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LECTURE 1 (BLOCK RELEASE) CHAPTER 1 INTRODUCTION Introduction Macroeconomics is concerned with the study of the whole economy. Macroeconomics is concerned with the study of economy wide aggregates, such as the analysis of total output and employment, total consumption, total investment and national product. (Vaish,1995). It is concerned with the behaviour of the economy as a whole- with booms and recessions, the economy’s total output of goods and services and growth of out[put, the rates of inflation and unemployment, balance of payments, exchange rates etc. Because it is closely related to real world issues, macroeconomics also involves many non-economic factors such as political, historic, cultural and sociological factors. (Dornbusch et al, 1998). Macroeconomics and Microeconomics The line between macroeconomics and microeconomics is less sharp than it used to be, but it is still there. What makes this module different is that we focus on the economy as a whole. Instead of talking about the demand and supply of (say) pizza (microeconomics), we talk about the aggregate demand and aggregate supply of output in the whole economy (macroeconomics). Instead of talking about what determines the demand for workers in the pizza industry (microeconomics), we talk about what determines the total demand for workers (macroeconomics). Policy objectives of all economies The macroeconomic problems arise when the economy suffers from high unemployment, inflation, or a balance of payments deficit or a decline in economic activity. All governments like to achieve the following 4 major macroeconomic policy objectives:(Low unemployment , Low inflation or more or less stable price level, A 1 balance of payments equilibrium especially a surplus, A satisfactory rate of economic growth ). 1. Full employment (or low unemployment)- available factors of production in the economy must be fully employed to avoid losing potential production for good. There is also moral degradation of those who were formerly employed and now can no longer support their families. On full employment of labour force it is not possible to achieve this in the strictest sense. The use of official unemployment statistics as basis for setting policy objectives is also suspect. The list by government includes those defined as being unemployed by government rather than those who would be willing to take up paid employment should it become available. Some people on the register may be unemployable-aged, disabled, criminals and those not intending to work. 2. Stability of prices (or low inflation rate)- this is less pressing than the full employment objective. Effects of inflation on certain sectors and groups of the economy are regarded as undesirable (negative effects include redistribution off income, BOP problems and the possibility of a misallocation of factors of production. 3. External stability (or balance of payments equilibrium)- a balance should exist between the value of exports and imports in order to ensure that the country will be able to pay for its essential imports. Policy must ensure that the balance of payments (a statement of all transactions with foreign countries) is stable and that the rate of exchange consequently remains relatively stable. 4. Economic growth (or a satisfactory rate of economic growth). Since a positive ratio exists between economic growth and employment this objective is often set as a goal together with full employment. Economic growth is largely complementary to greater employment. Problems of Policy Timing The timing of policy events may be crucial to the efficiency and effectiveness of policies. There are basically three forms of time lag to consider in relation to the behaviour of policy makers and operation of the economy. 2 (a) Recognition lag- authorities perceive problems after some time. (b) Administration lag- it takes time to set up the necessary administrative machinery in motion. For example Parliament approves income tax measures after debate but monetary policy options take days or hours to implement. (c) Implementation lag- by the time the policy is implemented, new issues have arisen hence new policies have to be implemented/formulated or adapt the policy instruments introduced. Chief Instruments of Economic Policy The two important subdivisions of economic policy are the monetary policy and the fiscal policy. These two policies are applied as mutually complementary policies to serve as instruments of government’s economic policy which is applied to achieve certain social goals. Often the two overlap, because it is almost impossible to envisage any major fiscal or monetary measure which does not affect the other. A. Fiscal Policy. This is the policy of government with regard to level of government spending and tax structure. Government expenditure includes transfer payments, government current expenditures and budgetary balance (extent of borrowing). Taxation (i) provides the funds to finance expenditure. (ii) Can also be used for income redistribution. Taxes are subdivided into direct and indirect. o Direct taxes – these are levied directly on persons / corporates and include income tax, corporate tax, poll tax and inheritance taxes, import duties. Typical uses for this instrument are a reduction in income inequalities, regulate aggregate demand, protection of domestic producers, reduce poverty, and provision of infrastructure and to adjust balance between aggregate demand and supply. Import duties are important sources of revenue in many African countries. Countries impose import tariffs for some or all of the following reasons: (a) Revenue, protection to local producers, (b) discriminate between essential and non-essential goods and (c) B.O.P purposes. o (ii)Indirect tax is levied on a thing and is paid by an individual by virtue of association with that thing, e.g. local rates on property, sales taxes and excise duties. Tax structure can be regressive proportional or progressive. Tax incentives may be given - investment allowances, tax 3 holidays, accelerated depreciation allowances, duty-free imports; notax concessions may be given by government for e.g. provision of roads, water and power. In some African countries rural taxation- was used e.g. Cameroon, Mali and Sudan. Problems of Fiscal Administration (a) Tax evasion (b) Shortage of trained and experienced staff. (c) Corruption. (d) Attitudes towards payment of taxes. (e) Poor co-ordination of budgets with development plans. B. Monetary Policy- the manipulation of the volume of credit, interest rates and other monetary variables. Monetary policy is a policy which employs central bank’s control over the supply, cost and use of money as an instrument for achieving certain given objectives of economic policy. The policy is used to improve credit and saving facilities and to regulate macroeconomic balance of the economy. All governments run deficits in that their total spending exceeds the value of their tax and other current receipts. The deficit is financed by long-term borrowing from abroad and from local residents. Sometimes the long-term borrowings will not cover the gap which means it has to be financed by other means. Government usually fills the gap by short-term borrowing from the central and commercial banks. This borrowing from the banking system (deficit financing) usually has highly expansionary effects on money supply. In other words it increases the money supply by the amount of the deficit but is likely also to result in secondary increases in money supply by increasing the cash base of the banking system and hence its ability to lend more to private borrowers. (N.B. Expansionary does not mean inflationary). Monetary policy can be used for antiinflationary purposes. Much industrial and commercial expansion is financed by bank credit (especially for working capital) so to restrict bank lending is liable to place a brake on new investment and economic expansion. It is possible for credit restrictions to be pushed to the extent of forcing a deflation on the economy, with serious avoidable losses of output and employment. Some economists have argued in favour of the use of high interest rates to curb aggregate demand. The effect of 4 a move along these lines is to encourage the holding of larger money balances, reducing the pressure of demand for commodities. Critique of the interest rate Reservations to the interest rate issue have been raised: Higher interest rates may discourage investment and thus impede the development of the economy. It can be counter argued that higher interest rates will raise the productivity of new investments because now only projects which promise large returns will be undertaken. Hence it may be possible to sustain the overall rate of economy growth even from a reduced volume of investment. A successful induction of people to substantially increase their money holdings may due to the withdrawal of purchasing power from commodity markets, be deflationary. Several studies have found the elasticity of demand for money with respect to the cost of holding it to be rather small. If this is the case, it would take a very large rise in interest rates to affect a significant increase in the demand for money. Limitations of the state in achieving Macroeconomic Policy Objectives The following are typical limitations of the state in achieving macroeconomic policy objectives especially in developing countries: Too many ministries, often with competing interests, too many public corporations and too many boards of one kind or another. Too much corruption of civil service, civil servants badly motivated. Too much red tape. Too much political instability with governments often changed by military coups and other unconstitutional means. Governments are therefore preoccupied with tasks of maintaining their own popularity, authority and power. BUSINESS CYCLES Business Cycles (or trade cycle) A business cycle is the more or less regular pattern of expansion (recovery) and contraction (recession) in economic activity around a growth trend (Dornbusch et al, 1998). Business cycles can also be described as the periodic booms and slumps in economic activities. The ups and downs in the economy are reflected by the 5 fluctuations in aggregate economic magnitudes, such as, production, investment, employment, prices, wages, bank credits etc. Fig. 1.1 Trade Cycles or business cycles- simplified diagram The upward and downward movements in these magnitudes show different phases of a business cycle (Dwivedi, 1996). Basically there are only two phases in a cycle, namely prosperity (boom) and depression (recession). Considering the intermediate stages between prosperity and depression, the various phases of trade cycle may be enumerated as follows: 1) 2) 3) 4) 5) Expansion Peak Recession; Trough Recovery and expansion Fig. 1.2 Phases of Business Cycles line of cycle Peak Growth Rates prosperity expansion peak recovery trough Time 6 steady growth line depression trough Expansion or prosperity (or boom) This boom is characterised by increase in output, employment, investment, aggregate demand, sales, profits, bank credits, wholesale and retail prices per capita output and a rise in standard of living. The growth rate eventually slows down and reaches the peak. However: A boom increases spending on imports, causing balance of payments problems. Once high levels of employment have been reached, output cannot be increased any further and the boom causes inflation. Peak This is characterized by slacking in the expansion rate, the highest level of prosperity, and downward slide in the economic activities from the peak. Recession The phase begins when the downward slide in the growth rate becomes rapid and steady. Output, employment, prices, etc. register a rapid decline, though the realised growth rate may still remain above the steady growth line. So long as growth rate exceeds or equals the expected steady growth rate, the economy enjoys the period of prosperity, high and low. When the growth rate goes below the steady growth rate, it marks the beginning of depression in the economy. Total output, employment, prices, bank advances etc. decline during the subsequent periods. In other words there is a slump in the economy. [A slump reduces spending on imports, thus improving the balance of payments. Reduced total spending lowers inflationary pressure.] The span of depression spreads over the period growth rate stays below the secular growth rate (or zero growth rate) in a stagnated economy. Trough This is the phase during which the downtrend in the economy slows down and eventually stops and the economic activities once again register an upward movement. Trough is the period of most severe strain on the economy. Recovery When the economy registers a continuous and rapid upward trend in output, employment, etc, it enters the phase of recovery though the growth rate. When it 7 exceeds this rate, the economy once again enters the phase of expansion and prosperity. If economic fluctuations are not controlled by the government, the business cycles continue to recur as stated above. Why worry about business cycles? Business cycles, cause not only harm to business but also misery to human beings by creating unemployment and poverty. Governments in many countries assume the role of a key player in employment and stabilization. Stabilization broadly means preventing the extremes of ups and downs or booms and depression in the economy without preventing factors of economic growth to operate. 8 LECTURES 2 AND 3 (BLOCK RELEASE) CHAPTER 6 UNEMPLOYMENT AND LABOUR FORCE PLANNING What is unemployment? Definition Unemployment is the pool of people above a specified age who are without work, are currently available for work and are seeking work during a period of reference. Unemployment results when the available workplaces cannot adapt to the job seekers. When the number of persons, who offer their working capacities, exceeds the number of available workplaces, this leads to a lack in workplaces. Unemployment is an overwhelming concern of policymakers and the general public. Unemployment often implies a waste of human resources that could otherwise be producing goods and services to satisfy the needs of society. At the same time, it can mean extreme personal hardship for the Unemployed, and therefore it is an important social concern. Unemployment rate fluctuates widely over time within a given country, in line with the business cycle. Unemployment increases during recession and declines during booms. Why unemployment is studied 1. The income aspect- income can mostly be earned if one is employed. Most economies gain from employment of their nationals. 2. The production aspect of employment- concern is on the labour utilisation. If labour is unemployed there is a waste of productive resources. 3. Recognition aspect- the type of employment determines social status and selfesteem. Studies found that people who had been unemployed for two or more years had self-esteem. Consequences of unemployment /Costs of Unemployment 1. Lost Output The opportunity cost of each unemployed person is their foregone output. 91 2. Increased Benefit Payments Each extra person who becomes unemployed stops paying tax ( perhaps $4000) and starts receiving benefit (upwards of $5000). The government therefore has to raise a additional funds to finance unemployment benefits for unemployed. As the figure falls the government pays out less unemployment benefits and receives more in tax. The savings to the exchequer from this will be considerable. 3. Lost Tax Revenue Growing unemployment means less direct and indirect tax revenue. When people lose their jobs they will stop paying income tax, and their spending will fall considerably reducing government receipts from VAT and other indirect taxes. 4. Human Costs of Unemployment The long-term and youth unemployed feel increasingly isolated and removed (alienated) from society. There will also be increased national health service costs as people's health often suffers when they are unemployed, and there will be increased costs to society in terms of crime. In a society where money means success the unemployed feel useless and consider themselves a failure. Studies have shown that people who have been unemployed for some time develop a low self esteem.They are dissatisfied and depressed and this may lead to alcoholism drug problems and homelessness and even to crime.Especially for families it’s difficult because they do not have enough money to afford their basics of life. Because of that that government has to help financially, but this causes high costs for working people who have to support the unemployed. High risk groups There are some high-risk groups, for example youths, women with little children after their maternity leave or elderly people aged 50 and over. Lots of those people cannot find a (good) job. Young people are part of the high-risk group because in most cases they do not have any practical experience and there are lots of young people searching for the same few jobs. That is why there is a high selection rate on the job market. Firms want to employ young people with lots of experience who want to work almost 24 hours a day and earn just a little pocket money. 92 Women in general, but especially women with little children who want to work again after their maternity leave are another high-risk group. Their problem is that the probability of their needing time off to nurse sick children is very high, especially if they have little kids. Another problem is that those women have not worked for the time of their child nursing and there might be new trends, new developments or things like that. The last high-risk group is the large group of over 50 year old people. Their problem is that they cost too much. If a firm employs younger workers they do not have to pay as much as they would for an older person. That is why they are fired. And it is almost impossible for those people to find a new work place. Measurement of Unemployment When calculating the level of unemployment many governments only count those people who register as unemployed and claim benefit(where available). A large number of people seeking work either do not register or do not claim benefit and are now excluded from official figures. Unemployment rate is the number of unemployed people as a proportion of the labour force. The labour force is the total of all those with work and all those seeking work. The unemployment rate is the percentage of the labour force officially jobless. Unemployment rate= Unemployed 100% Economically Active Population The unemployment rate in Zimbabwe is calculated by dividing the number of unemployed persons aged 15 years and above by the economically active population in that age range in Zimbabwe. The table below shows the unemployment rate in Zimbabwe for some given provinces in 1997 93 Table 6.1 Unemployment rates in selected Provinces (1997) Province Economically Unemployed Active Persons Manicaland 757009 27152 Unemployment Rate (%) 3.6 Mashonaland West 511354 35219 6.9 Matebeleland South 255670 4011 1.6 Midlands 624445 28693 4.6 Masvingo 500341 17432 3.5 Harare 831333 134105 16.1 Bulawayo 267200 51782 19.4 Source :CSO Compendium of Statistics, 2001 Unemployment Trends Unemployment is a flow and not a stock. There are always inflows onto the unemployment register, and there are outflows off the register as people get jobs or join training schemes. If all inflows rise and all outflows except training fall then overall unemployment will rise. Young people, women, the over-fifties and ethnic minorities tend to be the hardest hit. Inner cities and manufacturing areas also tend to have above-average unemployment. Natural rate of unemployment The natural rate of unemployment is the rate of unemployment associated with the output level at which the aggregate supply curve becomes vertical, that is the full employment level of output. The natural rate of unemployment is sometimes called the “the full employment” rate of unemployment conveying the sense that unemployment is excessive only when actual unemployment exceeds the natural level. Full employment occurs when the number of notified job vacancies exceeds the number of registered people unemployed. A more recent term for the natural rate of unemployment is the Non-Accelerating –Inflation Rate of Unemployment or NAIRU. The gap between actual unemployment and the natural rate is normally referred to as cyclical unemployment. In other words, cyclical unemployment is the amount of unemployment that can be reduced by expansionary macroeconomic policies without setting off an endless rise in the rate of inflation. 94 Types of unemployment We have to differentiate between a few types of unemployment: 1. Cyclical unemployment: if a country has an economical boom then people have jobs, if there is an economic recession people lose jobs. Cyclical unemployment is unemployment above the natural rate. 2. Frictional unemployment: This arises because people are always flowing into and out of unemployment. New workers are constantly entering the labour force, and existing workers frequently leave one job and look for another. During these transitions they spend time on their job searches e.g. you stop working in December and start your new work in March, these period between these months is called frictional unemployment 3. Structural unemployment: Structural unemployment can occur in factories when too old machines, cannot produce enough, sell less products, cannot pay their staff, and result in more unemployed people. This occurs when economic readjustments are not fast enough during economic growth, so that severe pockets of unemployment occur in areas, industries and occupations in which the demand for factors of production is falling faster than is the supply. Policies that discourage movement among regions, industries and occupations can raise structural unemployment. 4. Technological Unemployment- this comes about as a result of technological change. 5. Seasonal unemployment: e.g. tourism-areas, construction sector, and agricultural sector. In the rural areas or farming areas, everyone is fully employed during the rain season and harvesting periods but thereafter demand for labour is very low. The unemployment is mostly where there is single cropping 6. Hidden unemployment: dismissed people don’t ask for a new job, they also don’t register for unemployment benefits, e.g. women after their maternity leave often stay at home with their children. It can also include the discouraged, those nominally having jobs for which they are paid but in fact doing nothing; and those who can be withdrawn from rural areas because of their zero marginal product. 95 Causes of Unemployment 1. Rapid growth of labour forces due to high population growth rate in developing countries. Fast growth of labour force places a strain on the ability of the economy to generate new work opportunities on a sufficient scale to absorb rising numbers (economic dualism and rural- urban migration). In the Lewis model, an unlimited supply of surplus farm labor migrates to urban areas for wages in excess of rural, subsistence wages. Also inadequate capital, lack of technology, low educational and skill levels, the brain drain to urban areas, food price policies, below market foreign exchange rates, and governmental urban bias contribute to low incomes in rural areas. 2. Education system also contributes – the size of the educated labour force is growing more rapidly than the economy can absorb. The LDC unemployment is higher among the educated than the uneducated because the educated may have unrealistic earnings expectations or job preferences and because wages paid to educated workers are often inflexible. Although education can increase the entrepreneurial supply by making available skills needed for business, it can decrease this supply by increasing a person's job options. Cultural norms in LDCs defining how women should behave at work limit female entrepreneurial activity. 3. Shortage of saving and investment- investment per worker in developing countries is often less than that in developed countries. Some countries substantial savings and income from widespread rent seeking, acquiring private benefits from public resources. 4. Inefficient land tenure systems in many developing countries cause them not to be able to utilise their expanding labour resources. 5. Inappropriate developmemnt strategies they pursued and technologies adopted. They engaged in import substitution strategies hence limited jobs. Technology designed for the industrialized countries, which have a relative abundance of capital and scarcity of labor, is often not suitable for LDCs, with their abundant labor and scarce capital. This inappropriate technology increases unemployment. 6. Engineering bias, minimum wage laws, government salary structures, influence of trade unions, pay policies of multinational corporations all help to raise the urban wages well above competitive market clearing levels. 96 7. Laws and conventions holding down interest rates, tax concessions for foreign investors similarly hold the price of capital well below levels which would reflect their scarcity in the economy. Solutions to unemployment Possible solutions: Job-sharing and Early retirement- Job-sharing cannot be the best of solutions because if you share your job you won't earn enough money to afford the basics of life for your family. Early retirement sounds nice but it means a huge amount of costs for all the other working people who have to pay for that. This can therefore not be the best of ways. A good solution would be the attendance of further training courses, so that unemployed people are trained to find a new job and learn new skills. The only problem about that are the costs, which are very high and the question is who is going to pay them. Population control- if there is population restraint the growth of developing country labour force will be in check. Overhaul of the education systems to change from their present academic, elitist, white-collar job orientation to vocational and technical training systems to produce artisans and technicians the countries desperately need. Stress scientific and technical education. Resist pressures for a too rapid expansion of upper level education and refuse to subsidize this level of education. Sectoral priorities which particularly favour the development of small-scale agriculture and the informal sector. Small-scale agriculture and the informal sector are labour intensive, so their development will both generate more employment and raise productivities of those already working in them. Increase official purchases from small scale, labour intensive firms. Incomes policies designed to prevent formal sector wage levels from being raised by institutional factors to levels well above the true economic value of unskilled labour. This involves attention to the government‘s own pay policies, its policies towards the trade unions, towards multinational firms and 97 towards minimum wage legislation. Curtail wages in the organized (formal) sector. Rural development and decentralisation- this involves coordination of programmes for the improvement of agriculture, water, transport; access to goods and services and appropriate land tenure- aim is to reduce rural- urban migration. Encourage rural development and amenities. Informal Sector:The development of the sector is attractive because it does not require complex and expensive infrastructure and has high potential for creating jobs. It uses mostly locally produced resources or raw materials. It can be a major source of income generation both for rural and nonagricultural informal sections of the economy. It creates a platform for the exchange of locally produced goods and services. It provides strong base for local entrepreneurs. It is also a source of government revenue when these sectors grow and become registered. Informal sector in Zimbabwe The following problems have been cited in respect of informal sector in Zimbabwe: Procedures to be followed in obtaining licences and project approval are discouraging and they (operatives in the sector) pay high rentals to landlords. Because of the high corporate tax, they would rather remain unregistered. If they are taxed they face financial problems and hence cannot pay minimum wages. Lack of adequate transport and infrastructure to facilitate delivery of produce to the target market. Lack of technological support and managerial, technical and marketing skills. Lack of project planning and implementation. Inability to obtain loan and credit facilities hence due to lack of collateral security, 90% of microenterprises are automatically eliminated from getting financial assistance. However it must be pointed out that the development path whereby there is heavy emphasis on informal sector enterprise and small business development has limitations, although it provides employment and income. The disadvantage of informal enterprise is it does not lead to development of high technology non 98 traditional export.It does not invest in new technique, generate new skills and develop new products. Types, Causes, and Remedies for Unemployment – a summary The table below summarises the main causes and remedies for different types of unemployment. Table 6.2Causes and remedies of some unemployment Type Description Cause Workers temporarily Delays in applying Frictional between jobs interviewing and accepting jobs Workers have the wrong skills in the wrong place All firms need fewer Cyclical workers Technological Firms replace workers with machines Structural Regional Seasonal Declining industries and the immobility of labour Low total demand in the economy Automation and information technology High unemployment in Local concentration of one area declining industries Unemployment for part Seasonal variation in of the year demand Remedy Improve job information, eg computerised job centres Subsidies and improve the mobility of labour Increased government spending or lower taxes Retraining Regional aid, eg relocation grants Retraining LABOUR FORCE PLANNING Why planning? 1. Growing need for skilled labour force for economic growth and technological progress. 2. Response to employment difficulties and elimination of unemployment. Basically all economies aim at ensuring full employment and training the growing number of highly skilled personnel. Realistic Manpower planning -depends on extensive knowledge of the inherent relationships and tendencies underlying the objective processes in labour force. The processes are determined by dominant relations of production, given amount level and structure. -must consider major continuous movements affecting the labour force (external and internal). External include retirement and new engagements. 99 Internal-within active labour force e.g. place and kind of employment. These can be partly controlled through size, direction and structure may be accurately estimated. -must allocate and use the available labour force efficiently both qualitatively and quantitatively. 100 CHAPTER 7 INTERNATIONAL TRADE Introduction Basic condition of the world community is one of mutual interdependence. All countries of the world rely for their national well being on international trade and payments. Foreign currency or foreign exchange is used for effecting payments. The rate at which one country’s currency is exchanged for another. for example Z$44 000 / 1Rand is the exchange rate. International trade is the exchange of goods and services between countries. An import is the Zimbabwean purchase of a good or service made overseas. An export is the sale of a Zimbabwean-made good or service abroad. Benefits of Trade Participation in the international economy can improve living standards and the rate of economic development. This is in 3 ways: 1. Trade provides countries with an escape from confines of their national economies. It creates more profitable investment opportunities and this leads to accelerated growth. 2. By giving access to the products of other nations, it avoids the need to strive for self sufficiency within national boundaries- technology developed elsewhere is available. 3. Capital flows, an integral feature of world trade and payments give developing countries access to the savings of richer nations, to augment their own. Capital is obtainable from private sources as well as from ‘aid’ from foreign governments and agencies eg. World Bank. Reasons for Trade Domestic Non-availability -A nation trades because it lacks the raw materials, climate, specialist labour, capital or technology needed to manufacture a particular good. Trade allows a greater variety of goods and services. Theories of International Trade A number of theories were put forward to explain the basis of international trade: (1) Theory of Absolute Advantage 101 (2) Theory of Comparative Advantage or Comparative Costs (3) Factor Endowment Theory 1. Theory of Absolute Advantage Advanced by Adam Smith- Absolute advantage exists when one nation can produce a good more cheaply and efficiently than another. For example Kenya has an absolute advantage over the US in producing tea because of its climate and natural resources and labour force while the US has an absolute advantage over Kenya in computer production. 2. Principle of Comparative Advantage Initially developed by David Ricardo, the principle of comparative advantage states that countries will benefit by concentrating on the production of those goods in which they have a relative advantage. For instance, France has the climate and the expertise to produce better wine than Brazil. Brazil is better able to produce coffee than France. Each country benefits by specializing in the good it is most suited to making. France then creates a surplus of wine which it can trade for surplus Brazilian coffee. Exchange in international trade is more efficient if each country offers that particular good of which it has advantage in production relative to the good it receives in exchange. A country has comparative advantage in producing a good if the opportunity cost of producing the good is lower at home than in the other country. Even when one nation is absolutely more efficient in the production of every good, as long as there are differences in the relative costs of producing the various goods in the two potential trading nations the foreign trade is mutually beneficial. Numerical Example: The following is a breakdown of labour costs in the production of 1 unit of wine and 1 unit of cloth in Portugal and England. 102 Table.7.1 Production costs in England and Portugal Labour Cost of Production 1 unit wine 1 unit cloth Portugal 80 90 England 120 100 Portugal has an advantage in the production of both goods. The opportunity costs can be worked out for both goods in both countries. Table. 7.2 Opportunity costs Opportunity Cost for wine cloth Portugal 80 8 0.89 90 9 90 9 1.125 80 8 England 120 12 1.2 100 10 100 10 0.83 120 12 From this, Portugal has a comparative advantage in wine production while England has comparative advantage in cloth production. These countries can specialize in the production of the good for which each has a comparative advantage over the other. Portugal will specialize in the production of wine while England will specialize in the production of cloth. Therefore foreign trade is mutually beneficial, even when one nation is absolutely more efficient in the production of every good as long as there are differences in the relative costs of producing the various goods in the two potential trading nations. 3. Factor Endowment Theory -also called the Heckscher –Ohlin theory of international Trade. Assuming all countries have access to the same technological possibilities for all commodities, factors are immobile and the countries have different factor endowments, countries would trade in goods produced by the factor of production which is more abundant. Countries with more labour relative to capital would thus sell to other countries those goods produced using labour intensive technology. Those with more capital relative to labour will sell goods produced using capital intensive technology. 103 Protectionism Protectionism occurs when one country reduces the level of its imports. Arguments for Protectionism Reasons for protectionism include the following: Infant industries. If sunrise firms producing new-technology goods (eg computers) are to survive against established foreign producers then temporary tariffs or quotas may be needed. Unfair competition. Foreign firms may receive subsidies or other government benefits. They may be dumping (selling goods abroad at below cost price to capture a market). Balance of payments. Reducing imports improves the balance of trade. Strategic industries. To protect the manufacture of essential goods produced by strategic industries such as defence. Declining industries. To protect declining industries from creating further structural unemployment. Protecting consumers- e.g banning the sale and importation of hormone treated beef to protect consumers from the possible health consequences of meat treated with growth hormones. Arguments against Protectionism Prevents countries enjoying the full benefits of international specialization and trade. Invites retaliation from foreign governments. Protects inefficient home industries from foreign competition. Consumers pay more for inferior produce. Methods of trade restriction/ protectionism Tariffs Tariffs are a tax on goods produced abroad and sold domestically. In other words Tariffs (import duties) are surcharges on the price of imports. A tariff can be specific or advalorem. A specific tariff is a fixed amount for every amount of imports. For every unit of import a charge is put and this fixed amount for every unit of import is the tariff. An advalorem tariff is the charge per value of import. The principal objective of most tariffs is to protect domestic producers and employees against foreign competition; they also raise revenue for the state. The government 104 gains with increase in tariffs because tariff increases government revenues. Domestic producers also gain because tariff gives them some protection against foreign competitors by increasing the cost of imported foreign goods. The impact of a tariff raises the price of the import; moves a market closer to the equilibrium that would exist without trade. reduces the demand for imports; encourages demand for home-produced substitutes; raises revenue for the government MNKL The diagram below uses a supply-and-demand graph to illustrate the effect of a tariff. Fig. 7.1 The impact of a tariff on prices Equilibrium without trade Price with tariff P Govt Revenue P Price without tariff Imports with tariff Imports without tariff 105 Quotas An import quota is a limit on the quantity of a good that can be produced abroad and sold domestically. Put in other words Quotas restrict the actual quantity of an import allowed into a country. From the diagram below the world price is shifted to the right by exactly the amount of the quota. The supply curve below the world price does not shift because in this case importing is not profitable for the licence holders. A variant on the import quota is the Voluntary Export Restraint (VER). A VER is a quota on trade imposed by the exporting country, typically at the request of the importing country’s government. Fig. 7.2 The impact of quotas on domestic prices Domestic Supply Price Domestic Supply + import supply Equilibrium without trade Quota Price with quota Pq I Surplus for J Licence holders Pw H G K F Price without quota= world price Equilibrium with quota E World Price Domestic Demand Imports with quota A B C D Quantity Imports without quota Impact of a quota: raises the price of imports; reduces the volume of imports and moves a market closer to the equilibrium that would exist without trade; 106 encourages demand for domestically made substitutes; raises surplus for the licence holders equal to IGFJ. A quota is a non tariff restriction. Another example of a non tariff restriction is an embargo. An embargo is a complete ban on imports. Other Protection Techniques 1. Administrative practices can discriminate against imports through customs delays or setting specifications met by domestic, but not foreign, producers. Governments use a range of informal or administrative policies to restrict imports and boost exports. Administrative trade policies are bureaucratic rules designed to make it difficult for imports to enter a country. For example France required that all imported video tape recorders arrive through a small customs entry point which was both remote and poorly staffed. The resulting delays kept Japanese VCRs out of the French market. 2. Exchange controls (currency restrictions) prevent domestic residents from acquiring sufficient foreign currency to pay for imports. 3. Prior to imports deposits. Before you import you are supposed to put aside an import value. This reduces the amount of import. 4. Technical specifications on imported goods. The government put standards on the goods imported causing rejection of some. For example the local content requirements call for some specific fraction of a good to be produced domestically. For example 75% of component parts for this product must be produced locally. 5. Subsidies. A subsidy is a government payment to a domestic producer. The subsidies take many forms including cash grants, low interest loans, tax breaks, and government participation in domestic firms. By lowering costs, subsidies help domestic producers in two ways: they help compete against low cost foreign imports and they help them gain export markets. 6. Antidumping Policies. Antidumping policies are policies designed to punish foreign firms that engage in dumping. The ultimate objective is to protect domestic producers from “unfair” foreign competition. 107 Zimbabwe’s External Trade position The major destinations for Zimbabwean exports are South Africa, United Kingdom, Germany and lately China. The exports and imports statistics are shown in the table below. The major sources for Zimbabwean imports are again South Africa, United Kingdom, United State, Botswana and Germany. The main trading partner is South Africa. Table 7.3 Zimbabwe’s exports 1995-2000 Year Export Value ($000) 1995 29757834 1996 23169907 1997 28967449 1998 46317037 1999 73844947 2000 81258506 Source CSO Compendium , 2001 p 198 Table 7.4 Zimbabwe’s imports (1995-2000) Year Import Value ($000) 1995 37 900 116 1996 38 156 392 1997 37 646 358 1998 66 155 618 1999 83 407 195 2000 80 245 320 Source CSO Compendium , 2001 p 199 108 CHAPTER 8 BALANCE OF PAYMENTS AND THE FOREIGN EXCHANGE MARKET Definition of the Balance of Payments In order to know the position as regards international payments, governments compile records of transactions. This record of transactions is thus called the Balance of Payments (BOP). The balance of payments: o Is a systematic record of the economic transactions between residents of the exporting country and residents of the foreign countries during a certain period of time or o Is the difference between the total earnings on both invisible and visible items and total expenses or o Is a record of one country's trade dealings or transactions with the rest of the world. Any transaction involving Zimbabwean and foreign citizens is calculated in dollars Dealings which result in money entering the country are credit (plus) items while transactions which lead to money leaving the country are debit (minus) items. Components of the Balance Of Payments It consists of three parts: (1) Current Account- this records the current purchases and sales of goods and services to the rest of the world. (2) Capital Account- this records the financial or capital transactions, including the borrowing and lending of funds. Deals with overseas flows of money from international investments and loans. (3) Monetary Account- also called official financing account. It deals with foreign currency reserves and transactions with multilateral bodies. deals with overseas flows of money from international investments and loans; Current Account The current account consists of international dealings in goods (visible trade) and services (invisible trade). It records all transactions in goods and services, i.e. visibles and invisibles. Invisible exports and imports consist of factor plus noon-factor services. Receipt of interest, profits and dividends on loans and investments in foreign 109 countries; earnings from tourism and transportation and remittances home of income earned by nationals working abroad are included in this account as invisibles. Table 8.1 Example of Current Account 1985 Debits $m Credits $m Balance $m Visible imports 80 140 Visible exports 78 072 -2 068 Invisible imports 75 007 Invisible exports 80 027 5 020 By referring to above table you can see that in 1985: Zimbabwe bought $80 140 million worth of goods made overseas. Zimbabwe sold $78 072 million worth of goods overseas. The difference between visible exports and imports is known as the balance of trade or trade balance or visible balance. This amounted to -$2 068 million. Zimbabwe bought $75 007 million worth of foreign-produced services. Zimbabwe sold $80 027 million worth of services overseas. The difference between invisible exports and imports is called the invisible balance. This amounted to $5 020 million. Adding the balance of trade and balance on invisibles together gives the balance on the current account. This is an important concept with a view to economic policy because it indicates whether or not a country has been living within its current means. A deficit on the current account means that more goods and services have been imported into the country than have been sold abroad. A surplus on the current account means more goods and services have been exported than imported. Capital account It deals with transactions in Assets and liabilities. The transactions in assets and liabilities section of the balance of payments shows all movements of money in and out of the country for investment. This may be direct investment - investment in productive capacity (when firms invest in other countries to increase capital in these countries), or portfolio investment - investment in shares ,bonds or other assets in foreign countries. Changes in assets will be outflows from Zimbabwe, as Zimbabwean investors invest money overseas. These flows will be debits to the Zimbabwe’s Balance of Payments. Changes in liabilities will be credits to the 110 Zimbabwean Balance of Payments as overseas investors invest money into the country (Zimbabwe) The capital account is divided into 2 sections, that is long-term capital movements and short-term capital movements. (i) Long term capital movements. These include public authorities, public corporations, banking sector and non-bank private sector. (ii) Short-term capital movements- these consist of import and export credit granted by banks in Zimbabwe and in other countries. Monetary Account This is also called the official financing account. It records changes in the country’s official foreign currency/exchange reserves (consisting usually of a mixture of gold and foreign currencies) plus transactions with the IMF and other financial institutions. Gold and foreign reserves The reserves must be kept at a reasonable level for 3 reasons: Foreign reserves are needed to finance transactions with foreign countries especially as month to month payments and receipts do not necessarily coincide. Foreign reserves are also needed to even out undesirable fluctuations in the exchange rate. Foreign reserves indicate what the maximum foreign deficit is if no further loans are forthcoming Balance of Payments ProblemsA. Balance of payments deficit This is of concern especially in developing countries because it affects the ability of those countries to trade with other countries. A balance of payments deficit is a major problem if it is persistent. This can be the result of excessive purchases of foreign goods and services or excessive Zimbabwean investment overseas. Faced with existing or projected balance of payments deficits on the combined current and capital accounts a variety of policy options are available: 111 Balance of Payments Deficit This can be corrected through: 1. Long term capital from the rest of the world. This has the disadvantage of external indebtedness. 2. Using foreign currency reserves- this is a short term measure because most non-oil producing developing countries have very few months in which to exhaust this. 3. Attracting additional inflows of short-term capital by raising interest rates. Lack of stability in developing countries means that there is no guarantee funds will remain in the countries, i.e. there is capital flight. 4. Import substitution- this is the local production of previously imported goods. This requires the importation of capital equipment and protection of the infant industry by imposing tariffs or bans on imported goods. 5. Exchange control – this is designed to control foreign currency reserves. The foreign currency is rationed so that the most pressing needs of the country will be given top priority when the funds are allocated., eg. capital goods and essential raw materials. Measures also include import licensing as well as creating a state monopoly tasked to import essentials. 6. Use of multiple exchange rates- different rates for currencies/ transactions. Essentials such as exports, tourism and essential inputs for industry would have a separate rate(s) of exchange to encourage them while for nonessentials they would be discriminatory . In other words there is a multi-tiered market for foreign exchange. The Central Bank can discriminate between different types of transactions, encouraging some and discouraging others. There can also be a dual exchange rate system whereby two sets of exchange rates are used. One rate may be overvalued and may be much lower especially for luxury consumption goods imports. These however present serious problems of administration corruption and evasion. 7. Disguised depreciation- this is a policy whereby there is a deliberate effort by government to make imports more expensive. This includes raising import duties, taxing invisibles, and taxing remittances abroad; subsidize exports, charging high fees on sales of foreign currency. This policy is deflationary and also has loopholes. 8. Devaluation- reducing the external value of a currency. This increases the volume of sales abroad. 9. Promoting export expansion- drawbacks of duty, export incentive schemes. 112 10. Encouraging more private investment and seeking more foreign assistance. Much of the foreign aid comes in the form of loans which have to serviced. Interest has to be paid on the loans. The principal has also to be repaid in future. B. Balance of Payments Surplus This is also a cause for concern because if it is persistent, partners may retaliate by introducing import controls etc. A surplus implies an overvaluation of currency and this leads to exports becoming less competitive on the world market. It could also be inflationary because, it is argued by monetarists that it leads to an increase in money supply. A persistent surplus could mean a depression of domestic living standards. Correcting a Balance of Payments Surplus An unwanted balance of payments surplus can be the result of excessive foreign investment in Zimbabwe. This will place a future strain on the invisible balance. A reduction in interest rates ( an outflow of funds on the capital account) or the scrapping of protectionist measures (restrictive exchange controls) will correct the surplus. FOREIGN EXCHANGE MARKET Foreign trade involves payment in foreign currencies .eg. Br pound, US$, SAR. Zimbabweans have to pay in these currencies for the goods they buy and are therefore obliged to exchange Z$ for these currencies; i.e. there is demand on the part of Zimbabwean importers for DM, Pounds, US$, ZAR. On the other hand importers in other countries have to pay Z$ for Zimbabwean exports and must therefore offer DM, pounds in exchange for Z$. The rate of exchange therefore represents a ratio or proportion, but it is also a price. (Price of one monetary unit in terms of another monetary unit.) An increase in the value or price of one currency (also known as appreciation) automatically implies a decrease (depreciation) in the price of another currency. Players in the foreign currency market The foreign currency market is conducted by banks, foreign exchange brokers, foreign currency dealers, etc. through extensive international telephones, cables and communication networks. 113 Functions of the foreign exchange market 1. Provide some insurance against the risks that arise from changes in exchange rates (also called exchange risk) 2. Currency conversion- the market presents a medium by which amounts of money denominated in one currency can be converted into another currency. Each country has a currency in which the prices of goods and services are quoted. 3. International businesses use foreign exchange markets when they have spare cash that they wish to invest for short- terms in money markets. 4. Currency speculation- this typically involves the short-term movement of funds from one currency to another in the hopes of profiteering from shifts in exchange rates. Uses of the Exchange Rate As a price in a market or mixed economy it provides information and incentives to guide decisions about what to produce and what to consume. As a policy instrument it should provide sufficient incentive to export and produce local substitutes for inputs to keep balance of payments in equilibrium. As a price it affects all other prices. It links together the general level of prices in the national economy with prices in other countries. Countries with higher inflation than their exchange rates make their imports cheaper than locally produced goods. This implies balance of payments problems for these countries. This can however be overcome by depreciation. The rate of exchange An exchange rate is the price of one currency in terms of another. Foreign exchange refers to the actual foreign currency, or various claims on it such as cheques and promises to pay, that are traded for each other. Uses of the Exchange Rate As a price in a market or mixed economy it provides information and incentives to guide decisions about what to produce and what to consume. 114 As a policy instrument it should provide sufficient incentive to export and produce local substitutes for inputs to keep balance of payments in equilibrium. As a price it affects all other prices. It links together the general level of prices in the national economy with prices in other countries. Countries with higher inflation than their exchange rates make their imports cheaper than locally produced goods. This implies balance of payments problems for these countries. (This can however be overcome by depreciation). Quoting of exchange rates Because exchange rates actually represent a ratio the price of one currency in terms of another can always be quoted in two ways. These are the direct method and the indirect method. Direct Method - Most countries use the direct method whereby the exchange rate is expressed in terms of local currency, i.e. how much of local monetary unit (Z$) can be exchanged for one unit of a foreign monetary unit. The indirect method - With the indirect method on the other hand, the exchange rate is expressed as a certain amount of the foreign currency that would be equal to Z$1. This method of quotation is useful to a Zimbabwean tourist who can immediately ascertain how much of a foreign currency he can obtain for his Z$. If however the exchange rate is regarded as a price, it is more logical to quote the price directly in terms of the Z$ (i.e. direct method). Determination of Equilibrium Exchange rates In the diagram below the amount in Rands is measured on the horizontal axis, while the price of Rands in Z$ is measured on the vertical axis. This is the direct method of quotation. The demand for South African Rands is determined by the price and quantity of products and services that Zimbabweans wish to import from South Africa and to lend or invest in South Africa. Since Zimbabweans have to pay for these products and services in Rands, the price of these products will mainly be determined by the exchange rate between the two currencies. We assume that the price of products remains constant in South Africa for the time being. The higher the exchange rate on the vertical axis, the more expensive do South Africa products become for Zimbabweans and the less they can afford to import from ZA Any depreciation of the Z$ in terms of the rand (.i.e. a rise on the vertical scale from the current to a higher 115 rate on the axis) will give rise to a decrease in the amount of Rands demanded. Imports decline. Similarly, an appreciation of the Z$ in terms of the rand (i.e. a drop in the exchange rate on the vertical axis would lead to an increase in the amount of Rands demanded. Fig. 8.1 Determination of Exchange rate Z$/R D S A Excessive Supply B Exchange Z$* E Rate C D Excessive Demand S D R million Amount of Rands The supply curve of the Rand, is actually based on a demand phenomenon: the South African demand for Zimbabwean goods or to lend or invest in Zimbabwe The background to the supply of Rands (on the Zimbabwean foreign exchange market) is therefore the demand of South Africans for Zimbabwean goods. The supply curve will have a positive trend from bottom left to top right. The lower the exchange rate on the vertical axis, the more expensive it is for South Africans to buy Zimbabwean products. Should the position of the Z$ deteriorate (depreciate) to an exchange rate above Z$*, Zimbabwean goods would become so cheap to South Africans that the supply of Rands would increase to point B in the diagram. The exchange rate is therefore determined by the supply and demand for rands and is $ per rand Fluctuations in the Exchange Rate (flexible exchange rate) A fall in the value of the dollar (depreciation) means one dollar now buys fewer rands or more dollars have to be paid for a unit of the rand. The dollar depreciates if South Africans demand fewer dollars (hence fewer Zimbabwean goods) or if Zimbabweans offer more dollars for a rand (shown in the diagram below). Zimbabwean exports 116 become cheaper and its imports become dearer. Hence, a dollar depreciation improves the balance of payments. Fig. 8.2 Fluctuations in exchange rates D2 Exchange Rate Z$/R ER2 S D1 Depreciation ER1 Appreciation D2 S D1 Q1 Q2 Quantity of Rands A rise in the value of the dollar (appreciation) means one dollar now buys more rands (expressed differently less dollars are required now to purchase a rand.). The exchange rate changes from ER2 to ER1 while the corresponding demand shifts from D2D2 to D1D1). Zimbabwean exports become dearer and its imports become cheaper. Hence a dollar appreciation worsens the balance of payments. Foreign Exchange Rate Regimes The rate at which the currency of one country can be exchanged for that of another depends primarily upon the system of foreign exchange in operation at the time. The choice of the systems is between (1) Fixed exchange rate (2) Fully flexible exchange rate system and (3) Floating exchange rate system. 1. Pegged of Fixed Exchange rate system This is the system whereby exchange rates are pegged. The country aims to maintain a more or less fixed rate for its own currency in relation to the currencies of other countries. The exchange rate is however subject to occasional discontinuous change, i.e. changes in exchange are only permitted by respective authorities e.g. Z$ 30 000 117 /US$ from Z$250/ US$1. Exchange rates movements are controlled through fixing or pegging a soft currency against a more stable currency. Advantages- provides security to traders. Buyers and sellers can compare prices immediately and arrange by contract for goods to be delivered months ahead, knowing prices and costs are stable. Disadvantages- when a country is experiencing inflation concurrent with long term deficits (an indication of disequilibria) its currency becomes inflated and there is pressure for exchange value of its currency to fall i.e. to devalue or depreciate its currency. The rates therefore change in jumps instead of smoothly and this involves national pride. With short term disequilibria, fixed rates are alright but not with long term. 2. Free Floating Exchange Rates/ Fully flexible Exchange rates This is an alternative to devaluation. It allows foreign exchange rates to fluctuate freely in accordance with changing conditions of international demand and supply of foreign exchange. Because they are unpredictable and are subject to wide uncontrollable fluctuations the system is susceptible to foreign exchange and domestic currency speculations. Many developing countries do not like this system because they are heavily dependent upon imports and exports. Advantages- it is less cumbersome than the fixed exchange rates. Embarrassing devaluations are avoided because there is free determination of rates by market forces. With downward inflexibility of domestic prices and wages, floating or freely fluctuating rates may be a practical structure to clear away chronic deficits. Disadvantages- Certainty and stability which are necessary in international trade, are difficult as import costs or export costs are not known in advance. To avoid considerable risks, importers/ exporters can to a large extent use the futures market for foreign exchange. When a currency is weakened and depreciation looming, excess speculation may be created. Speculators may sell lots of currency before depreciation thereby lowering the price still further and increasing supply. When it eventually falls they buy back currency with the stronger currency realizing substantial capital gains. As currency declines and standards of living decline, government may, to avoid being blamed for the fall pursue monetary expansion (higher wages, etc.) to accommodate higher import prices. This worsens inflation and calls for further currency depreciation. 118 3. Managed Floating Exchange Rate system This is a managed system and is a compromise between a fixed (artificially pegged) and a fully flexible exchange rate system. Erratic swings are limited through Central Bank intervention. Some countries however peg their currencies to the movements of a weighted average of a large number of major currencies of major trading partners. There are two types of floating exchange rates: (a) Clean floating- market forces are left entirely free from intervention by the state. (b) Dirty floating- the Central Bank intervenes to smooth out exchange rate fluctuations to ensure they are not unduly influenced by purely seasonal or other temporary factors. A particular exchange rate regime may suit a country’s needs at the time. Currency Overvaluation Whenever the official price of foreign exchange is established at a level which in the absence of any government restriction or controls would result in an excess of local demand over the available supply of foreign exchange, the domestic currency in question is said to be overvalued. Some causes of Fluctuations in Exchange Rates Fluctuations in quoted rates of exchange may be frequent and considerable, particularly as a result of speculative dealings and rumour. Fluctuations may be due to interactions of a number of causes including: 1. Currency conditions. Any changes in a country’s monetary policy tend to be reflected in the foreign exchange. Inflation due to an increase in the note issue or to an over-expansion of credit would immediately lower the external value of the home currency. Low inflation rates compared with other countries should lead to an appreciating in the exchange rate. 2. Political conditions- political trends, labour unrest and a country’s budgetary position all exert a similar influence as above. 119 3. Speculation- Foreign currencies are often bought in anticipation of a rise or sold in expectation of a fall in the value of currency. The effect is to raise the value of the currency purchased and to lower the value of that with which the purchases are made, since it increases the supply available in the market. 4. Financial factors- resulting from transfers of money in the form of interest payments on loans and investments, profits, commissions, and banking and stock exchange operations. Most banks with international connections maintain a large proportion of their balances in liquid form in different centres and move them from one to another to take advantage of improved rates of interest. 5. Trade Conditions- which affect the balance of payments and weaken the currency of a country whose imports exceed its exports, since it increases the demand for foreign currencies and so raises their values. 6. Leads and lags- traders who anticipate significant changes in exchange rates may attempt to manipulate these changes to their own advantage by bringing forward or postponing currency payments due to them or from them in respect of their foreign trade. These actions do not affect the overall balance of payments situation. 7. Interest rates- High rates in country X compared to other countries will attract investment funds into that country, increasing demand for its currency. Low rates reduce the international value of the currency. 8. Confidence in the economy- when there is economic decline and poor prospects for the future, traders and investors will be deterred from dealings with the country while confidence has the opposite effect. Exchange Risks- It is often argued that flexible exchange rates would create uncertainty and instability and this would dampen foreign trade and investment. Foreign exchange rates which are flexible could increase the risks of foreign trade. With fluctuations in exchange rates exporters face the risk of loss through the movements in exchange rates between the date of the sales contract and receipt of proceeds. Importers also face problems with the exchange rate. Exchange rate can move before the goods are received and payments have to be made. Exporters can 120 protect themselves from losses due to adverse movements in the rate of exchange. They can do this in a number of ways: (1) By exchange clauses in the bills of exchange. (2) By forward exchange operations-trader can buy or sell foreign exchange at a fixed date in the future with the rate of exchange being agreed now. (3) By maintaining foreign currency accounts with banks in the countries they have dealings with. This is subject to Exchange Control approval by the Central Bank. (4) By maintaining foreign currency accounts with their home bankers. 121 CHAPTER 9 ECONOMIC GROWTH Definition Economic growth is defined variously as: (1). the annual rate of increase in real GDP or (2) the rate of increase in the real GNP or (3) the increase in the real national product or output over time (During any given time period it can be expressed as Y .) or t (4) “a long term rise in capacity to supply increasingly diverse economic goods to its population, this growing capacity based on advancing technology and the institutional and ideological adjustments that it demands.” by Professor Kuznets. (5) an increase in a country's ability to produce goods and services. Reasons for defining economic growth in terms of data expressed in constant prices (real values) is because an appreciable difference may exist between the change in GDP (current prices) and GDP (constant prices). Usually the former rises far more quickly than the latter especially when there is rising inflation. Growth is considered a real phenomenon. No economic growth is possible if the change in GDP or the GNP is simply the result of price rises. If we consider definitions (4) and (5), when an economy recovers after a period of slack or depression (with production below full capacity) and the GDP increases as a result of improved capacity utilisation, i.e. when economy moves from unemployment to full employment this does not constitute economic growth. (However it is extremely difficult to determine the real potential GDP from year to year especially where capacity like full employment is not easily measured). This can be illustrated using the diagram below. An increaser in the real GDP from Y1 to Yf1 on the total supply curve AS1 is not actually growth, because there has been no change in the production potential. However there is economic growth if the full employment level of the GDP increases from Yf1 to Yf2 that is when the whole AS curve shifts from AS1 to AS2. Economic growth (in terms of this interpretation) can therefore be defined as an increase in the real potential (full employment) income. Another qualification in respect of economic 122 growth is that growth always implies improvement of the economic lot or living standards of those who form part of the economy in question. From this we deduce that there must be an increase in the (potential) GDP per capita (per head of the population) before we can talk of economic growth. Fig 9.1 Economic growth as illustrated by an increase in AS. AS1 AS2 AS1 and AS2 = total supply curves General Price Level Y1 Yf1 Yf2 Total Income or GDP AS1 and AS2 = total supply curves With the exception of the fact that the GDP has to be measured in real terms, it is difficult to eliminate the other qualifications in respect of the definition and description of growth. Population figures can likewise be compared with GDP data only over relatively long periods. The advantage of economic growth is that an increase in real national income allows more goods for consumption or for investment. Measurement of Economic Growth It can be measured by the change in real GDP or real GNP (at constant prices) over time. The best indicator of growth is real GDP per capita. Factors affecting Economic growth Quantity and quality of capital – the manufactured means of production; further growth will depend largely on whether new capital can be created out of savings.With Capital accumulation ( accumulation of machinery, equipment and tools etc). These lead to increased capacity of plants. Capital accumulation also includes investment in human resources. 123 Population and labour force growth as well as size and quality of the labour force. - a larger labour force means more productive manpower while a larger overall population increases the potential size of domestic markets. The growing supply will have a positive impact if the economic system can absorb and productively employ these added workers. Labour force’s size is determined by composition of the population, especially according to age groups. In this context quality is used in the sense of production. Education and training are important as are the population’s willingness to work, and its state of health. Technological progress- this is the most important source of economic growth. In its simplest form technological progress can be said to result from new and improved ways of accomplishing traditional tasks. The productive resources, if used efficiently can increase economic growth. A highly developed technology naturally requires a sophisticated labour force to install, run and maintain it. It is clear that labour, capital and technology have become integral to the growth process. Patents- the right to an investor for exclusive use of an invention (up to 17 years in some countries). The idea of patents is to encourage inventions. Availability of natural resources. Some countries arte rich in natural resources, this factor is a great advantage in economic development. NB. Raw materials may also be imported profitably provided the knowledge and means are available locally to process them further, e.g. Switzerland, Japan, Taiwan and Singapore. Weather (Peculiar to Zimbabwe). Because of the importance of rain-fed agriculture and agro-industry in certain countries such as Zimbabwe, weather is also an important determinant of economic growth in the medium term. When making international comparisons we use the dollar as the common currency for measuring production in the different countries. The current exchange rates in the year in question are used for the conversion to dollar values. However this type of conversion appears reasonable the reliability of comparisons is dubious. Exchange rate is not necessarily an accurate reflection of the actual purchasing power of the two currencies. Furthermore in this era of volatile exchange rates sudden exchange rate 124 adjustment may cause considerable fluctuations in the dollar values of the different countries’ domestic product. In order to partly neutralize the worst year to year exchange rate fluctuations the average per capita GDP over say a five year period is used. We should also make consideration for such measures as number of hospital beds, number of telephones or kilometres of tarred roads. Economic growth describes the process of increases in GDP in developing countries. Growth is growth in what already exists, i.e. factors such as capital, technology and labour. Economic development too is a process which results in an increase in the real potential production (per capita). But whereas economic growth describes a gradual increase in the means of production, economic development implies a fundamental change in the community as a whole and in its economic system, that is, it affects how and where people live and work. Of particular significance is the physical; displacement from rural to urban areas, but also adjustments, often radical, in cultural patterns. Developing Countries A developing country or less developed country (LDC) is one that is not yet fully industrialised and tends to have the following features: Agriculture is more important than manufacturing. There is limited specialisation and exchange. There are not enough savings to finance investment. Population is expanding too rapidly for available resources. Population growth is equal to or more than the rate of GNP growth in some countries. There are high and rising levels of unemployment and underemployment. There are low incomes. In the income distribution, the gap between the rich and poor is generally greater in less developed than in developed countries. Inadequate housing. There are low levels of productivity. This may be due to the absence or severe lack of complementary factor inputs such as physical capital and or experienced management. 125 In education there are low levels of literacy, significant school dropout rates, inadequate and often irrelevant curricula and facilities. There is poor health. Most LDC people suffer from malnutrition and ill-health and high infant mortality and have a lower life expectancy than in developed countries (DCs) A low standard of living. A large portion of the population is living below the Poverty Datum Line. A developed country is more fully industrialised and has a high standard of living. Barriers to Economic Growth A country can increase production if it increases the amount of resources used or makes better use of existing factors. Economic growth is more difficult if: A country lacks the infrastructure (underlying capital) to produce goods more efficiently. There are three types of infrastructure: 1. basic including electricity, road and telephone networks; 2. social including schools, hospitals and housing; 3. industrial including factories and offices. A country lacks the machines or skilled labour needed to manufacture modern goods or services. A country lacks the technical knowledge. Technical progress results from a combination of research, development, invention, and innovation. Technical knowledge acquired from abroad is costly and usually incomplete. Workers are not prepared to accept specialisation and the division of labour. Population growth is too rapid. A country has too large a foreign debt. Most LDCs with a large private sector are limited to an indicative plan that states expectations, aspirations, and intentions but authorizes little public spending. Most LDCs have too few resources, skills, and data to benefit from complex macroeconomic planning models. Yet a simple aggregate model may be useful as a first step in drawing up policies and projects. Since they assume that most skills needed for an enterprise can be purchased in the market, Western economists frequently limit the entrepreneurial function to perceiving market opportunities and gaining command over resources. However, LDC entrepreneurs may have to provide some basic skills 126 themselves, such as marketing, purchasing, dealing with government, human relations, supplier relations, customer relations, financial management, production management, and technological management, which are all skills in short supply in the market In most mixed and capitalist LDCs, documents showing how to improve data collection, raise revenue, recruit personnel, and select and implement projects are more important for successful planning than planning models. Why capital does not flow from rich to poor countries is because LDC capital markets are imperfect and often subject to political risk. The LDC money markets are often highly oligopolistic and financially repressive, distorting interest rates, foreign exchange rates, and other financial prices. Poor nutrition and health reduce labor productivity. HIV infection and AIDS-related deaths have had a substantial adverse impact on economic growth in some developing countries, especially in Africa. Costs of Economic Growth Increased noise, congestion and pollution (solid waste, liquid and gaseous wastes, radioactive materials cause greater danger. Economic growth is usually associated with urbanisation because modern means of production are in towns/cities. This leads to overcrowding in cities Towns and cities may become overcrowded. Overcrowding also results in noise and litter everywhere.With urbanization, pressure on transport (peak hour congestion), water supplies, sewage and refuse disposal, urban sprawl (encroaching productive land) and shortage of space results, necessitating an expensive road network linking suburbs with the metropolitan area.. Extra machines can be produced only by using resources currently involved in making consumer goods. The traditional way of life may be lost. People may experience increased anxiety and stress. Roral- Urban Migration The factors affecting rural-urban migration are as follows: 1. Rural overpopulation. 2. Employment factors. 3. Lure of towns- better life. 127 4. Protection –when there is political instability). 5. Education. ECONOMIC DEVELOPMENT “is a multidimensional process involving the reorganization and reorientation of the entire economic and social systems. In addition to improvements in incomes and output, it typically involves radical changes in institutional, social and administrative structures as well as in popular attitudes and sometimes even customs and beliefs” (Michael Todaro1). Economic development is also defined in terms of the reduction or elimination of poverty, inequality and unemployment within the context of a growing economy. Development must have the objectives of -: increasing the availability and wider distribution of basic- food, shelter, health and protection; raising the levels of living (higher incomes, higher employment, better education and increased attention to cultural values). Indicators of Economic Development. The traditional view of economic development is GNP is an index of development. Another common economic index of development is the use of rates of growth of per capita GNP. Rapid industrialization was viewed as a way of having an increasing GNP, this often at the expense of agriculture and rural areas – these were to benefit through the “trickle down effect”. Obstacles to Economic Development in developing countries Overpopulation- high population growth. Low savings rate- has hampered industrial development. Limited range of exports (droughts and disease). Agricultural subsidies in the United States, European Union, and Japan are major barriers against LDC farm exports. Urbanization- this compounds population problems through congestion. Overcrowding promotes pollution, unemployment, disease and food shortages. 1 Michael P Todaro ( ) Economics For A Developing World 128 Lack of an infrastructure. Because LDCs generally do not have infrastructures, industrial firms will not normally locate plants there. Products manufactured for mass consumption simply cannot be distributed and used without transportation and communication facilities- few schools, roads, dams and bridges. In Zimbabwe the Infrastructural Development Bank was set up in 2005 to revamp infrastructure. Solutions for Economic Underdevelopment Foreign aid. The problem with this approach is in the debt trap whereby with increased indebtedness they fail to service their debts yet they require more debt to repay their debts. The ratio of debt service to GNP is not always a good indicator of the debt burden. Exportation of a major resource e.g. oil, minerals flowers/horticulture. Constraints include lack of up to date technology, insufficient storage capacity and transport problems. Export promotion is generally more effective than import substitution in expanding output and employment. Industrialization and protective tariffs and quotas. A large share of international trade is multinational corporations’ intra-firm trade. Industrialization and the export of manufactured goods. In Zimbabwe the Scientific Industrial Research Development Centre (SIRDC) has been mandated to carry out research into new products and processes. Although Multinational Corporations (MNCs) in developing countries provide scarce capital and advanced technology for growth, doing so may increase LDC dependence on foreign capital and technology. The LDCs need a judicious combination of MNCs, joint MNC local ventures, licensing, and other technological borrowing and adaptation. Membership of multilateral organizations such as WTO of which they (LDCs) get assistance in formulating and implementing export promotion programmes as well as import operations and techniques and training of staff. The International Trade Centre of the World Trade Organisation (WTO) provides information and advice on export markets and marketing techniques. Foreign Investment-investors do not only look at the specific resource or market they are targeting but the entire environment of the country they propose to invest 129 (for example tax rates, labour legislation, security situation, poor banking facilities, insufficient supply of raw materials and spare parts). They also look at: (i) Legal framework (the judicial system that allows for civil disputes to be settled in an orderly manner. (ii) Exchange control Regulations-guarantee to repatriate profits or their capital. (iii) Attitudes of local investors (investors take a close interest in the level of investment being made by residents of the country of interest). Conversely if locals are not investing foreigners may see this as a signal that the country is not attractive enough for them to invest in either. The argument here is that locals see opportunities first. (iv) Political stability. (v) Clean government-corruption among government officials takes place at varying levels in the world. It has the effect of slowing down the investment process, adding to the costs, and increasing the uncertainties and risks of an investment project. (vi) Economic stability- foreign investors will look to indicators such as inflation rates, interest rates and currency exchange rates as part of their overall assessment of the environment in which they operate. The more stable the exchange rate and lower the inflation rate and interest rates, the easier it will be for the investor to assess his future prospects. If government expenditure is excessive this is a significant contributor to high tax rates, high inflation, high interest rates and weakening exchange rate. (vii) General infrastructure- a good general infrastructure is important to foreign investors although the degree of importance attached by different investors will be determined by the nature of their potential investment. Foreign investment is welcome where it generates substantial export earnings, leads to transfer of technology skills, and access to foreign markets. Cross-border capital movements benefit LDC recipients in the long run but, because of potential reverse outflows, there is increased vulnerability to financial and currency crises. 130 Some Theories of Economic Development The vicious circle theory contends that a country is poor because its income is too low to encourage potential investors and generate adequate saving. Furtado's dependency theory contends that increased productivity and new consumption patterns resulting from capitalism in the peripheral countries of Asia, Africa, and Latin America benefit a small ruling class and its allies. Frank's dependency approach maintains that countries become underdeveloped through integration into, not isolation from, the international capitalist system. Policies used to reduce poverty and income inequality include credit for the poor, universal primary education, employment programs, rural development schemes, progressive income taxes, food subsidies, health programs, family planning, food research, inducements to migration, income transfers, affirmative action programs, targeting programs for the poorest groups, and workfare schemes for which only the poor will qualify. Taiwan's and South Korea's stress on land reform, education, and labor intensive manufacturing, and Indonesia's emphasis on rural development have succeeded in increasing the income shares of the poorest segments of their populations. Subsistence farming dominated LDC agriculture in the past but with globalization, a larger proportion of LDC farm output is contracted with multinational corporations. Africa's food security is low because of substantial fluctuations in domestic production and foreign-exchange reserves, reductions in food aid, and lack of a Green Revolution in most of the continent. 131