Bachelor of Engineering

Eng 4129 – Engineering, Management And Society I

Lecturer

Eng. Ngenda Situmbeko

Cell: 0955 763692
0967 526380
E-mail: [email protected]
[email protected]
[email protected]
Introduction to Economics

• Coverage - Economic Concepts

• Introduction to micro economics: elementary theories of demand and
supply, factors of production, production functions, diminishing returns,
comparative advantage.
• Introduction to Macro Economics:
• Circular flow of income, Gross Domestic and Gross National product,
• balance of payments, economic planning, public and private sectors,
economic theories of development.
• Domestic and foreign problems of development:
• economic growth, income distribution, poverty, population increase,
education, unemployment, urbanisation and rural migration, agriculture,
public spending; international trade, foreign aid.
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 Introduction to Economics: Selected Topics (EG 4129 - Engineering Management and Entrepreneurship
(Lecture Notes: August – November, 2023)

Why study economics? The Definition of Economics

• It will help you understand the world we live in
• The study of how society (households and firms) manages
Why for instance an increase in electricity scarce resources
tariffs, may result in prices of goods and
service to go up, why are some countries • The study of the allocation of scarce resources ( labour force,
relatively well developed than others capital stock, natural resources, technology) to meet
unlimited human wants (desired good and services)
• It will make you an astute participant in the economy
• Economists, therefore study how people make decisions:
Assist in making decision in your self run small how much they work, how much they buy, how much they
businesses or large corporations where you will save and invest their savings.
be employed(pricing, spending, savings and
investment} • They also study how the numerous buyers and seller of a
good together determine the price at which the good is sold
and the quantity that is sold
• It will give you a better grasp of the potential and limits of • Economists also analyse factors and trends that affect the
economic policy economy as a whole - These include but not limited to the
Issues such as subsidies, budget deficits, growth in average income, proportion of the population that
taxation, monetary policy and exchange rate can not find work, the rate at which prices are increasing
policy

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 Introduction to Economics

Ten Principles of Economics Ten Principles of Economics

The study of Economics is centred around 10 main building Principle 2: The Cost of Something Is What You
blocks or central ideas; Ten Principles of Economics Give Up to Get It:
Block A: How People Make Decision - Given that people face trade offs in
making decisions; requires comparing
Principle 1. People Face Trade-Offs: To get one thing we the costs and benefits of
alternative courses of action
like we usually have to give up another thing we also
like. - The opportunity Cost of an item is what
you give up to get that item. To get one
- Clean environment and a high level of income - thing we like we usually have to give
Govt can impose laws to reduce pollution up another thing we also like.
(improved health) and this is likely to increase the Principle 3. Rational People Think at Margins:
cost of production, reducing profits, lower Marginal changes describe small incremental
wages, high prices. adjustments to an existing plan of action
- Efficiency ( society getting the most out of - People compare additional benefits and
the scarce resources and Equity (benefits of additional costs when making a decision of
these resources are distributed fairly what course of action to take
among people)
• Govt policies (high income taxes on few
individuals to support welfare programmes)
may reduce the reward of working hard and
ultimately lead to low productivity

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 Introduction to Economics
Ten Principles of Economics Ten Principles of Economics
Principle 4. People Respond to Incentives: Intuitively Principle 6: Markets Are Usually a Good Way to
because people make decisions by comparing costs and Organise Economic Activity
benefits their behaviour may change when the costs and
benefits change
An economy allocates resources through decentralised
A price is a powerful incentive as it affects the behaviour of decisions that of many firms and households as
buyers and sellers in a market. they interact in markets for goods and services
- If the policy changes incentives, it will cause - Adam Smith’s notion of the Invisible Hand-
people to alter their behaviour (however policies Participants in the economy are motivated by
can have effects that are not certain in future or self interest and the ‘invisible hand’ of the
produce undesirable results) marketplace guides this self- interest into
promoting general economic well-being
Block B: How People Interact - Because households and firms look at prices
Principle 5. Trade Can Make Everyone Better Off when deciding what to buy and sell, they
unknowingly take into account the social
- As a person you can not do everything on your costs of their actions.
own, grow food, make own cloths and build
own home. Clearly one would benefit if they As a result, prices guide decision makers to
trade with others . reach outcomes that tend to maximize the
welfare of society as a whole.
- Competition results in gains from trading as most
economic agents produce similar products and - In contrast Communist countries worked on
the premise of centralised allocation of
compete for the same customers. resources- Government
- Trade thus allows each person to specialise in the
things they know best.
- Similarly countries would benefit if they trade
with one another
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 Introduction to Economics
Ten Principles of Economics
Principle 7: Government Can Sometimes Improve Market Outcomes:
• If the invisible hand of the market can deliver why then do, we need
Government?
• When the market fails (breaks down) government can intervene to promote
efficiency and equity.
• What does equity mean in economics?
• Equity in economics is defined as the process to be fair in an economy that
can range from the concept of taxation to welfare in the economy. It also
means how the income and opportunity among people are evenly distributed.
• Markets work only if property rights /contracts are enforced
• Market failure : Market left on its own fails to allocate resources efficiently.
• Causes:
• An externality: which is the impact of one person or firm’s actions on the
well-being of a bystander (pollution).
• Market Power: Ability of a single economic agent to have substantial
influence on market prices

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 Ten Principles of Economics

Block C: How the Economy as a Whole Works

Principle 8. An Economy’s Standard of Living Depends on its ability to
produce Goods and Services
How can we measure the standard of living?
Standard of living may be measured in different ways:
• By comparing personal incomes.
• By comparing the total market value of a nation’s production.
• Differences in the living standards among countries overtime is largely
attributable to productivity.
• Productivity : the amount of goods and services produced from each hour of a
worker’s time
• Thus improving the standard of living may entail implementing policies
aimed at raising productivity
• Creating an enabling policy and economic environment
• Investment in human capital, technology, infrastructure

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 Introduction to Economics

Ten Principles of Economics

Principle 9: Prices Rise When the Government Prints Too Much Money
• Inflation: an increase in the overall level of prices in the economy
• When the government creates large quantities of money, the value of the money falls.
• High inflation imposes various cost on society

Principle 10: Society Faces a Short - Run Trade - Off Between Inflation and
Unemployment
• Phillips Curve named after an economist who first examined the
relationship while working at the London School of Economics
• Simply put, over a period of a year or two many economic policies push
inflation and unemployment in opposite directions
• Policy makers can thus in the short - run use monetary or fiscal policies
to influence this relationship

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 Introduction to Economics

Ten Principles of Economics

- The Phillips Curve illustrates the tradeoff between inflation and unemployment
- It’s a short-run tradeoff!

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 Introduction to Economics

Ten Principles of Economics

Summary
• When individuals make decisions, they face trade-offs among alternative
goals.
• The cost of any action is measured in terms of foregone opportunities.
• Rational people make decisions by comparing marginal costs and marginal
benefits.
• People change their behaviour in response to the incentives they face.
• Trade can be mutually beneficial.
• Markets are usually a good way of coordinating trade among people.
• Government can potentially improve market outcomes if there is some
market failure or if the market outcome is inequitable.
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 Introduction to Economics

Economist View of the Real World

Why study economics?
Economics trains you to. . . .
- Think in terms of alternatives
- Evaluate the cost of individual and social choices
- Examine and understand how certain events and issues are related
The Scientific Method: Observation, Theory, and More Observation
- Involves thinking analytically and objectively
- Uses abstract models to help explain how a complex, real world operates.
- Develops theories, collects, and analyzes data to evaluate the theories.
- Makes use of the scientific methods.

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 Introduction to Economics

Economist View of the Real World

The Role of Assumptions
• Economists make assumptions in order to make the world easier to
understand.
• The art in scientific thinking is deciding which assumptions to make.
• Economists use different assumptions to answer different questions.
Economic Models
• Economists use models to simplify reality in order to improve our
understanding of the world.
• Two of the most basic economic models include:
• The Circular Flow Diagram
• The Production Possibilities Frontier

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 Introduction to Economics
Economist View of the Real World
Model 1: The Circular-Flow Diagram
• The circular-flow diagram is a visual model of the economy that shows how money flow through
markets among households and firms.

MARKETS
Revenue Spending
FOR
GOODS AND SERVICES
Goods •Firms sell
Goods and
and services •Households buy services
sold bought

FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services goods and services
•Hire and use factors •Own and sell factors
of production of production

MARKETS
FOR
Factors of Labor, land,
FACTORS OF PRODUCTION and capital
production •Households sell
•Firms buy
Income
Wages, rent,
and profit
= Flow of inputs
and outputs
= Flow of money
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 Introduction to Economics
Economist View of the Real World
Model 1: The Circular-Flow Diagram

Firms
• Produce and sell goods and services
• Hire and use factors of production

Households
• Buy and consume goods and services
• Own and sell factors of production

Markets for Goods and Services

• Firms sell
• Households buy

Markets for Factors of Production

• Households sell
• Firms buy

Factors of Production
• Inputs used to produce goods and services
• Land, labor, entrepreneurship and capital

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 Introduction to Economics
Economist View of the Real World Economist View of the Real World
Model 2: The Production Possibilities Frontier (PPF) Model 2: The Production Possibilities Frontier
• The production possibilities frontier is a graph that shows the • The economy can produce at any point on or
combinations of output that the economy can possibly inside the production possibilities frontier, but
produce given the available factors of production and the cannot produce outside the frontier.
available production technology.
• Concepts Illustrated by the Production
Quantity of
Computers
Possibilities Frontier:
Produced
 Efficiency
3,000  Trade- offs
D
 Opportunity Cost
2,200
C  Economic Growth
A
2,000 • Point A: An outcome is said to be efficient if the
economy is getting all it can from the scarce
Production
possibilities resources it has available:
frontier
• There is no way to produce more of one good
without producing less of the other
1,000 B
• Point B represents an inefficient outcome
(perhaps because wide - spread
unemployment), the economy is producing
less than it could from the resources
0 300 600 700 1,000 Economics (2006) ,N Gregory Mankiw & Mark P. Taylor
Quantity of
Economics (2006) ,N Gregory Mankiw & Mark P. Taylor Cars Produced
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 Introduction to Economics
Economist View of the Real World Economist View of the Real World
Model 2: The Production Possibilities Frontier Model 2: The Production Possibilities Frontier
• Trade - off arises once the economy reaches the
efficient points on the frontier, the only way of getting Quantity of
more of one good is to get less of the other Computers
Produced
(movement from point A to C)
4,000
• Opportunity cost: the cost of something is what you
give up to get it .i.e. the cost of one good measured
in terms of the other good
• Moving from point A to Point C , the economy gives 3,000
up 100 cars to get 200 additional computers. Thus at
point A the opportunity cost of 200 computers is 100 E
2,100
cars
2,000
• Economic growth : A shift in the Production A
Possibilities Frontier as depicted in the next chart is
possible if for example technological advances in
the computer industry causes production for both
goods to increase (Movement from Point A to Point
E
• While the PPF shows the trade - off between the
production of different goods at a given time Trade -
off can change over time reflecting technical 0 700 750 1,000
progress Quantity of
Cars Produced

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 Introduction to Economics

Economist View of the Real World Economist View of the Real World
Microeconomics and Macroeconomics The economist as policy advisor
• Microeconomics focuses on the individual • When economists are trying to explain the world,
parts of the economy. they are scientists.
• How households and firms make • When economists are trying to improve the world,
decisions and how they interact in specific they are policy advisor.
markets
• Macroeconomics looks at the economy as a
whole.
• Economy-wide phenomena, including
inflation, unemployment, and economic
growth

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 Introduction to Economics

Economist View of the Real World Economist View of the Real World
Positive versus normative analysis Positive versus normative analysis

• Positive Statements: statements that • Positive statements are descriptive in

attempt to describe the world as it is nature
• Objectivity
• Normative statements are prescriptive in
nature
• Normative statements are statements
about how the world should be.
• Subjective

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 Introduction to Economics

Economist View of the Real World Economist View of the Real World
Positive versus normative analysis Positive or Normative Statements?
• The income gains from a higher minimum wage
• An increase in the minimum wage will cause a are worth more than any slight reductions in
decrease in employment among the least-skilled. employment.
• POSITIVE • NORMATIVE
• Higher federal/central budget deficits will cause • State governments should be allowed to collect
interest rates to increase. from tobacco companies the costs of treating
smoking-related illnesses among the poor.
• POSITIVE
• NORMATIVE

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 Introduction to Economics
Economist View of the Real World
Economist View of the Real World
Why do Economist Disagree about the real
Positive versus normative analysis world?
• Which government agencies collect economic • They may disagree about the validity of
data? alternative positive theories about how the
world works.
• Some Important Government agencies that collect
economic data and make economic policy in
• They may have different values and,
Zambia: therefore, have different normative views
• Ministry of Finance and National Planning about what policy should try to
accomplish.
• Ministry of Commerce, Trade and Industry
• Bank of Zambia What are positive economic theories?
• Zambia Revenue Authority • Positive economics are based on data
and facts and provides solution to
• Zambia Statistics Agency (ZamStats) problems faced by the economy. It does
(formerly Central Statistics Office) not deal with value judgements .
• It states that what are and how the
problem of choice faced by an economy is
Economics (2006) ,N Gregory Mankiw & Mark P. Taylor solved.
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Why Economists disagree
• Economists disagree because • Certain "X" factors, such as natural
most of them usually fall into the disasters, wars, and pandemics,
two competing economic schools can throw a kink into economic
of thought: Keynesian economics forecasts, derailing economic
and free-market economics. theories.
• Keynesian economists believe that • Interpreting economic data is both
the government should play a role an art and a science, resulting in a
in markets whereas free-market different viewpoint of the many
economists believe that the economic factors that impact one
government should be hands-off another.
and let the market regulate itself.
• When forecasting, economists
weigh the importance of certain
economic factors differently, such
as gross domestic product (GDP),
inflation, unemployment, and
interest rates.
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 Introduction to Economics
Economist View of the Real World Economist View of the Real World
Summary Summary
• Economists try to address their subjects with a • A positive statement is an assertion about how
the world is.
scientist’s objectivity.
• A normative statement is an assertion about
• They make appropriate assumptions and build how the world ought to be.
simplified models in order to understand the
world around them. • When economists make normative statements,
they are acting more as policy advisors than
• Two simple economic models are the circular- scientists.
flow diagram and the production possibilities • Economists who advise policymakers offer
frontier. conflicting advice either because of differences
• Economics is divided into two subfields: in scientific judgments or because of
differences in values.
• Microeconomists study decision-making
by households and firms in the • At other times, economists are united in the
marketplace. advice they offer, but policymakers may
choose to ignore it.
• Macroeconomists study the forces and
trends that affect the economy as a whole.
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 Introduction to Economics

How Markets Work How Markets Work

Demand, Supply and the Market Demand, Supply and the Market
• Supply and demand are the two words that Competitive markets
economists use most often.
• Market takes many forms although most
• Supply and demand are the forces that make markets have some competitive features.
market economies work.
• A competitive market is a market in which
• Thus, supply and demand refer to the there are many buyers and sellers so that
behaviour of people as they interact with one each has a negligible impact on the market
another.
price.
• They determine the quantity of each good
produced and the price at which it is sold. • Buyers determine demand
• A market is a group of buyers and sellers of a • Sellers determine supply
particular good or service. • Thus, most economists begin the study
• Modern microeconomics is about supply, of the behaviour of the markets by
demand, and market equilibrium assuming that markets are perfectly
competitive.

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 Introduction to Economics
What are the main Types of Market Structure? What are the Features of Monopoly Market?

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The Features of the Four Types of Market Structure

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The Features of the Four Types of Market Structure
Perfect Monopolistic
Features Category Oligopoly Monopoly
Competition Competition
Number of Firms Many Several Few Single
Homogeneou
Nature of Product Homogeneous Differentiated s or Unique
Differentiated
Firm's Control Over
No Little Substantial Complete
Price

Highly
Entry Free Free Restricted
Restricted
Size of the Firms Small Small Large Very Large
Product Price Uniform Differentiated High Uniform
Government
No No Some Yes
Intervention
Competition Level High Moderate Low No
Profit Making
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Possibility
 Introduction to Economics
How Markets Work
Competition : Perfect and Otherwise How Markets Work
• Perfect competition Competition : Perfect and Otherwise
• Products are the same
• Numerous buyers and sellers so that • Oligopoly
each has no influence over price. • Few sellers
• Buyers and sellers are price takers. • Not always aggressive competition.
• Who is a price taker?
• Monopolistic competition
• A price-taker is an individual or
company that must accept prevailing • Many sellers
prices in a market, lacking the market • Slightly differentiated products
share to influence market price on its
own. • Each seller may set price for its own
• Due to market competition, most product
producers are also price-takers. Only
under conditions of monopoly or
monopsony do we find price-making.
• Monopoly
• One seller, and seller controls price.
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 Introduction to Economics
What are the Features of Monopolistic Competition? What are the Features of Perfect Competition?

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 Introduction to Economics

How Markets Work

Perfect competition
Demand
• Quantity demanded is the amount of a good that buyers are willing
and able to purchase.
• Law of Demand
• The law of demand states that, other things being equal, the
quantity demanded of a good falls when the price of the good rises.
• Demand curve: relationship between price and quantity demanded

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 Introduction to Economics
How Markets Work
Perfect competition
• Demand schedule
• The demand schedule is a table that shows the relationship between the price of
the good and the quantity demanded
Price of Quantity of
Ice -Cream Cone Cones Demanded
K0.00 12
0.50 10
1.00 8
1.50 6
2.00 4
2.50 2
3.00 0
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 Introduction to Economics
How Markets Work How Markets Work
Perfect competition Perfect competition
• The Demand Curve, which graphs the Demand Schedule, • The Demand curve slope downwards because lower
shows how the quantity demanded of goods changes as the price increases the quantity demanded
price varies
Price of 3.00 Demand Curve Market Demand versus Individual Demand
Ice
Cream
2.50
A = Price K2,
• Market demand refers to the sum of all individual
2.00 A Quantity, 4 demands for a particular good or service.
• Graphically, individual demand curves are summed
B B = Price, K1.5
horizontally to obtain the market demand curve.
1.50
Quantity, 6

1.00

0.50

0.00
1 2 3 4 5 6 7 8 9 10 11 12
Quantity of
Ice-Cream
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 Introduction to Economics

How Markets Work How Markets Work

Perfect competition Perfect competition
Movement along the Curve and Shifts in the Demand Shifts in the Demand Curve
Curve
• Change in Demand
• Change in Quantity Demanded • A shift in the demand curve, either to the left or right.
• Movement along the demand curve. • Caused by any change that alters the quantity
• Caused by a change in the price of the product. demanded at every price.
Price of Ice-
A tax that raises
• Consumer income
Cream the price of ice-
Cones cream cones • Prices of related goods
B
2.50 results in a • Tastes
movement along • Expectations
the demand • Number of buyers
A curve
2.00

2 4 Quantity of Ice-
Cream Cones

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 Introduction to Economics
How Markets Work How Markets Work
Perfect competition Perfect competition
Shifts in the Demand Curve
Shifts in the Demand Curve
• As income increases the demand for a
Price of Ice- normal good will increase.
Cream
Cones
• As income increases the demand for an
inferior good will decrease.
Increase in
demand

• Prices of Related Goods

D2 • When a fall in the price of one good

Decrease in
reduces the demand for another good,
demand D1 the two goods are called substitutes

• When a fall in the price of one good

D3 increases the demand for another good,
the two goods are called complements
Quantity of
Ice-Cream
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 Introduction to Economics

How Markets Work

How Markets Work
Perfect competition
Perfect competition Summary
Summary Variable that influence Buyers
• Demand curve: Shows what
happens to the quantity demanded
of a good when its price varies,
holding constant all other variables
that influence buyers.
• When one of these other variables
change, the demand curve shifts.

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 Introduction to Economics

How Markets Work How Markets Work

Perfect competition Perfect competition
• Supply Schedule
Supply • The supply schedule is a table that
shows the relationship between the price
of the good and the quantity supplied
• Quantity supplied is the amount of a good
that sellers are willing and able to sell. Price of Quantity of
Ice -Cream Cone Cones Demanded
• Law of Supply K0.00 0
0.50 0
• The law of supply states that, other
1.00 1
things being equal, the quantity supplied
1.50 2
of a good rises when the price of the good
rises. 2.00 3
2.50 4
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3.00 5
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 Introduction to Economics
How Markets Work How Markets Work
Perfect competition Perfect competition
• Supply Curve
• The supply curve is the graph of the relationship Market Supply versus Individual Supply
between the price of a good and the quantity • Market supply refers to the sum of all individual
supplied supplies for all sellers of a particular good or
Price of Ice- service.
Cream
Cones K3.00 • Graphically, individual supply curves are summed
horizontally to obtain the market supply curve.
2.50 B B = Price, K2.50
Quantity , 4 Movement along the Curve and Shifts in the
Supply Curve
2.00 A A = Price, K2.00 Change in Quantity Supplied
Quantity , 3
1.50 • Movement along the supply curve
• Triggered by a change in the price of a good
1.00 • Shifts in the Supply Curve
• Caused by a change in anything that alters the
quantity supplied at each price
0.50 • Input prices
• Technology
0 1 2 3 4 5 6 7 8 9 10 11 12 • Expectations
Economics (2006) ,N Gregory Mankiw & Mark P. Taylor Price of Ice- • Number of sellers
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Cones
 Introduction to Economics
How Markets Work How Markets Work
Perfect competition Perfect competition
Supply and Demand Together Supply and Demand Together
• Equilibrium refers to a situation in which the price
has reached the level where quantity supplied Demand Schedule Supply Schedule
equals quantity demanded.
Price of Price of Ice
• Equilibrium Price Ice -Cream Cream
Cone Cones Supply
• The price that balances quantity supplied, and Market Market
quantity demanded.
• On a graph, it is the price at which the supply K0.00 12 0.00 0
and demand curves intersect. 0.50 10 0.50 3
• Equilibrium Quantity 1.00 8 1.00 4
1.50 6 1.50 6
• The quantity supplied and the quantity
demanded at the equilibrium price. 2.00 4 2.00 7
2.50 2 2.50 9
• On a graph it is the quantity at which the supply
3.00 0 3.00 13
and demand curves intersect. At K1.50, the quantity demanded is equal to the quantity
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 Introduction to Economics
How Markets Work
How Markets Work
Perfect competition
Perfect competition Market Not in Equilibrium
Equilibrium of Supply and Demand
(a) Excess Supply
Price of Ice-
Cream Supply
Cones Supply
Price of
Ice-Cream
Cones Surplus

Equilibrium price 2.00

1.50 Equilibrium
1.50 Equilibrium

Demand
Demand
0 1 2 3 4 6 7 8 9 10 11 12 13
5 4 6 Quantity of
Quantity Ice-Cream 7
Quantity Ice-Cream
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Quantity
Cones Demanded Supplied Cones
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 Introduction to Economics

How Markets Work

How Markets Work
Perfect competition
Perfect competition
Market Not in Equilibrium Market Not in Equilibrium
• Surplus
(a) Excess Demand
• When price > equilibrium price, then quantity Price of Ice- Supply
Cream
supplied > quantity demanded. Cones
• There is excess supply or a surplus.
• Suppliers will lower the price to increase
sales, thereby moving toward equilibrium.
• Shortage 1.50 Equilibrium

• When price < equilibrium price, then quantity

demanded > the quantity supplied. 1.00
• There is excess demand or a shortage. Shortage
• Suppliers will raise the price due to too
Demand
many buyers chasing too few goods,
thereby moving toward equilibrium. 4 8 Quantity of
Ice-Cream
Economics (2006) ,N Gregory Mankiw & Mark P. Taylor Quantity Quantity Cones
Demanded Supplied
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 Introduction to Economics
How Markets Work How Markets Work
Perfect competition Perfect competition

Law of supply and demand How an Increase in Demand Affects the Equilibrium

• The claim that the price of any good adjusts to bring

the quantity supplied and the quantity demanded for
that good into balance Price of 1. Hot weather increases the demand for Ice Cream Cones
Ice-Cream
• Three Steps to Analysing Changes in Equilibrium Cones Supply
• Decide whether the event shifts the supply or
demand curve (or both). New Equilibrium
2.00
• Decide whether the curve(s) shift(s) to the left or
to the right. 1.50 Initial
• Use the supply-and-demand diagram to see 2. Resulting in Equilibrium
how the shift affects equilibrium price and a higher price

quantity.
D2

D1
4 7 Quantity of
Ice-Cream
Economics (2006) ,N Gregory Mankiw & Mark P. Taylor 3. .. and a higher quantity sold Cones
15/09/2023 Economics (2006) ,N Gregory Mankiw & Mark P. Taylor 41
 Introduction to Economics
How Markets Work How Markets Work
Perfect competition
Perfect competition
How an Decrease in Supply Affects the Equilibrium
Three Steps to Analysing Changes in
Equilibrium 1. An increase in the price of sugar reduces the supply of ice cream
Price of
• Shifts in Curves versus Movements along Ice-Cream
S2
Cones
Curves
S1
• A shift in the supply curve is called a change
in supply.
New
• A movement along a fixed supply curve is 2.00 Equilibrium
called a change in quantity supplied.
1.50 Initial Equilibrium
• A shift in the demand curve is called a
2. Resulting in
change in demand. a higher of
price Ice Cream
• A movement along a fixed demand curve is
called a change in quantity demanded.
Demand

Economics (2006) ,N Gregory Mankiw & Mark P. Taylor

4 6 Quantity of
Ice-Cream
3. …and a lower quantity of Ice Cream Sold Cones
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Economics (2006) ,N Gregory Mankiw & Mark P. Taylor
 Introduction to Economics
How Markets Work How Markets Work
Perfect competition Perfect competition
What Happens to Price and Quantity When Supply or Summary
Demand Shifts?
• Economists use the model of supply and demand to
analyze competitive markets.
• In a competitive market, there are many buyers and
sellers, each of whom has little or no influence on
the market price
• The demand curve shows how the quantity of a
good depends upon the price.
• According to the law of demand, as the price of
a good falls, the quantity demanded rises.
Therefore, the demand curve slopes downward.
• In addition to price, other determinants of how
much consumers want to buy include income,
the prices of complements and substitutes,
tastes, expectations, and the number of buyers.
Economics (2006) ,N Gregory Mankiw & Mark P. Taylor • If one of these factors changes, the demand
curve shifts.
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 Introduction to Economics
How Markets Work How Markets Work
Perfect competition Perfect competition
Summary Summary
• The supply curve shows how the quantity of a • Market equilibrium is determined by the
good supplied depends upon the price. intersection of the supply and demand curves.
• According to the law of supply, as the • At the equilibrium price, the quantity
price of a good rises, the quantity supplied demanded equals the quantity supplied.
rises. Therefore, the supply curve slopes
upward. • The behavior of buyers and sellers naturally
drives markets toward their equilibrium.
• In addition to price, other determinants of
how much producers want to sell include • To analyze how any event influences a
input prices, technology, expectations, and market, we use the supply-and-demand
the number of sellers. diagram to examine how the even affects
the equilibrium price and quantity.
• If one of these factors changes, the supply
curve shifts. • In market economies, prices are the
signals that guide economic decisions and
thereby allocate resources.

Economics (2006)
(2006) ,N
,N Gregory
Gregory Mankiw
Mankiw &
& Mark
Mark P.
P. Taylor
Taylor Economics (2006) ,N Gregory Mankiw & Mark P. Taylor
Economics

15/09/2023 44
 Introduction to Economics
How Markets Work How Markets Work
The Costs of Production The Costs of Production
How an Economist views the firms How an Economist views the firms

Economic
profit
Accounting
profit
Implicit
Revenue cost Revenue
Total
opportunity
Explicit costs Explicit
cost cost

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 Introduction to Economics
How Markets Work How Markets Work
The Production Function Total Cost curve
Marginal
No. of Output/ Product of Cost of Cost of Total Cost 150
workers Hour Labour Factory Workers of Input
140
(a) (b) (a)+(b) Quantity 130
of
Output 120
0 0 0 K30 K0 30
110
1 50 50 30 10 40 100
90
2 90 40 30 20 50
80

3 120 30 30 30 60 70
60
4 140 20 30 40 70 50
40
5 150 10 30 50 80
30
20
10

0 1 2 3 4 5 Number of
Economics (2006) ,N Gregory Mankiw & Mark P. Taylor Workers hired
Economics (2006) ,N Gregory Mankiw & Mark P. Taylor
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 Introduction to Economics
How Markets Work How Markets Work
Total Cost Curve Various Measures Costs
Total
Cost (K) Fixe Varia Average Average Average Margi
Quantity of d ble Fixed Variable Total nal
Output/hour Total Cost Cost Cost Cost Cost Cost Cost
80 TC = FC ∆TC/∆
Q +VC FC VC FC/Q VC/Q TC/Q Q
70
K2.0
0 K2.00 0 K0.00 - - - -
1 3.00 2.00 1.00 K2.00 K1.00 K3.00 K1.00
60
2 3.80 2.00 1.80 1.00 0.90 1.90 0.80
3 4.40 2.00 2.40 0.67 0.80 1.47 0.60
50
4 4.80 2.00 2.80 0.50 0.70 1.20 0.40
40
5 5.20 2.00 3.20 0.40 0.64 1.04 0.40
6 5.80 2.00 3.80 0.33 0.63 0.97 0.60
7 6.60 2.00 4.60 0.29 0.66 0.94 0.80
30
8 7.60 2.00 5.60 0.25 0.70 0.95 1.00
20
9 8.80 2.00 6.80 0.22 0.76 0.98 1.20
10 10.20 2.00 8.20 0.20 0.82 1.02 1.40
10 11 11.80 2.00 9.80 0.18 0.89 1.07 1.60
10 20 30 40 50 60 70 80 90 100 120 130 140 150 160
12 13.60 2.00 11.60 0.17 0.97 1.13 1.80
0 13 15.60 2.00 13.60 0.15 1.05 1.20 2.00
Economics (2006) ,N Gregory Mankiw & Mark P. Taylor 14 17.80 Economics
2.00 15.80 0.14Mankiw &1.13
(2006) ,N Gregory Mark P. Taylor 1.27 2.20
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 Introduction to Economics
How Markets Work How Markets Work
Marginal and Average Costs Curves Average Total Costs in the Short and Long Runs
Cost
(K) ATC ATC in short ATC in short
run with ATC in short ATC in long run
run with
small factory run with
large factory
3.00 Medium factory

2.50

2.00

MC
1.50
ATC
Economies Constant
AVC
1.0 of Diseconomies
returns to
scale scale of
0.5 scale
AFC

0 2 4 6 8 10 12 14 Quantity of
Output/Day
Quantity of Economics (2006) ,N Gregory Mankiw & Mark P. Taylor
Economics (2006) ,N Gregory Mankiw & Mark P. Taylor
Output/Hour
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 Introduction to Economics
How Markets Work How Markets Work
Economies and Diseconomies of Scale Summary
The U shape of the long-run average cost curve Explicit Cost: Costs that require an outlay of money
by the firm
• Contains information about technology (methods of
production) for producing a good Implicit Cost: Costs that do not require an outlay of
money by the firm
Economies of Scale:
Fixed Cost: Costs that do not vary with the quantity of
• The property whereby long-run average total cost falls as output produced
quantity of output increases
• Could be as a result of specialisation, financial leverage, good Variable Cost: Costs that do vary with the quantity of
business environment output produced
Diseconomies of Scale Total Cost: The market value of all the inputs that a
• The property whereby long-run average total cost rises as firm uses in production
quantity of output increases Average fixed cost: Fixed costs divided by quantity of
• Could be as a result of coordination problems associated with large output
organisations, scarcity of resources
Average variable cost: Variable costs divided by
Constant Returns to Scale quantity output
• The property whereby long-run average total cost stays Average total cost: Total costs divided by quantity of
the same as quantity of output changes output
• Efficiency Scale Marginal cost: The increase in total costs that arise
The quantity of output that minimizes the average total cost from an extra unit of production/output
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 Introduction to Economics
How Markets Work
How Markets Work
Firms in Competitive Markets
Firms in Competitive Markets
What is a Competitive Market?
The Revenue of a Competitive Firm
• A perfectly competitive market has the following
characteristics: • Total revenue (TR) for a firm is the selling price (P)
• There are many buyers and sellers in the market. times the quantity sold (Q)
• The goods offered by the various sellers are TR = (P  Q)
largely the same.
• Firms can freely enter or exit the market • Total revenue is proportional to the amount of output

• As a result of its characteristics, the perfectly • Average revenue tells us how much revenue a firm
competitive market has the following outcomes: receives for the typical unit sold.
• The actions of any single buyer or seller in the • Average revenue is total revenue divided by the
market have a negligible impact on the market quantity sold
price.
• Each buyer and seller take the market price as • In perfect competition, average revenue equals the
given price of the good
Total revenue
Average Revenue =
• A competitive market has many buyers and sellers Quantity
trading identical products so that each buyer and
seller is a price taker. Price  Quantity

• Buyers and sellers must accept the price Quantity
determined by the market
 Price
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 Introduction to Economics

How Markets Work How Markets Work

Firms in Competitive Markets Firms in Competitive Markets
The Revenue of a Competitive Firm
The Revenue of a Competitive Firm
Average and Marginal Revenue for a Competitive Firm
• Marginal revenue is the change in total
revenue from an additional unit sold
Quantity Price Total Revenue Average Revenue Marginal Revenue
MR = TR/ Q (Q) (P) (TR = P X Q ) (AR = TR/Q ) (MR = TR X Q )
• Given that TR = P x Q and P is fixed for a 1 gallon K6 K6 K6
competitive firm. Therefore when Q rises by 1 2 6 12 6 K6
unit, total revenue rises by P 3 6 18 6 6
MR = TR/ Q 4 6 24 6 6
5 6 30 6 6
TR = Q x P
6 6 36 6 6
MR = Q x P/ Q 7 6 42 6 6
MR = P 8 6 48 6 6

• For competitive firms, marginal revenue equals For competitive firms, average and marginal revenue equals
the price of the good the price of the good
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 Introduction to Economics
How Markets Work
Firms in Competitive Markets How Markets Work
Profit Maximization and the Competitive Firm Firms in Competitive Markets
• The goal of a competitive firm is to maximize profit. Profit Maximization and the Competitive Firm
• This means that the firm will want to produce the quantity • The firm maximises profit when it produces 4
that maximizes the difference between total revenue and
total cost or 5 gallons, when the profit is K7
Quantity Total Revenue Total Cost Profit Marginal Revenue Marginal Cost Change in Profit • Alternatively, the firm can think at a margin to
(Q) (TR = P X Q ) (TC) (TR - TC) (MR = TR X Q ) (MC = TC X Q ) (MR - MC) make this decision (using one of the 10
0 gallon K0 K3 -K3 Principles of Economics)
1 6 5 1 K6 K2 K4
2 12 8 4 6 3 3 • When MR > MC increase Q
3 18 12 6 6 4 2
4 24 17 7 6 5 1
• When MR < MC decrease Q
5 30 23 7 6 6 0 • When MR = MC profit is maximized
6 36 30 6 6 7 -1
7 42 38 4 6 8 -2
8 48 47 1 6 9 -3

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 Introduction to Economics

How Markets Work How Markets Work

Firms in Competitive Markets Firms in Competitive Markets
Profit Maximization for a Competitive Firm Marginal Cost as the Competitive Firm’s Supply Curve
The firm maximises profit An increase in price P1 to P2 leads to an increase
Costs and Price In the firm’s profit maximizing quantity from
by producing the quantity MC
revenue at which marginal cost equals Q1 to Q2. Because the marginal cost curve shows
Marginal revenue the quantity supplied by the firm MC
MC at any given price, it is the firm’s supply curve
2

P2
ATC
ATC
P = MR1 = MR2 P = AR = MR P1
AVC
AVC

MC1

0
Q1 Qmax Q2 Quantity 0 Q1 Q2 Quantity

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 Introduction to Economics

How Markets Work How Markets Work

Firms in Competitive Markets Firms in Competitive Markets
The Competitive Firm’s Short - run Supply Curve The Competitive Firm’s Short - run Supply Curve
In the short run the competitive firm’s supply curve
Costs
is its marginal cost, (MC) above the average variable cost • In essence, because the firm’s marginal cost curve
(AVC), if the price falls below the AVC, the firm is better determines the quantity of good the firm is willing
MC
off shutting down
Firm’s short - run to supply at any price, it is the competitive firm’s
supply curve supply curve
If P > ATC, the firm
will continue to • The Firm’s Short - run Decision to Shut Down
produce at a profit ATC
If P > AVC, firm • A shutdown refers to a short-run decision not to
will continue to
produce in the
produce anything during a specific period because
AVC
short run of current market conditions.
• The firm shuts down if the revenue it gets from
producing is less than the variable cost of
Firm shuts
Down if
production.
P < AVC • Shut down if TR < VC
0 • Shut down if TR/Q < VC/Q
Quantity
• Shut down if P < AVC
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 Introduction to Economics

How Markets Work

Firms in Competitive Markets
• The Firm’s Short - run Decision to Shut Down
• Exit refers to a long-run decision to leave the market
• Note: short - run and long - term decisions differ because most firms cannot avoid their
fixed costs in the short run but can do so in the long run.
• Thus, a firm that shuts down temporarily still has to pay its fixed costs whereas a firm
that exits the market saves both its fixed and its variable costs
• The firm considers its sunk costs when deciding to exit, but ignores them when deciding
whether to shut down (Care and Maintenance)
• Sunk costs are costs that have already been committed and cannot be recovered
• Sunk cost is the opposite of an opportunity cost which is what you have to give up if
you choose to do one thing instead, where as sunk costs cannot be avoided
regardless of the choices you make

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 Introduction to Economics

How Markets Work

Firms in Competitive Markets
• The Firm’s Long - run Decision to Exit or Enter a Market
• In the long run, the firm exits if the revenue it would get from producing is less
than its total cost.
• Exit if TR < TC
• Exit if TR/Q < TC/Q
• Exit if P < ATC
• A firm will enter the industry if such an action would be profitable.
• Enter if TR > TC
• Enter if TR/Q > TC/Q
• Enter if P > ATC
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 Introduction to Economics

How Markets Work

How Markets Work
Firms in Competitive Markets
Firms in Competitive Markets
• The Competitive Firm’s Long - run Supply Curve
• The Competitive Firm’s Long - run Supply
In the long - run, the firm’s supply curve is its marginal cost Curve
curve (MC) above average total cost (ATC). If the price falls
below average total cost, the firm is better off exiting the • The competitive firm’s long-run supply curve
Costs
market
Firm Long - run
is the portion of its marginal-cost curve that
Supply curve MC lies above average total cost

Firm enter
• The Supply Curve in a Competitive Market
if
P > ATC ATC
• Short-Run Supply Curve
• The portion of its marginal cost curve that
lies above average variable cost.
• Long-Run Supply Curve
Firm exits
I f, • The marginal cost curve above the
P < ATC
minimum point of its average total cost
curve.
Quantity
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 Introduction to Economics

How Markets Work How Markets Work

Firms in Competitive Markets Firms in Competitive Markets
• Measuring Profit for the Competitive Firm • Measuring Loss for the Competitive Firm
(i). A firm with profits (ii). A firm with losses
Price Price
MC

Profit = TR – TC or ATC MC ATC

( P – ATC ) x Q Loss = TC – TR or
( ATC – P) x Q

P P = AR = MR

ATC ATC

P AR = AR = MR
Loss

0 Q Quantity 0 Q
profit - maximizing quantity Quantity
loss - minimizing quantity

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 Introduction to Economics

How Markets Work How Markets Work

Firms in Competitive Markets Firms in Competitive Markets
• The Supply Curve in a Competitive Market • The Short Run: Market Supply with a Fixed Number of Firms
• The Short Run: Market Supply with a Fixed Number of Firms • When the number of firms is fixed the market supply curve
below reflects the individual firm’s marginal cost curves (i). In
• Market supply equals the sum of the quantities supplied by a market of 1000 firms, the quantity of output supplied to
the individual firms in the market. the market is 1000 times the quantity supplied by each firm
• For any given price, each firm supplies a quantity of output so • The market supply curve reflects the individual firms’
that its marginal cost equals price. marginal cost curves
(i). Individual firm Supply (ii). Market Supply

Price Price
MC
Supply
K2 K2

K1 K1

0 100 200 Quantity (firm) 0 100,000 200,000 Quantity ( market

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 Introduction to Economics

How Markets Work How Markets Work

Firms in Competitive Markets Firms in Competitive Markets
Firms will enter or exit the market until profit is driven to zero. Thus in
• The Long Run: Market Supply with Entry and Exit the long run, price equals the minimum average total cost (panel i).
The level of production with the lowest average total cost is the firm’s The number of firms adjusts to ensure that all demand is satisfied at
efficient scale this price. The long run market supply curve is horizontal at this price
(panel ii)
(i). Firm’s zero – profit conditions (ii). Market Supply
Price MC Price
ATC

P = minimum Supply
ATC

0
Quantity (market) 0
Quantity (market)

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 Introduction to Economics

How Markets Work How Markets Work

Firms in Competitive Markets Firms in Competitive Markets
• The Long Run: Market Supply with Entry • Why Do Competitive Firms Stay in
and Exit Business If They Make Zero Profit?
• At the end of the process of entry and exit, • Profit equals total revenue minus total cost.
firms that remain must be making zero • Total cost includes all the opportunity costs of
economic profit. the firm.
• The process of entry and exit ends only when
• In the zero-profit equilibrium, the firm’s
price and average total cost are driven to
revenue compensates the owners for the time
equality.
and money they expend to keep the business
• Long-run equilibrium must have firms going
operating at their efficient scale

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 Introduction to Economics

How Markets Work How Markets Work

Firms in Competitive Markets Firms in Competitive Markets

• A Shift in Demand in the Short Run and Long Run • A Shift in Demand in the Short Run and Long Run

• The market starts in the long - run equilibrium shown as point • Firms earn profits because price now exceeds average total
A in (i) cost

• An increase in demand raises price and quantity in the short

run (ii).
(i). Initial Condition
(i). Initial Condition
Firm Market
MC ATC Price
Price
Short run supply, S1

A
P1 P1 Long run
supply

Demand , D1

0 Quantity (market} 0 Q Quantity (market)

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 Introduction to Economics

How Markets Work How Markets Work

Firms in Competitive Markets
Firms in Competitive Markets
• A Shift in Demand in the Short Run and Long Run
• A Shift in Demand in the Short Run and Long Run

(ii). Short - run response (ii). Short - run response

Firm Market
Price Price
Profit MC S1
ATC B
P2 P2

A
P1 P1 Long run supply

D2
D1
0 Quantity (market) 0 Q1 Q2 Quantity (market)
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 Introduction to Economics

How Markets Work How Markets Work

Firms in Competitive Markets Firms in Competitive Markets
• A Shift in Demand in the Short Run and Long Run • A Shift in Demand in the Short Run and Long Run

(iii). Long - run response (iii). Long - run response

Price Market
Firm
MC ATC Price
S1
B
P2
S2
A C
P1 P1 Long run
supply
D2
D1

0 Q1 Q2 Q Quantity (market)
3
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 Introduction to Economics

How Markets Work How Markets Work

Firms in Competitive Markets Firms in Competitive Markets

• Why the Long-Run Supply Curve Might Summary

Slope Upward • Because a competitive firm is a price taker, its
revenue is proportional to the amount of output
• Some resources used in production may it produces.
be available only in limited quantities.
• The price of the good equals both the firm’s
• Firms may have different costs average revenue and its marginal revenue
• To maximize profit, a firm chooses the quantity
of output such that marginal revenue equals
marginal cost.
• This is also the quantity at which price equals
marginal cost.
• Therefore, the firm’s marginal cost curve is its
supply curve
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 Introduction to Economics

How Markets Work

Firms in Competitive Markets How Markets Work
Summary
Firms in Competitive Markets
• In the short run, when a firm cannot recover its
fixed costs, the firm will choose to shut down Summary
temporarily if the price of the good is less than • Discussion
average variable cost.
• In Zambia, which sector(s) are practicing
• In the long run, when the firm cannot recover a competitive market structure and
both fixed and variable costs, it will choose to
exit if the price is less than average total cost monopolistic market structure? Give
reasons to support your answer.
• In a market with free entry and exit, profits are
driven to zero in the long run and all firms
produce at the efficient scale.
• Changes in demand have different effects over
different time horizons.
• In the long run, the number of firms adjusts to
drive the market back to the zero-profit Economics (2006) ,N Gregory Mankiw & Mark P. Taylor
equilibrium
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 Introduction to Economics
How the Economy as a Whole How the Economy as a Whole Works
Works The Macro Economy
Macroeconomics
Microeconomics Determinants Outcomes
• Microeconomics is the study of how
individual households and firms make Jobs
decisions and how they interact with one Internal market
another in markets factors
Prices
Macroeconomics
• Macroeconomics is the study of the MACRO
economy as a whole. External shocks Growth
ECONOMY
• Its goal is to explain the economic
changes that affect many households, Output
firms, and markets at the same time Policy levers

International
balances
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Introduction to Economics

• What are policy levers?

• Policy levers are the tools that
government and its agencies have
at their disposal to direct, manage,
and shape changes in public
services.

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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
The Macro economy
The Macro economy
• Economists and Policy Makers use some data
to monitor and evaluate the performance of the
• Unemployment Rate is the percentage of the
whole economy- Health of the economy labour force that is currently not employed.

• Macroeconomic indicators include Gross • Government Budget balances refers to

Domestic Product (GDP), Inflation Rate, outturns: Surplus/Deficit occurs when total
Unemployment Rate, Government Budget revenue/expenditures by a govt. exceeds its
Balances, Trade Balance, Level of total expenditure/ revenue during a year
International Reserves
• Trade balance refers to outturns:
• Gross Domestic Income measures the total Surplus/Deficit occurs when the value of
value of all goods and services produced by a
Exports/Imports exceeds the value of
country during a year.
Imports/Exports during a year.
• Inflation Rate is the rate of change in the
general price level of prices in an economy. • International Reserves are foreign currency
assets held by the central banks of countries.
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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
Selected Macroeconomic Indicators Selected Macroeconomic Indicators
• Zambia’s macroeconomic objectives for 2022 were • Zambia’s macroeconomic objectives for 2023 are to:
to: a) Attain areal GDP growth rate of at least 4.0
a) Attain a real GDP growth rate of at percent;
least 3.5 percent; b) Reduce inflation to within the target band
b) Reduce inflation to single digits by end- of 6-8 percent by the end of the year;
2022 and within the target band of 6-8 c) Maintain international reserves above 3
percent by mid-2023; months of import cover;
c) Limit international reserves to at least 3 d) Mobilise domestic revenue to at least 20.9
months of import cover; percent of GDP;
d) Increase domestic revenue to not less e) Achieve a fiscal deficit of not more than
than 21.0 percent of GDP; 7.7 percent of GDP; and
e) Reduce the fiscal deficit to no more than 6.7 f) Limit domestic borrowing to not more than
percent of GDP; and 3.0 percent of GDP.
f) Limit domestic borrowing to no Discussion:
more than 5.2 percent of GDP.
How feasible are the above objectives?
Discussion:
How did the economy perform in 2022 relative to 2023 Budget Address By Honourable Dr. Situmbeko Musokotwane, MP, Minister Of
the macroeconomic objectives that were set? Finance And National Planning Delivered To The National Assembly On Friday, 30th
September, 2022
2022 Budget Address By Honourable Dr. Situmbeko Musokotwane, MP, Minister Of
Finance And National Planning Delivered To The National Assembly On Friday,
29th October, 2021
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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
Measuring a Nation’s Income Measuring a Nation’s Income
• GDP is the most closely monitored economic statistic GDP can be computed from the expenditure side by
because it is thought to be the most appropriate adding up total expenditure by households or Income side
measure of a society’s economic well-being by adding up the total income (wages, rent and profit paid by
• Thus when evaluating an economy whether its doing firms)
well or poorly, it is natural to look at the total income that GDP is the total market value of all final goods and services
everyone in the economy is earning. produced within a country in a given period of time.
• GDP measures the economy’s Income and Expenditure • GDP is the Market Value . . .”
that is, the total income of everyone in the economy and
the total expenditure on the economy’ s output • Output is valued at market prices.

• For an economy as a whole, income must equal • “. . . Of All Final . . .”

expenditure because: Circular Flow Diagram • It records only the value of final goods, not
intermediate goods (the value is counted only once).
• Every transaction has a buyer and a seller.
• “. . . Goods and Services . . . “
• Every Kwacha of spending by some buyer is a
Kwacha of income for some seller. • It includes both tangible goods (food, clothing, cars)
and intangible services (haircuts, housecleaning,
doctor visits).

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 Introduction to Economics
How the Economy as a Whole Works
How the Economy as a Whole
Measuring a Nation’s Income Works
• “. . . Produced . . .” Measuring a Nation’s Income
• It includes goods and services currently
produced, not transactions involving Components of GDP
goods produced in the past. • GDP includes all items produced in the
• “ . . . Within a Country . . .” economy and sold legally in markets.
• It measures the value of production within • What Is Not Counted in GDP?
the geographic confines of a country. • GDP excludes most items that are
• “. . . In a Given Period of Time.” produced and consumed at home and
that never enter the marketplace.
• It measures the value of production that
takes place within a specific interval of • It excludes items produced and sold
time, usually a year or a quarter (three illicitly, such as illegal drugs.
months).

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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
Measuring a Nation’s Income
Measuring a Nation’s Income
• GDP (Y) is the sum of the following:
• Net Exports (NX):
• Consumption (C)
• Investment (I) • Exports minus imports.
• Government Purchases (G) • Net exports equals the purchase of domestically
produced goods by foreigners (exports) minus the
• Net Exports (NX)
domestic purchases of foreign goods(imports)
Y = C + I + G + NX • Thus when we import goods and service from
• Consumption (C): abroad, the purchase reduces net exports but
• The spending by households on goods and because it also raises C, I or G, it does not affect
services, with the exception of purchases of new GDP.
housing.
Another common measure of national output/income
• Investment (I): is the Gross National Product (GNP).
• The spending on capital equipment, inventories, • Is the total income earned by a nation’s permanent
and structures, including new housing.
residents
• Government Purchases (G):
• A measure of national income that includes all
• The spending on goods and services by local,
state, and federal governments. production by citizens that occurs anywhere in the world
• Does not include transfer payments because they • It differs from GDP by including income of Zambian
are not made in exchange for currently produced citizens earned abroad and excluding income that
goods or services. foreigners earn in Zambia
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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
Measuring a Nation’s Income Measuring a Nation’s Income
Real VS Nominal GDP Real VS Nominal GDP
• Nominal GDP values the production of goods and • Assume an economy producing only lemons and oranges
services at current prices.
Table 1: Nominal and Real GDP
• Real GDP values the production of goods and Quantity of Price of Quantity of
services at constant prices. Year Price of lemons lemons oranges oranges
2010 K1 100 K2 50
• Given that GDP measures total spending of goods
2011 2 150 3 100
and services in all markets in the economy.
2012 3 200 4 150
• A rise in total spending will entail either of the
following
• The economy is producing a larger quantity or Calculating nominal GDP {reflects prices and quantities}

• Goods and services are being sold at higher Year

prices (K1 per lemon x 100 lemons) + (K2 per orange x 50 oranges) =
2010 K200
• An accurate view of the economy requires (K2 per lemon x 150 lemons) + (K3 per orange x 100 oranges) =
2011 K600
adjusting nominal to real GDP by using the GDP
(K3 per lemon x 200 lemons) + (K4 per orange x 150 oranges) =
deflator 2012 K1,200
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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Measuring a Nation’s Income Measuring a Nation’s Income

Real VS Nominal GDP Real VS Nominal GDP

• Nominal GDP uses current prices to place a value on the
Calculating real GDP economy’s production of goods and services
{reflecting value of quantities being produced}
(base year 2010) • Real GDP uses constant base year prices to place the
Year value on the economy’s production of goods and
services
2010 (K1 per lemon x 100 lemons) + (K2 per orange x 50 oranges) = K200

2011 (K1 per lemon x 150 lemons) + (K2 per orange x 100 oranges) = K350 • Thus, Real GDP is a measure of the economy’s
2012 (K1 per lemon x 200 lemons) + (K2 per orange x 150 oranges) = K500
production of goods and services as it reflects only
changes in the amounts being produced
• The GDP deflator is a measure of the price level
Calculating the GDP deflator (reflects the prices and not the calculated as the ratio of nominal GDP to real GDP times
quantities}
100.
Year
2010 (K200/K200)x 100 = 100 • It tells us the rise in nominal GDP that is attributable to a
2011 (K600/K350) x 100 = 171 rise in prices rather than a rise in the quantities produced
2012 (K1,200/K500) x 100 = 240

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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
Measuring a Nation’s Income
Measuring a Nation’s Income
Real VS Nominal GDP
Real Vs Nominal GDP
• The GDP deflator is calculated as follows:
• Converting Nominal to Real GDP
Nominal GDP
GDP deflator =  100
Real GDP
Nominal GDP20XX
• It measures the current level of prices relative Real GDP20XX  100
to the level of prices in the base year GDP deflator20XX
• Thus, it is one of the measures that is also
used to monitor the average level of prices in
the economy (similar to consumer price index)
• Given that the GDP deflator in 2010 was 100
and 171 in 2011, we can say that from 2010 to
2011, prices in the economy increase by 71
per cent.
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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
• GDP and Economic well - being • GDP and Economic well - being
• GDP is the best single measure of the • Some things that contribute to well-being
economic well-being of a society. are not included in GDP.
• GDP per person tells us the income and • These include:
expenditure of the average person in the • The value of leisure.
economy.
• The value of a clean environment.
• Higher GDP per person indicates a higher
• The value of almost all activity that takes place
standard of living. outside of markets, such as the value of the
• GDP is not a perfect measure of the time parents spend with their children and the
happiness or quality of life value of volunteer work.
• It is silent on the distribution of income
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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
Measuring a Nation’s Income Measuring a Nation’s Income
Summary Summary
• Given that every transaction has a buyer and a • Nominal GDP uses current prices to value the
seller, the total expenditure in the economy must economy’s production. Real GDP uses constant
equal the total income in the economy. base-year prices to value the economy’s
• Gross Domestic Product (GDP) measures an production of goods and services.
economy’s total expenditure on newly produced • The GDP deflator - calculated from the ratio of
goods and services and the total income earned nominal to real GDP - measures the level of prices
from the production of these goods and services. in the economy
• GDP is the market value of all final goods and • GDP is a good measure of economic well-being
services produced within a country in a given because people prefer higher to lower incomes
period of time.
• Though not a perfect measure of well-being as
• GDP is divided among four components of some things, such as leisure time and a clean
expenditure: consumption, investment, government environment, are not measured by GDP
purchases, and net exports
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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Measuring the Cost of Living Measuring the Cost of Living
The Consumer Price Index (CPI) • When the CPI rises, the typical family has to spend
more Kwacha to maintain the same standard of living.
• The consumer price index (CPI) is a measure of the
overall cost of the goods and services bought by a • How a Consumer price Index is Calculated
typical consumer • Fix the Basket: Determine what prices are most
important to the typical consumer.
• The Zambia Statistical Agency (ZamStats) (Central
• The ZamStats identifies a market basket of goods
Statistics Office (CSO)) reports the CPI each month. and services the typical consumer buys.
• It is used to monitor changes in the cost of living • Zambia - CPI composite; Food 53.5% : Non - Food
over time 46.5%
• The ZamStats conducts monthly consumer
• Economist use the CPI to measure the inflation rate. surveys for the prices of each of the goods and
services in the basket at a point in time.
• Inflation refers to a situation in which the economy’s
overall price level is rising. • Compute the Basket’s Cost: Use the data on prices to
calculate the cost of the basket of goods and services at
• The inflation rate is the percentage change in the different times
price level from the previous period.
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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Measuring the Cost of Living Measuring the Cost of Living
• Choose a Base Year and Compute the Index: • Compute the inflation rate: The inflation rate is
the percentage change in the price index from the
• Designate one year as the base year, making preceding period.
it the benchmark against which other years
are compared. • The Inflation Rate
• In Zambia base year is 2009 revised in 2012 • The inflation rate is calculated as follows:
• Compute the index by dividing the price of the
basket in one year by the price in the base
year and multiplying by 100. CPI in Year 2 - CPI in Year 1
Inflation Rate in Year 2 =  100
CPI in Year 1

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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Measuring the Cost of Living Measuring the Cost of Living

An Example of calculating the Consumer Price An Example of calculating the Consumer Price Index and
Index and inflation Rate inflation Rate

Step Survey consumers to determine a

1: fixed basket of goods Compute the cost of the basket of goods in each
Step 3: year
4 lemons 2 oranges
Year
Step 2: Find the price of each good in each year (K1 per lemon x 4 lemons) + (K2 per orange x 2
Year Price of lemons Price of oranges 2010 oranges) = K8
2010 K1 K2 (K2 per lemon x 4 lemons) + (K3 per orange x 2
2011 oranges) = K14
2011 2 3
(K3 per lemon x 4 lemons) + (K4 per orange x 2
2012 3 4
2012 oranges) = K20
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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
Measuring the Cost of Living Measuring the Cost of Living
An Example of calculating the Consumer Price Index
and inflation Rate
An Example of calculating the Consumer Price
Index and inflation Rate
Choose one year as base year (2010) and
• The inflation rate is 75% in 2011 and 43% in 2012
Step 4: compute the consumer price index
Year • Calculating the Consumer Price Index and the
Inflation Rate: Another Example
2010 (K8/K8) x 100 = 100
• Base Year is 2010
2011 (K14/K8) x 100 = 175 • Basket of goods in 2010 costs K8
2012 (K20/K8) x 100 = 250 • The same basket in 2011 costs K14
• CPI = K14/K8)  100 = 175.
Use the consumer price index to compute
• Prices increased 75% percent between 2010
Step 5: the inflation rate from previous year and 2011
Year
2011 (175 - 100)/100 x 100 = 75%
2012 (250 - 175)/175 x 100 = 43% Economics (2006) ,N Gregory Mankiw & Mark P. Taylor
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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Measuring the Cost of Living
Measuring the Cost of Living
• Problems in Measuring the Cost of Living
• The substitution bias, introduction of new goods,
• The CPI is an accurate measure of the selected and unmeasured quality changes cause the CPI to
goods that make up the typical bundle, but it is not a overstate the true cost of living.
perfect measure of the cost of living. • The issue is important because many
• Substitution bias: if the price index is computed government programs use the CPI to adjust
assuming a fixed/specific type of goods, then it for changes in the overall level of prices.
ignores the possibility of consumer substitution and The GDP deflator Vs CPI
therefore may overstate the increase in the cost of
living from one year to the next • Economists and policy makers monitor both the
GDP deflator and the consumer price index to
• Introduction of new goods gauge how quickly prices are rising.
• Unmeasured quality changes

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 Introduction to Economics
How the Economy as a Whole Works
Measuring the Cost of Living How the Economy as a Whole Works
• The GDP deflator VS CPI Measuring the Cost of Living
• There are two important differences between the • Correcting Economic Variables for the Effect of Inflation
indexes that can cause them to diverge. • Price indexes are used to correct for the effects of
• The GDP deflator reflects the prices of all goods and inflation when comparing Kwacha figures from
services produced domestically, whereas... different times
• …the consumer price index reflects the prices of all goods • Kwacha figures in different times
and services bought by consumers • Convert (inflate) Salary in 1990 to Kwacha in 2016:
• The consumer price index compares the price of a fixed
basket of goods and services to the price of the basket in
the base year (only occasionally does the ZamStats • Salary in 2016 = Salary in 1990 x (Price level in
change the basket)... 2016/Price level in 1990)
• …whereas the GDP deflator compares the price of
currently produced goods and services to the price of the
same goods and services in the base year (The group of
goods and services changes automatically)

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 Introduction to Economics
How the Economy as a Whole Works
How the Economy as a Whole Works
Measuring the Cost of Living
Measuring the Cost of Living
• Correcting Economic Variables for the Effect of
Inflation • Correcting Economic Variables for the
• Indexation Effect of Inflation
• When some Kwacha amount is automatically • The nominal interest rate is the interest rate
corrected for inflation by law or contract, the usually reported and not corrected for inflation.
amount is said to be indexed for inflation • It is the interest rate that a bank pays.
• The real interest rate is the nominal interest
• Real and Nominal Interest rate rate that is corrected for the effects of inflation.
• Price for money If you borrowed K1,000 for one year.
• Interest represents a payment in the future for a • Nominal interest rate was 15%.
transfer of money in the past • During the year inflation was 10%.
Real interest rate = Nominal interest rate –
Inflation
Economics (2006) ,N Gregory Mankiw & Mark P. Taylor
= 15% - 10% = 5%

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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Measuring the Cost of Living Measuring the Cost of Living
Summary Summary
• The consumer price index shows the cost of a basket of • The GDP deflator differs from the CPI because it includes
goods and services relative to the cost of the same basket goods and services produced rather than goods and
in the base year. services consumed.
• The index is used to measure the overall level of prices in • In addition, the CPI uses a fixed basket of goods, while
the economy. the GDP deflator automatically changes the group of
goods and services over time as the composition of GDP
• The percentage change in the CPI measures the inflation changes
rate
• Kwacha figures from different points in time do not
• The consumer price index is an imperfect measure of the represent a valid comparison of purchasing power.
cost of living for the following three reasons:
substitution bias, the introduction of new goods, and • Various laws and private contracts use price indexes to
unmeasured changes in quality correct for the effects of inflation.
• The real interest rate equals the nominal interest rate
minus the rate of inflation.

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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Money, Money Growth and Inflation Money, Money Growth and Inflation
• The Meaning of Money • Wealth is the total of all store of value
• Money is the set of assets in an economy that including both money and non - monetary
people regularly use to buy goods and services from assets.
other people • Liquidity is the ease with which an asset can be
• Three functions of Money converted into the economy’s medium of
exchange
• Medium of Exchange: an item that buyers give to
sellers when they want to purchase goods and • Money stock: the quantity of money circulating in the
services economy, affects most economic variables such as
income, prices of goods and service in the economy
• Unit of account:: the yardstick people use to post
prices and debts • Money stock comprises
• Currency in Circulation - the paper banknotes and
• Store of Value: an item that people can use to coins in the hands of the public - Narrow Money
transfer purchasing power from the present to the
future • Demand, Savings and Time deposits - balances in
bank accounts that depositors can access to pay for
• Money is not the only item that is the store of goods and services and discharge debt – Broad
value in the economy as transfer of purchasing Money
power from present to future can also be done • Important to note that the degree of access to the
by holding other assets. different type of money differs
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Characteristics of Money
• What characteristics money needs to have?
• Money must be portable. If you are going to walk around searching for
goods and services, you want to be able to carry money with you.
Sacks of coal would not make a very good money.
• Money must be divisible. Different goods have different prices, and
the money we use must accommodate that. Watches would not make
a very good money.
• Money must be durable. Daffodils would not make a very good
money.
• Money must be acceptable.
• Something can function as money only if people are willing to accept it as
money.

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 Introduction to Economics

How the Economy as a Whole Works

Money, Money Growth and Inflation How the Economy as a Whole Works
• The Role of Central Bank Money, Money Growth and Inflation
• The Central bank (Bank of Zambia - BOZ) is an
institution designed to regulate the quantity on • The Role of Central Bank
money in the economy Navigate the BOZ website : www.boz.zm
• Money supply is the quantity of money available in and answer the following questions
the economy • What was the narrow money stock as end April
• Monetary policy is a set of actions taken by the 2022?
central bank in order to affect the money supply • What was the Broad money stock as end April
• Open Market Operations - the purchase and sale of 2022?
government securities and treasury bills from and • What was the annual inflation rate for the month of
to the banking system to affect the level of money April, 2022?
supply
• What other statistics did you find useful for
• Change in reserve ratio: The proportion of deposits analysing the economic performance of Zambia
that commercial banks are required by statute to
hold with the central bank
• Change in policy rate set by the central bank
• These actions are meant to affect the price level
and ultimately output in the economy
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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Money, Money Growth and Inflation Money, Money Growth and Inflation
Problems in Controlling the Money Supply Principle 9: Prices Rise When the Government Prints Too
Much Money
• Central banks do not control the amount of money that
households choose to hold as deposits in the bank. • Inflation: an increase in the overall level of prices in the
economy
• Central banks have no control on the amount of money
commercial banks choose to lend. • When the government creates large quantities of
money, the value of the money falls.
• Given that the central bank cannot control or perfectly • However, some economies experience, deflation
predict the behaviour of households and commercial where prices on average decrease overtime.
banks, it cannot perfectly control the money supply.
• In addition, financial system stability is important for
monetary policy to work efficiently.
• Bank runs complicate the control of money supply.

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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Money, Money Growth and Inflation Money, Money Growth and Inflation
• Hyperinflation refers to very extraordinary high rates The Level of Prices and the Value of Money
of inflation experienced such as in Zambia in the early
1990s • When the price level rises, two things are likely to
happen:
Money Supply
Growth Rate Inflation Rate • People have to pay more for the goods and
services they buy.
Year
• Result in a lower value of money because each unit
1990 45.5 106.8
of money now buys a smaller quantity of goods
1991 95 111.1 and services.
1992 98 191.2 • In mathematical terms, suppose P is the price level
as measured by the CPI or GDP deflator, then P
measures the number of Kwachas needed to buy a
Musokotwane S and Ndalamei L (1993), Effects of Fiscal and Monetary basket of goods and services. Put differently the
Policy on the Private Sector: The Zambian Experience basket of goods and services bought with K1 is 1/P.
• 1/P is thus the value of money measured in terms
of goods and services, so that when the overall
price level rises the value of money falls.
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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Money, Money Growth and Inflation Money, Money Growth and Inflation
The Level of Prices and the Value of Money The Level of Prices and the Value of Money
• When the overall price level rises, the value of money • The Central bank (Bank of Zambia) is an institution
falls, and the quantity of money demanded by people to designed to regulate the quantity of money in the
buy goods and services increases economy
• Money supply is the quantity of money available in
the economy
• Monetary policy is a set of actions taken by the
central bank in order to affect the money supply
• The money supply is a policy variable that the BoZ
regulates
• Through instruments such as open-market
operations, the BoZ regulates the quantity of
money supplied
• Money demand has several determinants, including
interest rates and the average level of prices in the
economy
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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Money, Money Growth and Inflation Money, Money Growth and Inflation
How the Supply and Demand for Money Determines the • The demand curve for money is downward sloping
equilibrium Price Level indicating that when the value of money is low (and the
Price Level, P
Value of price level is high), people demand a larger quantity of it
Money,1/ P
Money supply to buy goods and services
(High) 1
1 (Low) • At Point A , the equilibrium, the value of money and the
price level have adjusted to bring the quantity of money
supplied and the quantity of money demanded into
3/4 1.33 balance

A • Thus the equilibrium of money supply and money

Equilibrium 1/2 2 Equilibrium demand determines the value of money and the price
Value of Price level
Money level
1/4 Money 4
Demand

(High)
(Low) 0 Quantity fixed by Quantity of
the central bank Money

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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Money, Money Growth and Inflation
Money, Money Growth and Inflation
• The Classical Theory of Inflation
• The Classical Theory of Inflation (David Hume)
• Provides an explanation of the equilibrium price level and
• The quantity theory of money is used to explain the inflation rate and for this to happen
long-run determinants of the price level and the inflation • The velocity of money is stable overtime
rate. • Because the velocity if stable, when the central
• Inflation is an economy-wide phenomenon that concerns bank changes the quantity of money (M), it causes
proportionate changes in the nominal value of
the value of the economy’s medium of exchange. output (P x Y)
MxV=PxY • The economy’s output of goods and services (Y) is
primarily determined by factor supplies (labour,
• M is Money supply, V is the velocity of money, the rate at physical capital, human capital and natural
which money changes hands, P is the price level, Y is the resources)
quantity of output (real GDP) • With output (Y) determined by factor supplies and
• The equation relates to the quantity of money, the technology, when the central bank alters the money
supply (M) and induces proportional changes in the
velocity of money and the Kwacha value of the nominal value of output (P x Y), these changes are
economy’s output of goods and services reflected in the price level .
• Therefore, when the central bank increases money
supply rapidly the result is high rate of inflation.

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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Money, Money Growth and Inflation
Money, Money Growth and Inflation
The effect of Monetary Injection
• Central bank (BoZ) increases the supply of money, from
Value of
Money,1/ P
Price Level, P MS1 to MS2, the value of money and the price level
MS1 MS2 adjusts to bring supply and demand into balance. The
equilibrium moves from point A to point B
(High) 1 (Low)
1
• Thus when an increase in the money supply makes
1. An Kwachas more plentiful, the price level increases, making
increase in the Kwacha less valuable
3/4 the money
1.33
supply

1/2
A 2 3. ..and
increases
the price
B level
1/4 4
2. ..
Decreases
the value of
money
(Low) (High)
0 M1 M2

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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Money, Money Growth and Inflation Money, Money Growth and Inflation
The classical Dichotomy and Monetary Neutrality The classical Dichotomy and Monetary Neutrality
• Classical dichotomy refers to the theoretical separation of • Changes in money supply do not affect real variables
nominal and real variable
• The irrelevance of monetary changes for real variables is
• Nominal variables are variables measured in monetary units. called monetary neutrality
• Real variables are variables measured in physical units. • This phenomenon may be true in the long - run while in
the short - run changes in money supply may have
• According to Hume and others, real economic variables do not important effects on real variable
change with changes in the money supply.
• According to the classical dichotomy, different forces
influence real and nominal variables.
• Changes in the money supply affect nominal variables but not
real variables

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 Introduction to Economics

How the Economy as a Whole Works

Money, Money Growth and Inflation
How the Economy as a Whole Works
• Inflation Tax Money, Money Growth and Inflation
• When the government raises revenue by printing money, it is • The Fisher Effect
said to levy an inflation tax • This is an example of the application of the principle of
monetary neutrality which postulates that an increase in the
• An inflation tax is like a tax on everyone who holds money. rate of money growth raises the rate of inflation but does not
• The tax itself is not a cost to society as it is merely a transfer affect any real variable
of resources from household to government. • The Fisher effect refers to a one-to-one adjustment of the
• The inflation ends when the government institutes fiscal nominal interest rate to the inflation rate.
reforms such as cuts in government spending. • According to the Fisher effect, when the rate of inflation
• Definition: Inflation tax is not an actual legal tax paid to a rises, the nominal interest rate rises by the same amount.
government; instead "inflation tax" refers to the penalty for • The real interest rate stays the same
holding cash at a time of high inflation.
• When the government prints more money or reduces
interest rates, it floods the market with cash, which raises
inflation in the long run. If an investor is holding securities,
real estate or other assets, the effect of inflation may be
negligible. If a person is holding cash, though, this cash is
worth less after inflation has risen. The degree of decrease in
the value of cash is termed the inflation tax for the way it
punishes people who hold assets in cash, which tend to be
lower- and middle-class wage earners.
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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Money, Money Growth and Inflation
Money, Money Growth and Inflation
The Costs of Inflation
The Costs of Inflation
A Fall in Purchasing Power? The Inflation Fallacy
• Shoeleather costs are the resources wasted when
• Inflation does not in itself reduce people’s real purchasing
power inflation encourages people to reduce their money
holdings.
• real incomes determined by real variables
• Inflation reduces the real value of money, so people have
• people believe inflation fallacy because they do not an incentive to minimize their cash holdings
appreciate monetary neutrality
• Less cash requires more frequent trips to the bank to
• When prices rise buyers of goods and services pay more withdraw money from interest-bearing accounts.
for what they buy but at the same time sellers of goods
and services get more for what they sell • The actual cost of reducing your money holdings is the
time and convenience you must sacrifice to keep less
• “The reason that inflation in reality has an economic money on hand.
impact is that new money is not instantly and
proportionally distributed to all holders of money. • Also, extra trips to the bank take time away from
Inflation doesn't reduce purchasing power in general, it productive activities
redistributes it from those who receive the money later
to those who receive the money earlier”.
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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Money, Money Growth and Inflation Money, Money Growth and Inflation
The Costs of Inflation The Costs of Inflation
• Menu costs are the costs of adjusting prices Inflation Induced Tax Distortions
• During inflationary times, it is necessary to update price lists • The combination of inflation and taxation causes distortions in
and other posted prices incentives because people are taxed on their nominal capital
gains and interest income instead of their real income from
• This is a resource-consuming process that takes away from these sources.
other productive activities
• Inflation exaggerates the size of capital gains and increases the
• Relative Price Variability and the Misallocation of Resources tax burden on this type of income.
• The cost of more frequent price changes induced by inflation • With progressive taxation, capital gains are taxed more heavily.
• Inflation distorts relative prices • The income tax treats the nominal interest earned on savings
• Opportunity cost expressed in relative price, that is, the as income, even though part of the nominal interest rate
price of one choice relative to the price of another. For merely compensates for inflation.
example, if beans costs K4 per medda and bread costs K2 per • The after-tax real interest rate falls, making saving less
loaf, then the relative price of beans is 2 loaves of bread attractive
• Consumer decisions are distorted, and markets are less able
to allocate resources to their best use.
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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Money, Money Growth and Inflation Money, Money Growth and Inflation
The Costs of Inflation The Costs of Inflation
• Confusion and Inconvenience Summary
• When the BoZ increases the money supply and creates • The overall level of prices in an economy adjusts to bring
inflation, it erodes the real value of the unit of account money supply and money demand into balance.
• Inflation causes Kwachas at different times to have different • When the central bank increases the supply of money, it
real values. causes the price level to rise.
• Therefore, with rising prices, it is more difficult to compare • Persistent growth in the quantity of money supplied leads
real revenues, costs, and profits over time. to continuing inflation
• A Special Cost of Unexpected Inflation: Arbitrary • The principle of money neutrality asserts that changes in
Redistribution of Wealth the quantity of money influence nominal variables but
not real variables
• Unexpected inflation redistributes wealth among the
population in a way that has nothing to do with either merit • A government can pay for its spending simply by printing
or need. more money, however, this can result in an “inflation tax”
and hyperinflation
• These redistributions occur because many loans in the
economy are specified in terms of the unit of account-money
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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Money, Money Growth and Inflation Money, Money Growth and Inflation
The Costs of Inflation The Costs of Inflation
Summary Summary
• According to the Fisher effect, when the inflation rate Six costs of inflation:
rises, the nominal interest rate rises by the same amount, • Shoe leather costs - Shoe leather cost refers to the
and the real interest rate stays the same. cost of time and effort that people spend trying to
• Many people think that inflation makes them poorer counter-act the effects of inflation, such as holding
because it raises the cost of what they buy. less cash and having to make additional trips to the
bank. Money loses value with inflation, leading to a
• This view is a fallacy because inflation also raises nominal drop in the purchasing power of an individual
incomes kwacha.
• Menu costs
• Increased variability of relative prices
• Unintended tax liability changes
• Confusion and inconvenience
• Arbitrary redistributions of wealth
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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply
Short - Run fluctuations in Economic Activity Short - Run fluctuations in Economic Activity
• Economic activity (GDP) fluctuates from year to year. • Three Key Factors about Economic Fluctuations
• In most years production of goods and services • Economic fluctuations are irregular and unpredictable.
rises.
• Fluctuations in the economy are often called the
• On average over the past 8 years, production in the business cycle.
Zambian economy has grown by about 3.5 percent
per year. • Most macroeconomic variables fluctuate together.
• However, in some years normal growth was sluggish • As output falls, unemployment rises
(-3.5 % in 2020) and at time does not occur, causing • Most macroeconomic variables that measure some
a recession type of economic performance fluctuate closely
• A recession is a period of declining real incomes, and together; income or production
rising unemployment. • Although many macroeconomic variables fluctuate
together, they fluctuate by different amounts.
• A depression is a severe recession

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GDP Growth Rate for Zambia
Date Value Change, % • The economic performance has been
2021 3.57 202.00% poor.
2020 -3.5 -342.68 % • In 2020, real GDP growth for Zambia was
-3.5 %.
2019 1.4 -64.29 %
• Real GDP growth of Zambia fell gradually
2018 4.0 15.15 %
from 5.3 % in 2001 to -3.5 % in 2020.
2017 3.5 -7.23 %
• The GDP growth rate for Zambia
2016 3.8 29.35 % improved from -3.5% in 2020 to 3.57% in
2015 2.9 -37.85 % 2021 and projected to be 3.0%
2014 4.7 -7.10 %
2013 5.1 -33.44 %
2012 7.6 36.53 %
2011 5.6 -45.96 %
2010 10.3 11.69 %
2009 9.2
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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply
Short - Run fluctuations in Economic Activity
Short - Run fluctuations in Economic Activity
• As output falls, unemployment rises.
The Basic Model of Economic Fluctuations
• Changes in real GDP are inversely related to changes
in the unemployment rate • Two variables are used to develop a model to
• During times of recession, unemployment rises analyze the short-run fluctuations.
substantially • The economy’s output of goods and services
Explaining Short Run Economic Fluctuations measured by real GDP.
• How the Short Run Differs from the Long Run • The overall price level measured by the CPI or
• Most economists believe that classical theory the GDP deflator
describes the world in the long run but not in the short • The Basic Model of Aggregate Demand and
run. Aggregate Supply
• Changes in the money supply affect nominal
variables but not real variables in the long run.
• Economists use the model of aggregate
demand and aggregate supply to explain
• The assumption of monetary neutrality is not short-run fluctuations in economic activity
appropriate when studying year-to-year changes
in the economy. around its long-run trend
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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply
Short - Run fluctuations in Economic Activity
Short - Run fluctuations in Economic Activity
The Basic Model of Aggregate Demand and Aggregate
The Basic Model of Aggregate Demand and Supply
Aggregate Supply
Price Level Aggregate Demand and aggregate Supply
• The aggregate-demand curve shows the quantity
Aggregate
of goods and services that households, firms, and Supply
the government wants to buy at each price level
• The aggregate-supply curve shows the quantity of Equilibrium
goods and services that firms choose to produce Price

and sell at each price level

Aggregate
Demand

Equilibrium Quantity of
Output Output

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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply
• The Aggregate Demand Curve • The Aggregate Demand Curve
• The four components of GDP (Y) contribute to the • A fall in the price level from p1 to p2 increases the
aggregate demand for goods and services. quantity of goods and services demanded from Y1 to Y2
Y = C + I + G + NX • Why the Aggregate Demand Curve Slopes Downward
Price • The Price Level and Consumption: The Wealth
Level Effect
• A decrease in the price level makes consumers
feel wealthier, which in turn encourages them to
P1 spend more.
• This increase in consumer spending means
P2
larger quantities of goods and services
demanded
1. A decrease
in the price
Aggregate Demand
• The Price Level and Investment: The Interest Rate
level
Effect
0 Y1 Quantity of
• A lower price level reduces the interest rate,
Y2
Output which encourages greater spending on
2. Increases the quantity investment goods.
of goods and services demanded
• This increase in investment spending means a
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larger quantity of goods and services demanded
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 Introduction to Economics
How the Economy as a Whole Works
How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply
Aggregate Demand and Aggregate Supply
• The Aggregate Demand Curve
• The Aggregate Demand Curve • Why the Aggregate - Demand Curve Might Shift
• The Price Level and Net Exports: The
Exchange-Rate Effect Price
Level
• A fall in the price level causes interest rates to
fall, the real exchange rate depreciates, which
stimulates net exports.
P1
• The increase in net export spending means a
larger quantity of goods and services
demanded
D2
Aggregate Demand, D1

0 Y1 Y2 Quantity of
Output

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 Introduction to Economics
How the Economy as a Whole Works
How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply
Aggregate Demand and Aggregate Supply
• The Aggregate Demand (AD) Curve
• The Aggregate Supply Curve
• The downward slope of the aggregate demand
curve shows that a fall in the price level raises the • In the long run, the aggregate-supply curve is
overall quantity of goods and services demanded. vertical.
• Many other factors, however, affect the quantity of • In the short run, the aggregate-supply curve is
goods and services demanded at any given price upward sloping
level. • The Long-Run Aggregate-Supply Curve
• When one of these other factors changes, the • In the long run, an economy’s production of
aggregate demand curve shifts goods and services depends on its supplies of
labor, capital, and natural resources and on
• Shifts arising from the available technology used to turn these
• Consumption factors of production into goods and services.
• Investment • The price level does not affect these variables
• Government Purchases in the long run.
• Net Exports Economics (2006) ,N Gregory Mankiw & Mark P. Taylor

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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply
• The Aggregate Supply Curve • The Aggregate Supply (AS) Curve
The Long-Run Aggregate-Supply Curve
• The Long-Run Aggregate-Supply Curve
• The long-run aggregate-supply curve is vertical
Price Quantity of at the natural rate of output.
Level Output
• This level of production is also referred to as
P1 potential output or full-employment output
• Why the Long-Run Aggregate-Supply Curve
P2 Might Shift
2… does not affect the • Any change in the economy that alters the natural
Quantity of goods and
1. A change
services supplied in the
rate of output shifts the long-run aggregate-supply
in the price
level
long run curve.
0
Natural rate of
Quantity of
Output
• The shifts may be categorized according to the
Output various factors in the classical model that affect
output
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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply
• The Aggregate Supply Curve • Long - run Growth and Inflation in the Model of AD and AS
• Why the Long – Run (LR) Aggregate - Supply LRAS980 LRAS1990 LRAS200
Curve Might Shift Price
Level 1. In the long - run,
• Shifts arising 2.. Growth in technological
Money supply progress shifts
• Labor shifts AD the long - run AS
• Capital P2000
• Natural Resources 4…and
ongoing P1990 AD2000
• Technological Knowledge inflation

P1980
AD1990

AD1980
0
Y 1980 Y1990 Y2000 Quantity of
3.. leading growth in Output
output

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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply
• A New Way to Depict Long - run Growth and • Long - run Growth and Inflation in the Model of
Inflation in the Model of AD and AS AD and AS
• Short-run fluctuations in output and price level • Thus any policy changes that raise AD should be
should be viewed as deviations from the continuing viewed as an attempt to increase output
long-run trends
• Similarly any policy changes that reduce AD should
• In the short run, an increase in the overall level of be viewed as an attempt to reduce inflation and
prices in the economy tends to raise the quantity of ultimately output
goods and services supplied.
• Discuss
• A decrease in the level of prices tends to reduce
the quantity of goods and services supplied

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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply
• Why the Aggregate - Supply Curve Slopes Upward in the Short - • Why the Aggregate - Supply Curve Slopes
Run Upward in the Short - Run
• The temporary positive relationship could be due to
sticky wages, stick prices or misperceptions
Price
AS
Level • Stick Wages Theory
• Nominal wages adjust slowly in the short - run
P1 because of worker - frim employment contractual
obligations which pushes the costs up and real
wages up.
P2 2…reduce the quantity of
Goods and services • Wages do not adjust immediately to a fall in the price
supplied in the short - run
1. A decrease level
in the price
level • A lower price level makes employment and
Y1
production less profitable, so firms reduce the
0 Y2 Quantity of output quantity of goods and services they supply
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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply
• Why the Aggregate - Supply Curve Slopes • Why the Aggregate - Supply Curve Slopes
Upward in the Short - Run Upward in the Short - Run
• Stick Price Theory • The Misperceptions Theory
• Prices of some goods and services adjust • Changes in the overall price level temporarily
sluggishly in response to changing mislead suppliers about what is happening in
economic conditions: the markets in which they sell their output:
• A lower price level causes misperceptions
• An unexpected fall in the price level
about relative prices.
leaves some firms with higher-than-
desired prices. • These misperceptions induce suppliers to
decrease the quantity of goods and
• This depresses sales, which induces services supplied
firms to reduce the quantity of goods
• Business do not like uncertainties
and services they produce

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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply
• Why the Short-Run Aggregate-Supply Curve Might The Long-Run Equilibrium
Shift
• Shifts arising from Long - Run
aggregate
• Labor Supply
Short - Run
• Capital Price Level
aggregate
• Natural Resources Supply

• Technology
• Expected Price Level Equilibrium
A
Price
• An increase in the expected price level reduces the
quantity of goods and services supplied and shifts the
short-run aggregate supply curve to the left (workers
are expected to negotiate for higher nominal wages, Aggregate
Demand
increasing costs and thus leading firms to reduce
output at a given price level).
Natural rate of
• A decrease in the expected price level raises the output
Quantity of
Output
quantity of goods and services supplied and shifts the
short-run aggregate supply curve to the right (signals
lower wages hence lower costs inducing higher
production/output)
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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply
The Long-Run Equilibrium • Contraction in Aggregate Demand
• The long - run equilibrium of the economy at point A
Long - Short – run
where aggregate demand curve crosses the long - Price Level
run AS AS1
run supply curve
AS2
• When the economy reaches the long - run equilibrium
wages, prices and perceptions will have adjusted so 3.. But over
time, the short-
that the short - run aggregate supply curve crosses P1 A run AS curve
point A shifts

• Two Causes of Economic Fluctuations P2 B

1. A decrease
• Shifts in Aggregate Demand P3 C
in aggregate
demand
2..Causes
• In the short run, shifts in aggregate demand output to fall Aggregate
cause fluctuations in the economy’s output of in the short run demand,
goods and services. AD1
AD2
• In the long run, shifts in aggregate demand
affect the overall price level but do not affect 0 Y2 Y1 Quantity of
4.. and output returns to Output
output its natural rate

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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply
• Two Causes of Economic Fluctuations • An Adverse Shift in Aggregate Supply
• An Adverse Shift in Aggregate Supply Long - run
, AS2
• A decrease in one of the determinants of Price Level
Aggregate
supply
aggregate supply shifts the curve to the left: Short - run
aggregate
• Output falls below the natural rate of supply AS1
employment.
• Unemployment rises. B
P2
• The price level rises 1. An adverse shift
in the short - run
P1 A Aggregated
3..and the supply curve
Price level
To rise

Aggregate
demand

0 Y2 Y1 Quantity of
Output
2..causes output to fall
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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply

• The Effects of a shift in Aggregate Supply • Policy Responses to Recession

• Stagflation • Policymakers may respond to a recession in
one of the following ways:
• Adverse shifts in aggregate supply cause
stagflation - a period of recession and • Do nothing and wait for prices and wages
inflation. to adjust.
• Output falls and prices rise • Take action to increase aggregate demand
by using monetary and fiscal policy
• Policymakers who can influence aggregate demand
cannot offset both of these adverse effects
simultaneously

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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
• Policy Responses to Recession
Aggregate Demand and Aggregate Supply
• Accommodating an Adverse Shift in Aggregate Supply
Summary
1. When short - run aggregate
supply falls • All societies experience short-run economic
Long - run
Price Level
aggregate AS2 fluctuations around long-run trends.
Short - run
supply
Aggregate supply • These fluctuations are irregular and largely
AS1
unpredictable.
2..policy marker • When recessions occur, real GDP and other measures
P3 C can accommodate of income, spending, and production fall, and
the shift by
expanding
unemployment rises
P2
aggregate demand
• Economists analyze short-run economic fluctuations
P1 A using the aggregate demand and aggregate supply
model.
3..which
causes the AD2 • According to the model of aggregate demand and
Price level 4..but keeps output
to rise at its natural rate
Aggregate demand, aggregate supply, the output of goods and services
AD1 and the overall level of prices adjust to balance
Natural rate Quantity of aggregate demand and aggregate supply
Of output output

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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply
Summary Summary
• The aggregate-demand curve slopes downward for three • Events that alter the economy’s ability to produce
reasons: a wealth effect, an interest rate effect, and an output will shift the short-run aggregate-supply
exchange rate effect. curve.
• Any event or policy that changes consumption, investment, • Also, the position of the short-run aggregate-supply
government purchases, or net exports at a given price curve depends on the expected price level.
level will shift the aggregate-demand curve
• One possible cause of economic fluctuations is a
• In the long run, the aggregate supply curve is vertical. shift in aggregate demand
• The short-run, the aggregate supply curve is upward
• A second possible cause of economic fluctuations is
sloping. a shift in aggregate supply.
• The are three theories explaining the upward slope of
• Stagflation is a period of falling output and rising
short-run aggregate supply: the sticky-wage theory, the
prices
sticky-price theory and the misperceptions theory

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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
The Influence of Monetary and Fiscal Policy on The Influence of Monetary and Fiscal Policy on
Aggregate Demand Aggregate Demand
• Aggregate Demand How Monetary Policy Influences Aggregate Demand
• There are a number of factors that influence aggregate • The aggregate demand curve slopes downward for
demand besides monetary and fiscal policy. three reasons
• In particular, desired spending by households and • The wealth effect: a lower price level raises the
business firms determines the overall demand for goods real value of household’s money holdings and
and services higher wealth stimulates consumer spending
• The aggregate demand curve shows the total quantity • The interest-rate effect: a lower price level
of goods and services demanded in the economy for lowers the interest rate as people try to lend out
any given price level their excess money holdings and the lower
• When desired spending changes, aggregate demand interest rate stimulates investment spending
shifts, causing short-run fluctuations in output and • The exchange-rate effect: when a lower price
employment. level lowers the interest rate, investors move
• Monetary and fiscal policy are sometimes used to funds abroad and causes the currency to
offset those shifts and stabilize the economy depreciate relative to foreign currencies. The
depreciation makes domestic goods cheaper
compared to foreign goods and therefore
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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
The Influence of Monetary and Fiscal Policy on The Influence of Monetary and Fiscal Policy on
Aggregate Demand Aggregate Demand
How Monetary Policy Influences Aggregate Demand
How Monetary Policy Influences Aggregate Demand
• Keynes developed the theory of liquidity preference
in order to explain what factors determine the • Money Demand
economy’s interest rate. • Money demand is determined by several factors.
• According to the theory, the interest rate adjusts to • According to the theory of liquidity
balance the supply and demand for money preference, one of the most important factors
• Money Supply is the interest rate.
• The money supply is controlled by the Central • People choose to hold money instead of other
bank (BOZ) through: assets that offer higher rates of return because
• Open-market operations money can be used to buy goods and services.
• Changing the reserve requirements • The opportunity cost of holding money is the
• Changing the discount rate interest that could be earned on interest-
earning assets.
• Because money is fixed by the Central bank, the
quantity of money supplied does not depend on • An increase in the interest rate raises the
the interest rate. opportunity cost of holding money.
• The fixed money supply is represented by a • As a result, the quantity of money demanded is
vertical supply curve reduced
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How the Economy as a Whole Works How the Economy as a Whole Works
The Influence of Monetary and Fiscal Policy on The Influence of Monetary and Fiscal Policy on
Aggregate Demand Aggregate Demand
How Monetary Policy Influences Aggregate How Monetary Policy Influences Aggregate
Demand Demand

• Equilibrium in the Money Market • Equilibrium in the Money Market

• According to the theory of liquidity • Assume the following about the economy:
preference: • The price level is stuck at some level.
• The interest rate adjusts to balance the • For any given price level, the interest rate
supply and demand for money. adjusts to balance the supply and demand
• There is one interest rate, called the for money.
equilibrium interest rate, at which the • The level of output responds to the
quantity of money demanded equals the aggregate demand for goods and services
quantity of money supplied.
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How the Economy as a Whole Works How the Economy as a Whole Works
The Influence of Monetary and Fiscal Policy on Aggregate The Influence of Monetary and Fiscal Policy on
Demand Aggregate Demand
How Monetary Policy Influences Aggregate Demand How Monetary Policy Influences Aggregate
Equilibrium in the Money Market Demand
• The Downward Slope of the Aggregate Demand
Money supply Curve
Interest rate
• The price level is one determinant of the
quantity of money demanded
r1 • A higher price level increases the quantity of
money demanded for any given interest rate.
Equilibrium
Interest rate • Higher money demand leads to a higher
interest rate
r2 • The quantity of goods and services demanded
Money demand falls

0 • In summary, there is a negative relationship between

Md1 Quantity fixed by Md2 Quantity of
central bank
the price level and the quantity of goods and
money
services demanded
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How the Economy as a Whole Works
How the Economy as a Whole Works
The Influence of Monetary and Fiscal Policy on Aggregate
The Influence of Monetary and Fiscal Policy on Aggregate Demand Demand
How Monetary Policy Influences Aggregate Demand How Monetary Policy Influences Aggregate Demand
• The Money Market and the Slope of the Aggregate-Demand Curve • The Money Market and the Slope of the Aggregate-Demand
Curve
i. The Money Market ii. The Aggregate Demand Curve
Price
Interest rate Money supply level

2…increases the
r2 demand for money P2

3..which r1 Money demanded P1

increases the at Price level p2,MD2
equilibrium 1. An
Interest rate increase in
the price
level Aggregate
Money demanded
at Price level p1,MD1 demand

0 Quantity of 0
Quantity fixed by Y2 Y1 Quantity of output
central bank money
4… which in turn reduces the quantity of goods and services
Demanded
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How the Economy as a Whole Works How the Economy as a Whole Works
The Influence of Monetary and Fiscal Policy on The Influence of Monetary and Fiscal Policy on
Aggregate Demand Aggregate Demand
How Monetary Policy Influences Aggregate How Monetary Policy Influences Aggregate
Demand Demand
• The BOZ can shift the aggregate demand curve • Monetary Injection
when it changes monetary policy. • When the BoZ increases the money supply, it
• An increase in the money supply shifts the money lowers the interest rate and increases the quantity
supply curve to the right. of goods and services demanded at any given price
level, shifting aggregate-demand to the right
• Without a change in the money demand curve, the
interest rate falls. • When the BoZ contracts the money supply, it raises
the interest rate and reduces the quantity of goods
• Falling interest rates increase the quantity of goods
and services demanded at any given price level,
and services demanded
shifting aggregate-demand to the left

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The Influence of Monetary and Fiscal Policy on Aggregate The Influence of Monetary and Fiscal Policy on Aggregate Demand
Demand
How Monetary Policy Influences Aggregate Demand
How Monetary Policy Influences Aggregate Demand
• Monetary Injection
• Monetary Injection

i. The Money Market ii. The Aggregate Demand Curve

Price
Interest rate Money level
Money
Supply, Supply
MS1 MS2

1. When the central

r1 bank increases the P
money supply

r2
Aggregate
2.. the
Demand, D2
equilibrium 3…which increases the
Interest rate Money demand Quantity of goods and
falls at price services demanded Aggregate
Level, P at a given price level Demand, AD1
0 Quantity of 0 Y1 Y2 Quantity of output
money

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How the Economy as a Whole Works How the Economy as a Whole Works
The Influence of Monetary and Fiscal Policy on The Influence of Monetary and Fiscal Policy on
Aggregate Demand Aggregate Demand
How Monetary Policy Influences Aggregate Demand How Fiscal Policy Influences Aggregate Demand
• The Role of Interest-Rate Targets in BoZ Policy: • Fiscal policy refers to the government’s choices
regarding the overall level of government purchases or
• Monetary policy can be described either in terms of the taxes.
money supply or in terms of the interest rate.
• Fiscal policy influences saving, investment, and growth
• Changes in monetary policy that aim to expand in the long run.
aggregate demand can be described either as
increasing the money supply or as lowering the interest • In the short run, fiscal policy primarily affects the
rate aggregate demand
• A target for the BoZ policy rate affects the money market • Changes in Government Purchases
equilibrium, which influences aggregate demand
• When policymakers change the money supply or taxes,
the effect on aggregate demand is indirect - through the
spending decisions of firms or households.
• When the government alters its own purchases of goods
or services, it shifts the aggregate-demand curve directly
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How the Economy as a Whole Works How the Economy as a Whole Works
The Influence of Monetary and Fiscal Policy on The Influence of Monetary and Fiscal Policy on
Aggregate Demand Aggregate Demand
How Fiscal Policy Influences Aggregate Demand How Fiscal Policy Influences Aggregate Demand
• Changes in Government Purchases • The multiplier effect refers to the additional shifts in
aggregate demand that result when expansionary fiscal
• There are two macroeconomic effects from the change policy increases income and thereby increases
in government purchases: consumer spending
• The multiplier effect
Price 2..but the multiplier effect can
• The crowding-out effect level amplify the shift in aggregate
Demand of output
• Government purchases are said to have a
multiplier effect on aggregate demand. K10 billion

• Each Kwacha spent by the government can

raise the aggregate demand for goods and 1. An increase in AD3
services by more than a Kwacha government purchases
Of K10 billion initially increases AD2
aggregate demand by K10 billion Aggregate demand, AD1

0 Quantity
of output

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How the Economy as a Whole Works
How the Economy as a Whole Works
The Influence of Monetary and Fiscal Policy on
Aggregate Demand The Influence of Monetary and Fiscal Policy on
Aggregate Demand
How Fiscal Policy Influences Aggregate Demand
How Fiscal Policy Influences Aggregate Demand
• Investment accelerator refers to the positive
feedback from demand to investment. • If the MPC is 3/4, then the multiplier will be:
• The multiplier effect arising from the response of Multiplier = 1/(1 - 3/4) = 4
consumer spending strengthened by the response of • In this case, a K20 billion increase in government
investment to higher levels of demand spending generates K80 billion of increased demand
• A Formula for the Spending Multiplier for goods and services
• The formula for the multiplier is: • The Crowding-Out Effect

Multiplier = 1/(1 - MPC) • Fiscal policy may not affect the economy as strongly
as predicted by the multiplier.
• An important number in this formula is the
marginal propensity to consume (MPC). • An increase in government purchases causes the
interest rate to rise.
• It is the fraction of extra income that a
household consumes rather than saves • A higher interest rate reduces investment spending

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How the Economy as a Whole Works How the Economy as a Whole Works
The Influence of Monetary and Fiscal Policy on Aggregate Demand The Influence of Monetary and Fiscal Policy on Aggregate
Demand
How Fiscal Policy Influences Aggregate Demand
How Fiscal Policy Influences Aggregate Demand
• This reduction in demand that results when a fiscal expansion
raises the interest rate is called the crowding-out effect. • The crowding-out effect tends to dampen the effects of fiscal
i. The Money Market policy on aggregate demand
Interest ii. The shift in aggregate Demand Curve
rate Money
supply 4….which in turn
2…the increases partly offsets the initial
In spending increases increase in aggregate
money demand K10 billion demand (Crowding - out
r2
effect

r1

AD2
3…which 1. When an increase in
increases MD2 government purchases
the equilibrium increases aggregate AD3
interest rate Money demand, demand (Multiplier Aggregate demand,
MD1 effect) AD1
0
Quantity fixed by Quantity of 0
Quantity of
central bank money
output
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How the Economy as a Whole Works How the Economy as a Whole Works
The Influence of Monetary and Fiscal Policy on The Influence of Monetary and Fiscal Policy on
Aggregate Demand Aggregate Demand
How Fiscal Policy Influences Aggregate Demand How Fiscal Policy Influences Aggregate Demand
• When the government increases its purchases by K10 • The size of the shift in aggregate demand resulting
billion, the aggregate demand for goods and services from a tax change is affected by the multiplier and
could rise by more or less than K10 billion depending crowding-out effects.
on whether the multiplier effect or crowding - out
effect is larger • It is also determined by the households’ perceptions
about the permanency of the tax change
• Changes in Taxes
• When the government cuts personal income taxes,
it increases households’ take-home pay
• Households save some of this additional
income.
• Households also spend some of it on
consumer goods.
• Increased household spending shifts the
aggregate-demand curve to the right
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How the Economy as a Whole Works How the Economy as a Whole Works
The Influence of Monetary and Fiscal Policy on The Influence of Monetary and Fiscal Policy on
Aggregate Demand Aggregate Demand
Using Policy to Stabilise the Economy Using Policy to Stabilise the Economy
• Should policy makers use policy levers to control • Some economists argue that monetary and fiscal
aggregate demand and stabilise the economy? Issues policy destabilizes the economy.
of timing -when and why not come to the fore.
• Monetary and fiscal policy affect the economy with a
• The Case for Active Stabilization Policy substantial lag.
• The government should avoid being the cause of • They suggest the economy should be left to deal with
economic fluctuations. the short-run fluctuations on its own
• The government should respond to changes in the
private economy in order to stabilize aggregate • Automatic Stabilizers
demand • Automatic stabilizers are changes in fiscal policy
that stimulate aggregate demand when the economy
goes into a recession without policymakers having to
take any deliberate action.
• Automatic stabilizers include the tax system and some
forms of government spending
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How the Economy as a Whole Works How the Economy as a Whole
The Influence of Monetary and Fiscal Policy on
Aggregate Demand
Works
Summary The Influence of Monetary and Fiscal Policy on
Aggregate Demand
• Keynes proposed the theory of liquidity preference to
explain determinants of the interest rate. Summary

• According to this theory, the interest rate adjusts to • Policymakers can influence aggregate demand with
balance the supply and demand for money monetary policy.

• An increase in the price level raises money demand and • An increase in the money supply will ultimately lead
increases the interest rate. to the aggregate-demand curve shifting to the right.

• A higher interest rate reduces investment and, thereby, • A decrease in the money supply will ultimately lead
the quantity of goods and services demanded. to the aggregate-demand curve shifting to the left.

• The downward-sloping aggregate-demand curve • Policymakers can influence aggregate demand with
expresses this negative relationship between the price- fiscal policy.
level and the quantity demanded • An increase in government purchases or a cut in
taxes shifts the aggregate-demand curve to the right.
• A decrease in government purchases or an increase
in taxes shifts the aggregate-demand curve to the
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How the Economy as a Whole Works How the Economy as a Whole Works
The Influence of Monetary and Fiscal Policy on
Aggregate Demand What is The Influence of Monetary and Fiscal Policy
on Aggregate Demand?
Summary
Summary
• When the government alters spending or taxes, the
resulting shift in aggregate demand can be larger or Discussion
smaller than the fiscal change.
• The multiplier effect tends to amplify the effects of
fiscal policy on aggregate demand. Both fiscal policy and monetary policy can impact
• The crowding-out effect tends to dampen the effects of aggregate demand because they can influence the
fiscal policy on aggregate demand factors used to calculate it:
• Because monetary and fiscal policy can influence • consumer spending on goods and services,
aggregate demand, the government sometimes uses
these policy instruments in an attempt to stabilize the • investment spending on business capital goods,
economy. • government spending on public goods and services,
• Economists disagree about how active the government
should be in this effort. • exports, and
• Advocates say that if the government does not • imports.
respond the result will be undesirable fluctuations.
• Critics argue that attempts at stabilization often
turn out destabilizing
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How the Economy as a Whole Works How the Economy as a Whole Works
Unemployment Unemployment
Identifying Unemployment Identifying Unemployment
• Categories of unemployment • Cyclical Unemployment
• The problem of unemployment is usually divided • Cyclical unemployment refers to the year-to-
into two categories. year fluctuations in unemployment around its
• The long-run problem and the short-run problem: natural rate.
• The natural rate of unemployment • It is associated with short-term ups and downs
of the business cycle
• The cyclical rate of unemployment
• Describing Unemployment
• Natural Rate of Unemployment
• Three basic questions:
• The natural rate of unemployment is
unemployment that does not go away on its own • How does government measure the
even in the long run. economy’s rate of unemployment?
• It is the amount of unemployment that the • What problems arise in interpreting the
economy normally experiences unemployment data?
• How long are the unemployed typically
without work?
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How the Economy as a Whole Works

How the Economy as a Whole Works
Unemployment
Unemployment
Measuring Unemployment
Measuring Unemployment
• A person is considered employed if he or she has spent
most of the previous week working at a paid job. • The unemployment rate is calculated as the
percentage of the labour force that is unemployed.
• A person is unemployed if he or she is on temporary
Number unemployed
layoff, is looking for a job, or is waiting for the start date Unemployment rate =  100
of a new job Labor force
• A person who fits neither of these categories, such as a • The labour-force participation rate is the percentage
full-time student, homemaker (housewife, house of the adult population that is in the labour force
husband), or retiree, is not in the labour force.
Labor force participation rate
• Labour Force
• The labour force is the total number of workers,
Labor force
including both the employed and the unemployed  100
Adult population

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How the Economy as a Whole Works How the Economy as a Whole Works
Unemployment Unemployment
Measuring Unemployment Measuring Unemployment
• Does the unemployment rate measure what we want it • How long are the unemployed without work?
to?
• Most spells of unemployment are short for
• It is difficult to distinguish between a person who is economies near full capacity.
unemployed and a person who is not in the labour force.
• Most unemployment observed at any given time is
• Discouraged workers, people who would like to work long-term.
but have given up looking for jobs after an unsuccessful
search, don’t show up in unemployment statistics. • Most of the economy’s unemployment problem is
attributable to relatively few workers who are jobless
• Other people may claim to be unemployed in order to for long periods of time.
receive financial assistance, even though they aren’t
looking for work.

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How the Economy as a Whole Works How the Economy as a Whole Works
Unemployment and Its Natural Rate Unemployment and Its Natural Rate
Measuring Unemployment Measuring Unemployment : Frictional unemployment
• Why are there always some people unemployed? • Job search
• In an ideal labour market, wages would adjust to • the process by which workers find appropriate
balance the supply and demand for labour, ensuring jobs given their tastes and skills.
that all workers would be fully employed • results from the fact that it takes time for qualified
individuals to be matched with appropriate jobs.
• Frictional unemployment refers to the unemployment
that results from the time that it takes to match workers • This unemployment is different from the other types of
with jobs. In other words, it takes time for workers to unemployment.
search for the jobs that are best suit their tastes and • It is not caused by a wage rate higher than
skills. equilibrium.
• Structural unemployment is the unemployment that • It is caused by the time spent searching for the
results because the number of jobs available in some “right” job
labor markets is insufficient to provide a job for
everyone who wants one.

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How the Economy as a Whole Works How the Economy as a Whole Works
Unemployment Unemployment
Measuring Unemployment: Frictional unemployment Measuring Unemployment: Frictional unemployment
• Why some frictional unemployment is inevitable • Government-run employment agencies give out
information about job vacancies in order to match
• Search unemployment is inevitable because the workers and jobs more quickly.
economy is always changing.
• Public training programs aim to ease the transition of
• Changes in the composition of demand among workers from declining to growing industries and to help
industries or regions are called sectoral shifts. disadvantaged groups escape poverty.
• It takes time for workers to search for and find jobs in • Unemployment insurance is a government program
new sectors. that partially protects workers’ incomes when they
• It takes time for workers to search for the jobs that best become unemployed.
suit their tastes and skills • Offers workers partial protection against job losses.
• Public Policy and Job Search • Offers partial payment of former wages for a limited
time to those who are laid off.
• Government programs can affect the time it takes
unemployed workers to find new jobs.
• These programs include the following:
• Government-run employment agencies
• Public training programs
• Unemployment insurance Economics (2006) ,N Gregory Mankiw & Mark P. Taylor
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How the Economy as a Whole Works How the Economy as a Whole Works
Unemployment Unemployment
Measuring Unemployment: Frictional unemployment Measuring Unemployment: Structural unemployment
• Unemployment insurance increases the amount of • Structural unemployment occurs when the quantity of
search unemployment. labor supplied exceeds the quantity demanded.
• It reduces the search efforts of the unemployed. • Structural unemployment is often thought to explain
longer spells of unemployment
• It may improve the chances of workers being
matched with the right jobs. • Why is there structural unemployment?
• Minimum-wage laws
• Unions
• Efficiency wages

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How the Economy as a Whole Works How the Economy as a Whole Works
Unemployment Unemployment
Measuring Unemployment: Structural unemployment Measuring Unemployment: Structural unemployment
• Minimum-wage laws : When the minimum wage is set • Union and Collective Bargaining
above the level that balances supply and demand, it
creates unemployment • A union is a worker association that bargains with
employers over wages and working conditions.
Wage Labour
Surplus of labour = Supply • In the 1940s and 1950s, when unions were at their peak,
unemployment about a third of the U.S. labour force was unionized.
Minimum • A union is a type of cartel attempting to exert its market
Wage power
W
E • The process by which unions and firms agree on the
terms of employment is called collective bargaining
Labour • A strike will be organized if the union and the firm cannot
demand reach an agreement.
0 L L Quantity of labour • A strike refers to when the union organizes a withdrawal of
D E LS
labour from the firm.

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How the Economy as a Whole Works How the Economy as a Whole Works
Unemployment Unemployment
Measuring Unemployment: Structural unemployment Measuring Unemployment: Structural unemployment
• A strike makes some workers better off and other workers • Are Unions Good or Bad for the Economy?
worse off.
• Critics argue that unions cause the allocation of labour to
• Workers in unions (insiders) reap the benefits of collective be inefficient and inequitable.
bargaining, while workers not in the union (outsiders) bear • Wages above the competitive level reduce the
some of the costs. quantity of labour demanded and cause
• By acting as a cartel with ability to strike or otherwise unemployment.
impose high costs on employers, unions usually achieve • Some workers benefit at the expense of other
above-equilibrium wages for their members workers.
• Advocates of unions contend that unions are a necessary
antidote to the market power of firms that hire workers.
• They claim that unions are important for helping firms
respond efficiently to workers’ concerns.

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How the Economy as a Whole Works

Unemployment
How the Economy as a Whole Works
The Theory of Efficiency Wages
Unemployment
• Efficiency wages are above-equilibrium wages paid by firms in
order to increase worker productivity. Discussion
• The theory of efficiency wages states that firms operate more The impact of technology on unemployment
efficiently if wages are above the equilibrium level
• A firm may prefer higher than equilibrium wages for the
following reasons:
• Worker Health: Better paid workers eat a better diet and
thus are more productive.
• Worker Turnover: A higher paid worker is less likely to
look for another job
• Worker Effort: Higher wages motivate workers to put
forward their best effort.
• Worker Quality: Higher wages attract a better pool of
workers to apply for jobs
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How the Economy as a Whole Works How the Economy as a Whole Works
Unemployment Unemployment
Summary Summary
• The unemployment rate is the percentage of those • Minimum-wage laws raise the quantity of labor
who would like to work but don’t have jobs. supplied and reduce the quantity demanded.
• The unemployment rate is an imperfect measure of • A third reason for unemployment is the market
joblessness power of unions.
• One reason for unemployment is the time it takes for • A fourth reason for unemployment is suggested by
workers to search for jobs that best suit their tastes the theory of efficiency wages.
and skills. • High wages can improve worker health, lower worker
• A second reason why our economy always has turnover, increase worker effort, and raise worker
some unemployment is minimum-wage laws. quality

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How the Economy as a Whole Works
How the Economy as a Whole Works
Unemployment
How Is Unemployment Measured? Unemployment

• In Zambia, Unemployment is measured by the Zambia How Is Unemployment Measured?

Statistical Agency (ZamStats). • Employed Population: Is the total number of persons
• Labour Force Survey who had a paid job, were in self employment, or were in
• Working age Population Refers to all persons aged unpaid family work.
15 years and above • Note that all persons who had a paid job and were on
• Labour Force: also referred to as the leave, as well as those in self employment but were
“economically active population.” This refers to all absent from work due to various reasons such as
persons above a specified minimum age who were inadequate raw materials, absence of business
either employed or unemployed at the time of the opportunities, etc, were all considered employed.
survey. • Employed population includes persons engaged in
• For the purposes of the Zambia Labour force market economic activities such as selling of goods,
surveys, the minimum age used is 15 years production of goods and services and some non-market
• Labour Force Participation Rate: Is the ratio of economic activities such as production of goods and
the economically active population to the working services for own consumption performed for at least one
age population expressed as a percent hour, e.g, collecting firewood, growing of crops for
household consumption only, fishing for household
consumption.

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How the Economy as a Whole Works How the Economy as a Whole Works
Unemployment Unemployment
How Is Unemployment Measured? How Is Unemployment Measured?
• Formal sector: refers to all enterprises that are registered • Unemployed Population: refers to all persons in
with a tax authority and/or a licensing authority such as the labour force who are completely jobless during
Zambia Revenue Authority (ZRA), Patents and Companies the reference period.
Registration Agency (PACRA), Local Authority (LA), etc.
• Unemployed population in addition to being jobless
• Formal Sector Employment: is the employment, whether is one that is available for work and is actively
formal or informal, in a registered enterprise. looking for work.
• Formal Employment: is the type of employment where • Unemployment Rate: is the ratio of the unemployed
employees are entitled to annual paid leave in addition to population to the labour force expressed as a
having an entitlement to social security coverage. percent
• Informal Employment: is the type of employment which is
characterized by the lack of an entitlement to annual paid
leave and absence of social security entitlement. This type
of employment could be found in both the formal sector and
informal sector enterprises.

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How the Economy as a Whole Works
The Short-Run Trade-Off between Inflation and How the Economy as a Whole Works
Unemployment
The Short-Run Trade-Off between Inflation and
The Phillips Curve Unemployment
The Phillips Curve

Inflation
Rate (per cent • Illustrates a negative association between the
per year inflation rate and the unemployment rate.
13 B

• At point A inflation is low and unemployment is high.

A
11
The Phillips • At point B inflation is high and unemployment is low
curve
0 2 4
Unemployment rate
(per cent)

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How the Economy as a Whole Works How the Economy as a Whole Works
How the Phillips Curve is related to the Model of How the Phillips Curve is related to the Model of
Aggregate Demand and Aggregate Supply Aggregate Demand and aggregate supply

(a). The Model of Aggregated Demand and Aggregate Supply (b). The Phillips Curve

Price Short-run aggregate Inflation

level supply Rate (per cent
per year
113 B 13 B
111 A
High aggregate A
demand 11

Low aggregate demand

0 1000 2000 Quantity of Output 0

(U -rate (U -rate 2% 4%
(Output is Unemployment rate
4%) 2 %) (Output is
2000) (per cent)
1000)
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 Introduction to Economics
How the Economy as a Whole Works How the Economy as a Whole Works
How the Phillips Curve is related to the Model of The Long Run Phillips Curve
Aggregate Demand and Aggregate Supply According to Friedman and Phelps, there is a breakdown of
the trade-off between inflation and unemployment in the
long run.
An increase in aggregate demand for goods and Thus, regardless of the inflation rate , the unemployment
services leads, in the short run to a larger output of rate gravitates towards its natural rate
goods and services and a higher price level.
Thus, the long run Phillips curve is vertical (Monetary
A larger output entails greater employment and thus Neutrality)
a lower rate of unemployment Long-run
Inflation
Thus, shifts in aggregate demand push inflation and rate Phillips Curve
unemployment in opposite directions in the short-run 1. When High 2.. But
a relationship depicted by the Phillips curve. central bank inflation
B unemployment
increases the remains at its
In short, the Phillips curve shows the combination of growth of natural rate in
inflation and unemployment that arise in the short money supply A the long run
Low
run, as shifts in the aggregate demand curve move inflation inflation
the economy along the short-run aggregate supply increases 0 Natural rate Unemployment
curve of unemployment rate
Economics (2006) ,N Gregory Mankiw & Mark P. Taylor Economics (2006) ,N Gregory Mankiw & Mark P. Taylor

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 Introduction to Economics

How the Economy as a Whole Works How the Economy as a Whole Works
How the Long-Run Phillips Curve is related to the Model of The Long Run Phillips Curve
Aggregate Demand and Aggregate Supply
(a). The model of aggregate demand and aggregate supply (b). The Phillips Curve

Price Long-run Inflation Long-run

level aggregate rate Phillips Curve
supply 1. An increase
in money 3… and
2…raises the supply increases the
price level increases inflation rate
P B aggregate
2 B
demand

P A AD A
1 2
Aggregate demand, AD
1
0 Natural rate Quantity of 0 Natural rate Unemployment
of output output of unemployment rate
4…. but leaves output and
unemployment at their natural rates
Economics (2006) ,N Gregory Mankiw & Mark P. Taylor
Economics (2006) ,N Gregory Mankiw & Mark P. Taylor
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Introduction to Economics

• The End