Form Five, Term One
[The Role of the Government in Stabilizing the Economy]
Taxation and Expenditure and Transfer Policies
{Expenditure}
There are two types of expenditure
1) Capital expenditure
2) Current expenditure
Capital expenditure involves investment on capital goods, e.g. roads, schools and
government enterprises to produce goods.
Current expenditure is spending on goods and services for present consumption and
expenditure on wages and salaries of government workers.
{Transfer Policies}
Transfer payments are monies given to one group by another for which no productive
activity took place, for example:
1) Pensioners
2) The long term sick
3) New mothers (maternity grant)
4) Unemployed people
5) Disabled people
{Taxation}
A tax is a compulsory payment to the government. Taxes are paid by people and
businesses and they are “levied” or charged on income, profit, property and the
purchase of goods and services.
Taxes have several main functions:
1) Raising revenue
2) Income distribution
3) Control of spending
{Functions of Taxation}
Raising Revenue- this is the main purpose of taxation. Governments need revenue to
pay for goods and services that the private sector would not produce. E.g. defense,
street lights, roads, education and healthcare.
Income Distribution- in a private sector-based economy there will be great
inequalities of income and wealth. Government would want to reduce these
inequalities and all a ‘fairer’ society with equal opportunities. They do this by taxing
the rich more heavily than the low-paid.
Control of Spending- if the government wants to control spending in the economy,
an increase in taxes can be used. This reduces disposable income leaving people with
less to spend. It can also be used to cut spending on certain goods e.g. alcohol and
cigarettes, by placing higher taxes on them, making them more expensive.
{Types of Taxation}
Direct Taxes- taxes are based on income, profits or wealth directly paid by an
individual or company they are levied on
Indirect Taxes- are taxes based on spending paid by the retailer but indirectly passed
on to the final consumer.
{Direct Taxes}
Income tax- paid by individuals as they receive an income, wage or salary. It is called
PAYE (Pay as you earn)
Corporation tax- this is paid by companies and calculated as a percentage of the
annual profits they make
Capital Gains tax- paid when a profit is made on the sale of investments or assets
e.g. shares, land, house
Capital Transfer tax- these are taxes paid when a person passes on wealth to others.
{Indirect Taxes}
Import Tariffs and Customs Duties- these raise the prices on imported goods and
make domestically produced goods appear cheaper
Excise Duties on specific goods- these not only raise revenue but also discourage
consumption of harmful goods such as alcohol and cigarettes.
Purchase tax- this tax is applied to a range of consumer goods and services e.g. VAT
Stamp Duty- a tax levied on the purchase of financial assets such as property.
[The Circular Flow of Income]
The circular flow of income is that flow of factor incomes from firms to households in return
for factor services. This factor income then flows back to firms as payment for goods and
services that the households purchase.
The flow of factor incomes from firms to households and the expenditure from households to
firms are balanced.
Households own the factors of production- land, labor, capital and enterprise and consume
the goods and services provided by Producers.
Firms employ the factors of production to produce the goods and services consumers need.
{Different sectors of the economy}
A closed economy is one that does not engage in international trade. This economy has only
three sectors: households, firms and government.
An open economy engages in international trade. There are households, firms, government
and the international sector.
Sector Role
Households Owners of f.o.p
Buyers of goods and services
Firms Buyers of factor services
Producers of goods and services
Government Taxes households and firms for revenue
Engages in recurrent and capital expenditure
Foreign Trade Sector Domestic buyers of imports
Foreign buyers of country’s exports
{Injections and Withdrawals}
When a household receives income, some might be saved, some might be paid in
taxes and some might be spent on imports
Savings, taxes and imports are called leakages or withdrawals from the circular flow
of income
Firms receive payment for goods and services, but use funds for investment purposes
which adds to the circular flow of income.
Government also spends in the economy and adds to the circular flow of income
Earnings from the sale of domestic output abroad is recorded as exports
Investment, government spending and export earnings are injections.
Injections include investment spending, government spending and exports. These are
additional forms of expenditure that are pumped into the circular flow of income.
J= I+G+X
Withdrawals or leakages include savings, taxation and imports. This income that is ‘leaks’
out from the circular flow of income.
W=S+T+M
[National Income]
National income is a measure of economic activity in an economy over a given
period, usually one year.
Governments use a variety of measures of the country output. These are known as
national income statistics.
Most widely used measure of national income is Gross Domestic Product (GDP).
{Methods of calculating National Income}
There are three main ways of measuring national income:
1) The output approach
Measure the value of output produced by industries e.g. manufacturing,
construction, distributive, hotel, catering and agriculture.
2) The income approach
The value of output produced is based on the costs involved in producing that
output. The cost includes wages, rent, interest and profits. It is income paid to
the factors of production
3) The expenditure approach
Found by adding all the spending on the final goods and services produced by
firms. It is the sum of consumption of domestically produced goods,
investment, government expenditure and net exports
GDP=C+I+G+X-M
{Gross Domestic Product}
GDP is a measure of output produced in a country over a given period, usually one
year, using the factors of production located in that country.
From GDP another measure can be calculated, namely GNP
Gross National Product= GDP+ Net property income from abroad.
Net property income from abroad is the income residents earn from their assets
(physical and financial) owned both locally and abroad MINUS returns on assets held
in the country, but owned by foreigners.
{Market Prices and Factor Cost}
GDP figures can be shown at market prices or factor cost
At market prices: this is the prices charged for goods and services in shops.
At factor cost: Output- indirect taxes + subsidies
{Nominal vs Real GDP}
Nominal GDP is GDP measured in current prices and does not take into account
inflation- changes in prices over the years.
Real GDP is a measure of GDP in constant prices that is, it takes into account
inflammation.
{Potential GDP}
Potential GDP is the output that could be achieved if all the resources were used
efficiently
This production level would take place on the boundary of the PPF
Economies tend to fall short of their potential and produce inside the PPF, typically
because of market failure.
{The Use of National Income Statistics}
National income statistics can be used to measure living standards and poverty.
Since national income is the total income generated in the economy, any increase in
the level of economic activity means that wellbeing has improved.
Consumers will now be able to afford increase quantities of goods and services
The increased level of production will also create additional employment
Increased employment then means that poverty levels will decline as more persons
earn an income.
The statistics can then be used to evaluate and compare living standards over time
Comparisons of relative living standards among countries can also be made.
Mid Term #2 Notes
Inflation and recession.
9. The major causes and consequences of inflation and recession.
10. Government’s role in reducing inflation.
11. Government’s role in relieving recession.
12. Types of unemployment:
(a) structural;
(b) cyclical;
(c) frictional;
(d) seasonal;
(e) real-wage.
13. Causes and measures to reduce each type of unemployment.
14. The role of Trade Unions in a free market economy
{Inflation}
Inflation is a sustained increase in the general level of prices, which results in a fall in the
purchasing power of money. The purchasing power or real value of money refers to the
amount of goods or services that it can purchase.
Inflation is measured by measuring the percentage change in the consumer price index.
Equation:
Price relative= (Current Price/ Base Price) x 100
{Causes/ Types of Inflation}
Inflation is not caused by one factor, rather it is caused by a number of factors. The types of
inflation are listed below:
1. Cost-push Inflation
2. Demand-pull Inflation
3. Monetary Inflation
[Cost-push Inflation]
This is caused by an increase in the prices of the factors of production. This causes firms’
costs to rise. The four factors of production are: land, labor, capital, and enterprise. If
payments to any of these factors of production increase, this will cause costs to increase.
Firms will, in most instances, increase prices in order to maintain profit levels. Other factors
that cause cost-push inflation are:
Rising costs of imported raw materials
Higher indirect taxes on goods and services imposed by the government
A depreciation of the exchange rate, which makes imports more expensive.
[Demand-pull Inflation]
This is caused by an increase in demand in the economy. Total demand in the economy by all
groups- households, firms, government and the export sector- is termed ‘aggregate demand’.
When aggregate demand increases and the supply of goods in the economy cannot be
expanded to meet this increase in demand, the result is rising prices.
Expenditure= C+I+G+X-M
[Monetary Inflation]
This is inflation caused by an increase in the money supply. If the government of a country
decides to print money for spending purposes, the result would be in an increase in the
amount of money circulating in the economy. When this money flows throughout the
economy, there would be greater spending. As a result, the prices of goods and services
would rise.
{Consequences of Inflation}
Fixed income earners suffer a fall in real income. The purchasing power of money
falls during inflationary times, so that a given amount of money can buy fewer goods
and services. The purchasing power of money is what goods and services the money
can buy.
When prices are increasing in the domestic economy, it means that the prices of goods
that the country is exporting will rise. As prices rise, foreigners will demand fewer of
the country’s goods and services. This means that the country will earn less foreign
income. If the level of exports falls and the level of imports remains constant, the
country will suffer a trade deficit.
Borrowers gain as the value of the debt to be repaid in real terms falls during an
inflationary period. Inflation tends to encourage borrowing.
Creditors lose out because the sum to be repaid will now be able to buy less.
Looking for better prices in times of continuous inflation means that people might
have to walk from place to place. These are costs in terms of time and effort, and they
are called shoe leather costs.
Shops, stores and restaurants also have to change price tags and menus. These are
called menu costs.
Employers might be forced to reduce the quantity of labor employed because of rising
labor costs this could result in some unemployment.
{Measures to reduce Inflation}
1. Demand-pull Inflation
In order to reduce demand-pull inflation. The government must put in place
deflationary fiscal policy. Reducing government expenditure and increasing taxes
reduces total spending in the economy, which in turn reduces the pressure on prices.
Deflationary monetary policy will also be effective, as higher interest rates and a
credit squeeze will limit borrowing and spending. This will reduce inflation, as there
is less spending and less pressure on prices to increase.
2. Cost-push Inflation
Regulations to limit the power of trade unions to increase wages will be effective in
curbing cost-push inflation. Also, government subsidies and grant to firms to help
increase production will make more goods and services available. This will put less
pressure on prices by increasing overall supply of goods in the economy, even though
aggregate demand in the economy remains the same.
3. Monetary Inflation
Deflationary monetary policy will be effective because higher interest rates and credit
squeeze both reduce the money supply in the economy. Reduced money supply and
limits on borrowing will reduce spending in the economy and so take away pressure
from prices.
{Recession}
A recession is a period during which the total output in the economy declines. During a
recession, firms are producing less, so national output decreases. As firms are producing less,
it means that firms will use less factor inputs, including labor. Unemployment grows during a
recession. A recession is short term, lasting a couple months or up to a year. A recession can
develop into a depression, lasting several years. A depression is falling national output over
several years with high levels of unemployment.
[Causes of a Recession]
The Trade Cycle.
Economic activity increases and then declines over time. This is called the trade
cycle. Economic activity will not simply increase all the time. The peak of economic
activity is called a ‘boom’ and the through is called a ‘depression’. As the economy
slides from a boom, this is a recession. A recession signals the end of the boom stage
of the trade cycle. At the point at which economic activity declines, this is the onset of
the recession.
During a boom, demand is increasing.
The increasing demand will fuel inflation. As the government puts in place
deflationary fiscal and monetary policy, this will cause aggregate demand in the
economy to fall. Prices will stabilize but there might be a decline in output and a rise
in unemployment. This is a recession.
Cautious entrepreneurs might feel pessimistic about the future.
This might simply be instinct that demand will fall in the future. As a result, they
might cancel investment plans. They might even avoid undertaking replacement
investment. This fall in investment will lead to a fall in national output.
The demand of household, firms, government and the export sector might fall. This
will cause aggregate demand in the economy to fall, thereby causing output to fall.
If firms are not making sufficient profits, they will close down. This will cause a
contraction of national output.
[Consequences of a recession]
In a recession, output is falling. This means that GDP and standard of living is falling.
If output is falling, firms will use fewer factors of production, including labor. This
will cause rising unemployment.
Rising unemployment and falling GDP will result in people having less income to
purchase goods and services. There will, therefore, be a fall in consumption.
The government will find that its tax revenue from taxes on g+s and taxes on incomes
will decline, as there is falling income and rising unemployment in the economy. This
will affect government’s ability to spend on the provision of merit goods, such as
health and education, and other amenities, such as water and electricity. Government
will also have to spend more on unemployment-related benefits.
In a recession output is falling, incomes are falling and unemployment is rising. This
leads to falling demand. This might result in further pessimism amongst entrepreneurs
and investors as they predict falling demand.
Falling incomes means that consumption will fall and, with the fall in consumption,
there will be a fall in the level of imports.
[Government Policies to reduce a recession]
Fiscal Policy- reflationary fiscal policy will relieve a recession. Increasing
government expenditure will create jobs for the unemployed. When they receive their
incomes, this will lead to increased spending in the economy. Cutting income taxes
and taxes on g+s will encourage consumers to spend mor. Reducing corporation taxes
will encourage firms to invest more. The increased spending in the economy will
encourage firms to produce more, they will employ more labor, and national income
and output will rise.
Monetary Policy- reflationary monetary policy will also relieve a recession. Reducing
interest rates will encourage firms to invest, and individuals will borrow more and so
consume more g+s. even governments will have access to borrowing at lower rates of
interest. Easier accessibility to loans will also encourage more spending. More
spending by households, firms and government increases aggregate demand. As
aggregate demand increases, firms will increase output. They will have to employ
more labor thus reducing unemployment. Output and incomes in the economy will
increase.
{Unemployment}
Any person who is actively seeking employment and is willing and able to work but unable to
find work is considered to be unemployment. The unemployment rate is the number of
unemployed persons measures as a percentage of the work force.
Equation:
Unemployment rate= (Number unemployed/ labor force) x 100
[Types of Unemployment]
1. Frictional unemployment. The frictionally unemployed are occupationally or
geographically immobile. Though there are jobs available, these unemployed do not
have skulls to match the jobs, or they are unwilling or unable to move to the part of
the country where the job is.
2. Search unemployment. This occurs when someone who is unemployed does not take
the first job that he or she is offered. They opt to search for a better paying or more
suitable job.
3. Seasonal unemployment. Some workers only have jobs at certain times of the year,
when there is demand for certain products or when a particular crop might be in
‘season’.
4. Structural unemployment. This occurs when there is change in the structure of an
industry. As a result, workers become unemployed.
5. Cyclical unemployment. This type of unemployment is also called Keynesian
unemployment of demand-deficient unemployment. There is a fall in aggregate
demand in the economy. Consumption might fall, investment firms may fall,
government expenditure might fall, or there might be a fall a foreigners’ demand for
exports. As demand falls, firms reduce output, meaning they will employ less f.o.p,
like labor. This will cause unemployment.
6. Real-wage unemployment. This occurs when trade unions succeed in raising wages
above the equilibrium level. At a wage above the equilibrium level, supply of labor
exceeds the demand for labor. The surplus is unemployed.
[The effects of Unemployment]
Benefits:
1. The unemployed have an opportunity to do extra training or to pursue hobbies.
2. When workers become unemployed, they embark on retraining programs.
3. Unemployment reduced cost-push inflation, as there are fewer workers in jobs to
demand higher wages and so put pressure on prices.
4. When there are unemployed workers, it means that the labor market is a buyer’s
market.
Costs:
1. The unemployed do not have the economic means tot enjoy a good quality of life.
2. The unemployed might be depressed and discontented, adding to social problems such
as crime, drug abuse and idleness.
3. When people are unemployed for a long time, it erodes the quality of the human
capital in the economy as they lose skills due to lack of practice.
4. Unemployment means that society is not using all its resources to produce g+s.
[Measures to reduce each type of unemployment]
1. Retraining programs will aid those who are occupationally immobile and thus
frictional unemployed. It will make those who are structurally unemployed more
employable, as well as help those who are seasonal unemployed to find hobs during
the ‘low’ seasons of the year.
2. Government projects, such as the construction of housing developments, schools,
shopping malls, and sports facilities in areas where there are jobs available will lure
workers int the area.
3. Job centers and more advertising of available hobs will also reduce frictional and
search unemployment. It increases the chances of those between hobs and those
searching for better jobs, to find jobs.
4. Regulations and agreements with trade unions to avoid making demands to increase
the wage rate above the equilibrium wage rate will help to reduce real-wage
unemployment.0
