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The Solutions for all Economics 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 an accessible way. 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. so o i t n u l or all sf solutions for all Solutions for all Economics Learner’s Book has been developed to support the content (knowledge, concepts and skills) contained in the new Curriculum and Assessment Policy Statement (CAPS) for Economics. Economics The Solutions for all Economics Learner’s Book is supported by the Solutions for all Economics Teacher’s Guide. This course provides everything the teacher and learners need to master Economics in Grade 12: a complete solution for the classroom. so so so 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 Phase: Also available in this series for the Further Education and Training Phase: Also available in Afrikaans. Learner’s Book B Serfontein Also available in Afrikaans. www.macmillan.co.za ISBN 978 143100 645 8 Teacher’s Guide www.macmillan.co.za ISBN 978 143100 000 0 Also available in Afrikaans. Learner’s Book Grade 11 Learner’s Book B Serfontein Grade 11 Learner’s Book ISBN 978 143100 645 8 Grade 10 Learner’s Book Grade 10 Learner’s Book www.macmillan.co.za 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 Phase: or all sf 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 this series for the Further Education and Training Phase: lution Economics In addition, learners are provided with: • Additionalhomeworkactivities • Extrapracticeactivitiesthatcaterforbothremediationand enrichment • Asummaryofacycleofwork.Acyclemayconsistofoneormore weeks’ work. 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 • 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. 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 sf 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 © Illustrations and design Macmillan South Africa (Pty) Ltd, 2013 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, photocopying, recording, or otherwise, without the prior written permission of the copyright holder or in accordance with the provisions of the Copyright Act, 1978 (as amended). Any person who commits any unauthorised act in relation to this publication may be liable for criminal prosecution and civil claims for damages. First published 2013 13 15 17 19 18 16 14 2 4 6 8 10 9 7 5 3 1 Published by Macmillan South Africa (Pty) Ltd Private Bag X19 Northlands 2116 Gauteng South Africa Typeset in Palatino Ltd Std 11.5pt on 14pt by The Design Drawer Cover image from The Bigger Picture Cover design by Deevine Design Illustrations by Alex Flemming, Ian Greenop, Doug Hughes Photographs by: Africa Media Online (141, 348), Afripics (64, 158, 212, 213, 233, 257, 359 and 362), Arianna Baldo (145), Cartoon Stock (135), Chris Madden (366), Digital Jungle (72), DTI (263), Fotostock (1, 37, 45, 60, 65, 70, 90, 149, 152, 186, 209, 212, 254, 312, 326, 332, 334 and 362), Gallo (227, 234, 235, 337 and 363), Greatstock (64, 65, 78, 146, 155 and 345), Health Systems Trust (88), Liesle Timol (140), United Nations (373 and 374), VMS Images (131 and 275) ISBN: 978-1-4310-1375-3 e-ISBN: 9781431024087 WIP: 4451M000 It is illegal to photocopy any page of this book without written permission from the publishers. The publishers have made every effort to trace the copyright holders. If they have inadvertently overlooked any, they will be pleased to make the necessary arrangements at the first opportunity. 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