CONSUMPTION, SAVINGS AND INVESTMENT

CONSUMPTION

Consumption refers to the portion of income spend in the current period on final goods and
Services aimed at satisfying one’s needs.

Types of consumption
 Autonomous consumption. This is consumption that is independent of the level of income. That
is, it is income inelastic.
 Induced consumption. This is consumption which depends on the level of income. An increase in
income leads to an increase in consumption and vice versa.

Factors influencing the level of consumption

1. Level of Income. The higher the income, the higher the level of consumption and the lower the
income, the lower the level of consumption.
2. The level of savings. The higher the savings, the lower the level of consumption and the lower the
savings, the higher the level of consumption.
3. The level of wages. An increase in the wage rate increases consumption and a reduction in the
wage level leads to a fall in the level of consumption.
4. Level of direct taxation. An increase in direct taxes reduces the disposable incomes of people
hence a reduction in consumption. But a reduction in direct taxes increases disposable incomes of
people hence an increase in consumption.
5. Level of government expenditure. Increase in government expenditure for example on transfer
payments leads to an increase in consumption and a reduction in government expenditure reduces
consumption.
6. Rate of interest on deposits. An increase in interest rate on bank deposits reduces consumption
and a decrease in interest rates on deposits increases the level of consumption.
7. Level of liquidity preference. The higher the level of liquidity preference, the lower the level of
consumption and the lower the level of liquidity preference, the lower the level of consumption.
8. Consumer’s expectations. If the consumer expects inflation in future, current consumption
increases and if a consumer expects a fall in prices in future, current consumption reduces.
9. Nature of income distribution. Consumption is low where there is high level of income
inequalities. But with fair income distribution, consumption increases.
10. Cost and availability of credit. Availability of credit facilities in form of hire purchases, cash
discounts etc. increase consumption and absence of such credit facilities reduce the level of
consumption.

The Household

Traditionally, a household is the basic unit of analysis comprising of several members (individuals). In
this case, it is assumed that the household produces one type of good, Q which has a fixed unit price
(P=1).
Suppose a given household produces a stream of output over n periods. That is;
Q1, Q2, Q3, -- - -- - ----- -- - - - - -- - - - - - - - - - - - - - - - - - - - - - --, Qn

(a) If a household lives in isolation and does not save any output, then the household has no choice
but to consume in each period exactly what it produces or else its output goes to waste. A utility
maximizing household will consume according to the rule C1= Q1; C2 = Q2. That is, it consumes what
is exactly produced.

(b) If the commodity can be stored, then the house hold can be able to improve on its consumption
pattern by storing some output for future period and consuming out of the accumulated saving in other
periods such that C1< Q1 and C2 > Q2.

(c) Suppose a household instead of storing the surplus output, it can save it when linked to other
households through the financial market by trading in financial assets such as bonds thereby earning
interest. Suppose each bond is purchased at unit price, it will pay the owner an amount equal to (1+ r)
in the next period where r is the interest and one is the principle.
Due to the existence of financial assets, the household consumption can differ from its income in any
given period. For example if it earns more than it consumes, it accumulates bonds which can be cashed
at a later date for higher future consumption. But if it consumes more than it earns, then it must cash
the stock of bonds or borrow.
That is, if Q1 – C1 > 0 the household accumulates bonds (net lender). If Q1 – C1 < 0 the household
cash the bonds (net borrower).
Note. Income (Y) and output (Q) in any period are different. Income includes output produced in that
period and interest earned on the previously accumulated bonds.
Let Bt-1 denote the stock of bonds held in the previous period measured in units of output. Then the
household income, Yt = Qt + rBt-1 ……………… (1)
Where r = interest rate and rBt-1= total interest earned on bonds

The household’s stock of bonds change over time depending on the difference between income and
consumption. If the household consumes more than it earns, income and its bond holdings diminish.
But if it earns more income than it consumes, then its bonds accumulate.
That is Bt = Bt-1 + (Y-C)
Bt - Bt-1 = Y – C ……………………(2)
Where Bt = Current stock of bonds
Bt-1 = Previous stock of bonds (Past savings)
Y-C = Current savings
If Bt > Bt-1, then the household earns more than it consumes, that is Y > C, (Y- C > 0)
If Bt < Bt-1 then the household consumes more than it earns, that is Y< C, (Y-C <0)

The Household inter – temporal Budget constraint

Inter-temporal means more than one period. In this case, we consider a household that lives more than
one period for example two periods that may not necessarily be equal in length.
 The first period is referred to as the present period (Period 1)
 The second period is referred to as the future period (Period 2)
Suppose a household inherits no assets and that the initial stock of bonds in period one is zero, that is
B0=0. The household leaves behind no assets such that B2 = 0. This implies that B1 – B0 = S1 =B1 (first
period savings).
Also, since there are no assets left for inheritance, it implies that B2 – B1 = S2 = - B1.
Therefore S1 = B1 and S2 = -B1 .This means that when a household is born with no assets and dies with
no assets and does not borrow, then its savings in the first period exactly matches its dissaving in the
second period that is S2 = - S1.
It also means that if a household saves income in the first period, it must dissave when it is old in the
future period.
From the analysis above, we can write;
S1 = Y1- C1
S2 = Y2 + rS1– C2
But S2 = -S1;
 S2 = Y2 + rS1 – C2 = -S1.
 Y2 + r S1– C2 = -S1
From S1 = Y1 – C1  -S1 = C1 – Y1
 Y2 + r(Y1 – C1)– C2 = C1 – Y1
C1 – Y1 = Y2 + r(Y1 – C1) – C2
C1 – Y1 = Y2 +r Y1 – rC1 – C2
C1 + rC1 – Y1 – r Y1 = Y2 – C2
C1(1+r) – Y1 (1+ r) = Y2 – C2
(C1 – Y1) (1+ r) = Y2 – C2
C1 – Y1 = Y2 . - C2
1+r 1+r

 C1 + C2 = Y1 + Y2 --------------------- (3)
1+r 1+r
Present discounted present discounted
consumption output (income)

Equation (3) is the inter – temporal budget constraint. It shows that the present discounted value of
lifetime consumption is equal to the present discounted value of lifetime income. This implies that the
household must keep within its means (should not borrow).

From C1 (1 + r) – Q1 (1+ r) = Q2 – C2.

 C2 = -C1(1+ r) + Q1(1+ r ) + Q2

dC2 = - (1+ r) = slope of the budget constraint

dC1

Household consumption decision making

The household derives utility from consumption in each period. This implies that the level of utility is
a function of C1 and C2. The household is assumed to be rational .i.e. he aims at utility maximization
given the budget constraint. The inter-temporal utility function behaves like any other utility function
i.e. Indifference curve
 0 CB1 C*1 Cc1 C1

The household can choose any consumption bundle along the budget constraint. At point B, the
household has more C2 and less C1. That is, the household plans to consume less in the current period
and more in the future (shifting present income to future consumption by lending at a rate r). At point
C, the household has more C1 and less C2. That is, the household plans to consume more in the current
period and less in the future (shifting future income to present consumption by borrowing at a rate r).
The interest rate r measures the market opportunity cost of converting consumption to the future and
vice versa. The household maximizes utility at point A where the utility function touches the budget
constraint.

Note. It can be shown that a household is better off when it borrows or lends than when it remains in
financial isolation.
Graph A

E = Utility maximization Point

A = Endowment (Production Point)

From graph A, point A is the endowment (production) point and point E is the consumption (utility
maximization) point. Consumption in the first period exceeds output (i.e. C1> Q1) such that the
household is a net borrower. In the second period, the household must consume less than its income so
that it repays the debt incurred in the first period (C2<Q2).
 Graph B

E = Utility maximization point

B = Endowment (Production Point)

From graph B, Point E is the consumption point while B is the endowment point. The household
consume less than it produces in the first period (i.e. C1<Q1) such that it is a net lender. Therefore, this
enables the household to consume more than its income in the second period (C2 >Q2).

Therefore, for a given level of income, consumption not only depends on current income but also on
the future income, interest rate and the tastes of the household.

Note that the utility level that passes through the endowment point is lower than the given indifference
curve that passes through the consumption point in both graphs. Therefore, a household is better off if
it borrows or lends in the bonds market at an interest rate than if it remains in financial isolation.

Theories of Consumption

(a) Life cycle theory (Hypothesis)

 This theory was developed by Franco Modigliani. The theory views individuals as planning their
consumption and savings behavior over a long period of time, with the intention of allocating their
incomes in the best possible way over their entire life cycle. It argues that consumption in a
particular period depends on expectations about life time income and not on income in the current
period.
 The life cycle hypothesis views savings as resulting mainly from the individuals desire to provide
for consumption in the old age. The theory identifies the age structure of the population as a major
determinant of consumption and savings behavior.
 It argues that income tends to fluctuate systematically over the course of a person’s life and that
personal saving behavior is determined by one’s stage in the life cycle.
 It says that when people are young, their incomes are low and they often go into debt (dissaving).
During their working years, their incomes rise to a peak at around the middle age and they repay
the debts incurred earlier. They also begin to save for the retirement years. When they are retired,
their incomes fall below their consumption so that they now consume their accumulated savings
(reserves).
 Illustration

Between t1 and t2, the individual is saving. Before t1 (young age) and after t2 (old age), the individual
is dissaving. Consumption during retirement is financed by both from savings that were accumulated
during the working years and from transfers that old people receive from the government and perhaps
from their children.

(b) Permanent income theory (Hypothesis)

 This theory was developed by Milton Friedman in the 1957. It argues that in a two period model, a
household’s consumption depends not only on current income but also on the expected future
income.
 Permanent income refers to the average income that a household expects over a long time horizon.
 According to this theory, a household prefers a stable consumption path to the unstable one. For
example a farmer whose income is higher at harvest and low the rest of the year is likely to smooth
consumption over the course of the year by saving during harvesting season in order to consume
more than his income in the rest of the time of the year.
 According to this theory, unlike the Keynesian model, households decide their consumption level
depending on permanent income (Yp) but not on current income. For a household whose income
fluctuates, Yp would be defined as the constant level of income that would give the household the
same inter-temporal budget constraint.
 Mathematically given a two period case, a household’s inter-temporal budget constraint is given
by: C1 + C2 = Y1 + Y2
1+r 1+r
Given that the household has the same inter-temporal consumption possibilities when income equals to
permanent income in each period, then

Yp + Yp = C1 + C2
1+r 1+r
C2
Yp 1+ 1 = C1 +
1+r 1+r
 Yp 2=
+r = C1 + C2

1+r 1+r

1+ r C1 + C2
Yp =
2+ r 1+r

If r = 0
Yp = ½ (C1 + C2). This shows that if r =0 and the household inherits no assets, permanent income is
the exact average of present and future consumption. However, if r0, then permanent income is a
“kind” of average of the future and current consumption.

SAVINGS

Savings refer to the part of disposable income that is not spent on the current consumption of goods
and services.
Dissaving. This refers to negative savings. It occurs when consumption is greater than disposable
income.

Types of savings

 Contractual savings. These are savings where an individual is supposed to save a fixed amount of
money in a given time for example per month such as saving with insurance companies, pension
schemes etc.
 Discretional savings. This is where people are not obliged to save a specific amount in a given
time for example bank deposits, building societies etc.

Determinants of the level of savings

1. Rate of interest on bank deposits. The higher the interest rate, the higher the level of savings and
vice versa.
2. The level of income. The higher the level of income, the higher the level of savings and vice
versa.
3. The rate of inflation. The higher the rate of inflation, the lower the level of savings. This is
because with a general increase in the price level, the real money value reduces hence discouraging
people from saving their money in cash form.
4. Age of an individual. People tend to save and dissave at different times of their life cycle. Young
people tend to save less while relatively older people tend to save for their retirement at old age.
5. Degree of occurrence of unforeseen circumstances. Most people put some money aside, if they
can, when they expect things like wife’s delivery, sickness, unemployment etc.
6. Habits and customs. Some people and societies have a higher saving culture than others for
example members belonging to a saving association are more likely to save than those ones who
do not belong to any saving association.
7. Health status of the person. Ill health discourages savings. This is because a sickly person who is
expecting death in the near future will only consume all that he/she has instead of saving.

Investment

Investment refers to the purchase of capital goods which can be used to add to the existing productive
capacities in the economy. It includes acquisition of new physical capital such as buildings, machines,
factories, dams, roads etc.

Types of investment

 Autonomous investment. This is the form of investment that is independent of the level of
income. It is influenced by exogenous factors such as war, weather changes, population growth,
labour force etc.
 Induced investments. This is the form of investment that depends on the level of income and
profits. The higher the level of income, the higher the level if investment and vice versa.

Determinants of investments

1. Level of income. An increase in the level of income leads to an increase in aggregate demand for
goods and services. This in turn leads an increase in induced investment and vice versa.
2. The interest rate on loans. When the interest rate is low, it becomes less costly for investors to
borrow money and buy capital goods hence an increase in investment and vice versa.

3. The marginal efficiency of capital. This refers to the highest rate of return expected from an
additional unit of capital asset invested.

MEC = Annual Yield of Capital Asset x 100

Supply price of capital asset.
4. A high marginal efficiency of capital encourages entrepreneurs to invest in capital assets and vice
versa.
5. Business expectations. When there is expectation of an increase in business activity, investors
would purchase more capital goods to earn more profit. Expectation of a depression discourages
investment.
6. Level of technology. Improvement in the level of technology through inventions and innovations
leads to more efficient methods of production which increases the marginal efficiency of capital
hence an increase in investments and vice versa.
7. Market size. A growing market which may be due to increase in the population size or increase in
foreign demand leads to an increase in demand and vice versa.
8. The level of existing capital stock. If the existing stock of capital is working to full capacity, an
increase in the demand for goods will raise the demand for capital goods hence an increase in
investments. But the presence of excess capacity in the existing stock of capital assets discourages
induced investment.
9. Government policy. If the government policy is favorable like providing subsidies and other
credit facilities to the investors, induced investment increases. But in case the government policy is
unfavorable in form of high taxes, and other bureaucratic processes, investment is discouraged.
10. Political climate. Existence of political stability on the economy encourages investment. But if
there is political instability both domestic and foreign investors are discouraged which leads to a
decline in investments.
11. The nature of social and economic infrastructure. Existence of good social and economic
infrastructure in form of good road network, communication services, banking facilities
encourages investments in the economy and vice versa.

Revision Questions

1. Show the relationship between investment, income and employment

2 (a) What is investment What factors determine the level of investment in economy
(b) What policies are being used in your country to promote investment?
3 What is consumption .What factors determine the level of consumption in an economy?
4. Discuss the major determinants of private investment in developing countries.
5 a) Derive and explain the inter-temporal budget constraint for a household who is born with no
assets, dies with no assets and lives for only two periods
b) Explain the following theories of consumption
i) Life cycle theory
ii) Permanent income theory
6. Show that the household is better off when it borrows or lends than to remain in a financial
isolation.
 INFLATION

Inflation refers to the continuous (persistent) rise in the general price level of goods and services in
the economy in a given time.
Inflation is measured using price indices by the following formula:

Inflation = Pt – Pt-1 x 100

Pt-1
Where Pt = Current year price index; Pt-1 = previous year price index.

State of Inflation. This refers to the speed (rate) at which the general price level of commodities is
increasing in the economy in a given time.

Classification of Inflation according to the state of inflation

(a) Mild (creeping / gradual/moderate) inflation: This is the type of inflation where the persistent
increase in the general price level proceeds at a slow rate usually not exceeding 10%. This state of
inflation is good since it acts as an incentive to the producers. It increases savings, investments,
and output and employment opportunities.

(b) Hyper (Run away / Galloping) Inflation: This is the type of inflation where the general price
level increases at a very fast rate, the increase taking place within hours, days or weeks and the
percentage point increase per annum exceeds 20%. In this case, there is total loss of money value
and people prefer to hold real goods to money. This state of inflation is bad because it discourages
investment, production and consumption of commodities in the economy.

Classification of Inflation according to its causes

(a) Demand pull inflation. This is the type of inflation that arises due to excessive aggregate demand
for goods and services over aggregate supply at conditions of full employment. It is described as a
situation where there is too much money chasing too few goods.

Increase in A.D from AD1 to AD3 is accompanied by higher output as well as higher prices. Increase
in A.D beyond AD3 to AD4 will not increase output but only prices. At AD3, the economy attains full
employment level OQf.
Causes of demand pull inflation

 Increase in money supply leading to increased aggregate demand. This at full employment leads
to increased prices of goods and services hence inflation.
 Increase in population growth which leads to an increase in demand goods and services hence
demand pull inflation.
 Increase in the level of disposable incomes resulting from increased wages and salaries for the
workers. This increases the purchasing power of individuals hence increased aggregate demand.
 Increase in exportation of commodities and a decrease in importation of scarce commodities.
 Increase in government expenditure in the economy.

Policies (solutions) for demand – pull Inflation

 Using restrictive monetary policies. For example increasing bank rate, sale of treasuring bills and
bonds to the public, credit squeeze etc. This helps to reduce money supply in the economy.
 Using restrictive fiscal policies in form of reducing government expenditure and increasing direct
taxes to reduce on the disposable income of individuals.
 Commercial (Trade) policies. These aim at increasing the importation of scarce commodities in
the economy and discouraging the exportation of the scarce commodities from the economy. This
helps to increase aggregate supply.
 Wage freeze. This is aimed at keeping down the salaries and wages of workers through maximum
wage legislation.
 The price policies: This is concerned with controlling prices of major consumer commodities in
the economy through use of maximum price legislations.
 Production policies to increase the volume of goods and services through liberalization and
privatization.

(b) Cost push inflation. This is the type of inflation that arises as a result of increase in the costs of
production which increases the general prices of commodities in the economy. For example
increase in wages, interest, rent and prices for raw materials. The costs are shifted to consumers
in form of high prices for consumer goods.

From the graph, the supply curve is shifting to the left (reducing in supply) due to increases in the
costs of production at constant demand. This leads to increased prices.
Forms (causes) of Cost-push inflation

 Wage – Push Inflation: This occurs when an increase in wage rate exceeds the marginal
productivity of workers. This leads to a reduction in supply of commodities hence cost push
inflation.
 Wage – wage Inflation: This occurs due to Inter-sector comparison of wages among workers. A
rise in wages in one sector or firm will cause an upward revision of wages in similar occupations
in the economy. As entrepreneurs increase wages, costs of production and prices also increases.
 Wage – price Inflation: This occurs when workers demand for higher wages through their trade
unions. The increase in wages leads to an increase in the costs of production and prices.
 Price – wage (Spiral) Inflation: This occurs when there is an increase in commodity prices
which forces workers to demand for higher wages. This increases the costs of production hence
cost push inflation.
 Profit Push inflation (Mark-up Inflation): This occurs when producer (monopolists) charge high
prices with the aim of getting high profit margins.

Policies (solutions) to Cost push Inflation

 Providing subsidies to the producers so as to reduce the costs of production.
 Encouraging the importation of scarce commodities in the economy by the government
 Discouraging the exportation of scarce commodities.
 Wage control measures to reduce on the high wage demands by workers.
 Using non monetary remunerations to workers by employers.

(c) Structural (Bottleneck) Inflation. This is the type of inflation arising out of supply rigidities in
the economy which keep down the level of production hence high prices.

Causes of Structural Inflation

 The poor performance of the agricultural sector due to bad weather, pests and diseases, floods etc.
 Break down of the industrial sector. For example due to depreciation of the machines. This results
into low production and hence high prices.
 Inadequate managerial and entrepreneurial skills which result in low production hence increase in
prices.
 Political instabilities which discourage both domestic and foreign investors. This reduces output
and hence high prices.
 Speculation by businessmen who create artificial shortages by hoarding goods.
 Infrastructural break down in form of poor roads.
 Scarcity of raw materials due to limited foreign exchange. Producers fail to import scarce raw
materials hence low levels of production.

Solutions to structural Inflation

 Economic diversification .Improving the export sector through export diversification and
production of quality exports. This leads to increase in foreign exchange earnings which can be
used to buy raw materials necessary for production.
 Encouraging local production of goods and services by offering incentives in form of credit
facilities to producers.
 Creating a favorable (conducive) investment climate by ensuring political stability.
 Improvement in technology so as to increase productivity of factors of production.
 Infrastructural development
 Expansion of the industrial sector
 Modernization of the agricultural sector

(d) Imported inflation. This is the type of inflation arising from importing highly priced commodities
and other raw materials from countries already experiencing inflation.

Policies (Solutions) for Imported Inflation

 Import restrictions aimed at reducing on the volume of imports into the country from countries
experiencing inflation.
 Adoption of import substitution strategy so that goods formerly imported are produced
domestically.
 Subsidization of importers of essential commodities by the government. This helps the importers
to incur less costs and hence charge low prices.
 Use of domestic raw materials where possible
 Total ban on certain imports
 Economic integration to obtain cheaper commodities through trade creation.

The concepts of Stagflation and Deflation

Stagflation. This refers to the situation in which high inflation rates co-exists with high levels of
unemployment in the economy. It is caused by decline in aggregate supply leading to a decline in
output hence unemployment as workers are laid off
Deflation. This refers to the persistent (continuous) fall in the general price level of goods and
services in the economy.

Reflation and Dis –inflation

Reflation. This refers to the policy used by the government to lift the economy out of a deflation or
depression.
Dis –inflation. This refers to the policy used by the government to curb inflation in the economy

General causes of inflation in Developing countries

1. Excessive printing of money by the central bank to finance budget deficits. This increases money
supply in the economy hence inflation.
2. Increasing costs of production. This is due to increase in wages, costs of raw materials, fuel prices,
high taxes etc. which force producers to increase the prices of commodities in the economy.
3. Persistent political Instabilities. These scare away the potential investors leading to low output.
They also create shortage of goods and services hence inflation.
4. Importing commodities and raw materials from countries experiencing inflation. High prices of
imports like fuel, capital goods other commodities lead to an increase in the production costs
leading to cost push inflation.
5. Supply rigidities such as bad weather, pests and diseases, poor infrastructure etc. especially in the
agricultural sector. This reduces agricultural output hence increase in the food prices.
6. Desire for excessive profits by businessmen
7. Excessive aggregate demand for goods and services as compared to their supply. For example due
to increase in population.
8. High level of speculation in business which leads to hoarding of commodities thereby creating
artificial shortages.
9. Depreciation of the local currency through forces of demand and supply.
10. Increased printing of counterfeit currency

Effects of Inflation

Positive effects (Benefits) of Inflation

Mild Inflation is healthy to the economy in the following ways;

1. It stimulates production of goods and services due to high prices and profit margins obtained by
producers. This leads to economic growth.
2. It stimulates people’s efforts as they work hard in order to maintain their standard of living.
3. It encourages forced savings resulting from the high profits realized by those involved in business.
This in turn promotes investments.
4. It increases employment opportunities due to increased investments in the economy.
5. It increases government revenue through taxation of the huge profits received by those involved in
economic activities.
6. It stimulates entrepreneurship skills. This is because it encourages people to become innovative
and creative in the economy which leads to an increase investments in the economy
7. It encourages food production for the domestic market due to high prices.
8. It encourages labour mobility as individuals tend to move to other areas in search of better paying
jobs so as to make their ends meet.
9. Borrowers (debtors) stand to gain as a result of inflation.
10. It increases resource utilization due to increased production of goods and services.

Negative effects (Costs) of inflation

Hyper Inflation is undesirable in the economy in the following ways;

1. It lowers the standards of living due to increased cost of living resulting from high prices of
commodities.
2. It discourages savings in the economy. People spend a lot of money to purchase few goods. This
reduces the level of investments in the economy.
3. It worsens balance of payment position of the country. This is because it discourages exports by
making them expensive and encourages imports as they become cheaper hence increased
expenditure on imports.
4. Inflation discourages both foreign and domestic investors as it increases the production costs. This
retards economic growth.
5. Inflation leads to brain drain as qualified and trained labour leaves the country to go and work in
foreign countries where the value of money is stable.
6. Inflation leads to income inequalities as it makes the rich richer and the poor poorer. This is worse
with the fixed salary earners.
7. Inflation results into rural urban migration as it becomes less profitable to grow crops in rural
areas. As a result, people move to urban areas to start businesses where the profit margins are
high.
8. It leads to mis allocation of resources. Resources are diverted from the production of essential
commodities to non-essential (luxurious) commodities which are more profitable.
9. It encourages illegal activities such as corruption, smuggling etc. as people struggle to maintain
their standard of living.
10. It encourages dumping as foreigners sell their commodities in markets at lower prices. This
retards the domestic infant industries which charge high prices due to high production costs.
11. It makes it difficult for the government to plan and budget due to the continuous fall in the value of
money caused by inflation.
12. It leads to loss of confidence in the domestic currency by the public
13. It discourages lending as creditors stand to lose.
14. It encourages industrial unrests due to demand for high wages by workers.

Policies (Measures) to control Inflation

1. Using restrictive monetary policies such as sale of government securities to the public: This aims
at reducing money supply in the economy as a way of controlling inflation.
2. Using restrictive fiscal policies such as reduced government expenditure with the aim of checking
on aggregate demand
3. Maintaining political stability and security as a way of creating a conducive investment climate
hence increasing the supply of goods and services in the economy.
4. Import and export policies: Policies aimed at restricting the exportation of scarce commodities and
importation of commodities which are scarce in the economy should be promoted. This helps to
increase on the availability of commodities in the economy.
5. Promoting import substitution strategies to produce commodities formerly imported. This helps to
check on imported inflation.
6. Infrastructural development in form of road construction, setting up industrial parks etc. in order to
facilitate the production and distribution of goods and services from rural to urban areas hence
controlling inflation.
7. Providing investment incentives by the government aimed at creating a conducive investment
climate for both foreign and local investors. For example subsidization and provision of tax
holidays. This helps to increase on production in the economy.
8. Economic liberalization to allow a large number of individuals to get involved in exchange of
goods and services with limited bureaucratic government intervention

Why is it difficult to control inflation in Developing Countries?

1. Continued importation essential commodities and raw materials at high prices. For example
petroleum products make it difficult to control imported inflation.
2. Low productivity of the agricultural sector leading to shortage of food hence increase in food
prices.
3. Failure of the government to fight against corruption and embezzlement of public funds.
4. High indirect taxes by the government forcing producers to increase prices of commodities.
5. High population growth rates leading to increased demand for food items especially in urban areas.
6. Increased incidences of unforeseen circumstances e.g. bad weather which cause shortages of
output especially in the agricultural sector.
7. Political instabilities and insecurity which increase government expenditure hence increased
money supply.
8. Limited local capital investment required to set up industries to increase domestic production of
goods and services.
9. Poor social and economic infrastructure required to distribute goods and services especially from
rural areas to urban centers.
10. Under developed banking sector which makes it difficult to use the tools of the monetary policy to
control money supply.

The Philips curve

It was developed by A.W Phillips (1958). It shows the negative relationship between the rate of
inflation and the unemployment rate .The curve implies that an economy faces a trade-off
between inflation and unemployment. The higher the rate of inflation, the lower the level of
unemployment and the lower the rate of inflation, the higher the level of unemployment

Suppose that the unemployment rate is u1 and the inflation rate is r1 at point A .This implies that
the government could pursue expansionary fiscal and monetary policies that would move the
economy to point B , where the unemployment rate falls to u2 and the inflation rate rises to r2
Depending on the national interests ,it might then be worthwhile to pursue fiscal and monetary
policies that would lower unemployment rate at the cost of a higher rate of inflation.
 The Phillips curve is expressed as a relationship between wage inflation, price inflation and
unemployment rate. The basic idea is that, if there is excessive demand in the labour market, there
will be pressure on wages to rise. The higher the level of unemployment, the lower the level of
excess demand for labour and the lower will be pressure on wages to rise.
 Phillips curve links wage inflation to price inflation through the labour market equilibrium
condition which states that the wage should be equal to the value of the marginal product of
labour. That is, w = pf(N)
In (w) = In (p) + In f(N)
w = p + f(N)
p = w – f (N) (Phillips curve equation)
This means that price inflation equals to wage inflation minus the growth in labour productivity.
 If w > f(N) => Inflation increases
 If w < f(N) => Inflation reduces

Phillips theorem was criticized by other economists such as Friedman, who noted that as inflation
takes place, market participants formulate inflationary expectations. The Phillips curve will shift as a
consequence of inflationary expectations. This led to the development of the expectations augmented
Phillips curve which takes into account the changes in the expected level of the prevailing prices due
expected inflation.
p = w – f (N) + pe.
The introduction of the expected inflation in the Phillips curve implies that there would be different
Phillips curves for each level of expected inflation, and that changes in inflationary expectations lead
to changes in the positions of the Phillips curve. The Phillips curve therefore is unstable with
inflationary expectations.
e
From p = w – f (N) + p
P – pe = w – f(N)
e
 If w > f(N) => p >p , Inflation increases
e
 If w < f(N) => p < p , Inflation reduces
e
 If w = f(N) => p = p , Inflation remains constant

10.13 Long –run Phillips curve

The long run Phillips curve is vertical .In the long run ,there exists an equilibrium unemployment
rate called the Natural rate of unemployment ,which persists regardless of the rate of inflation.

Figure 10.13 Long –run Phillips curve

SRPC – short run Phillips curve

LRPC – long run Phillips curve.

Suppose the economy is in equilibrium in the long run at point A with an unemployment rate u1
and inflation rate r1 ,unemployed workers have a reserve wage that makes them indifferent
between accepting the job and continuing their search for jobs. If the government pursues a
monetary policy which increases the inflation rate to r2 ,job searchers suddenly find many jobs
that meet their reservation wage and the unemployment rate falls in the short run ,moving the
economy to point B. Over time, workers realize that the inflation rate is higher and they adjust
their reservation wage upward ,returning the economy to point C .In the long run ,the
unemployment rate remains at u1 ,but there is now a higher rate of inflation ,.Therefore there is no
tradeoff between inflation and unemployment in the long run. Increases in inflation rate do not
reduce the natural rate of unemployment. They simply lead to higher prices.
Revision questions
1. Define the term Inflation and explain the effect of inflation on the real value of money.
2. Explain the following terms.
(a) State of Inflation (b) Deflation
(c) Dis-inflation (d) Stagflation
(e) Reflation
3. Distinguish between Mild inflation and hyper inflation
4. Discuss the causes and solutions to each of the following types of Inflation.
(a) Cost push Inflation
(b) Demand pull Inflation
(c) Structural Inflation
(d) Imported Inflation
5. (a) Explain the causes of inflation in your country.
(b) What policies are being adopted to check on inflation in your country?
6. (a) Examine the effects of inflation in your country.
(b)Why is it difficult to control inflation in developing countries?
7 Discuss the following theories of inflation giving the policy interventions in each case.
a) Demand Pull theory
b) Cost push theory
c) Structural theory.
8 (a) Explain why the long run Phillips curve is vertical
(b) Discuss what determines the expected inflation in the price adjustment model
9 (a) Explain the difference between the Phillips curve and the Augmented Phillips curve
(b) Derive and explain the Phillip’s curve linking inflation and unemployment
10 Write short notes on the following
(a) Short run and long run Phillip’s curve trade – off.
(b) Augmented Phillip’s curve
 UNEMPLOYMENT

Unemployment refers to failure of member of the labour force to obtain the job at the ruling wage rate
despite his ability and willingness to work.

Broad categories of unemployment

 Involuntary unemployment. This is a situation where a member of labour force is willing and
actively looking for jobs but cannot find employment at the ruling (on going) wage rate
 Voluntary Unemployment. This is a situation where jobs are available but a member of the
labour force is not willing to take on the jobs at the ruling (on going) wage rate.

Causes of Voluntary Unemployment

1. The low un acceptable current wage. Such individuals prefer a higher wage.
2. Rich family background. Some individuals could be from rich families and they are not willing to
do certain jobs of low status.
3. Strong desire for leisure by an individual.
4. Expectation of better paying alternative jobs. Some people may prefer to remain unemployed
hoping to get better jobs in future.
5. Early retirement. Some individuals can decide to retire before retirement age and therefore they
become voluntarily unemployed.
6. House wives may decide to remain at home to attend to their families.
7. Money reserves. Some people might be having a lot of money on reserve and they can survive
even if they are not working.
8. Unfavorable working conditions.
9. Laziness of some workers

Under employment. This refers to the state of under utilization of economic resources. In case of
labour, it is a situation where a person’s capacity to work is under-utilized.

Under employment can be experienced under the following situations;

 Labour working less hours than desired.
 Working full time in socially un desirable activities even if they are productive. For example
prostitution, thieves etc.
 Doing a job which is not in line with one’s training. For example a lawyer working as a History
teacher or as a farmer.
 Working full time in un productive activities due to lack of cooperate factors. For example
peasants using digging sticks instead of hoes.
 Working full time but getting wages below the wage fixed by the government.
 Being fully employed but not wholly effective because of poor attitude towards work.

Full employment. This is an economic situation in which productive resources are fully utilized. It is
brought about by the equality between job seekers (available labour force) and job opportunities.
OR It is a situation in which all persons capable of willing to work are employed
OR. It is a situation in which the rate of unemployment in an economy is less than three percent
of the labour force; that is, the unemployment people are those unemployed due to economic
frictions.
Types of Unemployment

Seasonal unemployment. This is the form of unemployment where labour is unemployed during
certain periods due to seasonal (climatic) changes. For example Change in the climate may render
people previously employed unemployed especially in the agricultural sector.

Solutions to seasonal unemployment

 Diversification of economic activities. Individuals should be involved in a variety of activities as

a way of increasing their employment opportunities.
 Industrialization. Industries are not affected by bad weather and other natural factors
 Irrigation in case of agriculture during dry seasons.

Technological unemployment. This is the type of unemployment caused by change in the techniques
of production where machines replace labour. For example the use of capital intensive techniques of
production results in some people being replaced by machines.

Structural unemployment. This is a long-term form of unemployment resulting from structural

changes in the conditions of supply and demand in the economy.

Causes of Structural Unemployment

 Changes in fashions or tastes. For example when tiled houses replace iron roofed houses, the
makers of iron sheets become unemployed.
 Changes in production techniques which reduce the demand for labour. For example use of capital
intensive technology where machines replace labour.
 Exhaustion of supply of major natural resources. For example mining which makes miners
unemployed.
 Rural urban migration due to regional imbalance between rural and urban areas.
 Political instability
 High population growth rates in the structure of the economy.
 Lack of co-operant factors of production .For example Capital

Solutions to Structural unemployment

 Flexibility in production to enable industries to change with changes in tastes and fashions.
 Use of appropriate technology which suits the socio-economic conditions of the economy.
 Diversifying labour skills and retraining workers whose skills are no longer in demand. This
enables the workers to cope with the changing structure of the economy.
 Control rural urban migration by making rural areas attractive. For example establishing good
economic and social infrastructure in rural areas.
 There is need for serious man power planning to forecast future trends of labour demand in the
economy.
 Ensuring political stability

Frictional (normal/transitional) unemployment. This is the short term form of unemployment

which arises when the labour force is unemployed in the process of moving from one job to another.
This is because workers and firms may take time to locate each other.
Causes of Frictional unemployment

 Lack of information about the available job opportunities on the side of the unemployed workers.
 Geographical immobility of labour that is where labour is not willing to move to other areas where
jobs can be found.
 Laying off of workers involuntarily and permanently due to government policy
 Lack of information on the side of employers of the existence of those unemployed whom they can
employ.

Solutions to Frictional unemployment

 Providing workers with information about the availability of jobs through advertisement of jobs in
Newspapers, Radio etc.
 Providing firms with information about unemployed workers.
 Encouraging labour mobility such that the unemployed can easily move to areas where there are
jobs.
 Reducing the unnecessary laying off of workers by the government.

Residual Unemployment. This is unemployment resulting from physical or mental disabilities which
makes the worker unable to work.

Disguised unemployment. This is the form of unemployment where the marginal product of labour is
zero or negative and a worker can be removed from the job without affecting total output.

Search (Graduate) unemployment. This is the form of unemployment where newly qualified
individuals are not working but are busy looking for jobs. This is mainly due to poor manpower
planning.

Hidden Unemployment. This is the form of unemployment where labour is employed in a low grade
occupation as compared to the high skills and qualifications attained. For example a female university
graduate becoming a house girl. OR. It is where one does a job which is not in line with one’s
educational training and qualifications For example an engineer working as a secondary school
Mathematics teacher.

Open-Urban Unemployment. This is where people are actively looking for jobs in urban areas but
cannot find them. It is mainly caused by increased number of job seekers from rural areas as a result
of rural urban migration.

Keynesian (Demand Deficient / Cyclical/ Mass/ General) unemployment. This is the form of
unemployment which is caused by deficiency in effective aggregate demand for goods and services
especially in times of economic depression.

Solutions to Keynesian unemployment

According to Keynes, the major remedy (solution) to unemployment is increasing effective aggregate
demand through the use of the following policies.

 Reducing direct taxes. When income taxes are reduced, consumers’ disposable incomes increase.
This enables consumers to increase their demand for goods and services.
 Increasing government expenditure as a way of stimulating consumption and production of
goods and services in the economy.
 Subsidizing consumers by providing goods and services especially educational and health
services at low prices.
 Using expansionary monetary policies. For example reducing interest rates.
 Creating a favorable investment climate. For example through the provision of investment
incentives such as tax holidays to investors. This increases investment which helps to create more
employment in the economy

General causes of unemployment in Developing countries

1. Rapid growth of population: The rate at which the population grows is high and therefore, it does
not match the rate at which jobs are being created. This results into unemployment and under
employment in the country.
2. The defective (Poor) education system. The system is theoretical in nature therefore prepares job
seekers instead of job creators. The white-collar jobs are in short supply yet the turnover of the
education system is high, leaving many school graduates unemployed.
3. Rural-urban migration. Due to rural-urban wage gap and other push and pull factors, most
people migrate from rural areas to urban centers primarily in search of better wage employment
opportunities which are not always available in urban centers. Since the rate of rural to urban
migration is higher than the rate of urban employment creation, many migrants from rural areas
become unemployed in urban centers.
4. Use of inappropriate technology. Use of capital intensive production techniques by some
industries reduces the demand for labour hence unemployment.
5. Discrimination and sectarianism in the labour market. This is based on tribes, gender, religion,
political ideologies and many other socio economic factors. This leaves some members of the
society unemployed due to lack of connections
6. Seasonal variations in economic activity. This is brought about by climatic changes especially in
the agricultural sector leading to seasonal unemployment.
7. Lack of information regarding the presence of jobs in the labour market. This leads to frictional
unemployment.
8. Political instabilities in some parts of the country. Political insecurity destroys productive
infrastructures and distorts production activities. This greatly discourages both domestic and
foreign investment hence unemployment.
9. Lack of proper manpower planning by the government. Government does not effectively
relate training in higher institutions of learning with the available employment opportunities.
Consequently, more labour force is produced for certain professions than the country’s ability to
absorb the trainees. This results into surplus labour supply for certain professions hence
unemployment.
10. Excessive use of foreign expatriates at the expense of the local labour. This is common in
foreign funded projects, NGO’s and in businesses owned by foreigners. This leads to
unemployment of the local labour force
11. Deficiencies in demand for some products. This forces some industries to lay off some workers
hence unemployment. For example the coffee industry.
12. Poor infrastructural facilities. This is in form of poor road network, poor communication
facilities etc. which leads to low levels of investments hence unemployment.
13. High levels of inflation in the economy. This increases the costs of production which discourages
both domestic and foreign investment hence unemployment.
14. Natural disabilities in form of physical and mental handicaps leading to residual unemployment.
15. The poor land tenure system. Land tenure system refers to the rights regarding ownership and
use of land in the economy. Some people have plenty of land which is under-utilized while others
do not have land at all and therefore they remain unemployed.
16. High levels of poverty. Most people earn low incomes and therefore this leads to low aggregate
demand. This discourages investments hence low levels of economic growth and employment.

Policies (measures) to reduce unemployment in Developing countries

1. Educational reforms. There is need to change the education system to suit the man power
requirements of developing countries. More emphasis should be put on vocationalisation of
education in order to make graduates job makers instead of job seekers. Science based subjects
should also be emphasized.
2. Economic diversification. There is need to diversify the economies of developing countries in
order to reduce dependence on few sectors. This can be done by encouraging the growth of a
number of sectors like small scale industries, fisheries, tourism etc. in order to increase the rate of
job creation.
3. Control of population growth rate. Measures should be taken to control population growth rate
through family planning, emphasizing girl child education etc. This helps to ensure that the
population growth rate matches the rate of resource exploitation hence controlling unemployment.
4. Modernization and commercialization of agriculture. This can be done through the application
of modern techniques of production, use of resistant crops and animals, agricultural research etc.
aimed at increasing production and reducing unemployment.
5. Encouraging the use of appropriate technology. Use of labour intensive technology should be
emphasized so as to absorb the surplus labour and reduce on unemployment.
6. Rural development and transformation. There is need to transform rural areas through
infrastructure development, rural electrification, health, rural water and sanitation etc. This is
aimed at increasing economic activities and employment opportunities in rural areas as a way of
reducing rural urban migration.
7. Political Stability. There is need to promote political stability through democratic governance and
the use of the amnesty laws. This is can help to create a conducive investment climate both for
local and foreign investors hence creating more employment opportunities.
8. Promoting investment. There is need to attract foreign investments by providing investment
incentives to foreign investors in form of tax holidays and tax exemptions. This leads to increased
investment and creation of employment opportunities in various sectors.
9. Infrastructural development. There is need to set up and improve on the infrastructure for
example construction roads, transport and communication facilities, as well as banks and
educational facilities in the country. This is aimed at creating more employment opportunities.
10. Economic integration. This is aimed at expanding the market for goods and services in the
economy as a way of stimulating investment hence creating more employment opportunities.
11. Privatization. There is need to expand the private sector as a way of creating efficiency in
production hence creating more employment opportunities.
12. Economic liberalization. There is need to remove the unnecessary controls from economic
activities to allow private individuals to freely participate in business activities. This helps to create
more employment opportunities as many people are involved in trade.
13. Advertising the existing jobs. There is need to guide jobs seekers on the availability of jobs by
advertising them in mass media. This helps to reduce frictional unemployment.
14. Providing credit to the local investors. There is need to provide soft loans to people to enable
them invest and create employment opportunities. This can be done through schemes like poverty
eradication programs, prosperity for all funds etc.
15. Control of inflation. There is need to controlling inflation by using restrictive fiscal and monetary
policies so as to encouraged investment hence creating more employment opportunities.
16. Land reforms: There is need to reform the land tenure system in order to enable the landless to
have access and ownership over land. This can promote meaningful use of land for investment
purposes.

Revision questions

1. Explain the causes and solutions to the following types of unemployment

(a) Voluntary unemployment.
(b) Involuntary unemployment
(c) Structural unemployment
(d) Seasonal unemployment
(e) Technological unemployment
(f) Frictional unemployment
(g) Keynesian unemployment
2. (a) Examine the causes of unemployment in developing countries.
(b) Suggest the possible measures to unemployment problem in developing countries.