy
andimpactonthebusinesscycle.However,aftertheelection,the
governmentwillhavetoreversesomeofitsdecisionsbecausesome
oftheiractionsmighthavenegativeconsequencesfortheeconomy,suchas
risinginflation,increaseddebtandbalanceofpaymentsdeficits.Theseactions
willthenimpactonthebusinesscycleandcontributetoincreasedinstabilityin
theeconomy.
2.3.4 Kitchin business cycle
TheKitchin business cycleisnamedafterJosephKitchin,aBritish
businessmanandstatistician.Itisalsoknownastheinventorycycle.The
Kitchinbusinesscycleisarelativelyshortbusinesscycleofabout3–5years.
Accordingtothisviewofthebusinesscycle,firmsdonotknowwhentostart
decreasingorincreasingtheirproduction.Aseconomicactivityaccelerates
duringtheprosperityphase,firmstendtooverproduceandendupwithan
increaseintheirinventories.Thismightthenleadtoproductionslowingdown.
2.3.5 Juglar business cycle
TheJuglar business cycleisnamedafterClementJuglar,aFrenchdoctor
andstatistician.Thisisalongbusinesscycleofabout8–11yearswherefixed
Business cycles
•
49
investmentbyfirmsisconsideredresponsibleforthecycle.Inthisbusiness
cycleprosperityisusuallyfollowedbyacrisis,whichthecausestheliquidation
ofbusinessesandeventuallyarecessionfollows.
2.3.6 Kuznets business cycle
TheKuznets business cycleisnamedafterSimonKuznets,aRussian–
Americaneconomist.Thisisalongbusinesscycleof15–25years.Inthismodel,
businesscyclefluctuationsarecausedbythedevelopmentofinfrastructure
investment.Thisiswhythismodelissometimescalledtheinfrastructural
investmentcycle.
2.3.7 Kondratieff business cycle
TheKondratieff business cycle,alsoknownastheK-WaveorSupercycle,was
developedbyNikolaiKondratieff,aRussianeconomist.Thisisaverylong
businesscyclelasting40–60years.Thecycleischaracterisedbyperiodsin
whichhighsectoralgrowthtakesplace,followedbyperiodsofslowgrowth.
Classroom activity 2.2 (7 marks)
In2010atsunamihitJapan,causingextensivedamageto
townsandcities,aswellastosomeofJapan’snuclearpower
stations.Aftertheseevents,Japan’seconomyexperienceda
recession.Wasthisrecessionduetoexogenousorendogenous
factors?
Brieflyexplainyouranswer.
(3)
BrieflyexplainwhattheimpactofaneconomiccrisisinEurope
mightbeontheSouthAfricanbusinesscycle.
(4)
1
2
3. Government policy and the business cycle
SincetheGreatDepressionandthepublicationofThe general theory of money,
interest and employmentbyJohnMaynardKeynes,governmentsalloverthe
worldhavetriedtosmoothorstabilisebusinesscyclesbyactivelyintervening
intheeconomythroughfiscalpolicyandmonetarypolicy.Thiskindofaction
isalsoreferredtoas‘fine-tuning’theeconomy.Theimportantinstruments
listedinTable2.1areatthegovernment’sdisposal.
Table 2.1 Instruments of fiscal and monetary policy
50
Fiscal policy instruments
Monetary policy instrument
Taxation
Governmentspending
Interestrate
• Business cycles
Topic 2
3.1 Using expansionary policy
Wheneconomicactivityslowsdownduringacontractionphase,thegovernment
canuseitsfiscalandmonetarypolicyinstrumentstostimulatethelevelof
economicactivity.
IfyoulookatthecircularflowmodelinTopic1,youwillseethatifthegovernment
decreasestaxation,householdshavemoredisposableincome.Households’
consumptionspendingalsoincreases.So,aninjectionintotheflowofspending,
outputandincometakesplaceandthelevelofeconomicactivityincreases.
Byincreasingitsspending,governmentcausesafurtherinjectionintotheflowof
spending,outputandincome.Thelevelofeconomicactivitywillincrease.
Decreasingtheinterestratereducesthecostofborrowingmoney.Households
andfirmscanthenborrowmoreandspendmore.Thisincreasedspending
increasesthelevelofeconomicactivity.
3.2 Using contractionary policy
Duringtheexpansionphase,theeconomymightoverheat(itgrowstoofast
inrelationtoitscapacity).So,somethingmustbedonetodecreasethelevel
ofeconomicactivity.Thisrequiresanincreaseintaxation,adecreasein
governmentspendingandanincreaseintheinterestrate.Thesepolicymeasures
willcausethetotalspendingtodecreaseandthelevelofeconomicactivityto
decline.
Classroom activity 2.3 (6 marks)
Whichofthefollowingpolicieswouldyouadvisegovernmentto
undertakeduringthe:
• downwardphaseofthebusinesscycle
• upwardphaseofthebusinesscycle?
Decreasetaxation
Increasetaxation
Increasegovernmentspending
Decreasegovernmentspending
Increaseinterestrates
Decreaseinterestrate
4. The new economic paradigm
Thesekindsofexpansionaryandcontractionarypolicieswereverypopularand
seemedtoworkuntilthelate1960s.Todaythereislessemphasisontryingto
smooththecycleandmoreemphasisonprovidingstability.Thisnewapproach
isreferredtoas‘theneweconomicparadigm’.
Inthenewparadigm,governmentfocuseslessonfine-tuningandmoreon
eliminatinguncertaintieswithregardtofiscalandmonetarypolicy.
Business cycles
•
51
Oneoftheproblemsoffine-tuningistoknowwhattodowhen.Wedonot
haveperfectknowledgeabouthowtheeconomyfunctions.So,itisdifficult
topinpointwhatiswrongandwhatthecausesoftheproblemsare.Evenif
weknowwhatiswrong,itmaybetoolatetotakeaction.Forexample,bythe
timethegovernmentrealisesthattheeconomyneedsaninjectionintheform
oflowertaxation,atroughcouldhavebeenreachedalreadyandtherecovery
phasemayhavestarted.Implementingsuchapolicyatsuchatimemightbe
moreharmfultotheeconomythandoingnothingatall.
Theotherproblemwithfine-tuningisthatanypolicyactiontakestimeto
implementandonceimplemented,ittakestimetoimpactontheeconomy.By
thetimeitsimpactisfeltontheeconomy,itmaynolongerbeneeded.This
mightonceagaindomoreharmthangood.
Thereisalsotheviewthat,inmanyinstances,thecausesofthebusinesscycle
areinappropriateactionsofgovernment.So,governmentshouldratherstickto
astableandpredictablepolicytoenhancethestabilityoftheeconomicsystem.
Sincefine-tuningseemstobeproblematic,theviewisthatgovernment
shouldratherconcentrateonthelongtermbydevelopingstable,credibleand
predictablemacroeconomicpolicies.Doingthiswillensurethatthereismore
certaintyaboutthegovernment’sintentions,makingplanningforthefuture
easierintheprivatesector.Thiswillcontributetoeconomicstability.
Classroom activity 2.4 (3 marks)
Namethreeproblemsassociatedwiththeuseoffiscaland
monetarypolicytofine-tunetheeconomy.
5. Features of forecasting in business cycles
Accuratepredictionisnotpossibleineconomics.Ifitwerepossible,all
economistswouldbeveryrich.Thebesteconomistscandoistotrytoforecast
whatmighthappenwithcertaineconomicvariables.Theymaybeableto
forecast,forexample,thatacertaintypeofspendingwillincrease,buttheycan
nevertellexactlybyhowmuch.Thisisalsotrueofforecastingbusinesscycles.
Therearemanytechniquesavailabletohelpeconomiststoforecastbusiness
cycles.Businesscycleindicatorsaregroupedintothreecategories:leading,coincidentandlaggingindicators.
5.1 Leading indicators
Leading indicatorsareeconomicindicatorsthatchangebeforetheeconomy
haschanged.Theytellussomethingaboutwhattheeconomywilllooklike
inafewmonths’time.Whenleadingindicatorsrise,itmeansthelevelof
economicactivitywillalsoriseinafewmonths’time.
52
• Business cycles
Topic 2
Level of economic activity
InFigure2.10,thedottedlineindicatesthechangeineconomicactivityin
termsoftheleadingindicators.Notehowtheleadingindicatorslead(happen
before)theactualbusinesscycle.
0
Peak
Leading
Peak
Trend
line
Peak
Peak
Trough
Trough
Trough
Time
Figure 2.10 Leading indicators lead the actual
business cycle.
InSouthAfrica,theleadingindicatorsofthe
businesscycleare:
• opinionsurveysonthevolumeofordersin
manufacturing
• opinionsurveysofstocksinrelationto
demandformanufacturingandtrade
• thecompositeleadingbusinesscycleindicator
ofmajortradingpartnercountries
• commoditypricesinUSdollarsforabasketof
SouthAfrica’sexportcommodities
• realM1moneysupply
• pricesofsharecategories
• thenumberofresidentialbuildingplans
passed
• labourproductivityinmanufacturing
• jobadvertisementsintheSundaynewspapers
• theaveragenumberofhoursworkedper
factoryworkerinthemanufacturingsector.
Forexample,thinkaboutthenumberofresidentialbuildingplanspassed.If
thisnumberincreases,itmeansthatpeopleintendtobuildmorehouses.So,
youcanexpectthatthebuildingsectorandotherrelatedsectorswillshow
increasedgrowthinafewmonths’timewhenthesehousesarebeingbuilt.
Let’slookatanotherexample.Ifthebusinesscycleindicatorofmajortrading
partnercountries(aleadingindicator)showsthatadeclineineconomicactivity
isexpectedinthesecountries,wewillprobablyexportlesstothem.Thelevel
ofactivityfortheexportsectorinoureconomywilldecrease.
5.2 Coincident indicators
Coincident indicatorsgiveusinformationaboutthecurrentstateofthe
economy.Thisisbecausetheyvaryatthesametimeastheeconomyand
becauseofchangesintheeconomy.Acontractionintheeconomycausesa
declineintheseindicators,whileanexpansioncausesariseintheseindicators.
ThecoincidentindicatorsfortheSouthAfricaneconomyare:
• grossvalueaddedatconstantprices,excludingagriculture,forestryand
fishing
• valueofwholesale,retailandnewvehiclesalesatconstantprices
• useofproductioncapacityinmanufacturing
Business cycles
•
53
• t otalformalnon-agriculturalemployment
• industrialproductionindex.
Forexample,anincreaseinthesalesofnewvehicleswouldindicatethatthe
economyisinanexpansionphase.Thisisbecausevehicleproductionaccounts
formorethan7%ofSouthAfrica’sgrossdomesticproduct.
Fromthecurrentphaseofthebusinesscyclewecanalsoformanopinion
ofwhatishappeningwiththesecoincidentindicators.Forinstance,ifthe
businesscycleisatitspeak,economistsalsoexpectthatretailsalesareata
peak.
5.3 Lagging indicators
Wegetapictureofwhatwashappeningintheeconomyfromlagging
indicators,becausetheseareindicatorsthatchangeaftertheeconomyhas
changed.
Examplesoflaggingindicatorsare:
• employmentinthenon-agriculturalsectors
• h
oursworkedinconstruction
• r ealinvestmentinmachineryandotherinvestment
• unitlabourcostinmanufacturing.
Fromthecurrentphaseofthebusinesscyclewecanpredict,forinstance,what
willhappentorealinvestment.Ifthebusinesscycleisinadownwardphase,
economistsexpectthatrealinvestmentwilldecline.
5.4 Extrapolation
Extrapolationisatechniquethateconomistsusetopredictthefuturebyusing
pastdata.LookagainatFigure2.1onpage41.Thetrendlineindicatesthe
generaldirectionoftheeconomy.Extrapolationinvolvestheextensionofthe
curvewhileweassumethatthestructuralvariablesintheeconomywillbe
largelyunchangedandthattheothervariableswillbehaveinthesamewayas
inthepast.AccordingtothetrendlineinFigure2.1,theeconomyisgrowing
(becausethetrendlineslopesupwards).
Extrapolationcanalsobeusedtoindicatewhatmighthappeninthenextfew
months.Onceweknowthatwehavegonethroughatrough,wecanpredict
thatthelevelofeconomicactivitywillincreaseinthenextfewmonths.
Whilethislookssensibleatfirstglance,extrapolationhasadefiniteflaw.This
isbecauseineconomics,pastbehaviourisnotnecessarilyagoodindicatorof
futurebehaviour.So,usingextrapolationtopredicteconomicbehaviourhas
proventobeveryunreliable.
54
• Business cycles
Topic 2
5.5 Moving averages
Movingaveragesareusedtominimisetheeffectofshort-termfluctuations.
Theaimistohighlightthelong-termmovementswhendealingwithtime
seriesdata(observationsofavariablemadeovertime)ineconomics.Applying
movingaveragestothebusinesscyclereducestheimpactofrandomevents
andrevealsunderlyingtrends.Thissmoothesthebusinesscycle.
Classroom activity 2.5 (9 marks)
Indicatewhetherthefollowingindicatorsareleadingindicators,coincidentindicatorsorlaggingindicators:
a) realM1moneysupply
b) thenumberofresidentialbuildingplanspassed
c) hoursworkedinconstruction
d) unitlabourcostinmanufacturing
e) useofproductioncapacityinmanufacturing
f) realinvestmentinmachineryandotherinvestments
g) totalformalnon-agriculturalemployment
h) pricesofshares
i) valueofwholesale,retailandnewvehiclesalesatconstantprices
Issues
S
of the day
Thebusinesscycleisafeatureofoureconomyandinfluencesallofusin
onewayoranother.
ThefollowingisanextractfromtheAnnualEconomicReportof2011by
theSouthAfricanReserveBank.
InSouthAfricathebusinesscyclereachedalowerturningpointin
August2009.Therecoverythatfollowedwaswellsynchronisedwith
theglobaleconomiccycle.Inthesubsequentsixquartersactivity
strengthenedinallthemainsectorsoftheeconomy,albeitfroma
lowbase.Acontractionof1,7percentinrealgrossdomesticproduct
in2009madewayforanexpansionof2,8percentin2010,with
annualisedgrowthratesofmorethan4percentinthefinalquarter
of2010andfirstquarterof2011.Ofparticularsignificanceisthat
employmentalsostartedincreasingfromthesecondquarterof2010.
(Source:SouthAfricanReserveBank.(2011).Annual Economic Report. Availablefrom:
http://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/4688/
AER%202011.pdf.(Accessed:24July2012).)
Business cycles
•
55
Homework activity 2 (111 marks)
Drawadiagramofthebusinesscycleinwhichyouidentifythe
fourphasesofthebusinesscycleandgiveashortdescription
ofeachphase.
(12)
Indicatewhetherthefollowingvariablesincreaseordecrease
duringacontractionphase:
1
2
Variable
(9)
Contraction phase
a)Grossdomesticproduct
b)Levelofeconomicactivity
c)Totalspending
d)Levelofproduction
e)Consumerspending
f)Investmentconfidence
g)Investmentspending
h)Imports
i)Inflation
Givesomereasonswhyanexpansionphasemightturnintoa
contractionphase.
Differentiatebetweenendogenousandexogenousfactorsofthe
businesscycleandgiveanexampleofeach.
(6)
DifferentiatebetweentheKeynesianandmonetaristviewofthe
businesscycle.
(10)
Copyandcompletethetable.Indicatewhetherthefollowingare
regardedasacauseofademand-drivenorsupply-drivenbusiness
cycle:
(5)
3
4
5
6
Description
Demand-driven
business cycle
(6)
Supply-driven
business cycle
a)Anincreaseintheeconomic
growthrateofourtrading
partners
b)Anincreaseinexports
(continued ...)
56
• Business cycles
Topic 2
Description
Demand-driven
business cycle
Supply-driven
business cycle
c)Anincreaseinconsumer
spending
d)Thediscoveryofoil
e)Achangeintechnology
Whataretheargumentsagainsttheuseofgovernmentpolicies
tosmooth(orfine-tune)thebusinesscycle?
(5)
Distinguishbetweenleadingindicators,coincidentindicatorsand
laggingindicators.Giveanexampleofeachindicatorandexplain
howitcanbeusedforprediction.
(15)
Discussthenatureandcausesofbusinesscycles.Includean
appropriatelylabelleddiagramtoillustratethenatureandcyclical
trendsinyourresponse.
(43)
7
8
9
Extra practice activity 2 (31 marks)
1 ompletethegivendiagramofabusinesscyclebyindicating
C
thefollowing:
a) Whatismeasuredonthehorizontalaxis?
b) Whatismeasuredontheverticalaxis?
c) Thetrendline
d) Thepeaks
e) Thetroughs
f) Anexpansionphase
g) Adownwardorcontractionphase
(1)
(1)
(1)
(1)
(1)
(1)
(1)
2 opyandcompletethefollowingtableandexplainwhatyouexpect
C
willhappentothevariablesduringacontractionphaseandan
expansionphaseofthebusinesscycle.
Business cycles
•
57
Variable
Outputinthemanufacturingsector
Pricesofgoodsandservices
Advertisedjobs
Hoursworkedinthemanufacturingsector
Useofproductivecapacityin
manufacturing
Grossdomesticproduct
Retailsales
Vehiclesales
Unemployment
Householdincome
Householdspending
Businessconfidence
Investmentspending
Imports
Contraction
Expansion
(14)
3 Readthefollowingscenarioandthenanswerthequestions:
Consumerconfidenceisatanall-timehighintheeconomyof
Landandia.Consumerspendinghasreacheditshighestlevelin
fiveyears.
However,somewarningsignsareappearingonthehorizon.
Creditextensiontohouseholdsfromthebanksisrisingatan
alarmingrate.Manufacturersindicatethat,duetothehigh
demandforconsumergoodsandcapacityconstraints,theyare
experiencinganupwardpressureontheircostofproduction.The
centralbankalsoreportsthatthedeficitonthecurrentaccountis
atanalarminglyhighlevel,whichisnotsustainableinthefuture.
58
a) Whatisthecauseoftheexpansionphase?
(2)
b) Arewedealingherewithademand-drivenorasupply-driven
businesscycle?
(1)
c) Willthisexpansionphasecontinueindefinitely?
(1)
d) Whatdoyouthinkisgoingtohappenintheeconomyof
Landandiainthecomingmonths?Explainyouranswer.
(6)
• Business cycles
Topic 2
Summary
• T
hebusinesscycleconsistsoffourphases:peak,downwardor
contractionphase,trough,upwardorexpansionphase(whichconsists
oftherecoveryphaseandtheprosperityphase).
• Acompletecycleismeasuredfrompeaktopeakorfromtroughto
troughandcanlastmanyyears.
• Exogenousfactorsarefactorsthatoriginatefromoutsidethedomestic
economicsystemwhileendogenousfactorsoriginatefromwithinthe
domesticeconomicsystem.
• Accordingtotheexogenousapproach,themarketsystemisinherently
stableandthecausesofthebusinesscycleareexogenousfactors.
• Accordingtotheendogenousapproachthemarketsystemisinherently
unstableandthecausesofthebusinesscycleareendogenousfactors.
• Governmentscanusefiscalpolicyandmonetarypolicytosmooth(or
‘fine-tune’)thebusinesscycle.
• Accordingtotheneweconomicparadigm,governmentshouldnot
tryto‘fine-tune’thebusinesscyclebutshouldratherconcentrateon
increasingcertaintyinthemarketeconomy.
• Leadingindicatorsareeconomicindicatorsthatchangebeforethe
economyhaschangedandprovideuswithinformationaboutwhat
mighthappenintheeconomy.
• Coincidentindicatorsareindicatorsthatchangewiththeeconomyand
provideuswithinformationaboutthecurrentstateoftheeconomy.
• L
aggingindicatorsareindicatorsthatchangeaftertheeconomyhas
changedandprovideuswithinformationaboutwhatwashappening
intheeconomy.
Business cycles
•
59
Topic
3 The public sector
What you will learn about in this topic
•
•
•
•
•
T
hecompositionandnecessityofthepublicsector.
Problemsofpublicsectorprovisioning.
O
bjectivesofthepublicsectoranditsbudgets.
F
iscalpolicy(includingtheLaffercurve).
R
easonsforpublicsectorfailure.
Let’s talk about this topic
Haveyoueverthoughtaboutwhoclearsupalltherubbish
afteraconcertorfestival?Theconcert-goersarenotinterested
oncetheconcertisoverbutiftherubbishisleft,itjust
blowsaroundandspoilsotherpeople’senjoymentofthe
environment.Rubbishandpollutionareexamplesofanegative
externality.Thegovernmentcanmakerulesaboutsuchissues
forthegoodofeveryone.
60
• The public sector
Topic 3
What you know already
InGrade11youlearntthatSouthAfricahasamixedeconomy.Thismeans
thatithaselementsofbothamarketandacommandsystem,withthe
government(publicsector)providingsomegoodsandservicesandalso
interveningintheeconomytoencourageeconomicgrowth.Youalsolookedat
thegoodsandservicesprovidedbythegovernmentandhowthegovernment
attemptstoredresspastinequalities.
ck
Che elf
mys
1. W
hatarethecharacteristicsofamixedeconomy?
2. Whatarethedifferentsocialservicesprovidedbythe
government?
Word bank A B C
Balanced budgetiswhengovernmentspendingequalstaxrevenues.
Budget deficit iswhengovernmentexpenditureisgreaterthan
governmentincome.
Budget surplusiswhengovernmentincomeisgreaterthangovernment
expenditure.
Economic efficiencyexistswhenresourcesareallocatedinsuchaway
thatnoonecanbemadebetteroffwithoutmakingsomeoneelseworse
off.
Free-ridersarepeoplewhoareabletomakeuseofagoodorservice
withoutpayingforit.
National budgetistheplannedincomeandexpenditurebythestatefor
givenyear.
Nationalisationisthetransferofownershipofabusinessfromtheprivate
sectortothestate.
Negative externalitiesarecoststhatareimposedonasecondorthird
partythatfirmsdonotfactorintothepriceoftheirgoodsandservices.
Non-excludabilitymeansthatnoonecanbepreventedfromusingagood
orserviceonceitisprovided.
Non-rivalryiswhenuseofagoodorservicebyonepersondoesnot
excludeitsusebyanotherperson.
Positive externalitiesexistwhenasecondorthirdpartygetsabenefit
fromtheconsumptionorproductionofagoodorservice.
Privatisationisthetransferofownershipofabusinessfromthestateto
theprivatesector.
Progressive taxation systemiswhentaxratesincreaseasincome
increases.
Public enterprisesarestate-ownedbusinesses.
The public sector
•
61
Public sectorconsistsofstate-runactivitiesorbusinesses.
Subsidiesareincomegivenbythestatetoindividualsorbusinessesfora
specificpurpose,forexampledisabilitygrants.
Top slice meansmoneythatissetasidefordebtrepaymentsand
emergencies.
What you still need to know
InTopic2,youstudiedbusinesscyclesandlearntabouthowtheSouth
AfricanReserveBank(SARB)canusemonetarypolicytotrytosmoothout
fluctuationsinthecyclicalnatureoftheeconomy.Inthistopic,youwilllearn
abouthowthepublic sector oftheeconomyfunctionsandwhatismeantby
fiscalpolicy.
1. The composition and necessity of the public sector
1.1 The composition of the public sector
ThepublicsectorplaysanimportantpartintheSouthAfricaneconomy.
Itconsistsofalltheorganisationsownedandcontrolledbythestateor
governmentandcanbedividedinto:
• n
ational(central)government,whichismainlyconcernedwithnational
issuessuchashealth,defence,education,safetyandsecurity.Itincludes
governmentdepartmentssuchashealth,educationandenvironmental
affairsandtourism.Italsoincludesnon-profitorganisations,suchasthe
CSIRandSABS
• provincial(regional)government,whichismainlyconcernedwiththe
administrationofthenineprovincesandanyeconomicissuesthatare
specifictotheregion
• localgovernment,whichisconcernedwithlocalissueswithinatownor
municipalarea,suchasrefusecollection,streetlightingandtrafficcontrol
• p
ubliccorporations,whicharestate-ownedenterprises(SOEs)thatprovide
publicgoodsandservices,suchasEskom,TransnetandSABS.The
governmenteitherhasmajorityshares(suchasEskom)orownstheseby
law(suchasSABS).
1.2 The necessity of the public sector
AdamSmith,areputableBritisheconomistwhowroteinthenineteenth
century,identifiedthefollowingthreedutiesofgovernment:
• toprotectitscitizensagainstthreats
• t omaintainlawandorderinsidetheeconomy
• toprovidecertainnecessitygoodsandservices.
62
• The public sector
Topic 3
YouwillrememberfromGrade11thatwelookedatthreedifferenttypes
ofeconomies:amarketeconomy,acommandeconomyandamixed
economy.Thereisn’tasinglecountryintheworldthatoperatesapure
marketeconomy.Therearealwaysreasonswhyitisinthebestinterestsof
acountry’sinhabitantsforthepublicsectortobeinvolvedintheeconomy.
Marketfailuremayoccurinamarketeconomyandsomegoodsandservices
maybeoversuppliedorundersupplied.Correctingthiswouldthenrequire
governmentintervention.
1.3 The South African Constitution and the public sector
TheConstitutionisthefoundationofthelawsandpoliciesofthiscountryand
itprotectsthefundamentalrightsofallSouthAfricans.TheConstitutionsets
outrulesforhowthegovernmentmustoperate.Nopolicyorbudgetcango
againsttheConstitution.
TheConstitutionsaysthatnational,provincialandmunicipalbudgetsand
budgetaryprocessesmustpromote:
• transparency
• accountability
• theeffectivefinancialmanagementoftheeconomy,debtandthepublic
sector.
Onpeople’shealthrights,itsaysthateveryonehastherighttoanenvironment
thatisnotharmfultotheirhealthorwell-being.Everyonehastherighttohave
accesstohealthcareservices,sufficientfoodandwaterandsocialsecurityif
theyareunabletosupportthemselvesandtheirdependants.Everychildhas
therighttobasicnutrition,shelter,basichealthcareservicesandsocialservices.
Itispartofthedutyofthepublicsectortoupholdtheserights.
1.4 Reasons for government intervention
1.4.1 To provide public goods and services
Therearesomegoodsandservicesthatwouldbeunderprovidediflefttothe
marketmechanism.Thisisbecausesomepeoplewouldbeunwillingtoshare
inpayingforthem,eventhoughtheyareinthepublicinterest.Examplesof
theseinclude:
• communitygoodssuchasdefence,police,streetlightingandfloodcontrol,
whicharesuppliedforthebenefitofallcitizens
• collectivegoodsthatweareallabletoenjoy,suchasparks,beaches,streets
androads
• meritgoods,suchaseducationandhealth,whichwouldbetooexpensive
forsomepeopletoafford,yetconsumingthemincreasesthewelfareof
thecountry.(Demeritgoodsaregoodsthatareharmfultosociety,suchas
cigarettes.)
The public sector
•
63
Publicgoodshavetwomaincharacteristics:
• W
hentheyareprovidedtooneindividualtheyareprovidedtoeveryone,
whichmeansthereisnon-excludability.
• Consumptionbyoneindividualdoesnotpreventconsumptionbyothers,
whichmeansthereisnon-rivalry.
Non-payers(free-riders)cannotbe
excludedfromthebenefitofsuchgoods.
Thisnon-excludabilitymeansthat
individualscannotbechargedaprice
onthebasisofuse.Thesegoodsand
servicesarenotofferedbytheprivate
sectorbecauseconsumptionbyonedoes
notexcludeconsumptionbyanother.For
example,whenstreetlightsareswitched
on,everyonebenefitsandnoonecan
beexcludedfromusingthemevenif
somepeopledonotpayratesandtaxes.
Acyclistdoesnotpayaroadlicence
butcanstillmakeuseofroads.Weall
benefitfromusingtrafficlights.
Figure 3.1 Street lighting benefits everyone who uses a street.
1.4.2 To provide merit goods
Meritgoodsaregoodsthatprovide
morepublicbenefitthanbenefittothe
individualandincludeservicessuchas
educationandhealthcare.Thesegoods
orserviceshaveabroadsocialbenefit
thatextendsbeyondthebenefittothe
individualwhousestheservice.Forthis
reason,peoplebelievethattheindividual
shouldnothavetobearthefullcostof
thesegoods.Thestateprovidesmerit
goodsbecausethereisariskthatthese
wouldbeundersupplied,orinadequately
consumed,duetolackofincome.For
example,offeringfreevaccinations
againstpoliohasmoreorlesseradicated Figure 3.2 Inoculating small children against infectious diseases
benefits the whole population.
poliofromtheworld,soweallbenefit.
Positive externalitiesexistwhenasecondorthirdpartygetsabenefit
fromtheconsumptionorproductionofagoodorservice.Forexample,by
inoculatingsmallchildrenagainstmeasles,welessentheriskofcatchingthe
diseaseforeveryone,especiallyexpectantmotherswhosebabiescouldbe
harmedbythedisease.
64
• The public sector
Topic 3
1.4.3 To protect natural resources
Ifpeopleareallowedtouseresources
insensitivelyandcarelessly,suchasoceansand
rivers,itcancausedamage.Thegovernment
intervenestoprotecttheenvironmentand
controlorpreventthecreationofnegative
externalities.TheBillofRights,whichispart
oftheSouthAfricanConstitution,statesthat
everyonehasarighttoanenvironmentthat
isnotharmfultotheirhealthandwell-being
andthattheenvironmentmustbeprotected
throughlegislation.
Negativeexternalitiesarecostsresultingfrom
theproductionofagoodoraservicethat
Figure 3.3 Environmental pollution is a negative
impactonasecondorthirdpartyandthatare
externality.
notreflectedintheprice.Businessesoftenfailto
takeintoaccountthecoststhatsocietyincursasaresultofproduction,suchas
pollution,noiseandcongestion.
1.4.4 To redistribute wealth and income
Oneaimofthepublicsectormaybetoobtainamoreequitabledistribution
ofincomeandwealthwithinacountry.Thiscanbeachievedthrougha
progressive taxation system anduseoftransferpaymentsofmoneyfromthe
governmenttoindividuals.Examplesoftransferpaymentsincluderetirement
pensions,sicknessbenefits,childbenefitsandunemploymentbenefits.This
helpstonarrowthegapbetweentherichandthepoorandcreatesamore
stablesociety.
1.4.5 To manage the economy
Themarketsystemdoesnotnecessarilybringabouthigheremployment,price
stabilityandanacceptableeconomicgrowthrate.Thegovernmentcanapply
suitablegovernmentpoliciestoachieve
theseobjectives.
Agovernmenthastomanagethe
economicinterestsofthecitizensto
ensurethatanenvironmentexists
inwhichindividualsandbusinesses
canpursuetheirownintereststothe
maximumandthateconomicgrowth
occurs.
Figure 3.4 Ministers debate policy-making issues in parliament.
The public sector
•
65