BBEK4203 Principles of Macroeconomics - Vdec19 PDF

BBEK4203
Principles of Macroeconomics
BBEK4203
PRINCIPLES OF
MACROECONOMICS
Munzarina Ahmad Samidi
Norehan Abdullah
Jamal Ali
Zalina Mohd Mohaideen
Assoc Prof Dr Nor’ Aznin Abu Bakar
Wan Azman Saini Wan Ngah
Dr Law Siong Hook
Copyright © Open University Malaysia (OUM)

Project Directors: Prof Dr Widad Othman
Prof Loo Sin Chun
Open University Malaysia
Module Writers: Munzarina Ahmad Samidi

Norehan Abdullah
Jamal Ali
Zalina Mohd Mohaideen
Assoc Prof Dr Nor’ Aznin Abu Bakar
Universiti Utara Malaysia
Co-Writers: Wan Azman Saini Wan Ngah

Dr Law Siong Hook
Universiti Putra Malaysia
Moderators: Lilian Kek Siew Yick

Chiam Chooi Chea
Enhancer: Khu Bee Kiaw
Developed by: Centre for Instructional Design and Technology

First Edition, August 2011

Second Edition, December 2012
Third Edition, August 2013 (rs)
Fourth Edition, December 2019 (MREP)
Copyright © Open University Malaysia (OUM), December 2019, BBEK4203
All rights reserved. No part of this work may be reproduced in any form or by any means without
the written permission of the President, Open University Malaysia (OUM).

Table of Contents
Course Guide xiiiăxix
Topic 1 Introduction to Macroeconomics 1

1.1 Macroeconomics 2
1.1.1 Issues in Macroeconomic Analysis 2
1.2 Macroeconomic Policies 7
1.3 Objectives of Macroeconomics 8
1.4 Business Cycle 9
1.4.1 Phases in Economic Activities 9
1.5 What Do Macroeconomists Do? 12
1.6 History of Macroeconomic Development 13
1.7 Aggregate Demand and Aggregate Supply 14
Summary 17
Key Terms 18
References 18
Topic 2 National Production 19

2.1 Circular Flow of Income Model 20
2.2 Gross Domestic Product (GDP) 22
2.2.1 What is the Total Value of Production? 23
2.2.2 What are the Final Goods and Services Produced? 23
2.2.3 Where are They Being Produced? 23
2.2.4 When are They Produced? 24
2.3 Gross National Product (GNP) 25
2.4 Method of Calculating GDP 26
2.4.1 Expenditure Approach 26
2.4.2 Production Approach 29
2.4.3 Income Approach 31
2.5 Adjusting Factor Cost to Market Price 33
2.6 Economic Activities that are Not Included 35
2.6.1 Traditional FarmersÊ Agricultural Produce 35
2.6.2 Illegal Activities 35
2.6.3 Productive Activities that are Not Paid 36
2.6.4 Non-cash Rewards 36

iv  TABLE OF CONTENTS
2.7 Real GDP and Nominal GDP 36

2.8 National Production Data Usage 38
2.9 Factors Affecting National Production Level 40
2.9.1 Internal Factors 40
2.9.2 External Factors 41
2.10 Problems in Calculating National Production 42
2.11 Business Cycle 44
Summary 45
Key Terms 46
Topic 3 Determinants of Equilibrium Income Theory 47

3.1 Two-sector Economy 47
3.1.1 Circular Flow of Income 48
3.1.2 Consumption, Savings and Disposable Income 54
3.1.3 National Income Equilibrium 55
3.1.4 Change in Aggregate Demand 59
3.1.5 Multiplier Effect 60
3.2 Three-sector Economy 61
3.2.1 Circular Flow of Income 63
3.2.2 Government and Fiscal Policy 64
3.2.3 Consumption, Savings and Taxes 66
3.3 Four-sector Economy 73
3.3.1 Import and Export 74
3.4 Fiscal Policy and Economic Problems 80
3.4.1 Fiscal Policy 81
3.4.2 Inflationary and Deflationary Gaps 84
3.4.3 Solving Inflationary and Deflationary Gaps 86
Summary 89
Key Terms 89

TABLE OF CONTENTS  v
Topic 4 Money and the Banking System 90

4.1 Money and the Banking System 91
4.1.1 Definition of Money 92
4.1.2 Functions of Money 92
4.2 Financial Institutions and the Banking System 94
4.2.1 Banking System 95
4.2.2 Non-bank Financial Institutions 99
4.2.3 Non-bank Financial Intermediaries 100
4.2.4 Islamic Banking 100
4.2.5 Philosophy, Objectives and Principles of Islamic 101
Banking
4.3 Credit Creation Process 102
4.3.1 Credit Creation Process ă An Example 103
4.4 Financial or Monetary Policy 107
4.4.1 Quantitative Monetary Policy 108
4.4.2 Qualitative Monetary Policy 109
4.5 Money Demand (Md) 110
4.5.1 Transaction Demands 110
4.5.2 Precautionary Motives 111
4.5.3 Speculative Demand 111
4.6 Money Supply 114
4.6.1 Narrow Measure of MoneyÊs Functions 114
4.6.2 Broad Measure of Money Supply 115
4.6.3 Broadest Measure of Money Supply 115
4.7 Equilibrium in the Money Market and Interest Rate 116
Summary 118
Key Terms 120
References 120
Topic 5 Money, Interest Rate and Income: Policy Analysis 121

5.1 Relationship between Goods Market and Money Market 122
5.1.1 Income, Demand for Money and Interest Rate 123
5.1.2 Investment, Interest Rate and Income 124
5.2 Goods Market and Money Market 126
5.2.1 Fiscal Policy Analysis 126
5.2.2 Monetary Policy Analysis 130
5.3 Mixed Fiscal and Monetary Policies 132
Summary 133
Key Terms 134

vi  TABLE OF CONTENTS
Topic 6 Aggregate Demand and Aggregate Supply 135

6.1 Aggregate Demand 136
6.1.1 Constructing the Aggregate Demand Curve (AD) 140
6.1.2 Aggregate Demand Determinants 142
6.1.3 Movement of Aggregate Demand Curve and 146
Aggregate Expenditure Model
6.2 Aggregate Supply (AS) 148
6.2.1 Constructing the Aggregate Supply (AS) Curve 149
6.2.2 Short-run Aggregate Supply 150
6.2.3 Determinants of Aggregate Supply Curve 152
6.3 Production Level and Equilibrium Price 155
6.3.1 Changes in Equilibrium 156
6.4 Aggregate Demand and Aggregate Supply: Fiscal Policy 160
and Monetary Policy
6.5 Constructing the Long-run Aggregate Supply Curve 163
6.5.1 Long-run Aggregate Supply Curve 165
Summary 166
Key Terms 167
Topic 7 Unemployment and Inflation 168

7.1 Unemployment 169
7.2 Measuring the Unemployment Rate 171
7.3 Labour Force Participation Rate 173
7.4 Discouraged Workers 173
7.5 Part-time Workers 174
7.6 Types of Unemployment 176
7.6.1 Frictional Unemployment 176
7.6.2 Structural Unemployment 177
7.6.3 Cyclical Unemployment 178
7.7 Full Employment and Natural Unemployment Rate 179
7.8 Reasons for Unemployment 180
7.8.1 Job Losers 180
7.8.2 Job Leavers 181
7.8.3 New Entrants and Re-entrants 181
7.9 Effects of Unemployment 182
7.9.1 Negative Effects of Unemployment on the 182
Economy
7.9.2 Negative Effects of Unemployment on the 183
Individual and Population

TABLE OF CONTENTS  vii
7.10 Inflation 184

7.11 Consumer Price Index (CPI) 184
7.12 Calculation of CPI 185
7.12.1 Calculate the Cost of CPI Consumer Basket at 185
Base Year Price
7.12.2 Calculate the Cost of CPI Consumer Basket at 186
Current Year Price
7.12.3 Calculate the CPI for Base Year and Current Year 186
7.13 Calculating the Inflation Rate 187
7.14 Effects of Inflation 188
7.14.1 Effects of Inflation on Total Production 188
7.14.2 Effects of Inflation on Savings and Investment 188
7.14.3 Effects of Inflation on Income Distribution and 188
Economic Wealth
7.14.4 Effects of Inflation on a CountryÊs Balance of 189
Payments
7.15 Consumer Price Index (CPI) and Living Costs 190
7.16 Factors that Cause Inflation 192
7.16.1 Demand Pull or Excess Demand 192
7.16.2 Increase in Costs 193
7.16.3 Supply Shock 194
7.16.4 Adaptive Expectations 194
7.17 Phillips Curve 194
Summary 196
Key Terms 197
References 197
Topic 8 International Trade 198

8.1 Why Do Countries Trade? 199
8.1.1 Different Factors of Production 200
8.1.2 Different Climate 200
8.1.3 Different Labour Skills 202
8.1.4 Different Consumption Patterns 202
8.2 Absolute Advantage 203
8.3 Comparative Advantage 206
8.4 Benefits of International Trade 208
8.5 International Trade Barriers 210
8.5.1 Tariff 210
8.5.2 Non-tariffs 211

viii  TABLE OF CONTENTS
8.6 Terms of Trade 213

8.6.1 Price 213
8.6.2 Goods 214
8.7 Why Protection Policies are Needed 214
8.7.1 Protect New Industries 215
8.7.2 Improve National Security 216
8.7.3 Diversify Local Economic Activities 216
8.7.4 Protect Resources 216
8.7.5 Act as Anti-dumping Measure 217
Summary 217
Key Terms 218
Topic 9 International Finance 219

9.1 Foreign Exchange Rate 220
9.2 How is the Foreign Exchange Rate Determined? 221
9.3 Changes in Demand or Supply 222
9.4 Factors that Influence the Foreign Exchange Rate 224
9.4.1 Price of Traded Goods 224
9.4.2 Inflation Level 225
9.4.3 Interest Rate 225
9.4.4 Income of the People in a Country 226
9.5 Balance of Payments 226
9.5.1 Current Account 228
9.5.2 Capital Account 229
9.5.3 Official Settlement Account 231
9.6 Strategies to Reduce Balance of Payments Deficit 233
9.6.1 Exchange Rate Devaluation 233
9.6.2 Demand Management 233
9.6.3 Supply-side Policy 234
Summary 234
Key Terms 235
Topic 10 International Trade and Finance: Problems and Policies 236

10.1 Gold Standard 237
10.2 Problems with the Gold Standard 238
10.3 Bretton Woods System and the Fixed Exchange Rates 239
10.4 Collapse of the Bretton Woods System 240
10.5 Flexible Exchange Rate System 241
10.5.1 Managed Floating Exchange Rate 242

TABLE OF CONTENTS  ix
10.6 Advantages and Disadvantages of Flexible Exchange 243

Rate System
10.6.1 Advantages of the Flexible Exchange Rate 243
10.6.2 Policy Advantages of the Flexible Exchange Rate 244
System
10.6.3 Disadvantages of Flexible Exchange Rate System 246
10.7 Advantages and Disadvantages of the Fixed Exchange 247
Rate System
10.7.1 Advantages of the Fixed Exchange Rate System 247
10.7.2 Disadvantages of the Fixed Exchange Rate System 247
Summary 248
Key Terms 249
Reference 249
Answers 250

x  TABLE OF CONTENTS

COURSE GUIDE  xiii
COURSE GUIDE DESCRIPTION

You must read this Course Guide carefully from the beginning to the end. It tells
you briefly, what the course is about and how you can work your way through
the course material. It also suggests the amount of time you are likely to spend in
order to complete the course successfully. Please keep on referring to the Course
Guide as you go through the course material, as it will help you to clarify
important study components or points that you might miss or overlook.
INTRODUCTION
BBEK4203 Principles of Macroeconomics is one of the courses offered at Open
University Malaysia (OUM). This course is worth 3 credit hours and should be
covered over 8 to 15 weeks.
COURSE AUDIENCE
This is a core course for all learners pursuing the Bachelor of Management,
Bachelor of Business Administration, Bachelor of Human Resource Management,
Bachelor of Accountancy, Bachelor of Hospitality Management and Bachelor of
Tourism Management programmes.
As an open and distance learner, you should be able to learn independently and
optimise the learning modes and environment available to you. Before you begin
this course, please confirm the course material, the course requirements and how
the course is conducted.

xiv  COURSE GUIDE
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.
Table 1: Estimation of Time Accumulation of Study Hours
Study
Study Activities
Hours
Briefly go through the course content and participate in initial discussion 3
Study the module 60
Attend 3 to 5 tutorial sessions 10
Online participation 12
Revision 15
Assignment(s), Tests and Examination(s) 20
TOTAL STUDY HOURS ACCUMULATED 120
COURSE LEARNING OUTCOMES

By the end of this course, you should be able to:
1. Apply the concepts of macroeconomics in economic perspectives;
2. Interpret the macroeconomics information using visual data/articles; and
3. Analyse the effects of various macroeconomics policies to the growth of a

country.

COURSE GUIDE  xv
COURSE SYNOPSIS
This course is divided into 10 topics. The synopsis for each topic is presented
below:
Topic 1 introduces the field of economics from the macro perspective. In this
topic, learners will be exposed to basic concepts that are often used in the context
of economics such as employment, unemployment, inflation, financial policy and
fiscal policy. Learners will also learn about the economic cycle, which is divided
into five phases. Besides that, learners will also study the basics of aggregate
supply and demand plus the views of classical and Keynesian economists.
Topic 2 introduces one of the important concepts in macroeconomics, which is

national production. This topic explains the circular flow of the income model,
which connects households and firms. The topic also discusses the method of
calculating gross domestic product (GDP), the use of national production data
and problems in calculating the national production.
Topic 3 focuses on the determinant of national income equilibrium in a two-

sector, three-sector and four-sector economy. Learners will study how aggregate
demand components such as consumption, investment, government expenditure
and net export affect the national income equilibrium. Besides this, learners will
be exposed to the AD-AS model and Injections-Leakage model that are used to
calculate the equilibrium level. The concept of multiplier is also explained in this
topic. Lastly, two main fiscal tools in achieving government objectives are also
discussed, namely government expenditure and taxes through automatic and
fiscal policies and discretionary fiscal policies.
Topic 4 focuses on money and the banking system in Malaysia. Firstly, learners
will be introduced to the term „money‰. This topic explains in detail the banking
system, which covers financial institutions, non-bank financial institutions, non-
bank financial intermediaries and Islamic banks. Learners will also learn about
the credit creation process as well as quantitative and qualitative financial
policies. Learners will find out the reasons for money demand and the terms
used for the various categories of money supply. Besides that, this topic also
discusses the equilibrium in the money market and its relationship with interest
rates.

xvi  COURSE GUIDE
Topic 5 discusses the relationship between the goods market and the money
market in which they operate interdependently. Any events in each markets will
affect the other. Learners will be exposed to the two important links between the
goods market and the money market. The effects of an expansionary and a
contractionary fiscal policy on the economy will also be discussed. The
combination of fiscal and monetary policies are aimed at achieving certain
objectives.
Topic 6 focuses on aggregate demand and supply. From the aspect of

aggregate demand, learners will learn about the factors that cause the aggregate
demand curve to slope negatively, components of aggregate demand such as
consumption (C), investment (I), government expenditure (G) and net export
(XăM), and the determinants of the aggregate demand curve. This topic also
discusses the short-term aggregate supply curve and its determinants. The topic
also explores how the production level and the equilibrium price are determined,
and how an AD-AS model is used to analyse the effects of budget policy and
financial policy. Lastly, the construction of a long-term aggregate supply curve is
explained.
Topic 7 discusses two important variables in the economy, namely

unemployment and inflation. The citizens of a country are categorised into
specific groups such as population of working age group, labour force,
unemployed, employed, discouraged workers and part-time workers. The
methods of calculating the rate of unemployment and the rate of participation in
the labour force are also explained. Learners will learn about the three types of
unemployment that exist in the economy, reasons for unemployment and the
effects of unemployment on the economy, individual and society. Lastly, the
trade-off between unemployment rate and inflation rate is discussed as well as
the Phillips curve.
Topic 8 introduces the concept of international trade. In this topic, learners will
discover about the factors that encourage international trade such as different
factors of production, different climate, different labour skills and consumption
patterns. In addition, the topic also focuses on two important concepts in
international trade ă absolute advantage and comparative advantage. Learners
will be exposed to the benefits of conducting international trade, the various
international trade barriers adopted by countries, terms of trade and the reasons
for implementing protection policies.

COURSE GUIDE  xvii
Topic 9 focuses on international finance. Learners will be introduced to the

importance of foreign exchange rate and how this rate is determined in
international trade. Besides that, the topic also discusses the factors that influence
the foreign exchange rate. Another important aspect of this topic is the concept of
balance of payments and its components, namely current account, capital
account and official settlement account.
Topic 10 discusses the various monetary systems that were used since the
beginning of the 20th century. Specifically, learners will study the Gold Standard
system and the Bretton Woods system. Problems that occurred in each system,
which eventually led to the demise of the system, will be discussed. In addition,
the topic discusses at length the flexible exchange rate system as well as the
advantages and disadvantages of both the fixed and flexible exchange rate
systems.
TEXT ARRANGEMENT GUIDE

Before you go through this module, it is important that you note the text
arrangement. Understanding the text arrangement will help you to organise your
study of this course in a more objective and effective way. Generally, the text
arrangement for each topic is as follows:
Learning Outcomes: This section refers to what you should achieve after you
have completely covered a topic. As you go through each topic, you should
frequently refer to these learning outcomes. By doing this, you can continuously
gauge your understanding of the topic.
Self-Check: This component of the module is inserted at strategic locations

throughout the module. It may be inserted after one subtopic or a few sub-topics.
It usually comes in the form of a question. When you come across this
component, try to reflect on what you have already learnt thus far. By attempting
to answer the question, you should be able to gauge how well you have
understood the subtopic(s). Most of the time, the answers to the questions can be
found directly from the module itself.

xviii  COURSE GUIDE
Activity: Like Self-Check, the Activity component is also placed at various

locations or junctures throughout the module. This component may require you
to solve questions, explore short case studies, or conduct an observation or
research. It may even require you to evaluate a given scenario. When you come
across an Activity, you should try to reflect on what you have gathered from the
module and apply it to real situations. You should, at the same time, engage
yourself in higher order thinking where you might be required to analyse,
synthesise and evaluate instead of only having to recall and define.
Summary: You will find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the Summary, you should
be able to gauge your knowledge retention level. Should you find points in the
Summary that you do not fully understand, it would be a good idea for you to
revisit the details in the module.
Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.
References: The References section is where a list of relevant and useful

textbooks, journals, articles, electronic contents or sources can be found. The list
can appear in a few locations such as in the Course Guide (at the References
section), at the end of every topic or at the back of the module. You are
encouraged to read or refer to the suggested sources to obtain the additional
information needed and to enhance your overall understanding of the course.
PRIOR KNOWLEDGE
Learners of this course are required to pass BBEK1103 Principles of
Microeconomics course.
ASSESSMENT METHOD
Please refer to myINSPIRE.

COURSE GUIDE  xix
REFERENCES
Case, K. E., Fair, R. C., & Oster, K. M. (2017). Principles of economics (12th ed.).
Boston Pearson
Mankiw, N. G. (2018). Principles of economics (8th ed). Boston, MA: Cengage

Learning
McEachern, W. (2017). Economics: A contemporary introduction (11th ed.).

Cengage Learning
Sloman, J., & Sutcliffe, M. (2006). Economics (6th ed.). New Jersey: FT Prentice
Hall.
Statista. (2018). Retrieved from https://www.statista.com/
Trading Economics. (2018). Retrieved from

https://tradingeconomics.com/malaysia/indicators
TAN SRI DR ABDULLAH SANUSI (TSDAS)

DIGITAL LIBRARY
The TSDAS Digital Library has a wide range of print and online resources for
the use of OUM learners. This comprehensive digital library, which is accessible
through the OUM portal, provides access to more than 30 online databases
comprising e-journals, e-theses, e-books and more. Examples of databases
available are EBSCOhost, ProQuest, SpringerLink, Books247, InfoSci Books,
Emerald Management Plus and Ebrary Electronic Books. As an OUM learner,
you are encouraged to make full use of the resources available through this
library.

xx  COURSE GUIDE

Topic  Introduction to
Macroeconomics
1
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Discuss four objectives of macroeconomics;
2. Describe the two economic phases in the business cycle; and
3. Differentiate between classical, Keynesian, Monetarist and rational
expectation economic theories in relation to macroeconomics.
 INTRODUCTION
What comes to your mind when we talk about macroeconomics? What does it
stand for? Macroeconomics is an analysis of a countryÊs economic structure and
performance as well as government policies that affect economic conditions.
Economists are interested to know the factors that contribute towards a countryÊs
economic growth because if the economy progresses, there will be more job
opportunities, goods and services, and this will eventually raise the peopleÊs
standard of living. Macroeconomics can be used to test a particular theory to see
how the overall economy functions. The theory is then used to forecast the effects
of a particular policy or event. How about the other concepts in macroeconomics?
Let us find out and continue our study on this interesting subject.

2  TOPIC 1 INTRODUCTION TO MACROECONOMICS
1.1 MACROECONOMICS
Economists define macroeconomics as a field of economics that studies the
relationship between aggregate variables such as income, purchasing power,
price and money. In other words, macroeconomics examines the function of the
economy as a whole system, looking at how demand and supply of products,
services and resources are determined and factors that influence them.
1.1.1 Issues in Macroeconomic Analysis

Do you know that there are five issues involved in macroeconomic analysis? The
issues are as follows:
(a) What are the Determinants of Economic Growth and Living Standards in a
Country?
Since a century ago, developed nations have achieved a high rate of economic
growth, which in turn has raised their peopleÊs standard of living.
Macroeconomics examines the reasons behind the speedy economic growth
in developed nations as well as why this growth is different between the
various countries.
Figure 1.1 shows MalaysiaÊs real output (measured using real gross domestic
product) from 2010 to 2018.
Figure 1.1: MalaysiaÊs real output from 2010 to 2018

Source: Trading economics (2018)

TOPIC 1 INTRODUCTION TO MACROECONOMICS  3
Based on Figure 1.1, we can see that there has been a steady increase in the
countryÊs output from 2010 to 2014 whereas there was a decline in the
economy (stock market crash) from 2014 to 2015.
(b) What is the Productivity Rate of Employees?

The average labour productivity or the output of a single worker is important
to determine the standard of living. Macroeconomics examines the factors
that determines the growth rate of employee productivity. Let us look at
Figure 1.2. What can you infer from it?
Figure 1.2: Productivity per employee in Malaysia from May 2018 to April 2019
Figure 1.2 shows the average productivity per employee in Malaysia from
May 2018 to April 2019. The productivity per employee increased every
quarter during this period.
ACTIVITY 1.1
Can employee productivity decline even though there is an increase in

total output? Share your answer with your coursemates in myINSPIRE
online forum.
(c) What is the Cause of Decline and Growth in an Economy?

Any economy will surely go through decline and growth. In relation to this,
macroeconomics will look at the causes of these changes in the economy and
the government policies that can be implemented to overcome an economic
problem.

Figure 1.3 shows the rate of economic growth (quarterly) in Malaysia

between 2016 and 2019.
Figure 1.3: Rate of economic growth (quarterly) in Malaysia between 2016 and 2019
Figure 1.3 shows both the economic growth and decline. For example, an
obvious economic downturn occurred in Malaysia in mid 2018 due to the
Great Recession in United States as well as the world economic crisis. These
situations slowed down the Malaysian economy, causing the growth rate to
be in the negative during this periods.
(d) What Factors Affect Unemployment?

What does the rate of unemployment mean? Rate of unemployment
means there is an available workforce that wants to work but there are no
available jobs. The rate of unemployment will increase when there is a
decline in the economy. However, unemployment can also happen when
the economic situation is good. Macroeconomics will examine the reasons
for unemployment, types of unemployment and ways to overcome
unemployment.

Let us look at Figure 1.4, which shows the rate of unemployment in Malaysia
from 2011 to 2018.
Figure 1.4: Rate of unemployment in Malaysia from 2011 to 2018

Based on Figure 1.4, the unemployment rate in Malaysia in 2018 was at

approximately 3.3 per cent.
(e) What Factors Cause the General Price Level or Inflation to Rise?
What does inflation mean? Inflation is an increase in the general price level
and is usually measured by looking at changes in the consumer price index.
In a macroeconomic analysis, the questions asked are as follows:
(i) What factors affect inflation?
(ii) Why does the inflation rate differ from time to time?
(iii) Why does the inflation rate differ from one country to another?

Figure 1.5 shows the rate of inflation in Malaysia from 2009 to 2019.
What can you conclude about it?
Figure 1.5: Rate of inflation in Malaysia from 2011 to 2018

Source: Plecher (2019)
As can be seen, the rate of inflation was high in in 2017 due to the rising price of
commodity goods. However, the price of goods and services in general are
relatively stable. Inflation rate is one of the macroeconomic variable indicators
used to measure the performance of a country.
ACTIVITY 1.2
In Malaysia, prices or goods were higher in 2010 compared to prices in
2012. Does this mean that the quality of life of Malaysians was much
better in 2012? Do you agree? Give your reasons in myINSPIRE online
forum.
EXERCISE 1.1
1. Define inflation.
2. Referring to Figure 1.4, what do you think of the unemployment rate?

1.2 MACROECONOMIC POLICIES

The study of macroeconomics relates to the economic growth of a country.
Although many factors such as natural resources, human resources, capital stocks,
technology and peopleÊs choice of economy contribute towards the economic
growth, government policies also play an important role. Therefore, it is also
important for you to understand the effects of the many government policies on
the economy and the need to develop better policies as this is an important aim in
macroeconomics.
Macroeconomic policies affect the overall performance of the economy. There are
two main macroeconomic policies, namely financial or monetary policies and
fiscal policies. However, other policies can also be used by the government to
influence the economic performance of a country. They are income policies and
supply-side policies.
(a) Financial or Monetary Policy

What is the purpose of this policy?
The purpose of financial policy is to influence the supply of money in

the economy.
Economists believe that changes in the money supply will influence

important macroeconomic variables such as national output, labour force,
interest rate, inflation, share prices and foreign currency exchange. Financial
policy is controlled by the central bank, which acts as a government agency
(in Malaysia, it is dealt with by Bank Negara).
(b) Fiscal Policy

The tools used in fiscal policy are taxes and government expenditure. A good
balance between government expenditure and government revenue is
important. When the government spends more than the income tax collected,
it suffers a budget deficit. Meanwhile, if the governmentÊs revenue is more
than its expenditure, then the government will have a budget surplus.
(c) Income Policy

This policy is used by the government to control prices and wages. The
government will specify the maximum amount by which prices and wages
are allowed to rise. Government and firms or labour unions sometimes
negotiate on the price and the wage-setting behaviour.

(d) Supply-side Policy

This policy focuses on the aggregate supply and on how production can be
increased. The main instrument of the supply-side policy is the tax system.
With a reduction on personal taxes, workers are encouraged to work more
and therefore increase labour supply.
SELF-CHECK 1.1
What is the difference between financial or monetary policy and fiscal

policy?
1.3 OBJECTIVES OF MACROECONOMICS

Do you know what the objectives of macroeconomics are? Among the vital
objectives of macroeconomics are:
(a) Achieving Full Employment

This does not mean that there will be no unemployment at all or that the rate
of unemployment will be zero in a country. Economists agree that there can
still be unemployment although the economy is at a level where it has
achieved full employment, meaning that those who are able and willing to
have a job can get one. We will take up this matter in Topic 7, when we
discuss in more detail the concept and issues of unemployment.
(b) Price Stability

Price stability means there are no changes in the general price levels. This
also means that the prices of some goods and services may increase while
others may decrease at the same time. When prices remain largely stable,
there is no rapid inflation or deflation.
(c) Good Economic Growth

Achieving good economic growth is also one of the aims of macroeconomics.
This would mean that there is an increase in the real per capita income from
year to year.
(d) Rapid International Trade Activities

All countries participating in international trade want to benefit from
specialisation and trade. Empirical studies have shown that countries that
are actively involved in international trade benefit in terms of more
production output and higher consumption level.

ACTIVITY 1.3
Refer to the websites of Bank Negara (www.bnm.gov.my) and the
National Statistics Department (www.statistics.gov.my). Can you find
the inflation rate and unemployment rate in Malaysia in 2018? What can
you conclude about these two rates? Share your finding with your
coursemates in myINSPIRE online forum.
1.4 BUSINESS CYCLE

Now let us move on to the business cycle. What does business cycle refer to?
Business cycle refers to the recurring and fluctuating levels of economic

activity that an economy experiences over a long period of time.
Economic growth and recession generally involve the entire country and the
world, affecting almost all economic activities and involving more than just
purchasing power and production.
Do you know that there are different phases in economic activities? Let us look at
these phases in the next subtopic.
1.4.1 Phases in Economic Activities

Economic activities can be divided into two main phases, namely the expansion
(growth) phase and the contraction (recession) phase.
(a) Expansion Phase

This is a phase where economic activities are on the rise as shown by the
growth in domestic production.
(b) Contraction Phase

There are two types of contraction, namely:
(i) Depression
If the economic downturn is very bad, it is known as depression.
Although there is no official definition, depression is a sudden
depreciation in the national production, followed by an increase in the
unemployment rate, which lasts for more than a year.

(ii) Recession
Recession is a more moderate economic slowdown, which involves a
decrease in total production and purchasing power, usually lasting for
at least six months.
Figure 1.6 shows a summary of the various phases in economic activities.
Figure 1.6: Summary of phases in economic activities
Now let us look at Figure 1.7, which shows an example of a business cycle.
Figure 1.7: Business cycle

Figure 1.7 shows the business cycle with its economic activities and movements
along the long-term growth trend line. Recession will occur when the previous
economic expansion has reached its peak and has fallen into a pit, which is the
trough. The economy will then begin to boom again after experiencing a recession
and it will continue to grow until it reaches a new peak. Therefore, the point from
one peak to another peak is called a cycle. Similarly, the point from one trough to
the next one is also a complete cycle.
Let us look at another business cycle. Figure 1.8 shows the business cycle in
Malaysia from 1960 to 2000, which is reflected through the actual national output
growth rate.
Figure 1.8: Business cycle in Malaysia from 1960 to 2000
Referring to the Figure 1.8, we can see that Malaysia suffered a recession during
the years between 1974 and 1975, 1985 and 1986, and 1997 and 1998, when the
economy was in a trough. Strong domestic demand is expected to keep the
economy on a robust growth path in 2019, despite moderating household
expenditure growth after last yearÊs stellar performance. The economy is growing
at 4.5 per cent in 2019, which is unchanged in the forecast, and is expected to
increase 4.5 per cent in 2020.

ACTIVITY 1.4
1. In your opinion, is the Malaysian economy currently at the level of

expansion?
2. What do you understand by the terms recession, trough and

recovery?
Share your answers in myINSPIRE online forum.
EXERCISE 1.2
1. What does business cycle mean?
2. How does the change in the unemployment rate relate to business

cycle?
3. Can the unemployment rate become zero? Explain.
1.5 WHAT DO MACROECONOMISTS DO?

Macroeconomists use their expertise to perform the following:
(a) Macroeconomic forecasting;
(b) Macroeconomic analysis;
(c) Macroeconomic research;
(d) Developing and testing economic theories; and
(e) Collecting data.
EXERCISE 1.3
List the main activities of macroeconomists. What is the role of their

analysis in each of these activities?

1.6 HISTORY OF MACROECONOMIC

DEVELOPMENT
There are four phases of development in the history of macroeconomics. They are
classical, Keynesian, monetarist and rational expectation.
Let us examine each of the developments.
(a) The Classical View

The classical view is based on the notion that individuals and firms or
businesses act in accordance with their own interests and wants. Wages and
prices will change rapidly to achieve market equilibrium. The classical view
sees the economy as being regulated by an „invisible hand‰, whereby the free
market economy will solve all problems on its own and government
intervention in the economy is restricted.
(b) The Keynesian View

The Keynesian theory states that wages and prices do not change rapidly.
The theory does not subscribe to the view that the „invisible hand‰ can solve
all problems effectively. According to this perspective, because wages and
prices change rather slowly, unemployment will remain at a high rate for a
longer period of time. Keynesians believe that government intervention will
definitely help improve a countryÊs economic performance.
(c) The Monetarist View

Professor Milton Friedman is the main leader for this view, which raises the
issue of stagflation that happened in the 1970s. What does stagflation mean?
Stagflation is the situation where the overall price level rises rapidly
during periods of recession or high unemployment.
According to this view, most of the instability in the economy could have
been avoided if the money supply had not been expanded rapidly.
Proponents of the monetarist view argued that the money supply should
grow at a rate that is equal to the average growth of the real output (Y).

(d) The Rational Expectation View

This view began to develop in the 1970s and received much attention after
the emergence of the stagflation problem. According to this view, it is
assumed that people have complete information about the economic
situation and they act rationally. For instance, based on the information and
previous experience, economists know how inflation is determined and they
use this model to forecast future inflation rates.
EXERCISE 1.4
Compare the classical and Keynesian views in relation to changes in

wages and prices. What are the implications of these different views?
1.7 AGGREGATE DEMAND AND AGGREGATE

SUPPLY
In this subtopic, we will learn about four concepts that are related to aggregate
demand and aggregate supply. Let us look at them one by one.
(a) Aggregate Output and Price Level

What does aggregate output mean?
Aggregate output is the economyÊs total production, which means the

total sum of an economyÊs production of goods and services in a given
period.
How about aggregate demand?
Aggregate demand is the total amount of goods and services demanded

in the economy at a given overall price level and in a given time period.

The price level in the economy is the weighted average of the prices of all
goods and services such as food, housing, clothing, entertainment, transport,
medical and all other products.
(b) Aggregate Demand Curve

Do you know what the aggregate demand curve represents?
Aggregate demand curve is a graph that shows the connection between

the price level of the economy with the total aggregate output in a given
period, assuming that all other factors remain the same.
Figure 1.9: Aggregate demand curve
Figure 1.9 shows an aggregate demand curve (AD) where the vertical axis
(y-axis) shows the average price level and the horizontal axis (x-axis) shows
the aggregate output or the actual gross domestic product (GDP), which will
be discussed in Topic 2. The negative slope of the aggregate demand curve
captures the inverse relation between the aggregate output and the price
level. This means that if the price level drops, consumers will demand more
goods and services, thus increasing expenditure.

(c) Aggregate Supply Curve

The aggregate supply curve shows the output quantity that firms are
willing to provide at a particular price level. Normally, there is a positive
relationship between the aggregate supply and price level.
Figure 1.10: Aggregate supply curve
(d) Equilibrium
The intersection of aggregate demand and supply will determine the balance
between price level and economic output, as shown in Figure 1.11.
Figure 1.11: Equilibrium (E)
Referring to the curve in Figure 1.11, equilibrium is attained at E where the

AD curve and the AS curve meet. The equilibrium price level is at P* while
the equilibrium aggregate output is at Q*.

 Macroeconomics is a field that is related to the connection between aggregate

variables that analyse the economy as a whole system.
 Macroeconomics focuses on national economic growth, which is measured

based on national income.
 Five main issues in macroeconomics are real output, productivity, economic

growth, unemployment and inflation.
 Two important macroeconomic policies are financial policy and fiscal policy.
These policies will be used to achieve macroeconomic objectives such as full
employment, price stability and satisfactory economic growth. However, there
are also other policies that can be used by the government to affect the
economy, namely income policy and supply-side policy.
 Economic changes in relation to the increase and decrease in output can be seen
from the business cycle.
 There are four objectives of macroeconomics. They are achievement of full

employment, price stability, good economic growth and rapid international
trade activities.
 Normally, the business cycle has two important phases ă expansion and
contraction. This can be seen in detail from its different levels ă peak, recession,
trough, recovery and expansion.
 This history of macroeconomic development includes the classical, Keynesian,

monetarist and rational expectation perspectives.
 The aggregate demand curve has a negative slope, which shows the inverse
relationship between price level and aggregate output demanded.
 Meanwhile, the aggregate supply curve shows a positive relationship between

price level and aggregate output quantity supplied.
 The interaction between the aggregate demand curve and aggregate supply
curve will determine the balance between price level and aggregate output in
the economy as a whole. It is known as the equilibrium.

Aggregate demand Inflation

Aggregate supply Objectives
Business cycle Phases
Depression Productivity
Economic growth Real output
Equilibrium Recession
Financial policy Stagflation
Fiscal policy Supply-side policy
Income Policy Unemployment
Trading Economics. (2018). Malaysia GDP. Retrieved from

https://tradingeconomics.com/malaysia/gdp
Trading Economics. (2018). MalaysiaÊs employed persons. Retrieved from

https://tradingeconomics.com/malaysia/employed-persons
Trading Economics. (2018). Malaysia GDP annual growth rate. Retrieved from
https://tradingeconomics.com/malaysia/gdp-growth-annual
Trading Economics. (2018). Malaysia unemployment rate. Retrieved from

https://tradingeconomics.com/malaysia/unemployment-rate
Plecher, H. (2019). Malaysia: Inflation rate from 1984 to 2024 (Compared to

previous year). Retrieved from
https://www.statista.com/statistics/319033/inflation-rate-in-malaysia/

Topic  National
Production
2
LEARNING OUTCOMES
1. Explain the circular flow of the income model;
2. Illustrate how gross domestic product (GDP) is calculated;
3. Distinguish the difference between real GDP and nominal GDP; and
4. Discuss four problems that arise during the measurement of national
production.
 INTRODUCTION
Macroeconomic theories began developing and gaining popularity following the
recession in 1929. The economic downturn continued for more than five years and
an unemployment rate of up to 25 per cent was recorded in the United States of
America. This meant that every one out of four persons was unemployed or did
not work and that was indeed a very high rate of unemployment.
Therefore, famous economists, headed by English economist named John

Maynard Keynes, suggested that a macro view be taken to solve problems. This
view is used since microeconomic theories used prior to this could not overcome
the high unemployment rate. Hence, macroeconomic theories started to flourish.

20  TOPIC 2 NATIONAL PRODUCTION
From time to time, other problems that needed to be solved using the macro
view cropped up such as inflation and deficit. In the absence of inflation and
unemployment, the system of free market economy cannot measure the stability
of the economic activity that is being carried out. The existence of such problems
helps open up more room for macroeconomics to grow. In this topic, the focus will
be on the main issue of macroeconomics, which is national production. Let us learn
more about national production in this exciting new topic.
2.1 CIRCULAR FLOW OF INCOME MODEL

The main aim of a countryÊs economic activity is to ensure that all its peopleÊs
needs for goods and services are satisfied. Nothing is more important than
providing shelter, food, clothing, education and recreation for each and every
citizen. Before you continue reading, pause for a moment to think about how
economic activities are measured.
A countryÊs economic activity is usually measured based on the countryÊs overall

output.
National production and national output mean the same thing. These terms
refer to the final products or goods and services produced by a country during
a specific period of time, for example, a year.
Before we look further into the concept of national production, it is important

for you to understand about the circular flow of the income model as shown in
Figure 2.1. The model shows the simplest economic activity involving two parties,
namely the household and the firm.

TOPIC 2 NATIONAL PRODUCTION  21
Figure 2.1: Circular flow of the income model
Figure 2.1 shows the circulation of physical goods (products and resources) and
cash between households and firms. Every circulation of physical goods will be
followed by a circulation of cash in the opposite direction.
The circulation of resources (production factors such as land, capital, labour and
entrepreneurs) from households to firms will be followed by cash from the firms
to the households. Resources possessed by households that are utilised by firms in
the production process will be paid for by the firms.
The circulation of goods from the firms to households will also be followed by the
circulation of cash from the households to the firms, which represents the payment
for the goods purchased by households from the firms.

2.2 GROSS DOMESTIC PRODUCT (GDP)
ACTIVITY 2.1
We always hear the term „gross domestic product‰ being mentioned in

economic news over the electronic media. What do you understand by
gross domestic product? Share your answer with your coursemates in
myINSPIRE online forum.
Every country has its own method of evaluating its economic activity. One thing
is certain, the process undertaken to do this is certainly not a simple one. The same
goes for Malaysia. Malaysia has its own method of measuring the total output and
the ins and outs of actual economic activities. Have you ever thought about how
the Malaysian government measures its national production?
One national production concept that Malaysia applies is the gross domestic
product (GDP). What does it stand for?
Gross domestic product (GDP) refers to the total market value of all final
goods and services produced within the borders of a nation during a specified
period.
There are four important elements of GDP as shown in Figure 2.2.
Figure 2.2: Four important elements of GDP
The four elements of GDP are explained in the following subtopics.

2.2.1 What is the Total Value of Production?

In order to calculate the total value of production, you will have to add the value
of all the goods. For example, the value of an orange is added to the value of a
computer, a car, a washing machine and so on. The GDP value of goods is based
on their market prices. The market price is the price at which an item, service or
asset is exchanged in a market system.
Example 2.1:
If an orange is sold for 30 sen and the price of a computer is RM1,000, the value
of 100 oranges and five computers is RM5,030, which is derived from RM30 for
the oranges and RM5,000 for the computers.
2.2.2 What are the Final Goods and Services

Produced?
The GDP calculations only take into account the market price of the final goods
and services. Final goods and services are those that are actually used or consumed
by individuals, households, firms or the government and will not be used as
components in producing other goods and services. In other words, they are not
intermediate goods and services.
Example 2.2:
Proton X70 (MalaysiaÊs national car) is the final product but the tyre it uses is
an intermediate good. GDP only considers the goods that are being sold in the
market. Therefore, goods produced for your own consumption are not taken
into account in the GDP.
2.2.3 Where are They Being Produced?

Only goods and services that are produced within the boundaries of a country will
become part of the GDP of that country. Therefore, goods and services produced
in Malaysia are part of MalaysiaÊs GDP.

Example 2.3:
Nike, an American company, produces clothing in Malaysia. The value of the
clothing produced in Malaysia is part of MalaysiaÊs GDP but not the GDP of
the United States.
Petronas, a Malaysian oil company, produces oil in Vietnam and contributes

towards VietnamÊs GDP but not ours.
2.2.4 When are They Produced?

GDP concerns only the production of new goods and services during a particular
period. Usually, the period is every three months or a year. Only the final products
and services produced during that period of time will be taken into consideration
in the GDP. GDP not only measures the total value of production but it also
calculates the total revenue and total expenditure of a country.
Example 2.4:
In Malaysia, Bank Negara uses the quarterly data to detect any changes in
short-term economic activities. Economists, on the other hand, use annual data
to evaluate the growth in long-term economic activities.
EXERCISE 2.1
True (T) or False (F) Statements
1. National production means goods and services produced within

the borders of a nation during a specified period. __________
2. In measuring the value of production, GDP values production

during a certain period only. Usually, the period is every six
months or three years. __________
3. Gucci is an Italian brand. The value of clothing that the company

produces in Malaysia is part of ItalyÊs GDP and not ours.
__________
4. Goods and services produced in Singapore are counted as

SingaporeÊs GDP. __________
5. In order to calculate national production value, GDP values the

goods based on market price. __________

2.3 GROSS NATIONAL PRODUCT (GNP)

How about gross national product (GNP)? How is it different from GDP? Let us
continue to find out the answers.
Another concept that is used to measure the production of a country is the gross
national product (GNP). In other words, GNP does not take into account the value
of output produced by a foreign firm even though the production operation is
carried out within the country.
Gross national product (GNP) means total market value of final goods and
services produced by a countryÊs nationals using their own resources,
regardless of whether the production operations are carried out within or
outside the country.
For example, the value of clothing produced by Nike in Malaysia is not included
in the calculation of MalaysiaÊs GNP. Instead, it is used in the calculation of
AmericaÊs GNP.
Similarly, the petroleum produced by Petronas in Vietnam is not added into

VietnamÊs GNP. Instead it is added to ours. Here is a simple formula for GNP:
GNP = GDP + Income earned by domestic residents through foreign

investments ă Income earned by foreign investors in the domestic market
ACTIVITY 2.2
While walking in shopping malls, you must have seen business premises
selling branded goods like Gucci, Laura Ashley, Guess, Dorothy Perkins,
Topshop, Nike and such.
After studying the concepts of GDP and GNP, in your opinion, what are
the contributions made by these businesses towards MalaysiaÊs economic
growth? Share your answer with your coursemates in myINSPIRE online
forum.

EXERCISE 2.2
1. State the difference between GDP and GNP.
2. A product was made in 2018 but sold in 2019. For the purpose of
calculating the GDP, which year will be taken into account?
3. For a developing nation like Malaysia, which value would be

higher, GDP or GNP? Justify your answer.
2.4 METHOD OF CALCULATING GDP

Generally, there are three approaches to measuring GDP, namely expenditure
approach, production approach and income approach. Although the methods are
different, they result in the same value. Let us look further into these approaches
in the following subtopics.
2.4.1 Expenditure Approach

Firstly, let us learn the definition of expenditure approach.
Expenditure approach sums up the total expenditure in a country (of

individuals, firms and government). The total is derived from the final
demand for goods and services.
There are four groups of people who will purchase final goods and services,
namely households, firms, government and overseas consumers.
The expenditure of these groups of people can be divided into four categories,
namely personal consumption expenditures, gross investments, government
purchases of final goods and services, and net exports. Figure 2.3 shows the four
categories of expenditure.

Figure 2.3: Four categories of expenditure
The description for each category of expenditure is explained in Table 2.1.
Table 2.1: Description of Four Categories of Expenditure
Expenditure Description
Personal consumption This category includes expenditures by households on
expenditures final goods and services. This includes expenses for food,
laundry, rental and so on.
Gross investments This category refers to investments by firms on capital
equipment such as machinery and building as well as
inventory. Produced goods that cannot be sold also add
on to the inventory and thus, is included in investment.
Purchase of shares and bonds are not considered as
investments since these are not the purchase of final
goods or services.
Gross Investment = Net investment + Depreciation of

capital assets

Government purchases of This category refers to central and local government

final goods and services purchases of goods and services from the private sector.
In order to function effectively, the government has to
purchase goods and services produced by firms.
For example, government buys computers, paper, pens

and ammunition. All these goods are necessary for the
government to function effectively.
Net exports This category reflects total exports minus total imports
(X ă M). If the total value of export exceeds total value of
import, then the net export is a positive value. Instead, if
the export value is less than the import value, then the
net export is a negative figure.
Some goods produced locally cannot be sold in the

country. Similarly, some goods that are required by the
people are not produced locally and therefore, need to be
imported from overseas.
Therefore, the total expenditure for the final goods and services produced by a
country is the sum after adding all the four categories as listed in the following:
(a) Personal consumption expenditures =C
(b) Investments =I
(c) Government purchases of final goods and services = G
(d) Net Exports = XăM
Total Expenditure = C + I + G + (X ă M) = GDP (market price)
Total expenditure represents the value or sum received by the firms that produce
the final goods and services.

2.4.2 Production Approach

By looking at Figure 2.4, can you describe the production approach?
Figure 2.4: Production approach
According to the production approach, all the values of final goods and services
from the various economic sectors are added in order to calculate the GDP.
Figure 2.4 shows examples of sectors found in Malaysia. For your information, the
economic sector in Malaysia can be divided into three groups, namely the main
sector, the industrial sector and the service sector. Information on the value of
production in each of these sectors is obtained through census.

This approach uses the concept of adding up all the values to avoid the problem
of counting a value twice. Value added refers to the additional value of the goods
and services when they moved from one stage to another during the production
process. The additional value of the goods and services obtained from each stage
of the production are calculated instead of the accumulated value at each stage.
What does the problem of counting a value twice mean?
The problem of counting a value twice is a situation whereby the value of the
goods is counted more than once when measuring the GDP.
What is the impact of this problem? It can cause the GDP to be overestimated and
the value will not reflect the actual figure. To make it easier for you to understand,
let us refer to Example 2.5. Table 2.2 is your guide to the example.
Table 2.2: Value Added Method
Process Value for Each Process (RM) Value Added (RM)

Firm I ă Cotton to thread 100 100
Firm II ă Thread to cloth 50 150
Firm III ă Cloth to dress 80 230
TOTAL 230
Example 2.5:
Assume that there are three steps to produce a dress. In the first process, cotton
is processed into thread and sold to Firm II for RM100. At this stage, a value of
RM100 is produced (assuming that the cotton is obtained for free).
Firm II then produces cloth using the thread and sells it to Firm III for RM150.
This process adds a value of RM50 to the original RM100.
Subsequently, the cloth is made into a dress at this third stage of production.
The dress is then sold by Firm III to consumers for the price of RM230.
Therefore, a value of RM80 has been added on to the price for which the cloth
was purchased.

According to the production approach, only the final value of production is

taken into account when calculating the national income. In this case, only the
final figure of RM230 is taken. If the values of the intermediate goods are
considered (example, 100 + 150 + 230), this would mean the values are added
twice and the national income would be overestimated.
2.4.3 Income Approach

How do we use the income approach when measuring the GDP? Measuring GDP
using the income approach means to sum up the incomes that firms pay
households for the factors of production that they hire, for example, labour, land,
capital and entrepreneurs. This approach divides income into five categories as
explained in Table 2.3.
Table 2.3: Five Categories of Income Approach
Factors of
Income Approach Explanation
Production
Labour Compensation to Means wages paid to employees. It includes net
employees/salary wages and salaries added to fringe benefits paid
by the employer such as health insurance, social
security contributions and gratuities/pension
fund contributions.
Capital Net interest Means the interest payments on deposits made
by banks to the customers/households. This
payment must deduct the interest paid by
customers/households for loans taken.
Land Rental income Means total rent collected for the use of land
and other inputs. It includes payment of house
rental and estimated rental, which should be
paid by those who live in their own homes.

Corporate profit Means the measure of profit earned by the

household sector for supplying entrepreneurship
services through corporations. Corporate profits
paid as dividends and profits that are not
divided are considered as income.
Entrepreneurs
ProprietorÊs income A proprietor is someone who owns his own
business. His income includes the total of
all four sources of income stated above. It
is the income of incorporated business, sole
proprietorships and partnerships.
We can conclude that the national income is measured by adding the total of all
income mentioned in Table 2.3 as shown in the following formula.
National Income:
Compensation of employees + Net interest + Rental income + Corporate profit
+ ProprietorÊs income = GDP (factor cost)
There are four factors of production, namely land, labour, capital and
entrepreneurs. Each factor of production has its own income (Table 2.3).
Entrepreneurs have two incomes depending on whether the individuals are
working corporates or running their own business. Individuals who work for
corporates will gain corporate profits while those who run their own business will
have proprietorÊs income instead. Corporate profits are made up of three
components ă dividends, corporate taxes and undistributed corporate profits
(development funds for future purpose).

SELF-CHECK 2.1
Provide the meanings of the following method using your own words.
Income Approach Meaning

Compensation to employees
Net interest
Rental income
Corporate profit
ProprietorÊs income
2.5 ADJUSTING FACTOR COST TO MARKET

PRICE
In the process of calculating the GDP, the expenditure approach values the goods
and services at market rates whereas the income approach values them based on
the factor cost of production used to produce the goods and services.
Indirect taxes and subsidies are two elements that differentiate the market price
from the factor cost. Sales tax causes the value of the market price to be more than
the factor cost whereas subsidies make the factor cost higher than the market price.
In order to adjust the factor cost to the market price, indirect taxes have to be added
and subsidies have to be deducted as shown in the following formula.
Factor Cost + (Indirect taxes ă Subsidies) = Market Price

Let us look at Example 2.6, which shows you how to calculate the value of GDP
for Country X at market price.
Example 2.6:
The following information concerns the national income of Country X.
GDP at factor cost (GDPfc) = RM100 million

Indirect taxes = RM25 million
Subsidies = RM7 million
What is the value of GDP for Country X at market price?
Answer
GDPmp = GDPfc + Indirect taxes ă Subsidies
= RM100 million + RM25 million ă RM7 million
= RM118 million
Therefore, GDP at market price for Country X is RM118 million.
EXERCISE 2.3
1. State three methods for calculating the GDP.
2. How can the value of factor cost be adjusted to the market price?
ACTIVITY 2.3
What is your opinion of the traditional agricultural production that is

being carried out in the villages in the context of GDP calculation? This
refers to farmers who do not sell their agricultural produce but instead
consume them for their household needs. How can these economic
activities be measured?

2.6 ECONOMIC ACTIVITIES THAT ARE NOT

INCLUDED
In measuring the GDP, only the production value from economic activities that are
productive, legal and marketed are considered. There are economic activities that
are unproductive, illegal and not marketed. The following subtopics explain four
examples of activities, which are not included in the calculation of GDP.
2.6.1 Traditional Farmers’ Agricultural Produce

In traditional farming, some of the output produced are used for the farmersÊ own
consumption. Although this economic activity is productive, however, it is not
marketed. Therefore, this type of farming on a smaller scale is not included in the
calculation of GDP. Figure 2.5 shows paddy planting as an example of traditional
farming.
Figure 2.5: Traditional farming ă Paddy planting

Source: http://images.google.com.my
2.6.2 Illegal Activities

Although activities such as drug trafficking, prostitution, gambling or black
market trading are all productive and generate a lot of money, they are not
included in the calculation of GDP. This is because these activities are illegal.

2.6.3 Productive Activities that are Not Paid

Are you aware that there are productive activities that are not paid for? For
example, housework done by homemakers is not paid for and is difficult to value.
Therefore, it is not included in the GDP calculation. However, if the job is given to
a maid and she is paid for the work done, then it will be accounted for in the GDP.
2.6.4 Non-cash Rewards

It is quite normal for a company manager to receive partial benefits in the form of
benefits other than cash, for example, free hotel stay or transportation. Although
this increases his real income, the value is not included in the GDP calculation.
Besides the activities that are not included in the measurement of GDP, there are
also limitations in the GDP concept in terms of social welfare. As we know, an
increase in GDP is a good thing and it is one of the main objectives of the
macroeconomic policy. However, can we use the GDP concept as a measure of
welfare? A decrease in crime level in one country will definitely improve social
welfare but crime level is not measured in GDP. If the crime level is decreased,
society would be better off but a decrease in crime is not an increase in output, thus
it is not reflected in GDP. Similarly in the case of pollution, GDP does not reflect
losses. It simply shows that GDP is higher when more outputs are produced
despite the effects of pollution on society.
2.7 REAL GDP AND NOMINAL GDP

The value of GDP for a country changes from time to time. The same goes for prices
that keep fluctuating from time to time. Information pertaining to the increase in
production is important. Thus, the element of change in pricing has to be set aside
from the national production value. The isolated data, which shows the price
difference, is more meaningful to economists and policymakers as it reflects the
actual economic activities.

There are two types of GDP, namely real and nominal. Let us check out their
definitions.
Nominal GDP is the market value of final goods and services produced on an
economy, unadjusted for inflation.
Real GDP is nominal GDP, adjusted for inflation to recent changes in

measurement.
To make it easier for you to understand these two concepts, let us refer to
Table 2.4. Imagine that Country X only produces two goods, namely food and
clothing. Table 2.4 shows the quantities and prices for the two items for the year
2018 and 2019.
Table 2.4: Quantities and Prices for Food and Clothing
Quantity (Unit) Price (Per Unit)

Year
Food Clothing Food Clothing
2018 5 10 RM20 RM15
2019 7 12 RM22 RM15
Based on the information in Table 2.4, the nominal GDP value, which is the value
of goods produced for a specific year for a country during 2018 and 2019, is stated
as follows:
Year 2018 (5 Food  RM20) + (10 Clothing  RM15) = RM250

Year 2019 (7 Food  RM22) + (12 Clothing  RM15) = RM334
On the other hand, the real GDP for the year 2018 based on the price in 2018 is:
(5 Food  RM20) + (10 Clothing  RM15) = RM250

Since the price used is the same, which is the price for the year 2018, the values of
real GDP and nominal GDP are the same, that is, at RM250.
Based on the pricing in 2018, the real GDP value for 2019 is:
(7 Food  RM20) + (12 Clothing ïRM15) = RM320
Comparatively, the value of real GDP for the year 2019 is lower than the nominal
GDP value for the same year.
The rate of growth in real GDP between 2018 and 2019 can be calculated as follows:
(RM320 ă RM250) / RM250  100 = 28%
The value of 28 per cent shows the average growth rate for both food and clothing
for Country X between year 2018 and 2019.
EXERCISE 2.4
1. State the types of activities that are not included in the calculation
of national production.
2. What is the difference between real GDP and nominal GDP?
2.8 NATIONAL PRODUCTION DATA USAGE

National production data reflects a countryÊs overall economic activities. It is very
useful for many parties. As for Malaysia, these parties can be the government,
policymakers and Bank Negara. What is the purpose of having this data?
Figure 2.6 shows five main uses of national production data.

Figure 2.6: National production data uses
Let us take a further look at the five main uses of national production data.
(a) To Measure Economic Performance

The economic growth rate can be calculated by comparing the current
national production data with that of the previous year. Information
regarding the economic growth rate helps the government make
comparisons with other countries.
(b) To Facilitate Policymakers in Planning

Policymakers need the national production data to draft economic policies
for the coming years. National production is an important guide, which
provides details about a countryÊs economic performance, and therefore, is
vital for planning purposes.

(c) To Show or Indicate the Success or Failure of Government Policies

The government is able to evaluate the effectiveness of an economic policy
that has been implemented based on information about national production.
It also allows the government to look at any economic problems that may
have surfaced and find ways to solve these problems.
(d) To Measure the PeopleÊs Standard of Living

The national production data is used to measure the standard of living of the
countryÊs citizens. Normally, the value of real GNP or real GDP per capita is
used as a measuring yardstick. With this data, one can compare the peopleÊs
standard of living from time to time or compare it against that of other
countries.
(e) To Evaluate the Contributions of Economic Sectors towards the CountryÊs

Economy
Based on the production approach, contributions made by each economic
sector towards the overall economic growth can be evaluated. The
government can identify the sectors that are considered to be the backbone
of the countryÊs economy. Based on each sectorÊs performance, the
government can also assess the success or failure of its policies with regard
to each sector.
2.9 FACTORS AFFECTING NATIONAL

PRODUCTION LEVEL
The national production level of a country fluctuates all the time. The national
production of developed nations such as United States and Japan are higher
compared with the national production of developing countries such as Sri Lanka
and Thailand. There are two types of factors that can affect the national production
level ă internal and external.
2.9.1 Internal Factors

Among the internal factors that can affect the level of national production are
natural resources such as petroleum and gas. Countries that are rich in natural
resources are bound to have a higher national production level compared to
countries that have no natural resources.
Energy or labour factors also play an important role in contributing towards

national production. Countries that have hardworking and capable employees, for
example, Japan will definitely increase the national production level compared to
nations with lazy and unproductive labourers.

Besides the mentioned factors, total capital owned by a country also affects the
level of national production. Countries that have less capital cannot afford to
produce large outputs compared to countries that have more capital.
The level of technology also determines the national production level. Countries
that have knowledge and technological advancement are able to produce goods
and services using faster and more efficient methods.
2.9.2 External Factors

Foreign investment plays an important role in increasing the national income and
economic growth of a country. Foreign investment, whether direct or indirect,
contributes towards a countryÊs economic growth and income level.
Did you know that terms of trade also affects the income of a country? What does
this mean?
Terms of trade refers to the ratio of the amount a country receives for its export
commodity to the amount it pays for its import commodity.
Terms of trade are good if they show that a country is receiving a higher import
quantity compared to its export quantity. This means the country pays less for the
products it imports, in other words, it has to give up less exports for the imports it
receives.
Receiving assistance from other countries can also improve the recipient countryÊs
standard of living. For example, assistance provided by international
organisations and developed nations can help reduce the rate of poverty in poor
countries. The national production of developing countries can be improved with
the help of other countries.
EXERCISE 2.5
1. What are the uses of national production data?
2. Discuss factors that affect the income level of a country.

ACTIVITY 2.4
The process of calculating national production is not easy. Often,

unforeseen problems arise and make matters more difficult. Discuss.
2.10 PROBLEMS IN CALCULATING NATIONAL

PRODUCTION
The calculation of national production is a very complicated process and many
problems can arise during this process. Figure 2.7 shows four problems that
usually arise during the process of calculating the national production.
Figure 2.7: Four problems in calculating the national production

These four problems are further discussed as follows:
(a) Gathering Information

Gathering information or data is difficult as there are some parties such
as small-time businessmen and farmers who do not keep detailed records
of their economic activities. The production values obtained from them
are usually estimated figures. Mistakes happen when classifying this
information, which could cause some confusions in the calculating process.
(b) Counting Twice/Double Counting

The difficulty in distinguishing final goods from intermediate goods might
lead to the problem of double counting. A product can be classified as either
a final or an intermediate goods depending on its usage. For example, flour
purchased by a homemaker is considered a final product. However, flour
purchased by a baker is considered as an intermediate product.
(c) Determining the Prices of Goods

Prices of goods usually differ from one area to another. In addition, prices of
certain goods are always changing, for example, the price of palm oil which
changes every day. Thus, the difficulty arises in determining the prices that
should be taken into account when calculating the national production.
(d) Devaluation (Depreciation)

It is difficult to calculate devaluation because there are no detailed records
for some economic activities. Besides this, there are many different methods
of calculating devaluation and each method results in a different figure.
ACTIVITY 2.5
Based on your understanding of the problems that usually arise in
calculating national production, identify if there are any problems that
were not mentioned and list them down. Share your answer in

2.11 BUSINESS CYCLE

Lastly, before we end this topic, let us learn about the business cycle for national
production. Can you still remember the meaning of business cycle, which you
came across in Topic 1?
Business cycle can be defined as a periodic fluctuation in the rate of economic

activity, as measured by levels of employment, prices and production.
A business cycle usually lasts for a period of between two and ten years,
accompanied by expansion and contraction of various sectors in an economy.
Let us look at Figure 2.8, which shows an example of a business cycle.
Figure 2.8: Example of a business cycle
Based on Figure 2.8, you can see that there are five stages of the business cycle ă
peak, trough, recovery, growth (expansion) and recession (contraction). The points
between the stages are indicated by peaks and troughs. The most important phases
in a business cycle are growth (expansion) and recession (contraction). An
economy is said to have achieved a full cycle when it has gone through the five
stages. For example, a business cycle that starts at the peak is complete when it
ends at the next peak.
Recession starts at the peak and ends at the trough. Recession occurs when the
value of real national production drops for two quarters of a year in a row. The
main characteristics of a recession include a decrease in demand for labour and a
reduction in spending by consumers. Recession is also reflected in a drop in firmsÊ
profits. Since consumer spending decreases during recession, all the firmsÊ unsold
products will increase and this will raise the firmsÊ inventories.

Expansion, on the other hand, begins at the trough and ends at the peak. The early
stage of expansion is called recovery. This happens when the national production
actually increases for six months continuously. A growth in the economy reflects
an increase in business sector confidence, a hike in investment and a demand for
labour. As income increases, the peopleÊs spending power increases as well. FirmsÊ
profits will also increase resulting in reduced inventories.
EXERCISE 2.6
1. There are many problems that have to be dealt with in the
calculation of national production. Explain the usual problems that
are likely to arise.
2. Define business cycle and discuss the five phases in a business

cycle.
 There are important economic variables that are related to national production.
The circular flow of the income model is used to explain the relationship
between income and expenditure.
 There are three approaches for measuring gross domestic product (GDP),
namely expenditure approach, production approach and income approach.
Although these three approaches are different, they result in the same GDP
value.
 There is a difference between real GDP and nominal GDP.
 There are five uses of national production data. In addition, internal and
external factors affect the national production level.
 Problems in calculating the national production include gathering

information, counting twice/double counting, determining the prices of goods
and devaluation/depreciation.
 There are five stages in a business cycle ă peak, trough, recovery, growth
(expansion) and recession (contraction). An economy is said to have achieved
a full cycle when it has gone through the five stages.

Business cycle National production

Circular flow Nominal GDP
Expenditure approach Problems
Gross domestic product (GDP) Production approach
Gross national product (GNP) Real GDP

Topic  Determinants
of Equilibrium
3 Income Theory
LEARNING OUTCOMES
1. Discuss the characteristics of two, three and four-sector economy;
2. Analyse the determinants of equilibrium income for two, three and
four-sector economy; and
3. Examine the role of fiscal policy in solving economic problems.
 INTRODUCTION
At the beginning of this topic, you will be introduced to the equilibrium of the two-
sector economy, followed by three-sector and four-sector economy. In the later
part of this topic we will discuss about fiscal policy and how it can be used to solve
inflation and deflation problems.
3.1 TWO-SECTOR ECONOMY

Did you know that a countryÊs balance of economy is closely related to the circular
flow of income? It involves macroeconomics market, goods and services market,
financial market and labour market.

48  TOPIC 3 DETERMINANTS OF EQUILIBRIUM INCOME THEORY
What are the components in a two-sector economy? A two-sector economy is made

up of two components, namely households and firms as described in Table 3.1.
Table 3.1: Two-sector Economy
Sector Explanation
Households Households are economic units that own the factors of production. They
decide on the use of goods and services as well as savings. Households
have the role of supplying services to the firms.
Firms Firms are economic units that decide on production. Firms buy the
factors/resources from households and sell/supply the goods and
services to the household sector.
3.1.1 Circular Flow of Income

The circular flow of income between sectors and both the goods and labour market
involves a physical flow and a cash flow. The flow can be seen in Figure 3.1.
Figure 3.1: Circular flow of income in a two-sector economy
A physical flow can be in the form of goods and services while a cash flow can be
in the form of fees, rental, interests, profits and payments for the use of goods and
services.
Firms produce a certain quantity of goods and services in a given period known
as the aggregate output (Y). Since each ringgit spent is received as income by
someone else, the aggregate output and aggregate income are the same.

TOPIC 3 DETERMINANTS OF EQUILIBRIUM INCOME THEORY  49
There are four important concepts in a two-sector economyÊs flow of income. Let
us analyse each of these concepts.
(a) Consumption (C)

Firstly, what does consumption (C) refer to?
The consumption (C) component refers to household expenditure,

namely all household expenditure to buy goods and services with the
income that households obtained.
The aggregate consumption (total consumption expenditure) for a specific

period depends on household income, wealth, interest rate and their plans
for the future.
We often state that that the higher the individualÊs income, the higher his
expenses will be. This concept is also applicable for the overall economy.
There exists a positive relationship between aggregate income and aggregate
consumption.
The function of consumption shows the connection between consumption

and income.
C = a + bYd
Where, C = Consumption
a = Autonomous consumption
b = Marginal propensity of consumption (MPC)
Yd = Disposable income (Y ă T ); Y = Income, T = Tax
Autonomous consumption (a) refers to consumption that does not depend

on income. It exists even when Y = 0, meaning that the household spends
even when there is no income.
Marginal propensity of consumption (b) measures the ratio of change in

consumption to the change in income. The formula to calculate MPC is
shown as follows:
Change in consumption C
MPC = 
Change in income Y

The ratio of total consumption to total income is measured through the

average propensity of consumption (APC).
Total consumption C
APC = 
Total income Y
The consumption function can be plotted as shown Figure 3.2.
Figure 3.2: Consumption function
Disposable income is the net income remaining after taxes have been paid
(Y ă T ). This income can be used to buy goods and services. As the
government sector does not exist in a two-sector economy, taxes T = 0, and
therefore Yd = Y.
(b) Savings (S)

In a two-sector economy (which does not involve international trade),
households can do two things with their income ă either spend it on
consumption or save it. In other words, savings is a part of income that is not
used by households to buy goods and services. Usually, savings will be
higher when income increases.
Savings function is the relationship between disposable income and savings.

Disposable income equals total consumption and savings, therefore:
Yd = C + S
Yd = a + bYd + S

As for savings function, the formula is:
S = ă a + (1 ă b)Yd
whereby, S = Savings
ăa = Negative savings (due to autonomous consumption)
(1 ă b) = Marginal propensity to save (MPS)
Yd = Disposable income
We can plot a graph for savings function as shown in Figure 3.3.
Figure 3.3: Savings function
Based on Figure 3.3, we can see that negative savings (ăa) is the value when
Y = 0.
The marginal propensity to save (MPS) measures changes in savings when

there is a change in income.
(1 ă b) refers to the ratio between increases in savings and increases in income

and is shown in the following:
Change in savings S
MPS = 
Change in income Y

The ratio between savings and income is referred to as the average

propensity of savings (APS) and is shown in the following:
Total savings S
APS = 
Total income Y
Savings by households and firms are considered as leakages in the circular

flow of income.
(c) Investment (I)

Do you know that investment is the firmsÊ main component of expenditure?
This can be seen in its definition here:
Investment is defined as a firmÊs expenditure in purchasing stocks for

capital goods and/or technology goods, which are not consumed but
instead to be used in future production of goods and services.
Investment includes constructing a building, factory or house, purchasing

capital goods such as machinery and adding net inventory or goods stock.
Real investment differs from planned investment in an economy because the

change in a firmÊs inventory is part of real investment and the change in
inventory is not wholly under the control of the firm. Change (increases and
decreases of inventories) sometimes depends on household consumption
decisions. However, the letter I in the formula usually refers to planned
investments.
There are two types of investments, namely:
(i) Induced investment; and
(ii) Autonomous investment.

What is the difference?
Induced investment is investment that depends on income. Changes in

income will induce changes in investment.
Factors affecting induced investments are income profits and increase in

population. An increasing number of people will cause the production of
goods and services to increase.
How about autonomous investment?
Autonomous investment is investment that do not depends on income,

for instance, interest rates, level of technological advancement and
expectations.
The functions of induced investment and autonomous investment are shown

in Figure 3.4.
Figure 3.4: Autonomous investment and induced investment
whereby, Ia = Autonomous investment

It = Induced investment

3.1.2 Consumption, Savings and Disposable Income

The relationship between consumption, savings and disposable income is shown
as follows:
Yd = C + S
When the equation is divided by Y, then
Y C S
 
Y Y Y
That is,
1 = APC + APS
If there is a change in the level of income, then
Y = C + S
When the equation is divided by Y, then
Y C S
 
Y Y Y
That is,
1 = MPC + MPS
MPC is the percentage or portion of additional income that is used for

consumption expenditure. MPS is the percentage or portion of additional income
that is used for savings. Since all income in the economy must either be spent or
saved, MPC + MPS = 1.

It can also be written as
MPC = 1 ă MPS
or
MPS = 1 ă MPC
3.1.3 National Income Equilibrium

Before the national income equilibrium is obtained, one needs to identify the
conditions in the national income equilibrium. The terms and conditions of
national income equilibrium is aggregate demand (AD) equals aggregate supply
(AS). In a two-sector economy, aggregate demand is made up of consumption and
investment, namely:
AD = C + I
Aggregate supply is the total goods and services produced within the country, that
is:
AS = National production = National income
Therefore, AS = Y
Since AD = AS, the terms and conditions of equilibrium is written as:
AD  AS Approach
C  I Y
or
AS  AD
Y C  I

In a non-balanced state, for instance, when the aggregate expenditure is more than
the aggregate output, there will be an unforeseen drop in inventory. Firms will
react by increasing output. This will help increase income and eventually the level
of consumption as well. This process will continue until the level of equilibrium is
achieved.
Since C + I = Y = C + S, the condition of equilibrium can also be written as:
Injections = Leakages Approach

I S
Did you know that the level of national income equilibrium can be determined by
using any of the following three methods?
(a) Table;
(b) Figure or graph; and
(c) Mathematical equation.
Let us look at each of the methods in detail.
(a) Table
If MPC = 0.75, consumption is RM500 million when income equals to zero
and autonomous investment is RM200 million.
Therefore, C = 500 + 0.75Yd and S = ă500 + 0.25Yd. By varying the value of Y

in the equation, Table 3.2 can be established.
Table 3.2: Determinants of Equilibrium in a Two-sector Economy
Y = AS Consumption (C) Investment (I) Savings (S) AD = C + I

0 500 200 ă500 700
700 1,025 200 ă325 1,225
1,400 1,550 200 ă150 1,750
2,100 2,075 200 25 2,275
2,800 2,600 200 200 2,800
3,500 3,125 200 375 3,325
4,200 3,650 200 550 3,850

National income equilibrium exists at Y = 2,800 when the conditions

AD = AS and I = S are satisfied.
What happens when Y is not equal to 2,800?
If the income is lower than 2,800, it will form an unstable condition because
AD > AS. This will encourage firms to increase production and economic
activities will increase until AD = AS is achieved.
If income exceeds 2,800, it will also form an unstable condition because

AS > AD. This means national output exceeds the planned aggregate
expenditure. As supply exceeds demand, firms will reduce their production
until a balance of AD = AS is achieved.
(b) Figure or Graph

The equation AD = AS involves the curves Y = AS and AD = C + I.
Equilibrium is achieved at the point when both the curves meet, which is at
e and income at Ye (refer to Figure 3.5).
Figure 3.5: National income equilibrium
However, the injection-leakage approach involves the savings curve (S ) and

investment curve (I ). The equilibrium is shown at the point where both the
curves meet.
(c) Mathematical Equation

Using the same value, the consumption and savings functions are:
C = 500 + 0.75Yd
S = ă500 + 0.25Yd

(i) Using Y = C + I, therefore:
Y = 500 + 0.75Y + 200

Y = 700 + 0.75Y
Y ă 0.75Y = 700
Y = 700/0.25 = 2,800
(ii) Using the Injections = Leakages method (I = S ), therefore:
200 = ă500 + 0.25Y

0.25Y = 700
Y = 700/0.25
Y = 2,800
Figure 3.6: National income equilibrium (consumption and savings curves)

3.1.4 Change in Aggregate Demand

Change in aggregate demand will change the level of national income equilibrium.
In a two-sector economy, this happens when factors affecting consumption and
investment change.
You can see the effects of change in AD (change in investment) as they are shown
in Figures 3.7 and 3.8.
Figure 3.7: The effects of change in AD using the AD = AS approach
Figure 3.8: The effects of change in AD using the injection-leakage approach

3.1.5 Multiplier Effect

What does a multiplier do?
A multiplier measures the effects of change in one variable against another

variable.
What about the definition of multiplier effect?
The multiplier effect can be defined as the ratio of increase in income or

national production to an increase in the aggregate demand (AD).
The size of the multiplier is obtained using the following formula:
Multiplier value (K ) = 1/(1 ă MPC ) or 1/MPS
The multiplier effect causes the income to change at a higher rate compared to the
change in AD earlier. In a two-sector economy, changes in the AD component is
based on the levels of investment (I ).
Let us look at Example 3.1 which describes the multiplier effect in more detail.
Example 3.1:
To understand the multiplier effect, assume MPC = 0.8 and change in
investment = RM150 million. It is found that the multiplier value K = 1/0.2 = 5.
This multiplier value indicates that the change in investment will change the
value of Y by the amount of the investment multiplied by five.
Therefore, change in Y = Multiplier value  Change in investment

Y = K  I
= 5  RM150 million
= RM750 million
Assuming the original equilibrium level is RM2,500 million. Therefore, the new
national income level is:
Y = RM2,500 million + RM750 million = RM3,250 million.

SELF-CHECK 3.1
Reflect on what you have studied so far. What are the characteristics of a
two-sector economy? State these characteristics in a table format.
EXERCISE 3.1
1. In a two-sector economy, explain the relationship between
consumption, savings and disposable income.
2. Give the definition of the multiplier and state how the size of the
multiplier is obtained.
3. In a simple model, if C = 100 + 0.8Y and I = 50, calculate the

equilibrium level of output.
4. If MPC = 0.75, the marginal propensity to save is

_________________.
5. An increase in autonomous consumption will move the aggregate

consumption curve to _______________________.
6. ________________________ is the percentage or portion of

additional income that is used for consumption expenditures.
7. What will happen when leakage is bigger than injection?
3.2 THREE-SECTOR ECONOMY

Did you know that a three-sector economy is also known as a closed economy?
The three sectors are as follows:
(a) Household sector;
(b) Firm or business sector; and
(c) Government sector.

Through the three-sector economy, the government can influence the economic
activities by using two specific policies. The policies are:
(a) Fiscal policy; and
(b) Financial or monetary policy.
What do these policies refer to?
Fiscal policy refers to government actions in making purchases and imposing

taxes.
Financial or monetary policy refers to the authority of a central bank in its

effort to determine the size and rate of growth of the money supply in the
market.
You will learn more about financial or monetary policy in the next topic. For now,
let us continue our discussion on fiscal policy.
In fiscal policy, government intervention exists directly in economic activities

through government expenditure (G) and government income sources through the
collection of taxes (T).
Government expenditure (G) includes government spending when purchasing

goods and services, and public investment expenditure. Meanwhile, the
government obtains income from taxes collected from households and firms.

3.2.1 Circular Flow of Income

There are three new flows in the three-sector economyÊs circular flow of income,
as described in Table 3.3.
Table 3.3: Three-sector EconomyÊs Circular Flow of Income
Type of Flow Explanation

Payment in exchange for goods and This flow exists because the government
services purchases goods and capital from the
business sector (firms).
Payment in exchange for factors of This flow exists because of government
production from where tax is collected spending on factors of production offered
by the household sector.
Taxes The government collects taxes from
households and the business sector.
The circular flow of income in a three-sector economy is shown in Figure 3.9.
Figure 3.9: Circular flow of income in a three-sector economy

3.2.2 Government and Fiscal Policy

Besides the four minor concepts that we have discussed in the two-sector economy,
(disposable income (Y), consumption (C), savings (S) and investment (I)), there are
two more important concepts to be added to a three-sector economy, which are
government expenditure (G) and taxes (T).
Let us look further into these two new concepts.
(a) Government Expenditure

This refers to public expenditure made by the government to provide
amenities for the public. Government expenditure can be seen from three
perspectives, namely:
(i) Government expenditure in purchasing goods and services produced

by the business sector (firms);
(ii) Government expenditure in paying for factors of production or labour

force provided by the household sector; and
(iii) Government expenditure in the form of pensions, scholarships and so

on.
Government expenditure is considered as an injection as it will bring

incoming flow of income into the circular flow of income.
Generally, government expenditure (G) depends on a few factors such as:
(i) Expected tax revenue;
(ii) Economic aim, for example, to reduce the unemployment rate; and
(iii) Political situation and peace, for example, increased expenses during
the election campaign.
The financial sources that cover government expenses are obtained mainly
from taxes, domestic loans such as from the Central Bank and Kumpulan
Wang Simpanan Pekerja (KWSP), loans from overseas such as the
International Monetary Fund (IMF) or sale of bonds and so on. The
government determines government expenditure exogenously.

(b) Taxes (T)

What do you understand about taxes?
Taxes are compulsory payments in the form of cash or kind imposed by

the government on households and firms to support government
expenditure.
Tax is considered a leakage in the circular flow of national income.
Taxes can be categorised into two types, namely direct taxes and indirect
taxes as explained in Table 3.4.
Table 3.4: Direct Taxes and Indirect Taxes
Direct Taxes Indirect Taxes

 Direct taxes are collected directly  Indirect taxes can be shared or
from the payee and the responsibility transferred to someone else.
of payment cannot be transferred to  Example: export duty, import duty,
someone else. excise duty, sales tax and service
 Example: personal income tax. tax.
In an economy, the government imposes three types of taxes:
(i) Progressive tax;
(ii) Regressive tax; and
(iii) Proportional tax.
Let us refer to Table 3.5 for a more detailed explanation on the three types of
taxes.
Table 3.5: Types of Taxes
Type of Tax Explanation

Progressive tax Tax rate increases with income.
Regressive tax Tax rate decreases with income.
Proportional tax Everyone pays the same percentage of income in taxes
regardless of the income level. As such, even if income
increases, the tax rate will remain the same but the amount of
tax to be paid will increase.

The proportional tax function shows the relationship between taxes and
income as follows:
T = s + tY
whereby, T = Level of tax

s = Autonomous tax
t = Marginal propensity to tax (MPT)
Y = Income
Did you know that autonomous tax (s) does not depend on income? It exists
even when Y = 0, in other words, households must pay taxes even if they do
not have an income.
Marginal propensity to tax (t ) measures the increase in tax due to the

increase in income.
3.2.3 Consumption, Savings and Taxes

How do we relate consumption, savings and taxes? The relationship between
consumption, savings and taxes is seen from the effects of a fixed tax on the value
of consumption and savings. Fixed tax on households and firms will reduce the
disposable income and subsequently influence consumption and savings.
The function of consumption with tax can be formulated as follows:
C = a + bYd
C = a + b (Y ă T )
As for function of savings with tax, the formula is:
S = ăa + bYd
S = ăa + b (Y ă T )
For example, if a = 9,000, MPC = 0.75 and T = 1,000, what is the value of
consumption and savings?
(a) In an equation without tax, when Y = 6,000,
Consumption, C = 9,000 + 0.75Y = 9,000 + 0.75(6,000) = 13,500

Savings, S = ă9,000 + 0.25Y = ă9,000 + 0.25(6000) = ă7,500
(b) In an equation with fixed tax:

C = 9,000 + 0.75(Y ă 1000)
C = 8250 + 0.75Y
C = 8250 + 0.75 (6000)
= 12750
S = ă9,000 + 0.25(Y ă 1000)

S = ă9250 + 0.25Y
S = ă9,250 + 0.25(6000)
S = ă7750

In a three-sector economy, the components of AD include consumption,
investment and government expenditure. Therefore, the equilibrium condition is
written as:
AD  AS Approach
C  I Y
or
AS  AD
Y C  I
Besides consumption, income is also used for savings and payment of taxes.
Therefore, the equilibrium condition can also be written as:

I  G  S T
Here, national income equilibrium is calculated using two main methods, which
are:
(a) Figure or graph; and
(b) Mathematical equation.

If it is given that a = RM900 million, MPC = 0.75, I = 150 million, G = 600 million
and T = 600 million, what is the consumption function and the savings function
with tax?
Consumption function = 900 + 0.75 (Y ă 600)

= 450 + 0.75Y
Savings function = ă900 + 0.25 (Y ă 600)

= ă1,050 + 0.25Y
Now let us look at how the two methods are used.
(a) Figure or Graph

The income equilibrium uses the equilibrium condition AD = AS and
Injection = Leakage as shown in Figure 3.10.
(i) AD = AS Approach (ii) Injection = Leakage Approach

Figure 3.10: National income equilibrium approaches
(b) Mathematical Equation

National income at equilibrium uses the AD = AS approach as shown in the
following:
Y = C+I+G
Y = 450 + 0.75Y + 150 + 600
Y ă 0.75Y = 1,200
Y = 1,200/0.25 = 4,800

The Injection = Leakages approach will also derive at the same answer:
I+G = S+T
150 + 600 = ă1,050 + 0.25Y + 600
750 + 1,050 ă 600 = 0.25Y
1,200/0.25 = Y
Y = 4,800
To double-check your answer when calculating the national income at

equilibrium, you can use both the approaches and, of course, you must
obtain the same answer. If you obtain different answers that means there
must be some mistakes in your calculation.
Prior to this, the calculation of national income equilibrium includes a fixed

tax or a lump sum. Now, let us look at the calculation for the national income
equilibrium when there is an induced tax function.
What is the level of the national income equilibrium for the following
problem?
Consumption function, C = 70 + 0.9Yd

Tax function, T = 25 + 0.2Y
Government expenditure, G = 20
Investment, I = 35
Equilibrium for a three-sector economy using the AD = AS method:
Y = C+I+G
Y = (70 + 0.9Yd ) + 35 + 20
Y = 125 + 0.9 (Y ă T )
Y = 125 + 0.9Y ă 0.9T
Y = 125 + 0.9Y ă 0.9(25 + 0.2Y )
Y = 102.5 + 0.72Y
(1 ă 0.72)Y = 102.5
Y = 102.5/0.28
= 366.07

Using the Injections = Leakages method:
I+G = S+T
35 + 20 = (ă70 + 0.1Yd ) + (25 + 0.2Y )
55 = ă70+0.1 (Y ă T ) + (25 + 0.2Y )
55 = ă70 + 0.1 (Y ă 25 ă 0.2Y ) + 25 + 0.2Y
100 = ă2.5 + 0.08Y + 0.2Y
102.5 = 0.28Y
102.5/0.28 = Y
Y = 366.07

Change in government expenditure can cause a change in AD and subsequently a
change in the level of equilibrium income.
Let us look at Figure 3.11.
Figure 3.11: The effects of change in government expenditure
In Figure 3.11, B represents the original equilibrium point, where AD = AS and the
income level = Yoriginal.
If there is a change in government expenditure, namely an increase in G, the AD0

curve will move to AD1. A new equilibrium point will emerge in C when AD1
crosses AS at Y 1.

On the other hand, a drop in government expenditure by ăG will cause the AD0
curve to move downwards to AD2. A new equilibrium point is reached at A when
AD2 crosses AS at income level Y 2.

In a three-sector economy, there are two types of multipliers. They are:
(a) Government expenditure multiplier; and
(b) Tax multiplier.
Now let us look further at the two types of multiplier.
(a) Government Expenditure Multiplier

(same as Investment Multiplier)
Government multiplier (KG) = 1/1 ă MPC or 1/MPS
Change in income, Y = KG  G
Using the same example, if the government reduces G from RM600 million
to RM400 million, (G = ă200),
Y = 1/0.25  G
= 4  ă200
= ă800
Therefore, the value of national income at the new equilibrium is:
Ynew = Yoriginal +Y

= 4,800 ă 800
= 4,000
A drop in government expenditure will cause the value of national income

to drop as well.

(b) Tax Multiplier

What about tax multiplier? Here is the formula to calculate the tax multiplier.
Tax multiplier (KT) = ăMPC/1 ă MPC or ăMPC/MPS
Change in income level, Y = KT  T
Using the same example, if the government reduces the tax by RM150 million
(which means a reduction from RM600 to RM450), then the value of KT =
ă0.75/0.25 = ă3 and the change in equilibrium income, Y = ă3  ă150 = 450.
Therefore, the new value of Y = Yoriginal + Y

= 4,800 + 450 = 5,250
The calculation shows that a decrease in tax will increase the national income.
EXERCISE 3.2
1. Elaborate on the two additional concepts as a result of the existence
of the government sector in a three-sector economy.
2. State the equilibrium condition of a three-sector economy using the

injection-leakage approach.
3. If an economy has MPC = 0.6, what is the value of the government

expenditure multiplier?
4. Assume that MPC = 0.4 and the government increases its

expenditure by RM2 million and taxes by RM1 million. What will
happen to the income level at equilibrium?

3.3 FOUR-SECTOR ECONOMY

Now let us move on to the four-sector economy. Did you know that the four-sector
economy is known as an open economy? This is because the nationÊs involvement
with foreign or international economy is also taken into consideration.
International business activities such as imports and exports of goods and services
will influence the economic circular flow of income. This can be seen in Figure 3.12.
Figure 3.12: Circular flow of an open economy
In a four-sector economy, the relationship between the players in the economy,

namely households, firms, government and overseas sector includes activities in
three main markets. They are the goods and services market, labour market and
financial market.

Figure 3.13 shows the players and markets in a four-sector economy or open
economy.
Figure 3.13: Players and markets in an open economy
3.3.1 Import and Export

You would have definitely heard or read about import and export activities in a
countryÊs economy. What do you understand from the terms „import‰ and
„export‰?
Import (M) is the purchase of goods and services produced by a foreign

country. Goods that are imported include consumer products, capital goods
and raw materials.
Export (X) is the sale of goods and services to foreign countries, regardless of
consumer products, capital goods or raw materials.
In the circular flow of national income, export is an injection because it causes

money to flow from outside to the country. On the other hand, import is a leakage
as it involves money flowing out of the country.
Net Export (X ă M ) = Xn
The value of all goods and services produced within the country that are sold
overseas MINUS the value of all goods and services produced overseas that are
purchased by the countryÊs local people.

Import can be categorised into fixed import and proportionate import. Import is
determined exogenously. The discussion in this topic involves the components of
fixed import and proportionate import.
Proportionate import function shows the relationship between import and income
as shown in the following equation:
M = n + mY
Where, M = Import level

n = Autonomous import
m = Marginal propensity to import

In a four-sector economy, the components of AD are made up of consumption,
investment, government expenditure and net export. The equilibrium condition is
written as:
AD  AS Approach
Y  C  I  G  X  M 
where, X = X 0
M = M0
The equilibrium condition can also be written as:

I  G X  S T  M

Let us look at an example of an open economy model.
C = 500 + 0.5Yd
T = 100
G = 100
I = 100
X = 100
M = 50
Using the AD = AS approach,
Yd = C + I + G + X ă M
Yd = 500 + 0.5(Y ă 100) + 100 + 100 + 100 ă 50
Yd = 750 + 0.5Y ă 50
0.5Yd = 700
Yd = 700/0.5
Yd = 1,400
Using the Injections = Leakages approach,
S+T+M = I+G+X
ă500 + 0.5(Y ă 100) + 100 + 50 = 100 + 100 + 100
0.5Y ă 50 = 300 + 500 ă 150
Y = 700/0.5
Y = 1,400
Now let us look at the same economy model but with the proportionate import
function.

An open economy model is given in the following. Calculate the level of output or
national income equilibrium.
C = 500 + 0.5Yd
T = 100
G = 100
I = 100
X = 100
M = 50 + 0.2Y
Using the AD = AS approach,
Yd = C + I + G + X ă M
Yd = 500 + 0.5(Y ă T ) + 100 + 100 + 100 ă (50 ă 0.2Y )
Yd = 750 + 0.5Y ă 50 ă 0.2Y
(1 ă 0.3Yd) = 700
Yd = 700/0.7 = 1,000
Using the Injections = Leakages approach,
S+T+M = I+G+X
ă500 + 0.5(Y ă 100) + 100 + (50 + 0.2Y ) = 100 + 100 + 100
0.7Y ă 50 = 300 + 500 ă 150
Y = 700/0.7 = 1,000
Both the examples clearly show the negative connection between import and the
equilibrium level of national income. This means that any increase in import will
reduce the equilibrium level of national income. On the other hand, a decrease in
import will help to increase the equilibrium level of national income.


A change in the nationÊs exports and imports can cause a change in AD and this
will subsequently change the level of income equilibrium as well.
In Figure 3.14, point B is the original equilibrium level where AD = AS and income
level = Yoriginal. If a positive change happens, meaning the net export is higher
(X > M ), then the AD0 curve will move to AD1. A new equilibrium will be achieved
at point C when AD1 crosses AS at Y 1.
Figure 3.14: The effects of change in net export
On the other hand, if there is a negative change whereby total imports exceed total
exports (X < M ), the AD0 curve will move downwards to AD2. A new equilibrium
will be achieved at point A when AD2 crosses AS at income level Y2.

Besides investment, government expenditure and tax multipliers, there are two
additional multipliers in a four-sector economy, namely the export multiplier and
the import multiplier.
(a) Export Multiplier

Here is the formula for export multiplier:
Export Multiplier (KX) = 1/1 ă MPC or 1/MPS

Change in income level, Y = KX  X
Using the same example, if exports increase by RM100 million, (X = 100),
Y = 1/0.5  X
= 2  100
= 200
Then the national income value at a new equilibrium will be:
Ynew = Yoriginal + 200

= 1,400 + 200
= 1,600
As an injection in the circular flow of national income, an increase in export

value raises the national income value.
(b) Import Multiplier

Here is the formula for import multiplier:
Import Multiplier (KM) = ăMPC/1 ă MPC or ăMPC/MPS
Change in income level, Y = KM  M
Y  = 50  Multiplier
= 50  2
= 100 million 
Therefore, the value of Ynew = Yoriginal + Y

= 1,400 ă 100
= 1,300 million
The calculation shows that an increase in imports will reduce the national
income value.

SELF-CHECK 3.2
Compare the characteristics that differentiate a three-sector economy

from a four-sector economy.
EXERCISE 3.3
1. List down all the players in a four-sector economy and explain the
additional two concepts that exist in this sector compared to a
three-sector economy.
2. What are the national income equilibrium conditions for a four-

sector economy?
3. An increase in the export level will ________the national output

level whereas an increase in the import level will ________ the
national output level.
4. In an open economy, MPC = 0.9 and marginal propensity to import

is 0.3. How much should the total export be increased in order to
increase the output level to 200?
ACTIVITY 3.1
To achieve government objectives, the government will utilise a few

policies. Can you identify them? Share your answer with your
coursemates in myINSPIRE online forum.
3.4 FISCAL POLICY AND ECONOMIC

PROBLEMS
Fiscal policy is a macroeconomic policy tool that can be used to achieve
government objectives or economic goals such as higher employment rates, stable
inflation rates and economic growth.

3.4.1 Fiscal Policy

Fiscal policy consists of two main tools, namely government expenditure and
taxes. The fiscal policy mechanism is made up of automatic fiscal policy and
discretionary fiscal policy (Figure 3.15).
Figure 3.15: Fiscal policy
What do we mean by automatic fiscal policy and discretionary fiscal policy?
Automatic fiscal policy is a stabiliser that operates automatically to slow down

expansion during economic growth as well as to slow down recession during
economic recession.
This policy is much easier to implement but it cannot overcome problems such as
unemployment and inflation. Basically, it depends on a countryÊs tax structure.
What about discretionary fiscal policy?
Discretionary fiscal policy refers to a situation when the government makes

some changes in taxes and government expenditure to overcome economic
problems that cannot be handled through the automatic fiscal policy.
Discretionary fiscal policy is applied on an ad hoc basis, as and when required.

Discretionary fiscal policy is divided into three types as described in Table 3.6.
Table 3.6: Discretionary Fiscal Policy
Type Explanation
Budget deficit policy This is the state of a governmentÊs budget when
government revenue is less than its expenditure. It is
carried out by reducing taxes, increasing government
expenditure, or both, to overcome deflation and
unemployment.
Budget surplus This is the state of a governmentÊs budget when
policy government revenue exceeds its expenditure. It is
carried out through an increase in taxes, decrease in
government expenditure, or both, to overcome inflation.
Balanced budget This is the state of a governmentÊs budget when the
policy government revenue equals its expenditure. It is carried
out when full employment is achieved and it aims to
ensure economic stability and to strengthen the
governmentÊs financial position.
A further explanation of balanced budget policy and balanced budget multiplier

are as follows:
(a) Balanced Budget Policy

When the government implements this type of policy, it would not change
the governmentÊs budget deficit. This is because the increase in government
expenditure would be matched exactly by an increase in tax income.
However, the equal increases in government expenditure and taxes would
have an effect on the income equilibrium. To help you understand better, let
us take a look at the following example:
Let us say that the government increases its spending by RM20 billion. At the
same time, the government finances its spending through an equal increase
in taxes. An increase in government spending has a positive impact on the
aggregate expenditure. Meanwhile an increase in taxes has a negative impact
on the overall spending in the economy. The net effect of an increase in tax
on aggregate expenditure would depend on how households respond to it.
As discussed earlier, the personal income received by households is used for
spending and savings. When disposable income decreases, both household
consumption and savings also reduce. An increase of taxes by RM20 billion
reduces disposable income and consumption. Consumption reduces by
RM20 billion  MPC (assuming that MPC = 0.8) = RM16 billion.

Meanwhile, an increase in government spending by RM20 billion shifts the

aggregate expenditure curve upward by RM20 billion. An increase in tax,
however, reduces the consumption by RM16 billion. The net effect is an
increase in the aggregate expenditure of RM4 billion, after the balanced
budget increase in government spending (G) and taxes (T) and this will
definitely raise the output.
(b) Balanced Budget Multiplier

Since both government spending and taxes increase, there are two types of
multipliers involved. To see the final effect of a simultaneous increase in G
and T, we should add multipliers of both G and T.
Based on our previous example, an increase in G would increase output by

RM100 billion (that is, RM20 billion  5). An increase in taxes would decrease
output by RM80 billion (that is, RM20 billion  ă4) = ăRM80 billion. The net
effect is RM100 billion ă RM80 billion = RM20 billion.
We can clearly see that an increase in output (Y) as a result of an increase in

G and T is exactly the same as the amount of the initial change in G or T
itself, that is,
Y = G or T  KBB (1)
= RM20 billion.
To get a balanced budget multiplier, you can use:
Balanced Budget Multiplier = 1
1 MPC 1  MPC
KB   
MPS MPS MPS
1  MPC
KB  1
1  MPC
The effects of government fiscal policy that can influence economic conditions can
be seen in inflationary and deflationary gaps. Let us find out more about them in
the next subtopic.

3.4.2 Inflationary and Deflationary Gaps

What is an inflationary gap?
Inflationary gap is defined as a situation when the real aggregate demand is

more than the aggregate demand required at full employment.
This situation exists in an economy that has achieved full employment. Since all
the resources have been used at this point, an increase in demand will cause a hike
in the production cost, resulting in an inflation.
Referring to Figure 3.16, at aggregate demand AD, equilibrium is reached at point

E, which is at income level Y. Level Y exceeds the potential income level or YF.
Figure 3.16: Inflationary gap
The difference between A and E1 is the inflationary gap. The problem of

inflationary gap can be overcome by reducing government expenditure or
investment.

What is a Deflationary Gap?

Deflationary gap is the opposite of an inflationary gap. But what does it really
mean?
A deflationary gap is defined as a situation when the real aggregate demand is

less than the aggregate demand required at full employment.
An economy is in a state of deflationary gap when the resources are not fully
utilised and unemployment still exists.
In Figure 3.17, the AD curve is the real demand curve and ADGTP is the curve
for aggregate demand required at full employment. At aggregate demand AD, the
equilibrium level is at E, which is at income level Y. Therefore, this level is less
than the potential national income level or YF.
Figure 3.17: Deflationary gap

3.4.3 Solving Inflationary and Deflationary Gaps

The value of inflationary or deflationary gaps can be measured using the following
formula:
Inflationary or Deflationary Gap = GNP gap/Multiplier

Y F  Y real
=
1/  1  MPC 
Now let us look at some examples on how to use this formula.
(a) Case of Inflationary Gap

If the national income at real equilibrium is RM3,000 million while the
national income at full employment is RM2,000 million and MPC is 0.8, the
inflationary gap can be calculated as follows:
Inflationary Gap = (2,000 ă 3,000)/(1/0.2)

= ă1,000/5
= ă 200 million
Two fiscal policy tools mentioned earlier can be used, namely reducing
government expenditure or increasing taxes.
(i) Reducing Government Expenditure
Therefore, ă1,000 = 1/MPS  G

ă1,000 = 1/0.2  G
G = ă200
This means that government expenditure has to be reduced by RM200

million, which is the same value as the inflationary gap, in order to
close the gap.

(ii) Increasing Taxes
Change in income, Y = KT  T
Therefore, ă1,000 = ăMPC/MPS  T

ă1,000 = ă0.8/0.2  T
T = 250
This means that taxes have to be increased by RM250 million in order

to close the inflationary gap.
(b) Case of Deflationary Gap

Now, if the national income at real equilibrium level is RM1,500 million
while the national income at full employment is RM2,000 million and MPC
is 0.8, the deflationary gap can be calculated as follows:
Deflationary gap = (2,000 ă 1,500)/(1/0.2)

= 500/5
= 100 million
Two fiscal policy tools can be used, namely increasing government

expenditure or reducing taxes.
(i) Increasing Government Expenditure
Therefore, 500 = 1/MPS  G

500 = 1/0.2  G
G = 100
This means that government expenditure has to be increased by

RM20 million, which is the same value as the deflationary gap, in order
to close the gap.

(ii) Reducing Taxes
Change in income, Y = KT  T
Therefore, 500 = ăMPC/MPS  T

500 = ă0.8/0.2  T
T = ă125
This means that taxes have to be reduced by RM125 million to close the
inflationary gap.
By now, I hope you know how to solve the problems of inflationary

and deflationary gaps. The role of the fiscal policy in handling these
problems can be categorised into two, that is, either using government
expenditure tools or using the tax system to achieve economic goals.
SELF-CHECK 3.3
Explain the role of fiscal policy in overcoming the problems of economic

gaps.
EXERCISE 3.4
1. Provide the definition of fiscal policy and state two tools of this
policy.
2. Explain discretionary fiscal policy.
3. Explain inflationary gap and deflationary gap.

 The determinants of the national income equilibrium theory differs in

two-sector economy, three-sector economy and four-sector economy.
 The approaches to determine the national income equilibrium can be

summarised as:
Injections = Leakages
AD = AS Approach
Approach
Two-sector economy Y=C+I I=S
Three-sector economy Y=C+I+G I+G=S+T
Four-sector economy Y=C+I+G+XăM I+G+X=S+T+M
 Fiscal policies that are used to solve inflationary and deflationary gap
problems.
Aggregate demand Households

Balanced budget multiplier Imports
Circular flow Inflationary gap
Consumption Investment
Deflationary gap Multiplier effect
Disposable income National income equilibrium
Exports Overseas sector
Firms Savings
Fiscal policy Taxes
Government expenditure

Topic  Money and
the Banking
4 System
LEARNING OUTCOMES
1. Discuss the functions of money and financial institutions and the
banking system in Malaysia;
2. Describe how the credit creation process works; and
3. Analyse the monetary policy in three economic situations.
 INTRODUCTION
Figure 4.1 summarises the concepts relating to money and the banking system that
will be discussed in this topic.

TOPIC 4 MONEY AND THE BANKING SYSTEM  91
Figure 4.1: Concepts in money and the banking system
The first part of this topic explains the definition and widely accepted features of
money as a mode of exchange, followed by a discussion of the four main functions
of money. Besides that, you will also be introduced to the financial institutions and
the banking system in this country regarding their roles and functions. It includes
an explanation on the credit creation process and the monetary policies practised
by central banks. In this country, Bank Negara Malaysia controls the money supply
in the market.
The second part of this topic focuses on money demand, money supply and market
equilibrium along with their association to interest rates. Are you ready to
continue? Let us start the lesson!
4.1 MONEY AND THE BANKING SYSTEM

„Money‰ is a term that needs no explanation. What thought crosses your mind
when you view the title of this topic? What is the relationship between money and
the banking system? Let us learn the general concepts of money in the following
subtopics.

92  TOPIC 4 MONEY AND THE BANKING SYSTEM
4.1.1 Definition of Money

What can you say about money? How do you define it?
Money can be defined as something that is universally accepted as a mode of

exchange.
For something to be accepted as money, it must have certain qualities or features

that are universally accepted. It has to have a stable value, long lasting and not
easily forged. It must be easy to carry around and it must be possible to be divided
into smaller units.
How about its functions? Let us find the answer in the following subtopic.
4.1.2 Functions of Money

Money has four important functions as shown in Figure 4.2.
Figure 4.2: Functions of money

Let us look in detail at each of the functions.
(a) Medium of Exchange

Money is very important in order to purchase goods and services. With
money, the buying and selling of goods and services become easy since a
price system can be established. Retailers can conduct business with
wholesalers who are selling sugar, rice, flour, canned food, cooking oil
and such with great ease because of the existence of money. Similarly,
with money, consumers can purchase what they need easily from
businesspersons. This situation is completely different from the barter
system because in a barter system, you have to be sure that the other party
wants what you have to offer. For example, if someone has flour and wants
rice, he has to find someone who has rice and wants the flour. This makes it
difficult to do business.
(b) Unit of Account

Money is used as the common benchmark to designate the prices of goods
throughout the economy. A unit of account or measure of value means
money is functioning as the measuring unit for prices. In other words, prices
of goods are stated in terms of the monetary unit. Just like weight is
measured in kilograms and distance in kilometres, we can use Ringgit
Malaysia (RM) to measure the value of goods and services. This makes the
accounting system much simpler. The measurement of goods, services and
wealth can be done using the same measuring unit, which is money.
(c) Store of Value

Since money is an easily exchangeable asset, it is easier to store it for future
use. Thus, economic sectors such as households, firms, governments and
overseas sectors are willing to save and borrow money.
(d) Standard of Deferred Payment

Money is used as a standard benchmark for specifying future payments for
current purchases, that is, buying now and paying later. Similarly, loans from
financial institutions can be quantified with the rate of money.

EXERCISE 4.1
1. What is the definition of money?
2. Explain the four main functions of money.
4.2 FINANCIAL INSTITUTIONS AND THE

BANKING SYSTEM
Do you know that there are four types of financial institutions in Malaysia? The
four types of institutions are shown in Figure 4.3.
Figure 4.3: Types of financial institutions in Malaysia

4.2.1 Banking System

(a) Central Bank
In Malaysia, the central bank is Bank Negara Malaysia (BNM). BNM was
formed on 26 January 1959. BNM belongs to, and is controlled by, the
government of Malaysia. It is a non-profit institution. BNM has six
objectives. They are:
(i) To Issue Currency and Safeguard the Value of the Currency

Only BNM has the right to print money and safeguard the value of the
currency. The Ringgit Malaysia has security features embedded in the
currency note to prevent any attempt to print false currency.
(ii) To Keep Sufficient Reserves to Safeguard the Value of the Currency

In international trade activities, there will be demand for and supply
of Ringgit Malaysia when import and export activities take place.
Therefore, BNM must have sufficient foreign reserves of currencies
from countries that constantly conduct business with Malaysia to
ensure the value of Ringgit Malaysia is stable and does not undergo
much changes compared with other major currencies around the
world.
(iii) To Control and Supervise All Activities of Financial Institutions

The two main policies to control economic activities are monetary
policy and fiscal policy. Monetary policies carried out by BNM aim at
overcoming economic problems such as inflation, unemployment or
recession. In such situations, BNM will control the money flow in the
market.

(iv) To Act as a Banker to Commercial Banks, Merchant Banks, Financial

Institutions and Discount Houses
If the financial institutions have an overflow of deposits, they can
keep them in BNM. Similarly, if the financial institutions are having
difficulties, they can ask BNM for advice or assistance, for instance,
during the financial crisis in 1997.
(v) To Act as a Banker and Financial Adviser to the Government

BNM is responsible for government accounts such as receiving and
making payments on behalf of the government. BNM is also
responsible for selling and buying liquid assets that are produced.
(vi) To Promote Monetary Stability in the Country by Creating a Good

Credit Situation
To ensure that the countryÊs financial situation in is good condition, the
government uses BNM as a control body to set interest rates and other
terms and conditions in borrowing-lending activities.
ACTIVITY 4.1
Visit the official website of Bank Negara Malaysia. Surf the website to
obtain further information about the functions and importance of Bank
Negara at http://www.bnm.gov.my. Share what you found on the
myINSPIRE forum.
(b) Commercial Banks

How do we define a commercial bank?
A commercial bank is a financial institution owned by the private sector,

which provides financial services with the objective of making profits.

The six functions of commercial banks are shown in Figure 4.4.
Figure 4.4: Functions of commercial banks
Commercial banks are also one of the most important and biggest groups of
financial institutions in a country. Examples of commercial banks in Malaysia
include Malayan Banking Berhad, RHB Bank Bhd and Public Bank Bhd.
Banks will use the money deposited in their current, savings and fixed
deposits to provide loans to clients who require financial assistance. The
banks will charge interest at a certain rate based on the conventional or no
interest banking systems. Banks can also be directly involved in investing in
economic projects.

Commercial banks have six functions. They are:
(i) Receiving Deposits or Savings

Commercial banks receive deposits and savings from individuals and
businesses. There are a few types of deposits received by the bank such
as current deposits, savings deposits and fixed deposits. Commercial
banks do not pay interest on current savings but the account holder has
the right to withdraw his savings by using cheques.
What are fixed deposits? Fixed deposits are savings for a specific time
period (a month, three months, six months, a year and so forth). The
account holder may withdraw his money before the specified timeline.
The bank also receives savings deposits, upon which interest is paid
by the bank and which can be withdrawn at any time. However, the
accounts have no chequing facilities.
(ii) Providing Loans

The act of providing loans is one of the commercial bankÊs important
functions. The loans are differentiated based on time, either short-term
or long-term loans. Generally, commercial banks provide loans
through three main methods ă current account, overdraft facility and
discounted bills of exchange.
(iii) Making and Receiving Payments on Behalf of Clients

Current account holders can make payments using cheques. When a
cheque is issued, the bank will pay the cheque holder based on the
amount stated on the cheque. On the other hand, if the account holder
receives a cheque and he deposits it into his account, then the other
issuing bank will make the payment to him. Once the cheque has been
cleared, the bank will credit the total value of the cheque from the other
bank into the clientÊs current account.
(iv) Issuing CashierÊs Cheques and Bank Drafts

Commercial banks can issue cashierÊs cheques and bank drafts to their
clients. CashierÊs cheques are issued by the bank and can be exchanged
for cash.
What is a bank draft? A bank draft is a cheque issued by the bank upon
request from a client. A bank draft instructs the bank or one of its
branches to pay a certain sum of money, as stated on the bank draft, to
a specific person.

(v) Carrying Out Investment Activities

Commercial banks carry out investments in the open market through
asset purchases, resulting in returns in the form of interest, with the aim
of making profits. For example, commercial banks in Malaysia invest
in treasury bills and Malaysian government securities.
(vi) Providing Other Services

Besides all the functions mentioned earlier, commercial banks also
provide other services. Commercial banks can offer advice to clients
who wish to invest. The banks can also provide financial advice for car
loan instalments and insurance premiums.
Commercial banks also act as trustees to administer a clientÊs property.

The banks also act as safe vaults to keep valuable things and important
documents in their safe deposit boxes. In addition to that, commercial
banks provide currency exchange services. The banks will buy the
foreign currency from the client and give them Ringgit Malaysia based
on the fixed exchange rate.
4.2.2 Non-bank Financial Institutions

There are two types of non-bank financial institutions. They are financial firms and
merchant banks. The two types of institutions are described in the following:
(a) Financial Firms

Financial firms began operations in 1960 under Bank Negara MalaysiaÊs
supervision. The types of deposits received by the financial firms are savings
deposits and fixed deposits. As far as credit activities are concerned, financial
firms specialise in providing loans for vehicle hire purchase, mortgages and
loans to purchase houses.
The characteristics of financial firms are almost the same as savings banks.
These firms allow the public to make two types of savings, namely fixed
deposits and savings deposits.
(b) Merchant Banks

Merchant banks do not take money from the public for savings purposes. To
a large extent, savings in this type of bank are obtained from savings made
by commercial banks, financial firms and large public listed companies. The
giving of loans is also focused on large industries. Examples of merchant
banks include Arab-Malaysian Merchant Bank, Public Merchant Bank and
Perwira Affin Merchant Bank.

ACTIVITY 4.2
Can you list three examples of insurance companies in Malaysia?
4.2.3 Non-bank Financial Intermediaries

There are three types of non-bank financial intermediaries. Let us look at each one
of them.
(a) Insurance Companies

This type of non-bank financial intermediary collects money in various
forms. The main form is through life insurance. Other forms are insurances
against theft, fire and accident. Insurance companies guarantee that they will
pay compensation to the affected parties when such incidents happen.
(b) Savings Bank

Savings banks are not allowed to issue cheques. Therefore, the types of
deposit facilities offered by the banks are fixed deposits and savings deposits.
Examples of such banks in Malaysia are Bank Rakyat, Agro Bank (Bank
Pertanian Malaysia) and Bank Simpanan Nasional.
(c) Other Financial Bodies

Besides all the financial bodies discussed earlier, there are also other types of
financial bodies in the economy. However, their roles are not as significant
as those already mentioned. Most of these financial bodies focus on some
specific activity. Examples are EmployeesÊ Provident Fund (Kumpulan
Wang Simpanan Pekerja), Lembaga Urusan Tabung Haji, Permodalan
Nasional Berhad, Koperasi and Syarikat Perumahan Malaysia.
4.2.4 Islamic Banking

Islamic banking refers to a system of banking that complies with Islamic laws, also
known as Shariah laws. The underlying principles that govern Islamic banking are
mutual risk and profit sharing between parties, the assurance of fairness for all and
that transactions are based on an underlying business activity or asset.
These principles are supported by Islamic bankingÊs core values whereby activities
that cultivate entrepreneurship, trade and commerce, and bring societal
development or benefit are encouraged. Activities that involve interest (riba),
gambling (maisir) and speculative trading (gharar) are prohibited.

Through the use of various Islamic financial concepts such as sale-based, equity-
based, leasing-based deposit and financing products, for example, murabahah
(mark-up sale), ijarah (leasing), mudharabah (profit sharing) and musyarakah
(partnership), financial institutions have a great deal of flexibility, creativity and
choice in the creation of Islamic financial products. Furthermore, by emphasising
the need for transactions to be supported by genuine trade or business-related
activities, Islamic banking sets a higher standard for investments and promotes
greater accountability and risk mitigation.
4.2.5 Philosophy, Objectives and Principles of Islamic

Banking
The underlying intentions or objectives of Islamic finance are as follows:
(a) Elimination of riba (literally means increase or addition), that is, usury or
rent on money in all forms and intents;
(b) Prohibition of involvement in haram or non-permissible transactions or

economic activities such as alcohol, non-halal food, pork production, gaming
or number forecasting and prostitution;
(c) Prevention of excessive leveraging;
(d) Strong direct linkages to productive economic activities;
(e) Avoidance of maisir (speculation or gambling) and gharar (preventable

uncertainty or ambiguity) in transactions;
(f) Deterrence of zulm (oppression) and exploitation;
(g) Introduction of safety net mechanisms for the benefit of the poor and the less-
haves through zakat (tithe) or Islamic tax, sadaqah (alms), waqaf (trust) and
qardhasan (benevolent loan);
(h) Upholding universal social, moral and ethical values with emphasis on
maslahah (public interest); and
(i) Achieving Âadalah (justice) and musawah (fairness) in the distribution of
resources.

SELF-CHECK 4.1
After studying the four types of financial institutions, contrast the three
types of financial institutions mentioned with Islamic banking. What are
the obvious differences? Elaborate your answer.
ACTIVITY 4.3
The following website is the website of Bank Islam in Malaysia. Surf

this website to learn more about the functions of Bank Islam.
http://www.bankislam.com.my. Share what you found on the
myINSPIRE forum.
EXERCISE 4.2
1. Explain the function of BNM in controlling and supervising all
financial institutionsÊ activities.
2. List three types of deposits accepted by commercial banks.

Differentiate amongst the three types of deposits.
4.3 CREDIT CREATION PROCESS
ACTIVITY 4.4
Did you know that credit can be created? Explain the credit creation that
is practised by commercial banks.

Credit creation is a unique function of commercial banks. Because commercial

banks can afford to give credit to clients, money supply in the market can be
increased. The way to increase the money supply is by receiving deposits from
clients who have extra money and giving credit to clients who have insufficient
money.
Therefore, credit creation can be explained as a process where a small deposit

results in a larger money supply in the economy.
In order for the credit creation process to take place, we assume the banking
system has to abide by certain rules:
(a) The required reserve rate is fixed by the central bank;
(b) All excess reserve is loaned to bank clients;
(c) All purchase of goods is done by cheque; and
(d) Total reserves are in the form of current deposits.
4.3.1 Credit Creation Process – An Example

Let us assume that:
(a) The required reserve rate (RR) is fixed at 10 per cent of the total deposit (for
all banks);
(b) Excess reserve (ER) is given as loans to clients;
(c) All transactions are made by cheques. There is no leakage in the banking
system;
(d) There are only two forms of assets, namely cash reserves and loans; and
(e) There are many banks in the economic system and each consumer saves his
money in a different bank.

In order to understand the credit creation process, let us look at Example 4.1:
Example 4.1:
Encik Mohd Akib, a businessman, saves RM1,000 in Bank A. When Bank A
receives this money, it will record this sum as an asset in the form of cash
(RM1,000) and liability in the form of deposits (RM1,000). Asset records show
that the money or property belongs to the bank whereas the deposit records
show the bankÊs liability. The bankÊs balance sheet is shown as follows:
Balance Sheet of Bank A

Asset Liability
Cash RM1,000 Deposit RM1,000
Total Reserves = Required Reserves + Excess Reserves
Required reserve = 10% Total reserves

= 10%  RM1,000
= RM100
Excess Reserve = Total Reserves ă Required reserves

= RM1,000 ă (10%  RM1,000)
= RM1,000 ă RM100
= RM900
Let us say that Bank A gives its excess reserve amounting to RM900 as loans to
another businessman, Mohd Arif.
After the loan is given, Bank AÊs balance sheet will be as follows:
Balance Sheet of Bank A

Asset Liability
Reserves 10% RM100 Deposit RM1,000
Loans 90% RM900
Total RM1,000 Total RM1,000

Mohd Arif receives a cheque from Bank A and he can either deposit the cheque
into the same bank or into another bank, or spend it on goods and services. Let us
say that Mohd Arif buys a TV set from a TV vendor (Encik Vellu) for RM900. Encik
Vellu then deposits the money into Bank B. Bank BÊs balance sheet is shown as
follows:
Balance Sheet of Bank B

Asset Liability
Cash RM900 Deposit RM900
Excess reserves = Total reserves ă Required reserves

= RM900 ă (10%  RM900)
= RM900 ă RM90
= RM810
From the total reserves of RM900, the excess reserves amounting to RM810 has
been loaned to Miss Chin by Bank B because the bank has to retain 10% of the total
reserves as cash reserves (RM90). Bank BÊs balance sheet is shown here after the
loan is given:
Balance Sheet of Bank B

Asset Liability
Reserves 10% RM90 Deposit RM900
Loans 90% RM810
Total RM900 Total RM900
After receiving the cheque from Bank B, Miss Chin keeps it in Bank C.
Subsequently the same process takes place, whereby Bank C will give excess
reserve loan totalling 90% of the original deposit. After giving the loan, Bank CÊs
balance sheet will be as follows:
Balance Sheet of Bank C

Asset Liability
Reserves 10% RM81 Deposit RM810
Loans 90% RM729
Total RM810 Total RM810

The process will stop when excess reserves become zero. The entire process is
shown in Table 4.1.
Table 4.1: Credit Creation Process
Required Reserve ă 10% Excess Reserve

Total Reserves
Bank of Total Reserves (ER)
(RM)
(RM) (RM)
A 1,000 100 900
B 900 90 810
C 810 81 729
D 729 72.90 656.10
E 656.10 65.60 590.50
: : : :
: : : :
Total 5,904.90 49.49 5,314.40
Other banks
TOTAL 10,000 1,000 9,000
As shown in Table 4.1, the total credit created by the banking system multiplies,
depending on the percentage of reserves fixed by the central bank. By fixing the
rate of required reserves at 10%, the credit creation increases 10 fold. Therefore,
money supply in the economy has increased. The total increase of money supply
in the whole banking system can be calculated using this formula:
1
Money Supply (total created deposit) =  initial deposit
Reserve rate
1
=  1, 000
10%
= RM10,000

This means that with the rate of required reserve at 10%, the money multiplier has
increased the money supply by 10 fold.
Money multiplier = 1/ Rate of Required Reserves

= 1/10%
= 1/0.1
= 10
Total money created = Money supply ă Initial deposit

= RM10,000 ă RM1,000
= RM9,000
EXERCISE 4.3
If BNM fixes the rate of required reserves at 25% or 0.25 of total deposits:
(a) How much is the deposit multiplier?
(b) How much of money supply can be created with an initial deposit
of RM2,000?
4.4 FINANCIAL OR MONETARY POLICY

You have learnt the definition of this policy in Topic 3. Can you still recall it? Now,
let us learn more about this policy. There are two types of monetary policy, namely
quantitative monetary policy and qualitative monetary policy. Let us look at the
two types in more detail in the next subtopics.

4.4.1 Quantitative Monetary Policy

Quantitative monetary policy involves the application of specific regulations for
banking institutions, which subsequently affects the economy. The quantitative
monetary policy tools are:
 The rate of fixed required reserves;
 Open market operations; and
 Fixed interest rates and repayment periods.
(a) The Rate of Fixed Required Reserves

There is an inverse or negative relationship between the rate of cash required
reserves and total money supply. The higher the rate of cash reserves, the
lower the credit can be created and vice versa.
Look at this example:
Case 1: Case 2:
 The Rate of Cash Required  The Rate of Cash Required
Reserves is 10% Reserves is 20%
 Initial Deposit is RM100  Initial Deposit is RM100
Money supply 1 1
 initial deposit  initial deposit
Reserve rate Reserve rate
1 1
 100  RM1, 000  100  RM500
10% 20%
Total money = RM1,000 ă RM100 = RM500 ă RM100
created = RM900 = RM400
The example shows that when the rate of required reserves is increased from
10 per cent to 20 per cent, credit creation reduces from RM900 to RM400.
(b) Open Market Operations

Besides cash reserves, commercial banks also have to keep liquid assets
issued by Bank Negara Malaysia (BNM) such as treasury bills and
government securities. The more required liquid assets are held, the less
credit can be created. The required minimum amount of liquid assets is fixed
by BNM and this is used as a monetary policy tool to control the economic
stability in Malaysia.

In open market operations, besides selling the liquid assets to commercial

banks, BNM also sells treasury bills and government securities to the public,
firms, EmployeesÊ Provident Fund and Pensions Fund. The money from the
sales can be used by the government to sustain its expenses when its
expenditure exceeds the revenue from taxes collected (G > T ).
(c) Fixed Interest Rates and Re-payment Periods

Consumers look at interest rates as the cost of loans. The higher the interest
rate, the less consumers will borrow. The same applies to loan repayment
periods. Shorter repayment periods deter consumers from taking loans
because they cannot afford to pay a high monthly instalment.
4.4.2 Qualitative Monetary Policy

After discussing quantitative policy, let us now look at qualitative policy.
Qualitative policy aims to control and encourage activities in specific economic
sectors.
(a) Moral Persuasion

This is done by the central bank when meeting with representatives of
commercial banks. During the meeting, the central bank will explain the
economic and financial state of the country and asks the commercial banks
to take certain steps to overcome any financial and economic problems faced.
For example, during an economic downturn, commercial banks will take into
account the borrowerÊs financial state and restructure the borrowerÊs term
loan payments, for example, lengthening the repayment duration.
(b) Monitoring Bank Loan Portfolio Choice

This strategy focuses on the direction of loans given by the commercial
banks. Usually the banking sector is not interested in giving loans to the
agricultural sector, food producers as well as small and medium-sized
industries. Therefore, the central bank can ask commercial banks to allocate
certain funds to be given to these loan seekers.

EXERCISE 4.4
1. A bank manager informs you that his bank does not create money,
instead it only gives loans from the money deposited by the bankÊs
clients. How do you explain to him that, in actual fact, the bank
does create money?
2. The government finds that agro-based industries such as rice and

oil palm production are important for MalaysiaÊs economic growth.
Suggest a financial policy that can be implemented to encourage
the growth of such industries.
4.5 MONEY DEMAND (Md)
ACTIVITY 4.5
Money is needed for our daily existence. But how is the money being
used? What will happen if there is no money system? Discuss.
We know that people demand money for various reasons, for example, when
buying provisions or purchasing a car. According to John Maynard Keynes, a
famous English economist, money demand exists for three main reasons, namely
transaction demands, precautionary motives and speculative demands.
4.5.1 Transaction Demands

In our daily lives, we usually see people buying things that they need, regardless
from the market, supermarket or night market. Since money is a commonly
accepted mode of exchange in transactions, people will have to hold a certain
amount of money to pay for goods and services.
How much money a person holds depends upon the value of the transaction that
is anticipated, the frequency of the transactions and, of course, the personÊs total
income. When the level of income increases, so does the amount of money held for
transaction purposes. On the contrary, when the level of income drops, the amount
of money held for transactions also reduces. Therefore, the quantity of money
demand for transactions is proportional to the income level.

Money demand for transaction purposes is usually considered the main motive
for money demand and it can be planned. Moreover, people will also have to set
aside some money for rainy days, to be used for expenses that cannot be
preplanned. This is known as money demand for precautionary motives.
4.5.2 Precautionary Motives

In life, we often face unforeseen events. These unexpected events usually make it
difficult for us to plan our expenses. An example is when you are retrenched
because the company suffered losses due to the recession. While looking for a new
job, you will probably have to use up your savings for your daily expenditures.
Therefore, you should keep aside a portion of your income or salary for any
unforeseen expenditures.
In conclusion, how much money a person holds as a precautionary measure

depends on his level of income. The higher the income, the more money will be
saved for this purpose. As the money demand for both unforeseen events and
transactions depend on income, the money demand for both these purposes can
be grouped together. In the following discussion, both these components are
referred to as demand for transactions.
4.5.3 Speculative Demand

Did you know that money demand is also made for speculation? This is based
on the motive to earn profits. After setting aside money for transactions and
precautionary measures, people have a choice to hold the remainder of their
money by purchasing other financial assets such as shares and bonds, which will
give them profits in return.
The speculative process takes place when a person buys shares or bonds at a low
price and sells them at a higher price in the future. For this, the bonds have to be
purchased when the interest rate is highest because the price of bonds will be
lowest at that stage. The bonds should then be sold when the interest rate is lowest
because the price of bonds will be highest at this time. There is an inverse
relationship between interest rates and the price of bonds.
Therefore, when the interest rate is low, it is the perfect time to hold money and
not bonds as the return for the bonds is low.

From this explanation, you can draw a curve showing the negative relationship
between speculative money demand and interest rate (see Figure 4.5).
Figure 4.5: Money demand for speculation curve
Based on Figure 4.5, we can see that when the interest rate is low (r 0) the money
demand is M 0. If the interest rate goes up to r 1, then the money demand will
decrease to M 1. Therefore, we can conclude that money demand for speculation
depends on interest rates. When the interest rate is high, people will purchase the
bonds as bonds are cheap at this point in time, and then sell the bonds when the
interest rate is lower, to obtain profits.
Therefore, when the interest rate is high, people hold more bonds and less money.
On the other hand, when the interest rate is low, bonds are more expensive. Thus,
more people will choose to keep their money.
After analysing the three categories of money demand in the economy, we can
come up with the following equation:
Md = Mdt + Mds
where, Md = Total money demand

Mdt = Money demand for transactions
Mds = Money demand for speculations

Therefore, the money demand curve (M d ) in the economy is a combination of the

money demand for transactions curve (M dt) and money demand for speculations
curve (M ds). This is shown in Figure 4.6.
(a) Money demand for (b) Money demand for (c) Money demand curve
transactions curve speculations curve
Figure 4.6: Money demand curves
From Figure 4.6(a), M dt is the money demand for transactions curve. This
curve is more of a straight vertical line, which shows that money demand for
transaction purposes is not influenced by interest rates. On the other hand, M ds is
the money demand for speculations curve and goes downwards from left to right
as shown in Figure 4.6(b). This shows that money demand for speculative
purposes depends on interest rates.
Finally, combining both (a) and (b) curves, the money demand curve Md can be
drawn as in Figure 4.6(c).
EXERCISE 4.5
1. What is meant by money demand for precautionary purposes?
2. What factors influence the money demand for precautionary
purposes?

4.6 MONEY SUPPLY

We have already discussed money demand, but what about money supply? In this
subtopic, we are going to learn about money supply.
Money supply can be categorised into three components. The components are
shown in Figure 4.7.
Figure 4.7: Three components of money supply
Now let us learn about the three components.
4.6.1 Narrow Measure of Money’s Functions

According to economists, the narrow measure of money supply is M1 and it
includes two forms, namely all physical money such as cash and currency, and
demand deposits or current deposits.
(a) Cash and Currency

This includes coins and currencies issued by Bank Negara Malaysia. Coins
are issued in the form of specific metals such as nickel and bronze. In
Malaysia, coins are available in several denominations ă 5 sen, 10 sen, 20 sen
and 50 sen.
(b) Current Deposit

It is a deposit made by an individuals or private companies into commercial
banks, which allow them to withdraw money from their accounts using
cheques.

4.6.2 Broad Measure of Money Supply

The broad measure of money supply is known as M2, which covers M1 and „near
money‰ assets (see Figure 4.8). M2 is closely watched as an indicator of money
supply, future inflation and as a target of monetary policy.
Figure 4.8: Illiquid assets
Near money refers to savings deposits, money market securities, mutual funds and
certificates of deposit are illiquid assets as they cannot be accepted directly in all
transactions. They will have to be converted to cash before they can be used in
transactions.
4.6.3 Broadest Measure of Money Supply

This is referred to as M3, which includes M2 and large time deposits of private
sectors in non-bank institutions such as merchant banks, financial firms, discount
companies and Islamic bank.
Note:
(a) Includes M1 plus private sector savings deposits and fixed deposits in Bank
Negara Malaysia and commercial banks, Bank Negara Malaysia certificates
and certificates of deposit.

(b) Includes cash and currency in circulation and all private sector deposits with
Bank Negara Malaysia, merchant banks and discount companies but not
inclusive of deposits between these financial institutions.
4.7 EQUILIBRIUM IN THE MONEY MARKET

AND INTEREST RATE
When does equilibrium in the money market and interest rate occur? Equilibrium
in the money market and interest rate occurs when the money demand curve and
money supply curve overlaps. Money supply is determined by the central bank.
The money supply curve is a straight vertical line. This shows that the quantity of
money supply is not influenced by the interest rate. However, the money demand
curve is inversely related to the interest rate. Figure 4.9 explains the method in
which equilibrium in the interest rate is determined.
Figure 4.9: Determining the equilibrium in the interest rate
Based on Figure 4.9, M s is the money supply curve and M d is the money demand
curve. When the money supply curve crosses the money demand curve, the
equilibrium level of interest rate in the economy is achieved. We find that r * is the
equilibrium interest rate that makes total money supply equivalent to total money
demand, amounting to M *.

How is the money market maintained so that interest rate stays at equilibrium
level?
To understand this, let us assume that interest rate remains at r 2. At this level,
money supply exceeds money demand. Here, out of the total M * that is supplied,
only M 2 is held by the people. This means there is an excess of money supply,
M * ă M 2. To use up this excess money supply, the public will buy financial assets
such as bonds because bonds can be purchased at a low price when the interest
rate is high (r 2).
Therefore, many people will be tempted to buy bonds when the interest rate is at
r 2. This will increase the demand for bonds and eventually the price of bonds will
increase as well. Since the prices of bonds are inversely related to interest rates, the
interest rate will fall. The interest rate will keep dropping until total money
demand equals total money supplied. Equilibrium of the interest rate at r * will be
achieved.
Now, assume that the interest rate is at r 1, which is a situation when money
demand exceeds money supply. In order to fulfil the increase in money demand,
people will sell their bonds because when the interest rate is low at r 1, the price of
bonds will be higher. Therefore, at this rate (r 1), there exists an excess supply of
bonds which will cause the price of bonds to drop while interest rate to go up. This
interest rate will increase until an equilibrium is formed in the money market,
which means the quantity of money supply equals the quantity of money demand
and the equilibrium of the interest rate is formed at r *.
Therefore, it can be concluded that interest rate equilibrium can be achieved when
money supply equals money demand or when the money supply curve and the
money demand curve overlaps at r *. If there is extra money demand or money
supply, an adjustment will happen until the money demand (M d ) equals money
supply (M s ).

EXERCISE 4.6
1. What is meant by current deposits?
2. What happens to the bond market and interest rate when money
supply exceeds money demand?
3. In Country X, a smart card has replaced the function of currency

and demand for money has reduced. The new smart card has
boosted the economy and the GDP has gone up.
(a) Using a money demand graph, draw a new money demand

curve with the information given.
(b) Assume that the central bank in that country wants to stop
the interest rate from changing. What should be done to the
money supply?
(c) Which monetary policy should the central bank practise (an
expansionary policy or a contractionary policy)? Note that an
expansionary policy increases the total supply of money in
the economy while a contractionary policy decreases the total
money supply.
 Money can be defined as something that is widely accepted by the public as a

medium of exchange. Money fulfils four main functions ă it is used as a
medium of exchange, unit of account, store of value and standard of deferred
payment.
 The central bank in Malaysia is Bank Negara Malaysia. Its functions include:
 Issuing currency and safeguarding the value of the currency;
 Keeping sufficient reserves to safeguard the value of currency;
 Controlling and supervising all activities of financial institutions;

 Acting as a banker to commercial banks, merchant banks, financial

institutions and discount houses;
 Acting as a banker and financial adviser to the government; and
 Promoting monetary stability in the country by creating a good credit

situation.
 Islamic financing comprises of concepts such as sale-based, equity-based,

leasing-based deposit and financing products, for example, murabahah
(mark-up sale), ijarah (leasing), mudharabah (profit sharing) and musyarakah
(partnership).
 There are two monetary policies to control and change the quantity of money
supply in the market, namely quantitative policy and qualitative policy.
 Money demand usually has three main objectives, namely transaction

purposes, precautionary measures and speculative purposes.
 Money supply is divided into three groups ă narrow measure, broad measure
and broadest measure.
 Credit creation is a way to increase the money supply in the market.
 Equilibrium in the money market and interest rate occurs when the money
demand curve and the money supply curve overlaps.
 Commercial banks perform the following functions:
 Receiving deposits or savings;
 Providing loans;
 Making and receiving payments on behalf of clients;
 Issuing cashierÊs cheques and bank drafts;
 Carrying out investment activities; and
 Providing other services.

Banking system Islamic banking

Commercial bank Monetary policy
Credit creation process Money
Current deposits Money demand
Equilibrium Money supply
Fixed deposits Non-bank financial institutions
Functions Savings deposits
Bank Negara Malaysia. (2019). Retrieved from

http://www.bnm.gov.my/index.php?ch=fs_mfs&pg=fs_mfs_bank
Islamic Banking and Finance Institute Malaysia (IBFIM). (2019). Retrieved from
http://www.mifc.com/index.php?ch=ch_contents_directory&pg=pg_dir_
provider&ac=571&sec=04

Topic  Money,
Interest Rate
5 and Income:
Policy Analysis
LEARNING OUTCOMES
1. Discuss the link between the goods market and the money market;
2. Analyse the effects of expansionary and contractionary fiscal policy
on the economy; and
3. Analyse the effects of expansionary and contractionary monetary
policy on the economy.
 INTRODUCTION
In Topic 3, we discussed the goods market in which the equilibrium level of
aggregate output (Y) is determined. For specific levels of planned investment (I),
government spending (G) and taxes (T), one should be able to determine the
equilibrium level of output in the economy. Also in Topic 4, we have discussed the
money market, in which the equilibrium level of interest rate is determined. These
two markets are actually interrelated, whereby events in both markets have
important effects on each other. By examining the two markets together, we can
determine the value of aggregate output (Y) and interest rate (r) that are consistent
with the existence of equilibrium in both markets.

122  TOPIC 5 MONEY, INTEREST RATE AND INCOME: POLICY ANALYSIS
At the same time, the implementation of fiscal policy and monetary policy will
affect both the money market and the goods market, provided that we analyse
both markets simultaneously. Specifically, we will examine how the monetary
policy affects the equilibrium level of output and income. We will also analyse how
the implementation of fiscal policy affects interest rates and investment spending.
5.1 RELATIONSHIP BETWEEN GOODS

MARKET AND MONEY MARKET
In general, there are two important associations between the goods market and the
money market. The first link is between income and the demand for money. How
are they related? In the previous topic, we saw that demand for money depends
on income. When income increases, the demand for money also increases as more
transactions are carried out. With an interest rate that is held constant, an increase
in output level will lead to an increase in money demand. In short, we can say that
income, which is determined in the goods market, will have a significant influence
on the demand for money in the money market. Let us look at the first link in
Figure 5.1.
Figure 5.1: The first link ă between income and the demand for money
How about the second link? The second link is between planned investment and
the interest rate. How are they related? In Topic 3, we assumed that the planned
investment is fixed at a certain level, however, in reality investment is not fixed
but depends on several variables. One of the variables is interest rate. When the
interest rate is high, the planned investment level is low. In short, we can say that
the interest rate, which is determined in the money market, will have a significant
influence on the planned investment in the goods market. This relationship can be
simplified in Figure 5.2.

TOPIC 5 MONEY, INTEREST RATE AND INCOME: POLICY ANALYSIS  123
Figure 5.2: The second link ă between planned investment and the interest rate
Further explanations of the link between the goods market and the money market
is given in the following subtopics. Let us continue!
ACTIVITY 5.1
Compare two links between the goods market and the money market.
5.1.1 Income, Demand for Money and Interest Rate

In Topic 4, we saw that the money demand depends on the level of income in
the economy. More income means more transactions and, therefore, leads to a
higher demand for money. The equilibrium level of interest rate is given by the
intersection between money supply and money demand as shown in Figure 5.3.
(a) (b)
Figure 5.3: Money market equilibrium
Note: y-axis is quantity of money, Figure 5.3(b) at the intersection Md 0 with Ms is

E 1 and Md 1 with Ms is E 2.

Figure 5.3 shows how the money market achieves equilibrium. It shows the
relationship between interest rate and quantity of money. For Figure 5.3(a), at
point E 1, the money market is in equilibrium, where Md = Ms at r = 5%. When
there is an increase in aggregate output (Y), the demand for money will increase.
The money demand curve shifts to the right as shown in Figure 5.3(b). At an
interest rate of 5%, there is an excess demand for money and the interest rate will
rise from 5% to 8%.
Obviously, we can see that the equilibrium level of interest rate is not determined
solely in the money market but also in the goods market. An increase in aggregate
output (Y) shifts the money demand curve and, therefore, leads to a change in the
interest rate.
In short we can say that:
5.1.2 Investment, Interest Rate and Income

Did you know that the relationship between interest rate and planned investment
can be negative? This happens when the interest rate falls and this leads to a rise
in planned investment, and vice versa. Why is this so? Before firms undertake
certain projects, they will compare the cost and the expected profit of the project.
If the expected profit is greater than the cost, firms will undertake the project. The
money needed to carry out the project is usually borrowed and will be paid after
a certain period of time. The cost of borrowing, which is reflected by the interest
rate, is part of the real cost of an investment project. If the interest rate increases,
this means that the cost of borrowing is higher; thus, fewer projects will be
undertaken. Conversely, if the interest rate falls, the cost of borrowing is lower
and more investment projects will be undertaken. This relationship is shown in
Figure 5.4.

(a) (b)
Figure 5.4: Relationship between investment and income
As can be seen in Figure 5.4(a), the relationship between the interest rate and
planned investment is a downward-sloping curve. The higher the interest rate,
the lower the level of planned investment. At an interest rate of 5%, planned
investment is I 0. When the interest rate falls from 5% to 2%, planned investment
increases from I 0 to I 1. When the interest rate increases from 5% to 8%, planned
investment falls from I 0 to I 2.
From here we can see how planned investment, which depends on the interest
rate, affects planned aggregate spending (which is the sum of consumption,
planned investment and government spending). As mentioned earlier, when the
interest rate changes, planned investment also changes and, therefore, leads to a
change in aggregate planned expenditure.
A drop in interest rate from 5% to 2% leads to an increase in investment from I 0 to

I 1. A change in investment from I 0 to I 1 will affect aggregate expenditure, as
shown by an upward shift in the AE curve. Output also will increase from Y 0 to
Y 1, that is, an increase of I  investment multiplier (1/(1 ă MPC).
In short we can say that:

Obviously, we can see that the equilibrium level of output (Y) is not determined
solely by events in the goods market but also in the money market. Changes in the
money market affect the interest rate level, which in turn affects planned
investment in the goods market.
SELF-CHECK 5.1
After discussing the relationship between the goods market and the
money market, what do you think will be the effect of increasing
investment spending?
5.2 GOODS MARKET AND MONEY MARKET

Once we fully understand the links between the goods market and the money
market, we can proceed to analyse the two markets simultaneously. To see
how the two markets interact, we will examine the effects of changes in fiscal
and monetary policies in the economy. Specifically, the determination of the
equilibrium levels of aggregate output (Y) and the interest rate (r) when variables
such as government spending (G), taxes (T) and money supply (Ms) changes, that
is, by increasing or decreasing.
Firstly, we will discuss fiscal policy and see what will happen when the
government implements expansionary fiscal policy and contractionary fiscal
policy.
Secondly, we will discuss monetary policy and analyse the impact on the
economy when the government implements expansionary monetary policy and
contractionary monetary policy.
5.2.1 Fiscal Policy Analysis

In this subtopic, we will analyse how the economy is affected by fiscal policy,
which involves changes in government spending (G) or changes in taxes (T). This
action aims to influence aggregate output (Y).

(a) Expansionary Fiscal Policy: An Increase in G or a Decrease in T

Firstly, let us look at the meaning of expansionary fiscal policy.
Expansionary fiscal policy is an increase in government spending (G) or

a decrease in taxes (T) or both aimed at increasing the aggregate output
(Y).
As mentioned before, there are two tools of government fiscal policy.

The government can stimulate the economy and increase aggregate output
(Y) either by increasing government spending or by reducing taxes.
Nevertheless, the impact of a tax cut is smaller than the impact of an increase
in government spending.
As you may recall from Topic 4, the multiplier effect for the government
spending is 1/(1 ă MPC) while the multiplier effect for tax is MPC/(1 ă MPC).
To help us see it more clearly, let us say there is an increase in government
spending (G) of RM20 million. An increase in government spending
causes firmsÊ inventories to be less than the planned investment. When this
happens, production and output increase. An increase in output means that
income will also increase and this results in an increase in consumption
spending and savings. Once again, inventories will be smaller than planned
and output will definitely increase even more. At the end, the equilibrium
level of output will be higher and it is a multiple effect of the initial increase
in government spending or ΔG  1/(1 ă MPC).
In Topic 4, the planned investment (I) is assumed as fixed. However, planned

investment actually depends on the interest rate. As government spending
increases, output or income (Y) will increase and this will have an impact on
the demand for money (Md) and, thus, the money market. Assuming that the
central bank does not increase the money supply, the money market will be
in disequilibrium as Md > Ms and this causes the interest rate to increase.
Thus, the initial increase in government spending will lead to an increase in
aggregate output (Y) and interest rate (r) as shown:
At the same time, an increase in interest rate (r) will create a side effect
where a higher interest rate will cause planned investment (I) to decrease.
An increase in government spending (G) increases planned aggregate
expenditure (C + I + G) and this leads to an increase in aggregate output (Y).

However, a decrease in planned investment due to a higher interest rate (r)

reduces planned aggregate expenditure and decreases aggregate output (Y).
The reduction in private investment spending as a result of an increase in
government spending (G) is known as the „crowding out effect‰. If the
money supply is held constant, a rise in income, and therefore in money
demand, will lead to a reduction in planned investment (I) spending as the
interest rate (r) increases.
What does crowding out effect mean?
Crowding out effect is a reduction in private investment that occurs

because of an increase in government spending.
The crowding out effect can be seen in Figure 5.5. An increase in government
spending from G 0 to G 1 shifts the planned aggregate expenditure upward
from (C + I + G 0) to (C + I + G 1). The new equilibrium point is at E 1,
and income increases from Y 0 to Y 1. This causes the money demand to
increase and the money market will be in disequilibrium, as can be seen in
Figure 5.5(a). The increase in money demand raises the interest rate (r) from
r 0 to r 1 and investment will decrease from I 0 to I 1. With lower investment,
the new planned aggregate expenditure shifts downward and the
equilibrium level of income will be at point E 2 ă Y 2.
(a) (b)
Figure 5.5: Crowding out effect
However, the crowding out effect depends on the sensitivity of the planned
investment spending to the changes in the interest rate, as can be seen in
Figure 5.6. If the planned investment is sensitive to changes in the interest
rate, the crowding out effect will be larger. On the other hand, if it is not
sensitive at all, there will be no crowding out effect.

(a) (b)
Figure 5.6: Crowding out effects depends on the sensitivity of the
planned investment spending
The effects of an expansionary fiscal policy can be summarised as follows:
EXERCISE 5.1
1. Discuss how the crowding out effect occurs.
2. Explain how the sensitivity of the planned investment spending to

changes in interest rate influences the crowding out effect.
(b) Contractionary Fiscal Policy: A Decrease in G or an Increase in T

The government can use this policy to reduce inflation in the economy.
The government can use contractionary fiscal policy by reducing

government spending (G) or increasing taxes (T). Both are used to decrease
aggregate output (Y).
What is meant by contractionary fiscal policy?
Contractionary fiscal policy is a decrease in government spending (G)

or an increase in taxes (T) or both aimed at decreasing aggregate output
(Y).

If we take into account the money market, a decrease in government

spending (G) or an increase in taxes (T) leads to a decrease in aggregate
output (Y), a decrease in the money demand (Md) and subsequently, a
decrease in the interest rate (r). When this happens, the reduction in
aggregate output (Y) will be less since a decrease in the interest rate (r) will
cause the planned investment (I) to increase. Increasing planned investment
offsets some of the decrease in planned aggregate expenditure brought about
by the decrease in government spending (G).
The effects of a contractionary fiscal policy can be summarised as follows:
5.2.2 Monetary Policy Analysis

In this subtopic, we will look at how the economy is affected by monetary policy,
which involve changes in the money supply. This action aims to influence
aggregate output (Y). The government can use either expansionary monetary
policy or contractionary monetary policy to influence the economy.
(a) Expansionary Monetary Policy: An Increase in Money Supply

The government can use an expansionary monetary policy to stimulate
economy through an increase in money supply. As mentioned in Topic 4, this
can be done through several ways. Let us say the government decides to do
this through open market operations. By doing so, the money supply
increases and the money supply curve shifts to the right. As the quantity of
money is now greater than what people want to hold, the interest rate falls.
Consequently, planned investment spending increases and this will lead to
an increase in planned aggregate expenditure. An increase in the money
supply will cause the interest rate to fall and output (Y) to increase. At a
higher level of income, the demand for money increases. This means that the
interest rate will not fall as far as it otherwise would.
Expansionary monetary policy is an increase in money supply (Ms)

aimed to increasing the aggregate output (Y).

The effects of an expansionary monetary policy can be summarised as

follows:
However, the effectiveness of the monetary policy depends on the sensitivity

of the investment spending to changes in the interest rate. If investment is
sensitive to changes in interest rate, for example, a fall in interest rate, which
induces firms to invest more, then the expansionary monetary policy will
be effective in stimulating the economy. Conversely, if investment is not
sensitive to changes in interest rate, an expansionary monetary policy will
not be very effective. The effectiveness of the monetary policy depends on
the shape of the investment function as shown in the previous Figure 5.6.
ACTIVITY 5.2
The government can use monetary policy to influence the economy.

Explain how interest rate sensitivity of investment demand can affect the
effectiveness of the policy. Discuss on the online forum.
(b) Contractionary Monetary Policy: A Decrease in Money Supply

Firstly, let us look at its definition.
Contractionary monetary policy is a decrease in the money supply (Ms)

aimed at decreasing aggregate output (Y).
The government can use a contractionary monetary policy by reducing the

money supply (Ms) in order to decrease aggregate output (Y). When the
money supply increases, interest rate falls. Planned investment spending is
negatively related to the interest rate. With a higher interest rate, planned
investment is less and, therefore, the aggregate expenditure also is lower,
which leads to a lower equilibrium level of output (Y). Since the level of
output (Y) is lower, demand for money will also be lower.

The effects of a contractionary monetary policy can be summarised as

follows:
5.3 MIXED FISCAL AND MONETARY POLICIES

In the previous subtopics, we have looked at the effects of both policies, fiscal and
monetary, separately. However, the government can use these two policies
simultaneously. For instance, the government can use expansionary fiscal policy
(that is, by increasing government spending (G)) with expansionary monetary
policy (that is, by increasing the money supply). Increasing government spending
(G) alone will increase both aggregate output (Y) and the interest rate (r) while
increasing the money supply alone will increase the aggregate output (Y) but will
decrease the interest rate (r). Thus, if the objective of the government is to increase
the aggregate output (Y) but keep the interest rate (r) constant, it can achieve this
objective by increasing both government spending (G) and the money supply (Ms)
by a certain amount.
In other words,
Policy mix is the combination of fiscal and monetary policies in use at a given
time to achieve certain objectives, that is, to increase the output (Y) while
keeping the interest rate (r) constant.
ACTIVITY 5.3
The implementation of a mixed policy consisting of fiscal and monetary

policies can be used by the government to avoid the crowding out effect.
Discuss this matter in a group and post your answer in myINSPIRE
online forum.

 The goods market and the money market operate interdependently. Any
events in the goods market will affect the money market and vice versa.
 There are two important links between the goods market and the money
market:
ă the level of income (Y), which is determined in the goods market, will
determine the volume of transactions during each period and, therefore,
affects the money demand (Md) in the money market; and
ă the interest rate, which is determined in the money market, affects the level
of planned investment in the goods market.
 Planned investment and the interest rate are negatively related as interest rate
determines the cost of investment projects.
 With different interest rate values, planned investment spending and

equilibrium level of output are also different.
 The use of fiscal and monetary policies can be summarised as follows:
Policy G T Ms
Expansionary Fiscal Policy Ę ę
Contractionary Fiscal Policy ę Ę
Expansionary Monetary Policy Ę
Contractionary Monetary Policy ę
 Policy mix is the implementation of both fiscal and monetary policies

simultaneously to achieve certain objectives, that is, to increase output (Y)
while keeping the interest rate (r) constant.

Contractionary fiscal policy Goods market

Contractionary monetary policy Income
Crowding out effect Interest rate
Demand for money Investment
Expansionary fiscal policy Money market
Expansionary monetary policy Policy mix

Topic  Aggregate
Demand and
6 Aggregate
Supply
LEARNING OUTCOMES
1. Explain the meaning of aggregate demand and aggregate supply;
2. Describe the factors that cause the aggregate demand and aggregate
supply;
3. Describe the determinants of aggregate demand and aggregate
supply;
4. Summarise how the level of production and price equilibrium are
determined; and
5. Summarise the formation of long-term aggregate supply curve.
 INTRODUCTION
In earlier topics, you were introduced to supply and demand. Knowledge about
factors that affect or influence money demand and money supply is important so
that you can understand their effects on interest rate, investment and national
income. This topic will explain the concept of aggregate demand (AD) and
aggregate supply (AS) and the related issues. Let us look at Figure 6.1 for a
summary of what we will learn in this topic.

136  TOPIC 6 AGGREGATE DEMAND AND AGGREGATE SUPPLY
Figure 6.1: Summary of aggregate demand and supply
6.1 AGGREGATE DEMAND

What do you understand about aggregate demand?
Aggregate demand is the total demand for goods and services in the economy
during a specific time period.

TOPIC 6 AGGREGATE DEMAND AND AGGREGATE SUPPLY  137
Usually, aggregate demand is shown using a curve or table that shows the various
types of goods and services (real production) that are collectively purchased by
consumers at a certain price level.
An aggregate demand curve (AD) that slopes downwards shows a negative

relationship between price and production level, assuming that all other factors
remain the same (unchanged). When prices are low, demand for production is
high. Vice versa, when prices are high, demand for production is low.
Although both the aggregate demand curve (AD) and aggregate market curve
look the same, the factors that cause the curves to slope downwards are different.
The market demand curve slopes negatively because of the substitution effect and
income effect. The factors that cause the aggregate demand curve to slope
negatively are shown in Figure 6.2.
Figure 6.2: Three factors underlying the negative slope of the AD curve
Now, let us look at the important explanation on the factors that make the
aggregate demand curve slope negatively.
(a) Real-balance Effect

Consumer expenditure or consumption depends on how much money
consumers have. It is a positive relationship. The more money you have, the
more you spend.
Having money also refers to wealth and the amount of bonds, shares,
houses or physical assets one possesses. The amount of wealth owned
depends on the price level.

However, there is a negative relationship between price level and consumer

wealth. If price level increases, the real purchasing power reduces since the
same amount of money cannot buy as many goods and services as before.
On the contrary, if price drops, then purchasing power increases.
Let us look at the following example:
Example 6.1:
If Ahmad has RM5,000 and the price level has increased by 10 per cent,
then the value of AhmadÊs money has decreased by 10 per cent because
the price of the goods he wishes to buy has gone up by 10 per cent.
Therefore, an increase in price causes the purchasing power to drop. This
will indirectly reduce consumption and production. Thus, the real-
balance effect brings about a negative relationship between price and
production. However, if the increase in general pricing is the same as the
increase in share prices or properties prices, that means the real value of
the shares and properties have not changed.
(b) Interest Rate Effect

Changes in interest rates can have a big impact on consumption and
investment expenditure. Interest rate tends to increase and decrease as the
price level increases and decreases. This means that a higher price level
induces a higher interest rate, which raises the cost of borrowing and
discourages investment and consumption or spending. A lower price level
has the opposite effect. Assuming that money supply remains the same,
when the price level increases money demand also increases, and when that
happens, interest rate also goes up.
For example, in Figure 6.3, when the price goes up, money demand will move
up from M d0 to M d1. Assuming money supply M s is fixed, the interest rate
will increase from r 0 to r 1.

Figure 6.3: Changes in interest rates
The change in interest rate will affect the consumption by households and
firms. For example, say the interest rate is 15 per cent per annum. At the same
time, the rate of returns that firms obtain from capital purchase is 20 per cent.
This definitely allows firms to reap some profits because the investment
returns exceed the interest rates. This will encourage firms to increase
investment. If the reverse were to happen, with the interest rate at 15 per cent
and the rate of returns only at 10 per cent, firms will reduce their investments.
This decision will induce them reduce their production too.
When the interest rate is high, households will delay consumption or

purchases. Households perceive an increase in interest rate as an indication
of an increase in expenses and costs. For instance, consumers may delay
purchasing a house because of the high interest rate and vice versa.
In conclusion, increases in price will push money demand upward and

eventually cause a hike in interest rate (assuming money supply remains the
same).

(c) Net-export Effect

The total export and import in an economy depends on domestic and foreign
prices. If Malaysian goods are expensive, Malaysia will import more from
overseas. This will reduce the value of net exports. Generally, the relative
increase in domestic price level will reduce exports and the aggregate
demand on production. On the other hand, the relative decrease in domestic
price level will increase exports and aggregate demand for production.
From the explanation, it can be concluded that the aggregate demand curve (AD)
is not a combination of individual demand curves. The AD curve has a negative
slope because of the real-balance effect, interest rate effect and net-export effect.
6.1.1 Constructing the Aggregate Demand Curve (AD)

How do we construct the aggregate demand curve (AD)? The AD curve can be
constructed from the aggregate expenditure model. The aggregate expenditure
components can be seen in Figure 6.4. Aggregate demand (AD) is the total demand
for goods and services in the economy.
Figure 6.4: Aggregate expenditure components
At every point along the AD curve, the demanded quantity is the same as the
aggregate expenditure [C + I + G + (X ă M )].
In the analysis on how to draw the AD curve, we have to assume that the fiscal
policy and monetary policy are fixed.

In Figure 6.5, (a) shows the money market, (b) shows the investment curve that
reflects the negative relationship between interest rates and investment levels,
(c) is the aggregate expenditure model or market for goods and (d) is the aggregate
demand curve that shows the inverse relationship between prices and quantity of
production demanded.
Figure 6.5: Constructing the aggregate demand curve (AD)
We assume the original equilibrium is at E 0, which is at price P 0 and production

Y 0, interest rate r 0, quantity of money M 0, investment level I 0 and aggregate
expenditure AE0. The change in price will influence the real value of wealth, the
interest rate and net exports. If the price level goes up, the real value of wealth and
net exports will reduce but the interest rate will increase and vice versa. If the price
level moves up to P 1, the quantity of money demand will increase as more money
will be needed for expenditure.
Therefore, the M d0 curve will shift to M d1, creating an increase in money demand,
assuming that money supply is fixed. In order to achieve equilibrium in the money
market, the interest rate increases to r 1. The subsequent increase in interest rate
will bring down investments to I 1. The same goes for consumption and net
exports. This situation is shown by the shift AE0 to AE1 (P 1) and the decrease in
production level to Y 1 (Figure 6.5(c)).

If the price level goes down to P 2, the opposite will happen. The production
level will go up to Y 2 at the equilibrium point E 2 as shown in Figure 6.5(c). In
Figure 6.5(d), if the points a, b and c are joined, a negatively-sloped AD curve
can be seen, which shows an inverse relationship between price and production
level (Y).
We can summarise that an increase in price level will cause the AE curve to shift
downwards and a reduction in production Y. On the contrary, a decrease in price
will cause AE to shift upwards and an increase in production Y.
6.1.2 Aggregate Demand Determinants

The AD curve shows a negative relationship between price and income.
Therefore, any changes in price will cause a change in aggregate demand, which
is a change in the aggregate demand production quantity. This change happens all
along the AD curve, assuming that all other factors are fixed (ceteris paribus). In
reality, besides price, there are several other factors that can influence aggregate
demand (AD). The factors work through four aggregate expenditure categories ă
consumption (C), investment (I), government purchases (G) and net exports
(X ă M ).
(a) Consumption Expenditure (C)

Consumption expenditure is usually related to households. Among the
factors that influence consumption and cause the AD curve to shift either to
the left or right, are:
(i) Consumer wealth;
(ii) Consumer expectations;
(iii) Household debts; and
(iv) Taxes.
Let us now look at each of these factors in detail.
(i) Consumer Wealth

This includes financial assets (stocks, bonds and shares) and physical
assets (houses and land). A decrease in the real value of assets will
encourage more people to save and spend less in order to improve their
economic situation. As a result, they will reduce their expenses and the
AD curve will move to the left. If the reverse happens, the AD curve
will shift to the right.

Reminder: This concept differs from the concepts in wealth and real-
balance because here, the AD curve changes when there is a change
in price.
The change in real wealth does not depend on a price change but on
non-price factors that cause the shifts in the AD curve. For example,
reduction in price or in the real value of a house will decrease the
consumerÊs economic condition although the price level does not
increase.
(ii) Consumer Expectations

Consumer expectations focus on real income. Expectations of future
economic conditions are an important determinant. If households
expect real income to increase in the future, then they are inclined to
buy more today, causing consumption expenditure and aggregate
demand to increase and shifting the AD curve to the right. If real
income is expected to fall, consumers will avoid spending. This will
shift the AD curve to the left.
(iii) Household Debts

Consumers with hefty debts will reduce their expenses because their
income or money will be used to settle their debts. Therefore, consumer
expenditure will decrease. This drop is demonstrated by the shifting of
the AD curve to the left.
(iv) Taxes
Income tax is a leakage in consumer income. The hike in the income tax
rate will reduce peopleÊs disposable income. This phenomenon will
cause a drop in expenditure and the AD curve will move to the left.
(b) Investment Expenditure

Investment expenditure is usually incurred by firms. The change in
purchasing capital goods and other investments will cause the AD curve to
move either to the left or to the right.
The change in investment can be caused by:
(i) Interest rate;
(ii) Expected returns from investment projects;
(iii) Business tax;

(iv) Level of excess capacity; and
(v) Technology.
Let us look at each of these factors in Table 6.1.
Table 6.1: Factors that Cause a Change in Investment Expenditure
Factor Explanation
Interest rate An increase in the interest rate due to reasons other than
pricing will cause the AD curve to shift. For instance, a hike
in money supply will cause the interest rate to drop. This
phenomenon will create an increase in investment. Therefore,
the AD curve will move to the right while the reverse situation
will cause it to move to the left.
Expected returns High returns from an investment project means profits to
from investment firms. If the expected returns are high, then firms will increase
projects the investment by buying capital goods. This will increase the
firmsÊ expenditure and the AD curve to shift to the right. The
reverse situation will cause the curve move to the left.
Business tax Business tax is a leakage to firms. The high rate of business tax
will reduce profit after tax. This factor will eventually decrease
the incentives for firms to increase investment. Therefore,
reducing the firmÊs expenditure and the AD curve will move
to the left, and vice versa.
Level of excess This refers to excess production resources that are not used.
capacity Higher excess capacity will slow down the demand for new
capital goods and reduce the aggregate demand as shown by
the shift of the AD curve to the left. If the firm collectively finds
that capacity level is low, it will increase its purchase of capital
goods and build new premises. This will increase the firmÊs
expenditure and the AD curve will move to the right.
Technology The discovery of new technology will increase investment
expenditure and hike up the aggregate expenditure (AD curve
will move to the right). For instance, with the discovery of new
technology in the automobile industry, more money will be
invested in this industry. This phenomenon will cause the AD
curve to move to the right.

(c) Government Purchases (G)

In order to explain government purchases, let us take the example of
government providing infrastructure facilities. If the government increases
its expenses in providing infrastructure through an expansionary fiscal
policy, the AD curve will shift to the right. Instead, if the government
practises a contractionary fiscal policy, then the AD curve will move to the
left.
(d) Net Exports (X ă M )

The change in exports that causes the movements of the AD curve is
influenced by factors other than price. Let us refer to Table 6.2 for more
details.
Table 6.2: Factors Other than Price that Cause Changes in Exports
Factors Explanation
Foreign income When the income of foreigners are high, their demand for
domestic or foreign goods will be relatively high too. The
increase in demand for foreign goods will increase the exports
of the exporter country (assuming that exporter country
imports less). The increase in net exports is shown in the shift
of the AD curve to the right. If the incomes in foreign
countries are low, net exports will decrease and the AD curve
will move to the left.
Foreign currency Changes in foreign currency exchange rates also influence
exchange net exports and aggregate demand (AD). Let us use the
exchange rate between Ringgit Malaysia and American Dollar
(exchange rate, E = RM/Dollar) as an example. If the value of
the Ringgit deteriorates, the rate of exchange will increase.
Americans can get more Ringgit for each Dollar whereas
Malaysians will get lesser amount of Dollar. The deterioration
in the value of the Ringgit will make Malaysian goods appear
relatively cheaper compared to American goods. Therefore,
MalaysiaÊs net exports will increase (assuming that our
imports are less than our exports). This phenomenon will
move the AD curve to the right. The reverse situation will
make the curve move the other way.

Based on the explanation in Table 6.2, the movement of the AD curve is

shown in Figure 6.6. The original AD curve is at AD0. The shift to the right is
from AD0 to AD1. The shift to the left is from AD0 to AD2.
Figure 6.6: Movements of the AD curve
From this discussion, we can now conclude that the price factor will cause changes
along the aggregate demand curve (AD), which means changes in the production
quantity demanded. Subsequently, factors other than price, namely aggregate
expenditure components such as consumption (C), investment (I), government
purchases or expenditure (G) and net exports (X ă M) will cause the AD curve to
shift either to the left or right.
6.1.3 Movement of Aggregate Demand Curve and

Aggregate Expenditure Model
Try to recall the aggregate expenditure components that we discussed earlier.
Aggregate expenditure includes consumption (C), investment (I), government
purchases (G) and net exports (X ă M ). If a change happens in one of these
components, the AD curve will shift, assuming that the price level is fixed.
From Figure 6.7, we assume the original equilibrium is at AE0, which produces real
production (Y) at Y 0, and the AD curve is AD0. If investors are optimistic and
expect profits to increase in the future, the investment level will increase as well.
This is shown by the movement of the curve AE0 to AE1, with the price fixed at P 0
and the new production level is achieved at Y 1. In line with this, the AD curve also
moves to the right to AD1.

Figure 6.7: The movement of AD curve and AE model
The actual increase in investment is shown by the AD curve shifting from AD0 to
the dotted line. However, the multiplier process has caused AD to move to AD1
and production to increase from Y 0 to Y 1. Therefore, the rise in investment will
shift the AD curve to the right. The distance between AD0 and AD1 is the increase
in investment (I) times the multiplier value k (I  k). Therefore, the movement of
AE and AD is towards the same direction, or simply,
The distance of AD0 to AD1 = I  k
whereby k is the multiplier.

Besides the mentioned factors, any change in the supply of money (Ms) also causes
the aggregate demand (AD) to shift either to the right or to the left from AD0 to
AD1 or AD2 as in the previous Figure 6.7.
For example, if there is an increase in the money supply and the price level is
constant, the interest rate will fall and this induces planned investment.
Subsequently, planned aggregate expenditure will also increase. The AD curve
then shifts from AD0 to AD1.
6.2 AGGREGATE SUPPLY (AS)

Prior to this, you have been introduced to the concept of demand. Now, let us look
at the definition of aggregate supply.
Aggregate supply means the total of real production of final goods and
services available in the economy.
This definition is an analogy to the definition of an individualÊs supply of goods

and services. The AS curve slopes positively, showing the positive relationship
between price and production quantity supplied, assuming ceteris paribus.
The AS curve is reflected in a table or curve that shows the real production level
(Y) that is produced and supplied by the firms at various price levels while other
factors remain fixed (ceteris paribus). However, the AS curve is not a combination
of individual supply curves in the economy.

6.2.1 Constructing the Aggregate Supply (AS) Curve

How do we construct the aggregate supply (AS) curve? The aggregate supply
curve can be constructed by looking at the labour market and the production
function curve. Let us look at Figure 6.8.
Figure 6.8: Constructing the aggregate supply curve (AS)
Figure 6.8(a) shows the nominal wage curve with the price level on the vertical
axis while Figure 6.8(b) shows the labour market with labour demand and labour
supply curves; Figure 6.8(c) shows the production function curve and Figure 6.8(d)
shows the aggregate supply curve.

We assume the original equilibrium is at E 0, which is at P 0 and Y 0, and the

employment level is L0 and real wage is W 0/P 0. The change in price will influence
the real wage rate, level of employment, and therefore, the output level, Y. Now
let us say that the price level decreases to P 1 and the real wage rate is at (W 0/P 1),
meaning that the real wage is now higher than before. Supply of labour will be
greater than demand for labour. We assume that nominal wage is rigid downward,
therefore, unemployment occurs when S L > D L. Total unemployment will be L1L2.
At L1, the total output that will be produced is Y 1. Therefore at P 1, the total
number of workers that will be employed is L1.
When the price level is at P 2, the real wage rate is at (W 0/P 2), which is lower than
before. Therefore, demand for labour will be higher. With the assumption that
nominal wage is rigid downwards and not upwards, nominal wage will increase
until (W 0/P 2) = (W 0/P 0). The number of workers that will be employed is L0
and output that will be produced is Y 0. Therefore, at P = P 1, Y is at Y 1 and when
P = P 2, Y is at Y 0. When we join all the points, we will obtain the aggregate supply
curve.
However, the aggregate supply curve will have a different shape depending
on the assumptions made, for example, the classical case or Keynesian case as
described in the following subtopics.
6.2.2 Short-run Aggregate Supply

Aggregate supply curve (AS) can be divided into three parts, namely:
(a) Horizontal (Keynesian);
(b) Upward sloping; and
(c) Vertical (classical).

Figure 6.9 shows the three parts of the AS curve. How can this situation exist?
Figure 6.9: Short-run aggregate supply curve
(a) Horizontal Section (Keynesian)

This part shows that the economy is suffering from a recession. Faced with
falling economic activity, resource employment and real production tend to
fall. When there is an increase in production, there is no increase in price.
This situation relates to Keynes analysis during the recession that took place
in the 1930s. In line with that, this section of the AS curve is named the
Keynesian section. Increase in production will not cause the price level to rise
because unused resources (labour and raw materials) will be used to increase
production. Consequently, the overall average cost is constant. Therefore,
there is no reason for the price to go up as there is no increase in the average
cost of production.
This level also shows the position when the production quantity is reduced.
However, the production price level and input does not decline. This means
that production and employment may reduce but the price of input and
production may be difficult to change.

(b) Upward Sloping Section

At this level, the production increases from Y 0 to Y 1 and the production
factor decreases by a reciprocal amount. Firms will compete against each
other for resources that are scarce. This will cause the input price to rise, in
other words, the cost of production will increase. Firms will increase the
production price as an incentive to increase production. Therefore, at this
level, there will be a direct connection between real production (Y) and price
level. The increase in production from Y 0 to Y 1 will cause a hike in price from
P 0 to P 1.
(c) Vertical Section (Classical)

At this level, the economy has achieved full employment (Y 1). Here, it is
difficult to increase production unless there is a price increase. Therefore, the
AS curve is vertical. This part is also known as the classical section because
it is in relation to the theories by classical economists who opined that the
economy always operates at full employment. Firms will compete to get
resources and increase production. However, this will cause losses to some
firms as the competition will increase the production costs and price levels.
However, the actual production will not change, which means the price
increases to P 2 but the production remains at Y 1. This situation accelerates
the inflation process.
6.2.3 Determinants of Aggregate Supply Curve

From the positive slope of the AS curve, we can see that price is one of the
determinants of the AS curve. However, a change in price will only cause changes
along the aggregate supply curve, that is, changes in the production quantity
supplied. For instance, referring to the previous Figure 6.9, when the price goes up
from P 0 to P 1, the production quantity supplied will increase from Y 0 to Y 1.
Besides the price factor, other factors that can cause the AS curve to shift either to
the left or right are:
(a) Input price;
(b) Productivity;
(c) Government policy; and
(d) Environment.

Now let us learn more about the four factors.
(a) Input Price

Did you know that input price can be categorised into domestic resource and
imported resource? What are they?
(i) Domestic Resource

Domestic resource includes land, labour, capital and entrepreneurs.
Innovation can reduce the price of the resource. Let us look at the
example of a domestic resource and how it affects the AS curve. There
has been an increase of womenÊs participation in the labour market.
This phenomenon will increase the labour supply and eventually cause
the production cost per unit to drop. The drop in production costs will
become an incentive for firms to increase production, as shown by the
AS curve moving to the right. The reverse position will cause the curve
to shift to the left.
(ii) Imported Resource

In production processes that use imported resources, the rise in input
price or a cost shock will cause the AS curve to shift to the left. When
the reverse happens, the AS curve will move to the right.
(b) Productivity
Productivity measures the average real production (total production divided
by total input). An increase in productivity means the economy enjoys a large
amount of real production based on limited resources. For example, a firm
would like to produce 10 units of production. If you need a total input of five
units at RM2 per unit, the productivity and average costs are calculated as
follows:
Total production
Productivity 
Total input
10
 2
5
Total cost
Average cost 
Total production
RM2  5

10
 RM1

If the firm intends to increase production to 20 units at the same price and
unit input, the productivity value is four, that is, 20/5 and the cost per unit
is RM0.50. Therefore, productivity increases from two to four and production
cost reduces from RM1 to RM0.50. This means productivity doubles and
production cost per unit drops by half. This situation will cause the AS curve
to shift to the right. On the other hand, if productivity drops, the reverse will
happen.
(c) Government Policy

There are two components in government policy. They are:
(i) Business Subsidies and Taxes

Increases in business tax such as excise sales tax will increase
production cost. This will cause the AS curve to move to the left. If the
government provides subsidies, it will reduce the production costs, and
this will be shown by the AS curve shifting to the right.
(ii) Regulations
It is normal for the government to control the production of certain
products. In order to comply with government regulations, firms are
forced to allocate some money to carry out control activities. For
instance, each firm is required to form a quality control unit. This will
increase the firmÊs cost of operations and the AS curve will shift to the
left.
(d) Environment
Let us learn about the final determinant, which is the environmental factor.
Environment includes weather, natural disasters and wars. For example,
during the monsoon season, fishermen cannot go out to sea. This will cause
a reduction in seafood supply, as shown in the movement of the AS curve to
the left in Figure 6.10. Instead, when there is no monsoon season, supply will
increase and the AS curve will shift to the right. The shift to the right is from
AS0 to AS1, whereas the shift to the left is from AS0 to AS2.

Figure 6.10: Movement of the aggregate supply curve (AS)
SELF-CHECK 6.1
Price can affect the aggregate supply curve (AS). Can you identify factors
other than price that might affect the AS curve?
6.3 PRODUCTION LEVEL AND EQUILIBRIUM

PRICE
How do we determine the production level and the equilibrium price? What are
the factors that determine them?
Equilibrium happens at the point where the AD curve and AS curve meet as
illustrated Figure 6.11.
Figure 6.11: Equilibrium price and production

Equilibrium price and production is achieved at Pe and Ye. If the price level
exceeds Pe, for example, if it is at P 1, then there will be excess aggregate supply
amounting to Y 0Y 1. At this price level, consumers only demand Y 0 but firms
supply Y 1. This situation will force the price level to fall again to equilibrium price
Pe.
If the price level is lower than Pe, for instance, if it is at P 2, then there will be an
excess demand totalling Y 0Y 1. At a price lower than the equilibrium price, the
quantity demanded is higher than the quantity supplied. This phenomenon will
force the price level to rise towards the equilibrium price, Pe. The equilibrium for
both price and production is achieved at the point where the AD curve and the AS
curve meet, which is at price Pe and production Ye.
6.3.1 Changes in Equilibrium

Changes in equilibrium can happen due to changes in the AD and AS curves.
(a) Changes in Aggregate Demand

We assume that the AS curve does not change here. Therefore, the change in
the AD curve will happen if there is a change in one of the aggregate
expenditure components or AD determinant factors other than the price
level. The effect of a change in the AD curve depends on the part of the AS
curve which crosses the AD curve. The analysis is based on Figure 6.12 for
AD increases (shift to the right).
Figure 6.12: Movement of the aggregate demand curve (AD) from AD0 to AD1

At the horizontal section (Keynesian), we assume the original equilibrium is

at AD0 and AS0 (P 0 and Y 0). The changes in AD will affect the price. For
example, if the government increases its expenditure (G), the AD curve will
move from AD0 to AD1. This affects production, which will increase to Y 1
but the price level will remain at P 0. This is because the unused resources
will be used to increase production while maintaining the production cost
per unit. Therefore, the price level does not rise because there is no increase
in the average production cost per unit.
If equilibrium happens at the upward sloping section as shown in

Figure 6.13, the original equilibrium at AD2 and AS0 (P 2 and Y 2), will shift
the AD curve from AD2 to AD3 when there is an increase in government
expenditure. This will cause a hike in the price and production level to P 3
and Y 3. The increase in price happens because there is a shortage in
resources.

Look at Figure 6.14. Let us assume that the original equilibrium at the vertical
section as AD4 and AS0 (P 4 and Y 4). The increase in government expenditure
will cause the AD curve to shift to AD5 and the price level will increase to P 5
but the production level will remain at Y 4 (production at full employment).
If the reverse happens (AD decreases), the AD curve shift to the left. In
conclusion, it can be seen that a shift of the AD curve will bring about
changes in price and quantity. However, the final effect depends on the
section of the AS curve which overlaps the AD curve as illustrated in
Table 6.3.
Table 6.3: Final Effect on the Section of AS Curve which overlaps the AD Curve
AD increases ă AD Shifts to the Right

AS Section Price Quantity
Keynesian (Horizontal) No change Increases
Upward Sloping Increases Increases
Classical (Vertical) Increases No change
AD decreases ă AD Shifts to the Left

AS Section Price Quantity
Keynesian (Horizontal) No change Decreases
Upward Sloping Decreases Decreases
Classical (Vertical) Decreases No change

(b) Changes in Aggregate Supply (AS)

Equilibrium price and output quantity for goods and services change when
the aggregate supply curve shifts. The movement in the AS curve is due to
several determinant factors other than the price level. This analysis is based
on equilibrium at the upward sloping section of the AS curve, assuming that
the AD curve is fixed (refer to Figure 6.15).
Figure 6.15: Shift of the AS curve
We assume that the original equilibrium is at AS0 and AD0 (P 0 and Y 0). If
there is an increase in technology or productivity, the AS curve will shift to
AS1. This phenomenon will cause an increase in production level to Y 1 and
a decrease in price to P 1.
If the reverse happens, for example, the rise in production costs will shift
the AS curve to the left to AS2. The effect of this is an increase in price to P 2
and decrease in production to Y 2.
In the horizontal and vertical sections, the effect is the same. A shift of AS
to the right brings a hike in production and a price drop. Conversely, when
AS shifts to the left, the price will go up and production will drop.
ACTIVITY 6.1
Give your analysis of other determinants of aggregate demand. Share

your answer with your coursemates in myINSPIRE online forum.

6.4 AGGREGATE DEMAND AND AGGREGATE

SUPPLY: FISCAL POLICY AND MONETARY
POLICY
The AD and AS model or approach can be used to analyse the effects of budget
policy and financial policy (refer to Figure 6.16).
Figure 6.16: Policy components
Fiscal policy is divided into two types, namely expansionary policy and
contractionary policy. Expansionary policy will shift the AD curve to the right
whereas contractionary policy will move the AD curve to the left. This
phenomenon will eventually change the equilibrium price level and production
quantity.
The effects of a fiscal or monetary policy can be analysed based on Figure 6.17.
Assume the economy is short-term and the original equilibrium is at AD0 and AS0
(P 0 and Y 0) at the upward sloping section, or in other words, the economy has not
achieved full employment.

Figure 6.17: Effects of fiscal and monetary policies and movements

in the curve from AD0, AD1 and AD2
If expansionary monetary or fiscal policy is carried out, the AD curve will shift to
the right from AD0 to AD1. Price and production will increase to P 1 and Y 1. On the
contrary, contractionary fiscal policy will shift the AD curve to the left from AD0
to AD2. Price level and production will drop to P 2 and Y 2.
Figure 6.18: Effects of fiscal and monetary policy and movements


If the economy operates at full employment, at the vertical section of the AS curve,
the effects of the fiscal policy will differ. Look at Figure 6.18, assume the original
equilibrium is at AS0 and AD4 (P 4 and Y 4). Expansionary fiscal policy (assuming
that the monetary policy is fixed) will move the AD curve to the right to AD5. This
expansion will not cause an increase in output because all resources have been
used for production. Therefore, expansionary budget policy, which is the shift of
AD4 curve to AD5, with a fixed monetary policy will cause a hike in interest rates.
An increase in interest rate will reduce investment and eventually there will be a
drop in production level (Y). When there is an increase in government expenditure
(G) and at the same time there is a same amount of decrease in investment (I), there
will be no change in production level. The final effect is an increase in price from
P 4 to P 5 but production is fixed at Y 4.
Figure 6.19: Effects of fiscal and monetary policy and movements

When there is a recession (horizontal section), expansionary or contractionary;

fiscal or monetary policy will only change the production level (fixed price level).
Based on Figure 6.19, we assume the original equilibrium is AS0 and AD6. If an
expansionary fiscal or monetary policy is practised, the AD curve will move to the
right from AD6 to AD7. The price level will remain at P 6 but the production level
will increase to Y 7. If a contractionary policy is implemented, the production level
will drop to Y 8.

6.5 CONSTRUCTING THE LONG-RUN

AGGREGATE SUPPLY CURVE
In the short-run, the changes in cost and price do not occur simultaneously. At the
upward sloping section of the aggregate supply curve (AS), the increase in cost is
higher than the increase in production. Therefore, the increase in price is higher
than the increase in production level. However, in the long-run, adjustments can
be made to suit the changes that occur based on knowledge of real price level. The
adjustment is made so that there will be no surprises regarding the price in the
long-run.
The construction of the long-run aggregate supply curve can be analysed based on
Figure 6.20.
Figure 6.20: Long-run AS curve
Assume that the original short-term AS curve is AS0. Equilibrium is achieved at

point a, with price and production levels at P 0 and Y 0. Y 0 is the potential
production level and P 0 is the expected price. If the aggregate demand rises, as
shown by movement of the curve from AD0 to AD1, the new short-run equilibrium
is achieved at point b (P 1 and Y 1). The short-term real price level exceeds the
expected price and the production level is higher than the potential production.
This excess total is known as the expansionary gap, which amounts to Y 0Y 1.

When real production exceeds potential production, the actual unemployment rate
will be lower than the natural unemployment rate. Therefore, there will be
overtime for labour and capital costs. Since the price in the short-run is more than
the expected price, the nominal fee at expected price P 0 drops. Besides this, when
real production exceeds potential production, the pressure of inflation begins to
set in. The more the short-run production exceeds the potential production, the
expansionary gap becomes bigger and the pressure for price increase also rises.
What is meant by „long-run‰? Long-run is the period when firms and resource
suppliers (production factors) know the market situation, specifically the aggregate
demand and real price level. Firms and resource suppliers have time to bargain
based on the actual price. The price hike to P 1 will drag down the value of real
nominal fee. Employees will now bargain with the firms to obtain a higher fee. If
this process succeeds, it will increase the firmsÊ production costs.
The increase in costs will shift the AS curve to AS1, to the left, (assuming that the
increase in price is adjusted by the cost hike at the same rate). The new equilibrium
is achieved at AD1 and AS1 (P 2 and Y 0). At this new equilibrium (point c), only
the price is found to have increased but the production remains the same at Y 0 and
the real price is the same as the expected price. Therefore, this equilibrium is for
both the short-run and long-run.
If the reverse happens, which means a drop in demand as shown by movement of

the AD curve to the left (AD2), the new price and production levels are achieved
at point d (P 3 and Y 2). P 3 is the real price level, which is less than the expected
price (P 0), and Y 2 is the real production level, which is lower than the potential
production (Y 0). This total is known as a contractionary gap amounting to Y 2Y 0
and the unemployment rate exceeds the natural unemployment rate.
When the unemployment rate exceeds the natural unemployment rate, it

encourages an increase in the real fee during the short-run. In the long-run,
producers are unwilling to pay a high nominal fee due to the actual price level.
The actual price is lower than the expected price and the unemployment rate but
higher than the natural rate of unemployment. With high unemployment rate,
those who are unemployed will compete with one another to obtain a job and they
are willing to receive lower wages (assuming the price and fee levels are flexible).
A low nominal fee rate will reduce the firmÊs production costs. This is shown by
the movement of the AS curve to the right to AS2. The new equilibrium is achieved
at point e (AS2 and AD2). The price level drops to P 4 and production falls back to
potential production (drop in price equals drop in fee level). Since the expected
price is the same as the real price, the short-run and long-run equilibrium are both
at point e.

Generally, what has happened at points a, c and e are:
(a) The real price level equals the expected price level; and
(b) Production quantity demanded and supplied in the short-run is the same as
that in the long-run.
In summary, actual production can be more or less than potential production in

the short-run but not in the long-run. Equilibrium in the long-run is achieved when
the AD curve crosses the potential output vertical line. If the points a, c and e are
joined, the vertical long-run AS curve (LRAS) can be observed.
6.5.1 Long-run Aggregate Supply Curve

The long-run aggregate supply curve is vertical because in the long-run,
adjustments will take place. We know that fiscal and monetary policies will shift
the AD curve. Let us look at Figure 6.21.
Figure 6.21: Long-run aggregate supply curve and policy effects
Based on Figure 6.21, assume the original equilibrium is at e (P 0 and Y 0). If an

expansionary budget or financial policy is implemented, the policy will cause the
AD curve shift to AD1. The new equilibrium price and production will be P 1 and
Y 0, which means the production level remains the same and only the price
increases. Therefore, the multiplier effect of a change in government spending (G)
on aggregate output (Y) in the long run is zero. Similarly, the tax multiplier is also
zero.

On the other hand, if contractionary fiscal or monetary policy is implemented, the

AD curve will shift to the left (AD2). The new price and production level will be
P 2 and Y 0.
Conclusively, in the long run, whether an expansionary or contractionary policy is

implemented, only the price level changes.
EXERCISE 6.1
1. Why is the aggregate demand curve sloping negatively from left to

right? Explain.
2. Explain four factors that influence changes in the aggregate supply

curve either to the left or to the right.
3. What is meant by macroeconomic equilibrium in the short run?
4. If the government of Malaysia increases its expenses by buying

more goods and services, is this change a fiscal policy or monetary
policy? Why?
5. Why is the long-run aggregate supply curve vertical?
 Aggregate demand is the total demand for goods and services by consumers
in an economy.
 An aggregate demand curve (AD) is negatively sloped, showing the negative

relationship between price and production level, assuming that all other
factors are fixed (not changed).
 Factors that cause the aggregate demand curve to slope negatively are real-
balance effect, interest rate effect and net-export effect.
 Aggregate expenditure is the total expenses of households, firms, government

and net exports. Aggregate supply means the total supply of goods and
services in an economy.

 Aggregate supply curve can be divided into three sections, namely horizontal
(Keynesian), upward sloping and vertical (classical). Aggregate supply is
determined by input price, productivity, government policy and environment.
 Changes in equilibrium occur due to changes in aggregate demand and

aggregate supply curves.
 Fiscal policy involves government expenditure and taxes, whereas monetary

policy involves money supply. There are two types of policies, namely
expansionary and contractionary.
 Expansionary policy will shift the AD curve to the right, whereas

contractionary policy will move the AD curve to the left.
 The long-run aggregate supply curve is vertical because in the long run
adjustments will be made.
Aggregate demand Equilibrium

Aggregate supply Expansionary policy
Classical Government expenditure
Consumer wealth Investment
Consumption Keynesian
Contractionary policy Net exports

Topic  Unemployment
and Inflation
7
LEARNING OUTCOMES
1. Describe the concept of unemployment and the method to measure
unemployment rate;
2. Discuss the types and effects of unemployment;
3. Explain the concept of inflation and the consumer price index (CPI);
4. Discuss the effects and causes of inflation; and
5. Summarise the Phillips curve, which is the trade-off between
inflation and unemployment.
 INTRODUCTION
Now we come to a new topic on unemployment and inflation. Did you know that
when individuals evaluate the economic activity level, they not only look at the
countryÊs production or output but also at other factors as well? These other factors
are national production, and information on unemployment and inflation, factors
which are also important to determine the economic activity of a country.
What can unemployment and inflation tell us? Unemployment is an important

indicator of the labour market while inflation shows the countryÊs overall price
level. Before 1920s, issues related to unemployment and inflation were not hot
topics of discussion. Only after the great recession of 1929 did these issues become
increasingly important and the focus of economists.

TOPIC 7 UNEMPLOYMENT AND INFLATION  169
Based on that, let us learn more about unemployment and inflation in this topic.
Are you ready? Let us start the lesson!
7.1 UNEMPLOYMENT
Are you currently working or are you still in the process of looking for a job?
Are you a homemaker or a university student? We often hear the term
„unemployment‰ being mentioned but how much do we understand about its
actual meaning?
An unemployed person is one who has the necessary qualifications to work,

is willing to work and agrees to work for a market wage but, unfortunately, is
not offered a job.
In order for you to understand the concept of unemployment, several factors that
are related to unemployment will be discussed at length. The population of a
country is divided into two, namely:
(a) Population of working age group; and
(b) Others (this includes those who are too young to work, those who are ill or
cannot work).
Population = Working age group + Others
What does working age group mean?
Working age group means the number of persons who are 16 years old
and above, who are eligible to work and those with certain obligation or
difficulties such as, those who are serving the sentence in prison, ill (health
matters) etc.

170  TOPIC 7 UNEMPLOYMENT AND INFLATION
Let us look at Figure 7.1.
Figure 7.1: Population of working age group
As summarised in Figure 7.1, the working age group is divided into two
categories, namely those who are not in the labour force and those who are in the
labour force. Those who are not in the labour force include mostly full-time
students, housewives, retirees, sick patients and prisoners inmates. The working
age group can be simplified as:
Working age group = Those who are not in the labour force + those who are
in the labour force
Those who are in the labour force can also be divided into two categories, namely
those who are employed and those who are not. What can we conclude about
unemployment?
Labour force = Employed + Unemployed
In the context of economics, unemployed refers to those who are not working
but are actively looking for jobs.

Figure 7.2 shows the unemployment rate in Malaysia from 2011 to 2018.
Figure 7.2: Percentage rate of unemployment in Malaysia from 2011 to 2018

Source: https://www.statista.com/statistics/319019/unemployment-rate-in-malaysia/
Based on Figure 7.2, the unemployment rate in 2018 in Malaysia was at

approximately 3.3 per cent. Malaysia achieved its lowest level of unemployment
in 2014, with an approximate of 2.85 per cent.
7.2 MEASURING THE UNEMPLOYMENT RATE

Did you know that the rate of unemployment is an important guide for a countryÊs
economic situation? We can measure the rate of employment using the following
formula, where the unemployment rate measures the percentage of the labour
force who are not working:
Number of unemployed
Unemployment rate  ï 100
Labour force

Let us look at how to measure unemployment rate by referring to the example in

Figure 7.3.
Figure 7.3: Employment in Country X for the year 2019
Based on the information from Figure 7.3, the unemployment rate in Country X in
2019 is:
0.35 million
Unemployment rate   100 = 3.54%
0.35 million + 9.54 million
EXERCISE 7.1
1. What is meant by unemployment?
2. A country reports its unemployment rate as 4 per cent. What does

this value mean?

7.3 LABOUR FORCE PARTICIPATION RATE

What is the purpose of labour source participation rate?
Labour force participation rate measures the percentage of the working age
group population who are in the labour force group.
How do we calculate that? We can do so by using a simple formula. This is how

the labour force participation rate is measured:
Labour force
Labour force participation rate  ï 100
Working age g roup population
An increase in labour force participation rate may be due to expansionary

economic conditions. On the other hand, the rate may drop because of an increase
in the number of retirees or those who are continuing education or because the
number of older people in a given the population has increased.
7.4 DISCOURAGED WORKERS

Who is referred to as a discouraged worker?
Discouraged worker is someone who is unemployed, ready to work but has

not made any efforts looking for a job in the last four weeks.
A discouraged worker will usually make excuses to say that he has tried to look
for a job but is disappointed or feels that the current labour market is not good.
Therefore, any efforts to look for a job will be unfruitful.

Since a discouraged worker has not made any efforts to look for a job in the last
four weeks, census will classify him as a discouraged worker and not as an
unemployed person. Therefore, this group of workers is not included in the labour
force. Some parties if of the opinion that discouraged workers should be classified
as unemployed persons in order to give a more accurate picture of the labour force
situation.
ACTIVITY 7.1
In your opinion, should discouraged workers be classified as

unemployed persons? Why? Give your reasons and post it on
7.5 PART-TIME WORKERS

Have you ever worked on a part-time basis? What is the difference between a
full-time worker and a part-time worker? Let us look at their definitions to help us
differentiate between the two.
Part-time workers are those who work less than 35 hours a week.
Full-time workers are those who work 35 hours or more in a week.
Part-time workers can be divided into two categories, namely those who work
part-time due to economic factors and those who do so due to non-economic
factors. Table 7.1 shows the difference between these two categories.

Table 7.1: Differences between Part-time Workers Due to Economic Factors and
Non-economic Factors
Part-time Workers Due to Economic Part-time Workers Due to Non-economic

Factors Factors
They are called non-voluntary part-time They are not interested in getting a full-
workers. time job.
They work between 1 and 34 hours. They are not ready to undertake an
available job.
At the same time, they try to be full-time Include those who:
workers.  Have medical problems;
They have failed to get a full-time job.  Have family commitments; and
 Have limited time due to studies.
To test your understanding, attempt Exercise 7.2.
EXERCISE 7.2
1. State the differences between a discouraged worker and an

unemployed worker.
2. What is the main difference between a full-time worker and a

part-time worker?
ACTIVITY 7.2
Assume that you are a part-time worker. You are not tied down by any
long-term contract and you get good payments from working for several
different companies. One day, you are offered a full-time job with one of
the companies at which you are working part-time with. What are the
factors that will assist you on how to decide? What would be your
decision? Share what you found on the myINSPIRE forum.

7.6 TYPES OF UNEMPLOYMENT

The unemployment issue is one of the most important economic issues. It can be
analysed in detail when you understand the different types of unemployment. As
shown in Figure 7.4, there are generally three types of unemployment ă frictional
unemployment, structural unemployment and cyclical unemployment.
Figure 7.4: Types of unemployment
The following are explanations for each type of unemployment.
7.6.1 Frictional Unemployment

Let us ponder on Figure 7.5. What can you say about it?
Figure 7.5: Frictional unemployment

Basically, frictional unemployment is described as the following:
Frictional unemployment or normal unemployment exists only for a short

period. It happens when individuals are moving between jobs, careers and
locations.
Sometimes people are willing to be unemployed while waiting to get another job
and not because they are unable to look for a job.
Frictional unemployment continues to exist at all times, mostly when the economy
is having continuous rapid growth. This type of unemployment also exists even
when the economy is at full employment.
However, since this type of unemployment is short term, it is not considered as a

serious problem.
7.6.2 Structural Unemployment

How about structural unemployment? When does structural unemployment
exist?
Structural unemployment happens because workers do not have the expertise

and the ability to work in a new sector. It usually exists for a longer period of
time and a government policy has to be implemented to overcome this
problem.
Economic growth of a country will usually be followed by structural changes and

changes in economic activities. For example, in early 1980s, MalaysiaÊs industrial
sector became more prominent than the agricultural sector. This caused some
workers to be laid off because the skills possessed by farmers could not be applied
in the industrial sector.
Various factors cause structural economic changes in a country, for example,

changes in consumer preference and technology advancement.

7.6.3 Cyclical Unemployment

Lastly, let us learn about cyclical unemployment. Do you know the cause of this
problem?
Cyclical unemployment is caused by economic conditions which go up and

down. It occurs when the unemployment rate moves in the opposite direction
as the GDP growth rate. Therefore, when GDP growth is small (or negative),
unemployment is high.
When there is a recession, demand for goods and services will decrease. This will
force firms to reduce their production and thus, cut down on their labour
requirements.
For instance, when recession hit the Asian region in 1998 because of the currency
crisis, many workers had to be laid off. In order to overcome unemployment
caused by private sector demands, the government had to increase expenditure
through a fiscal policy. The increase in government expenditure was aimed at
creating new job opportunities and subsequently, reducing the unemployment rate.
SELF-CHECK 7.1
For each description in the table below, write down the corresponding
type of unemployment.
No. Description Answer

1 This type of unemployment is due to unstable
economic conditions which go up and down.
2 This type of unemployment is short term and is not
considered serious.
3 This type of unemployment happens because workers
do not have the expertise and the ability to work in a
new sector.
4 This type of unemployment usually exists for a longer
period of time and the government has to find a way
to solve the problem.
5 This type of unemployment usually exists at all times.

7.7 FULL EMPLOYMENT AND NATURAL

UNEMPLOYMENT RATE
Firstly, let us look at the definition of full employment.
Full employment is an economic condition whereby every individual who

wants a job at the current market salary or wage gets a job. One of the main
economic goals of a country is to achieve full employment.
Full employment can also be defined based on natural unemployment rate.

This rate can be defined as natural unemployment rate equals to structural
unemployment plus frictional unemployment.
Natural unemployment rate = Structural unemployment +

Frictional unemployment
Full employment is achieved when the real unemployment rate is the same as the
natural unemployment rate. This means, when the real unemployment rate of a
country at a specific time only consists of structural and frictional unemployment,
the country is said to have achieved full employment. In other words, cyclical
unemployment does not exist at full employment level.
Each country has a different natural unemployment rate depending on various

economic factors. For instance, the natural unemployment rate in Malaysia is
between 3 and 4 per cent. The rate in the United States of America is between
4 and 5 per cent, whereas in Europe, the rate is between 7 and 8 per cent.
EXERCISE 7.3
1. Describe three types of unemployment.
2. What does natural unemployment rate mean?
3. What is meant by full employment and how is it related to natural

unemployment rate?

7.8 REASONS FOR UNEMPLOYMENT

There are three main reasons for being unemployed, namely:
(a) Job losers;
(b) Job leavers; and
(c) New entrants and re-entrants.
Let us look at the three factors in the next subtopics.
7.8.1 Job Losers

Look at Figure 7.6. What can you say about the situation?
Figure 7.6: Job loser
Based on Figure 7.6, we can define job losers as the following:
A job loser is someone who has been involuntarily terminated or laid off from
a job, regardless if it is temporarily or permanently.

There are many reasons for this, for example, failure of the worker to fulfil his work
requirements or conditions, or the firmÊs failure to fulfil its employeesÊ needs.
Those who have lost their jobs have two choices ă to look for a new job or leave
the labour force. Those who leave the labour force are not considered unemployed.
ACTIVITY 7.3
Think of the psychological effects on a person who has lost his job. What
are the pressures and problems that he is likely to face? Who can he
discuss this problem with?
7.8.2 Job Leavers

There are some workers who voluntarily leave their jobs and not necessarily
because they were laid off. If they are leaving the current job because they plan to
accept another offer, this would not constitute as an increase in unemployment
rate. The unemployment rate will only increase if these job leavers are still in the
process of looking for a new job.
7.8.3 New Entrants and Re-entrants

Who are new entrants referred to?
New entrants are those who have just completed their studies and are ready
to join the workforce.
New entrants have never been employed before and are actively seeking
employment for the first time. However, while looking for a suitable job, they
remain unemployed.
What about re-entrants?
Re-entrants are those who had previously been classified as employed but
have been out of the labour force for a period of time before actively seeking
employment once again.

Usually, they are considered to be unemployed while trying to look for a new job.
ACTIVITY 7.4
Are you aware that some graduates are very choosy about the types of
jobs that they will do? They would like to hold a high position and/or
insist on being paid a lot higher than the market rate despite not having
any experience. What is your opinion about this scenario? State your
opinion in myINSPIRE online forum.
7.9 EFFECTS OF UNEMPLOYMENT

Unemployment is a common phenomenon. However, a high unemployment rate
will affect a countryÊs economic growth. Do you know how much unemployment
can affect or influence our countryÊs economic growth?
Many people think that frictional unemployment is just a short-term phenomenon

and nothing to worry about. This type of unemployment also occur as a result of
the economic growth of a country.
However, unemployment due to reduced job opportunities caused by recession

such as cyclical unemployment, will bring about negative effects on the countryÊs
economic stability. The negative effects of unemployment can be categorised into
two, namely, effects on the economy and effects on the individual and population.
7.9.1 Negative Effects of Unemployment on the

Economy
A high rate of unemployment will ruin a countryÊs economic growth. Table 7.2
shows the negative effects of unemployment on the economy.
Table 7.2: The Negative Effects of Unemployment on the Economy
Negative Effect Description

Unemployment does A high unemployment rate will ruin economic growth and
not encourage performance. There will also be excess capacity from industrial
economic growth production factors such as machinery. This will indirectly cause
a drop in investment level.

Drop in government When people are unemployed, tax collection is also reduced. As
revenue a result, the government has to reduce its expenditure to boost
economic growth.
Wastage of A high rate of unemployment forces the economy to operate at
production resources a level that is below maximum. The wastage of resources
resulted in output production that is far lower than the
potential output.
7.9.2 Negative Effects of Unemployment on the

Individual and Population
Besides the negative effects on the economy, unemployment also affects the social
life of the individual, the community and the population as a whole. Table 7.3
shows the negative effects of unemployment towards individuals and the
population.
Table 7.3: Negative Effects of Unemployment on Individuals and the Population

Loss of job Temporary unemployment will not ruin the lives of the people as
daily activities can be carried out using savings or loans.
However, continuous unemployment will create unhealthy side
effects such as being forced to take part in illegal activities to
obtain money.
Loss of skills Some skills can only be maintained if they are used or practised
often. Long-term unemployment might cause an individual to
lose his skills.
Political instability Long-term or continuous unemployment can create chaos and the
government will be under pressure and will receive criticisms
from many parties. This problem indirectly contributes towards
social problems and causes an increase in crime rates. An increase
in crime rates can cause foreign investors to shy away.
EXERCISE 7.4
1. What are the reasons for unemployment?
2. What are the negative effects of unemployment on the economy?

7.10 INFLATION
Inflation generally refers to continued increase in general price levels. General
price reflects the price level for all goods and services that exist in the economy at
any given time. Do you know the method used in Malaysia to measure the general
price level? It can be derived from the definition of inflation.
Inflation can be defined as a continued increase in general price level of goods.
Inflation is one of the important topics of discussion in economics. A rise in price

does not refer to any specific item or product. It refers to prices in general, which
is measured based on the price index. There are a few price indexes that are
commonly used to portray the general price level and one that is frequently used
is the consumer price index (CPI).
7.11 CONSUMER PRICE INDEX (CPI)

Who uses the consumer price index (CPI) and for what purpose? CPI is usually
used by the government and the private sector to measure the price level paid by
consumers. In other words,
CPI is a measure that is used to track changes in prices of goods and

services purchased by households, also know as the consumer basket. The
composition of goods in the consumer basket is fixed based on consumer
spending patterns.
EXERCISE 7.5
1. Price hikes are always related to inflation. However, not all price
hikes reflect the presence of inflation. Describe the situation where
price hikes can be an indication of inflation.
2. What are the main components in the consumer basket for the
Malaysian CPI?

7.12 CALCULATION OF CPI

The process of calculating the actual CPI is a complicated one because the
consumer basket contains many goods. In order to give a clear picture of how the
CPI is calculated, let us look at a model of two items. Assume that the consumer
basket has two items: apples and rice. The year 2018 is picked as the base period
or year for comparison purposes and the current year is 2019. Basically, there are
three main steps in the calculation of CPI, namely:
(a) Calculate the cost of CPI consumer basket at base year price;
(b) Calculate the cost of CPI consumer basket at current year price; and
(c) Calculate the CPI for base year and current year.
7.12.1 Calculate the Cost of CPI Consumer Basket at

Base Year Price
At the base year, a consumer buys 10 apples and consumes 5kg of rice. The apples
cost RM0.50 per apple and the rice costs RM1 a kilogram. Table 7.4 shows the
consumer expenditure information for the base year.
Table 7.4: Cost of CPI Consumer Basket at Base Year Price
Consumer Basket
Cost of Basket
Item Quantity Price
Apple 10 RM0.50/pc RM5.00
Rice 5 RM1.00/kg RM5.00
Cost of CPI basket at base year price RM10.00
Based on the information in Table 7.4, the consumer spent RM5 on apples and RM5
on rice. The total consumer expenditure for that particular year was RM10.

7.12.2 Calculate the Cost of CPI Consumer Basket at

Current Year Price
The cost of the consumer basket for the current year is calculated after counting
the cost of the consumer basket for the base year. During the current year, the
quantity of goods purchased did not change. However, the price of apples
increased to RM0.60 per apple and the price of rice increased to RM1.10 per
kilogram. Table 7.5 provides information regarding the cost of apples and rice for
the current year.
Table 7.5: Cost of CPI Consumer Basket at Current Year Price
CPI Basket
Cost of CPI Basket
Item Quantity Price
Apple 10 RM0.60/fruit RM6.00
Rice 5 RM1.10/kg RM5.50
Cost of CPI basket at current year price RM11.50
Overall, the consumer spent RM11.50 to purchase the same amount of apples and
rice. RM6 was spent on apples and RM5.50 was spent on rice.
7.12.3 Calculate the CPI for Base Year and Current

Year
After calculating the cost of the CPI basket at base year price and current year price,
the next step would be to calculate the CPI for both years. The formula to calculate
the CPI for base year and current year is:
Cost of CPI basket at current year price

CP I   100
Cost of CPI basket at base year price
Therefore, CPI for the year 2018 is:
10
CPI for year 2018   100  100
10

However, CPI for the year 2019 is:
11.50
CPI for year 2019   100  115
10
Based on the CPI that has been calculated, it can be concluded that the average
price of goods and services for the year 2019 is 15 per cent higher than for the year
2018.
7.13 CALCULATING THE INFLATION RATE

Inflation rate is one of the important guides in an economy. It is used by various
parties including the government and policymakers to evaluate the price changes
in a country. Basically, the inflation rate measures the percentage increase in the
price of goods and services (CPI) over a given period of time. The following
formula is used to calculate the inflation rate:
New CPI  Old CPI

Inflation Rate = ï 100
Old CPI
For instance, the CPI value in 2019 is 115. The CPI value in 2018 is 100. Based on
this information, the inflation rate in 2019 can be measured as follows:
115  100
Inflation rate for 2018   100
100
 15%
Conclusively, the average price of the consumer basket in 2019 is 15% higher than
in 2018. In order to obtain the same quantity of goods as in 2018, consumers have
to increase their spending by 15%.
EXERCISE 7.6
1. Explain the three steps required to calculate the CPI. Provide

suitable examples.
2. State the formula used to calculate the inflation rate.

7.14 EFFECTS OF INFLATION

Besides unemployment, inflation is also another serious economic problem.
Inflation not only affects economic activities, it also has an impact on individuals
and on societyÊs welfare. The following subtopics explain the effects of inflation,
which can be divided into four categories.
7.14.1 Effects of Inflation on Total Production

In the short term, inflation will encourage the increase of national production if the
factors of production are not fully utilised. Price hike is a sign to producers that
they can reap more profits if they increase production.
However, if production is already utilising full resources, inflation will only

increase the price and not the production. Therefore, only medium-sized inflation
that has not utilised the full resources will bring about an increase in national
production.
7.14.2 Effects of Inflation on Savings and Investment

Inflation causes purchasing power to shrink (drop in the value of money). This
means that those who hold wealth in the form of cash will suffer losses. This
situation encourages people to spend and, hence, reduce their savings.
Besides that, inflation also encourages people to use their savings to purchase
shares and assets such as properties. This is because during inflation, prices of
assets are prone to increase. The increase in price level also encourages firms to
start new investments because of the increased profits. This usually happens when
the economy is expanding.
7.14.3 Effects of Inflation on Income Distribution and

Economic Wealth
Inflation affects different people in different ways. Those who work for a fixed
salary will suffer losses. This is because price hikes will deteriorate the value of
money. Individuals with fixed salaries will suffer from reduced purchasing power.
The same effect is felt by retirees who receive pensions.

Those who are fond of saving money (either in savings account or through
purchase of government bonds) will also suffer losses. The interest rates received
on their savings could be lower than the inflation rate.
Those who make money when inflation hits are businessmen. During this time,
they will increase the price at a higher rate compared to the rate of increase in
production costs. This situation allows businessmen to obtain higher profits.
Inflation also brings profits to those who own shares and permanent assets such
as houses and buildings. Shareholders will get higher returns when the company
makes profits. Those who own properties such as land and houses will get more
profits because the price of property will be higher during inflation periods.
Inflation also causes uneven distribution of income between those who borrowed
money and those who lent out money. Those who borrowed will reap some
benefits because the actual value of the repayment will deteriorate. Although the
amount repaid will be the same, the actual value of the sum (measured based on
quantity of goods that can be purchased) has decreased. Therefore, those who lent
out money will suffer some losses because the same amount now has a lower
purchasing power.
7.14.4 Effects of Inflation on a Country’s Balance of

Payments
Inflation causes local products to become more expensive in foreign markets and
foreign products to become cheaper in local markets. This will cause an increase
in imports and a decrease in exports. This will bring about a balance of trade
deficit. This means cash outflow is more than cash inflow into the country. If the
capital account balance does not change, it will cause the countryÊs balance of
payments to suffer a deficit.
However, if other factors do not change, the rise in export price and a drop in
import price of a country will create better trade conditions. This means that with
the same export quantity, the country can obtain higher import quantity. This
situation happens only if the demand to export the countryÊs goods remains fixed.

7.15 CONSUMER PRICE INDEX (CPI) AND

LIVING COSTS
What does consumer price index (CPI) actually mean?
The CPI is frequently called a cost-of-living index. It measures the change or

increase in money that is needed to maintain the current existing lifestyle.
However, the usage of CPI in measuring living costs does not reflect the
consumerÊs complete standard of living. This is because the CPI has some
problems and weaknesses.
The six problems and weaknesses of CPI are listed in Figure 7.7. Meanwhile
Table 7.6 provides explanations to these problems and weaknesses.
Figure 7.7: Problems related to CPI

Table 7.6: Weaknesses of CPI
Weakness of CPI Description

Choice of goods The goods chosen must reflect societyÊs expenditure pattern.
and services However, this expenditure pattern is not permanent and keeps
changing in line with peoplesÊ preferences. CPI fails to consider
these changes in due time.
Price difference of This problem arises due to the price difference in goods and
goods and services services according to the time and place. For instance, a new
product such as a computer will cost more in the earlier year when
it was launch than in later years and this makes it more difficult
to make comparisons against the earlier year.
Change in quality It is only fair that prices of goods and services increase due to
of goods and better quality. This does not mean that the power has weakened
services because the price hike is in line with the increase in quality.
However, the CPI fails to take into account changes in the quality
of goods and services. Another question that we need to ask is
whether the change in quality is more significant than the change
in living costs.
Choice of base year The base year is chosen based on the price stability in that year.
The choice of the base year is needed for purpose of comparison.
However, it is a little difficult to choose a particular year that has
price stability because inflation and deflation exist all the time.
Not taking into People now have a choice as to where they would like to go to
account purchase goods and services. For example, people are nowadays
opportunity costs are more interested to shop in hypermarkets that give discounts
compared to small neighbourhood shops. This shows that CPI does
not look at opportunity costs and only considers the absolute costs.
Overvalued or Due to some problems in calculations mentioned earlier, the
undervalued calculated CPI may contain some inaccuracies. Therefore,
estimation information about the inflation rate of a country is not accurate
because the figure may have been overvalued or undervalued.
ACTIVITY 7.5
You have studied the concept of inflation. Think about these questions
for a moment: In what situations can inflation happen. As a consumer,
how would you react to inflation?

7.16 FACTORS THAT CAUSE INFLATION

There are various factors that can cause inflation (see Figure 7.8).
Figure 7.8: Four factors that cause inflation
Let us look at these factors one by one in the next subtopics.
7.16.1 Demand Pull or Excess Demand

Inflation that is caused by high or excess demand is called demand-pull inflation.
Demand-pull inflation is defined as a situation where „lots of money is used

to obtain a small quantity of goods.‰
This inflation happens when excess demand at full employment level causes an
increase in the average price. Referring to Figure 7.9, the increase in demand from
AD to ADÊ at full employment output level (Y*) causes a price hike from P to PÊ.

Figure 7.9: Demand-pull inflation
7.16.2 Increase in Costs

What about the effects of an increase in costs?
Increase in production costs will force producers to shift their burden to

consumers by increasing the selling prices. This inflation is called cost-push
inflation.
For example, when workersÊ union demands a salary hike, this will increase the
firmÊs production costs. The increase in costs will decrease supply at every price
level. Let us refer to Figure 7.10.
Figure 7.10: Cost-push inflation

The increase in costs will cause the supply curve to move left from AS to ASÊ and
price to increase from P to PÊ. This situation will continue because an increase in
the price of goods will cause a drop in an individualÊs real income.
7.16.3 Supply Shock

Did you know that supply shock can cause a drastic change in the production costs
of basic goods? For instance, a long and terrible drought can be disastrous for the
agricultural sector. It can cause an increase in food prices. When petrol prices go
up, most firms that use petrol for their production also suffer as their costs
increase. This will eventually make the end-product much more expensive,
resulting in inflation.
7.16.4 Adaptive Expectations

Inflation can also happen if consumers expect it to happen. This psychological
factor is an important factor in the field of social science. If people expect prices to
go up, they will purchase goods before the price increases.
Increase in demand causes prices to go up and this will trigger inflation to occur.
Inflation due to this psychological factor is called adaptive expectation inflation.
7.17 PHILLIPS CURVE

Lastly, before we end this topic, let us learn about the Phillips curve. What is the
relationship between inflation and the unemployment rate? The Phillips curve
(named after A. W. Phillips, the first person to examine inflation using data in the
United Kingdom) shows the relationship between the inflation rate and the
unemployment rate. It is a trade-off between inflation and unemployment,
whereby we have to accept a higher inflation rate to lower the unemployment rate
and vice versa. The Phillips curve is shown in Figure 7.11.

Figure 7.11: The Phillips curve
In 1950s and 1960s, there was a smooth relationship between inflation and
unemployment rate and most people relied on the Phillips curve as the main
explanation for inflation. However, in 1970s and 1980s, apparently there
was no particular relationship between inflation and unemployment since the
curve did not show a negative relationship between the two variables, unlike in
the past. Based on this, can we conclude that there was no trade-off between
inflation and unemployment? Not necessarily. This is because we can see that
other factors besides unemployment also affect inflation. Changes in any factors
such as real purchasing power by consumers, cost of factors of production,
income of consumers etc. can also affect the relationship between inflation and
unemployment.
Referring to Topic 1, the objectives of a country is to reduce unemployment and

have price stability in the market. However, these two objectives tend to have
trade-off with one another and that is why policy makers need to make decisions
deemed necessary at the time based on the economic situation.

 The two main problems in macroeconomics are unemployment and inflation.
 In the context of economics, unemployed refers to those who are not working
but are actively looking for jobs.
 The unemployment rate measures the percentage of the labour force who are
not working or [(Number of unemployed/Labour force)  100].
 There are three types of unemployment, namely structural, frictional and

cyclical unemployment.
 Full employment can also be defined based on natural unemployment rate.

This rate can be defined as natural unemployment rate equals to structural
unemployment plus frictional unemployment.
 There are three main reasons for being unemployed ă job losers, job leavers as
well as new entrants and re-entrants.
 Unemployment due to reduced job opportunities caused by recession such as

cyclical unemployment will bring about negative effects on the countryÊs
economic stability.
 The negative effects of unemployment can be categorised into two, namely

effects on the economy and effects on the individual and population.
 Inflation means a continued increase in the general price level of goods.
 The consumer price index (CPI) is a measure that is used to track changes in
prices of goods and services purchased by households, also known as the
consumer basket.
 There are three main steps in the calculation of CPI. Firstly, calculate the cost
of the CPI consumer basket at base year price. Secondly, calculate the cost of
CPI consumer basket at current year price and finally, calculate the CPI for
base year and current year.
 There are four main effects of inflation. They are effects on total production,
effects on savings and investment, effects on income distribution and economic
wealth, and effects on the countryÊs balance of payments.

 The CPI is frequently called a cost-of-living index. It measures the change or

increase in money that is needed to maintain the current existing lifestyle.
However, it also has its problems and weaknesses.
 This trade-off between inflation and unemployment can be explained using the
Phillips curve.
Consumer price index (CPI) Job losers

Cyclical unemployment New entrants
Demand-pull inflation Part-time worker
Discouraged worker Phillips curve
Frictional unemployment Re-entrants
Full employment Structural unemployment
Full-time worker Unemployment
Inflation Working age group
Job learners
Department of Statistics, Malaysia. (2012). Principal statistics of labour

force, Malaysia, September 2012. Retrieved from
http://statistics.gov.my/portal/images/stories/files/LatestReleases/empl
oyment/Labour_Force_Indicator_Malaysia_Sept_2012BI.pdf
Department of Statistics, Malaysia. (2012). Free download ă Consumer Price

Index, Malaysia October 2012. Retrieved from
http://www.statistics.gov.my/portal/download_Prices/files/CPI/2012/
OKT/BI/02Malaysia.pdf

Topic  International
Trade
8
LEARNING OUTCOMES
1. Describe what international trade is and why countries trade;
2. Explain absolute advantage and comparative advantage;
3. Discuss the benefits and barriers to international trade; and
4. Explain why protection policies are needed.
 INTRODUCTION
Do you realise that most of us are involved in international trade? For example, if
you walk into an international coffee shop like The Coffee Bean & Tea Leaf, where
you are able to buy Maui Blend or Tanzania Peaberry coffee, you are experiencing
the effects of international trade.
These days, most countries are involved in international economic activities.

International trade allows us to expand our markets for both goods and services
that otherwise may not have been available to us. This is the reason why you can
choose to buy a Japanese, German or American car. As a result of international
trade, there is more competition in the market and therefore, prices are more
competitive, which brings cheaper products to consumers. This topic will focus on
discussions about international trade.

TOPIC 8 INTERNATIONAL TRADE  199
8.1 WHY DO COUNTRIES TRADE?

Trade is important for a country. Without trade, a country cannot diversify its
production. Before you start reading, try to think of one important reason why
trade is needed, especially international trade in a country like Malaysia.
A country does not only produce goods for local consumption, some of the
products are exported to other countries. Goods that cannot be produced locally
are imported from other countries. This process of exchanging goods or sale-
purchase transaction for goods and services between two or more countries is
called international trade.
International economic activities refer to economic activities with other countries.

Each country depends on other countries to obtain goods and services, and to
carry out other economic activities such as investment and production. The
advancement in computer technology and communication, and the reduction in
trade restrictions make it possible to carry out international trade with ease.
Generally, there are four main factors that encourage international trade between
one country and another (see Figure 8.1).
Figure 8.1: Four main factors that encourage international trade
Detailed explanation for all the factors is as follows.

200  TOPIC 8 INTERNATIONAL TRADE
8.1.1 Different Factors of Production

Each country has its own factors of production with differences in type, quality
and quantity of goods produced. These differences are the main factors why
countries conduct trade with one another. Different factors of production allow
each country to focus on different types of production.
For instance, countries that have capital and high technological knowledge
such as Japan and the United States of America will focus on industrial products.
Figure 8.2 shows an example of the automobile industry which requires high
capital and technology.
Figure 8.2: Automobile industry

Source: http://www.bloomberg.com/image/irjYaws34d0U.jpg
Countries that are rich in natural resources like Malaysia and China will focus on
producing main goods, for example, oil, gas and so on. Because each country
produces different types of goods, each country will carry out international trade
to obtain goods that are not produced locally.
8.1.2 Different Climate

Differences in climate causes countries to concentrate on producing different types
of products. For instance, the hot and wet climate found in most of Southeast Asian
countries like Malaysia, Indonesia and Thailand, tend to focus on rubber and palm
oil plantations (see Figure 8.3). Palm oil is one of a major commodity crops in
Malaysia.

Figure 8.3: Palm oil is a commodity crop in tropical countries

Source: http://travel.mongabay.com/malaysia/
The cold climate in Australia and New Zealand allows both these countries to
focus on the production of fruits like apples and oranges. Thus, different climates
result in the production of different goods. The difference in agricultural produce
encourages countries to trade with one another. Figure 8.4 shows grapes ă one of
the fruits planted in countries with temperate climates.
Figure 8.4: Grapes are among the fruits produced in countries with temperate climates
Source: http://tourcoverage.files.wordpress.com/2012/02/

8.1.3 Different Labour Skills

Every country has its own level of labour skills. For instance, countries like Japan,
United States of America and Singapore have skilled labour force in their
industrial sector. Therefore, these countries focus on the production of industrial
goods. Other countries like New Zealand, Australia, China and Malaysia have
skilled labour force in the agricultural sector. The difference in labour skills
encourages the production of different types of goods for international trade.
ACTIVITY 8.1
Much of the current labour force in Malaysia is from other countries such
as Indonesia, Vietnam, India and Philippines. What is the effect of these
foreign workers on our local skills and expertise in respect to the job
market?
8.1.4 Different Consumption Patterns

Different societies have different tastes, preferences and spending patterns. As a
result, goods are produced in accordance with the societyÊs needs and preferences.
The different types of goods produced by these unique societies or countries

encourage international trade.
EXERCISE 8.1
1. What do you understand by the term „international trade‰?
2. Discuss the factors that encourage international trade.

8.2 ABSOLUTE ADVANTAGE

In order to make it easier for you to understand the concept of absolute advantage,
we will use a scenario to illustrate. Assume that countries X and Y produce two
types of products each, namely oranges and apples. Table 8.1 shows the output
quantity produced by each country using the same resource. Country X can
produce 100 oranges or 10 apples using this resource. Meanwhile Country Y can
produce 50 oranges or 20 apples.
Table 8.1: Absolute Advantage for Country X and Y
Country Orange Apple

X 100 10
Y 50 20
Table 8.1 clearly shows that country X is more efficient at producing oranges while
Country Y is better at producing apples. This means, each country has an absolute
advantage. What does absolute advantage mean?
Absolute advantage is defined as a countryÊs ability to produce more of the

product than another country can, with the same amount of resources.
This situation could be due to the possession of natural resources or high

production efficiency.
Country X is said to have an absolute advantage in the production of oranges while

Country Y has an absolute advantage in the production of apples. Therefore,
Country X should specialise in producing oranges while Country Y should focus
on producing apples. The question now is, „What is a suitable exchange rate for
these two countries in order to trade?‰
Assume 30 oranges are exchanged for 10 apples. What will happen to Country Y
if all the resources are utilised to produce apples and exchange them with the
oranges produced by Country X?

At this rate, Country Y will get 60 oranges, which means it will get 10 more fruits
than if it were to produce the oranges itself. Besides that, Country X also benefits
from this specialisation. Through this trade, Country X exchanges 60 oranges for
20 apples. Besides still having a remainder of 40 oranges, Country X also receives
10 more apples than if it had produced the apples itself.
Conclusively, Country X receives an excess of 40 oranges and 10 apples after

carrying out trade with Country Y. Meanwhile, Country Y also gets 10 extra
oranges from the trade. This situation is shown in Figure 8.5.
Figure 8.5: Each country has an absolute advantage in one product
With the same resources by both countries, Country X can produce 100 oranges
and zero apples or 10 apples zero oranges, while Country Y can produce
50 oranges and zero apples or 20 apples and zero oranges. All other points on the
production possibility line are possible combinations of the two goods that can be
produced given current resources. Point A on both graphs is where the countries
start producing and consuming before trade. Point B is where they end up after
trade. Country X will export 60 units of orange and import 20 units of apples. As
for Country Y will export 20 units of apples and import 60 units of oranges. This
example shows that both the countries benefited from the trade. There is no reason
for the benefits to be equally divided. Instead, both countries obtained more goods
after the trade. By specialising in the production of one product, and carrying out
trade, both the countries obtained more goods than they would have if they had
produced both the goods themselves.
In another example, let us assume that two countries, M and R, produce two types
of goods but the output quantity is different. Table 8.2 shows the quantity of goods
that can be produced using the same specified quantity of resources.

Table 8.2: Absolute Advantage for Country M and R
Country Orange Apple

M 100 20
R 30 10
Table 8.2 shows that Country M can produce 100 oranges or 20 apples. Country R
can produce 30 oranges or 10 apples. It is noted that Country M has an absolute
advantage over Country R for the production of both oranges and apples. In this
situation, is it necessary for the countries to specialise and trade with one another?
Assume that trade is agreed upon at the rate of 40 oranges to 10 apples. Although
Country R does not have absolute advantage, if it produces 10 apples, then it can
exchange them for 40 oranges. The oranges it gets will definitely be more than the
quantity it is able to produce on its own. However, Country M can afford to let go
of 10 apples to produce 50 more oranges and exchange 40 oranges to obtain
10 apples. In this manner, country M gets 10 more oranges. This situation can also
be demonstrated using diagrams (see Figure 8.6).
This shows that although a country does not have absolute advantage, it can still
specialise and trade with another for mutual benefits.
Figure 8.6: Country M has absolute advantages in both products
With the same resources by both countries, Country M can produce 100 oranges
and zero apples or 20 apples zero oranges, while Country R can produce
30 oranges and zero apples or 10 apples and zero oranges. All other points on the
production possibility line are possible combinations of the two goods that can be
produced given current resources. Point A on both graphs is where the countries
start producing and consuming before trade. Point B is where they end up after
trade. Country M will export 40 units of orange and import 10 units of apples. As
for Country R will export 10 units of apples and import 40 units of oranges.

8.3 COMPARATIVE ADVANTAGE

Let us move on to comparative advantage.
Comparative advantage refers to a countryÊs ability to produce a product at a

relatively lower cost compared to other countries.
Trade is not determined by the production efficiency of certain goods but by the
opportunity cost of producing the goods when compared with other countries. A
country is said to have a comparative advantage in the production of certain goods
if the opportunity cost is lower than other countries. Table 8.3 shows the
opportunity cost for the production of apples in the unit quantity of oranges that
had to be given up.
Table 8.3: Comparative Advantage for Apples
Country Opportunity Cost of Producing 1 Apple

M 5 oranges (100/20)
R 3 oranges (30/10)
Based on Table 8.3 (using date from previous example), we can see that country M
is forced to give up five oranges to produce one apple whereas Country R has
to give up three oranges to produce one apple. This difference allows for
specialisation and trade to be carried out between the two countries. Country R is
relatively more efficient at producing apples. Although it does not have an
absolute advantage, Country R has a comparative advantage in producing apples.
Table 8.4 shows the opportunity cost in the production of oranges, expressed in
unit quantity of apples that had to be given up. Since Country R has a comparative
advantage in producing apples, Country M will have a comparative advantage in
producing oranges. Table 8.4 shows that the opportunity cost for Country M to
produce oranges is 1/5 apples whereas it is 1/3 apples for Country R. Because 1/5
is less than 1/3, Country M only has to sacrifice fewer apples to produce oranges
compared with Country R. Relatively, Country M is more efficient in the
production of oranges.

Table 8.4: Comparative Advantage for Oranges
Country Opportunity Cost of Producing 1 Orange

M 1/5 Apples (20/100)
R 1/3 oranges (10/30)
As a conclusion, comparative advantage, not absolute advantage, is an important

condition for specialisation and trade. What is important is which country can
afford to produce a product with relative efficiency and not which country can
produce a cheaper product.
Whether a country decides to trade with another depends on the opportunity

cost and not on the quantity of resources utilised in production. A country will
specialise in the production of goods for which it has a lower opportunity cost
compared with other countries.
EXERCISE 8.2
1. Provide the definitions for absolute advantage and comparative

advantage.
2. What is the difference between the concepts of absolute advantage

and comparative advantage?
ACTIVITY 8.2
International trade has existed in Malaysia since the era of the Malacca
Sultanate. What could have been the benefits gained from international
trade at that time? Compare them to the benefits of international trade
today.

8.4 BENEFITS OF INTERNATIONAL TRADE

Almost all countries worldwide carry out international trade. This is because
international trade benefits those countries involved. The benefits derived from
international trade are stated in Figure 8.7.
Figure 8.7: Four benefits of international trade
Now let us look at Table 8.5 for a detailed explanation of all the benefits.
Table 8.5: Benefits of International Trade
Benefits of
Description
International Trade
Acquire goods that Citizens in every country need a variety of goods. However,
cannot be produced every country is unable to produce all the goods that it wanted
locally and needed. Therefore, trade between countries is carried out to
acquire goods that cannot be produced locally.
For instance, Malaysia specialises in the production of palm oil

and rubber to be exported to other countries. In return, Malaysia
obtains goods that cannot be produced in this country such as
aeroplanes, apples and oranges.

Widen the market for A countryÊs production can be marketed widely through
local products international trade. Goods that are locally made can be exported
to other countries. A higher production quantity will help to
efficiently utilise factors of production.
This will reduce the cost of production and the price. It will
increase the living conditions of the people.
Increase efficiency in International trade encourages specialisation. Specialisation
the usage of means each country specialises in producing a particular
production factors product which it can produce efficiently. This will ensure
efficiency in the usage of production factors.
Acquire modern International trade allows modern technology to be imported
technology from developed countries to developing countries. Modern
technology will enable developing countries to increase their
production capabilities. International trade also allows
developing countries to enjoy the usage of high technology
products like computers, digital cameras and such.
ACTIVITY 8.3
There are also other benefits from international trade. List down other
benefits and discuss your list with your classmates in the myINSPIRE
online forum.
ACTIVITY 8.4
International trade barriers are efforts made by a country to restrict or

reduce the total imported goods from other countries. Other countries
that wish to carry out trade with Malaysia for example, will have to go
through the international trade barriers implemented by the Government
of Malaysia. Think of the effects on local production if Malaysia does not
implement any trade barriers on foreign countries. Share your input on
the myINSPIRE forum.

8.5 INTERNATIONAL TRADE BARRIERS

International trade is often associated with the loss of jobs for local people. For
instance, if free enterprise is allowed in the automotive industry, Proton factory
may have to be shut down due to its inability to compete with foreign automotive
companies. This will directly cause many of our local workers to lose their jobs and
eventually raise the unemployment rate.
In order to overcome this problem, the government will have to intervene by

imposing trade barriers. There are two types of trade barriers, namely tariffs,
which can be divided into three types and non-tariff barriers such as quota,
subsidy, voluntary export restraint (VER), foreign currency control and other
restrictions to control international trade.
8.5.1 Tariff
Do you know what tariff means?
Tariff is a tax on foreign goods upon importation.
Tariff can be divided into three types, namely ad valorem tariff, specific tariff and
compound tariff. Let us refer to Table 8.6 to identify the differences in these tariffs.
Table 8.6: Types of Tariffs
Type of Tariff Explanation Example

Ad-valorem An import tax that is calculated If the import tax for a car is 50 per
tariff based on the percentage of the cent, then the tax that is imposed
value of the imported goods. on a RM20,000 imported car is
RM10,000.
Fixed tax figure that does not One tonne of teak wood was
depend on the value of the imposed an import tax of RM200.
imported goods. Although the It does not matter whether the
Specific tariff values of goods keep changing, price of the teak wood increases or
the total tax imposed is fixed. decreases, the tax imposed is the
same at the rate of RM200 per
tonne.

Compound A combination of specific and ad A country needs to pay a specific

tariff valorem tariffs ă often applied tax of $50 plus 5 per cent of the
to manufactured products which product value that it imports.
incorporate raw materials that are
subject to tariffs.
Tariff will cause the cost of imported goods to go up and this means the price of
the goods will increase as well. Indirectly, tariff reduces the local consumersÊ
intention to purchase imported goods.
8.5.2 Non-tariffs
Non-tariff barriers can be divided into five categories. Let us learn more about the
five categories.
(a) Quota
How do we define quota?
Quota is the maximum limit set on the quantity of an item that can be
imported into a country during a given period of time.
Implementation of quotas will not influence government revenue. In fact,

quotas provide protection for local firms. There is no more competition from
foreign firms once the quota is fulfilled.
The main effect of a quota is that it increases the price of the imported goods.
However, because of the limited quantity of goods, consumers are willing to
spend a lot of money to obtain those products.
(b) Subsidy
How about subsidy?
Subsidy is a payment made by the government to domestic producers

to improve their trade competitiveness.

Government grants subsidies to the producers to improve their market

position. With subsidies, producers can market their products at prices that
are lower than their actual cost. Subsidies can be in various forms such as
outright cash disbursements, tax concessions, loans at below market interest
rates and so on. Two types of subsidies that are usually used are domestic
production subsidy, which is granted to producers of import-competing
goods and export subsidy, which is granted to producers of goods that are
exported to foreign countries.
(c) Voluntary Export Restraint (VER)

With VER, governments are able to moderate the intensity of international
competition by allowing less efficient domestic producers to participate in
markets that would otherwise be controlled by foreign producers that can
sell products at a lower price.
(d) Foreign Currency Control

Besides tariffs and quotas, governments can also control the foreign currency
used for imports. Governments can impose various forms of controls to
influence international trade activities such as imports. Among the methods
used to control the quantity of goods imported is by controlling the total
foreign currency that is usually used to import the goods. Another
alternative is by selling the foreign currency at a higher rate compared to the
market rate.
(e) Other Restrictions

Besides the mentioned barriers, the government can also use other methods
to reduce usage of imported goods. For example, the government can direct
all its departments to use only locally made products such as the national car
Proton.
The government can also direct financial institutions such as banks to reduce
the lending of loans to support the purchase of imported goods.
EXERCISE 8.3
1. Discuss four benefits of international trade.

2. What are the methods undertaken to restrict free trade between
countries?

8.6 TERMS OF TRADE

Trade will only take place if it benefits both countries that carry out trading. The
exchange rate agreed upon by both countries is called the terms of trade. What is
meant by terms of trade?
Terms of trade can be defined as the ratio of price or quantity of export

commodity to price or quantity of import commodity.
There are two methods of measuring terms of trade for a country price and goods.
Let us look further at these two methods in the following subtopics.
8.6.1 Price
Firstly, let us learn the definition of price terms of trade.
Price terms of trade means the ratio of price of export commodity to price of
import commodity in a country.
The terms of trade can be measured using this formula:
Price terms of trade = Px / Pm
Where, Px = Export price

Pm = Import price
When export price drops and import price goes up or remains the same, the price
terms of trade for that country will deteriorate.
On the other hand, when export price increases or remains unchanged and the
import price reduces, the price terms of trade will increase.

8.6.2 Goods
How about goods terms of trade?
Goods terms of trade measures the ratio of quantity of export commodity to

quantity of import commodity in a country.
Goods terms of trade can be measured with the following formula:
Goods terms of trade = Qx/Qm
Where, Qx = Export quantity

Qm = Import quantity
When the same export quantity can obtain a lower import quantity, the goods
terms of trade will increase.
On the other hand, when the same export quantity can obtain a higher import
quantity or lower export quantity can obtain the same import quantity, the goods
terms of trade will drop.
8.7 WHY PROTECTION POLICIES ARE NEEDED

Although international trade can increase the welfare of the trading countries,
some countries will still implement protectionism ă an economic policy of
restraining free trade between nations. Let us refer to Figure 8.8 to identify the
reasons why protection policies are needed.

Figure 8.8: Reasons why protection policies are needed
Each of the reason is explained in the following subtopics.
8.7.1 Protect New Industries

Each country has a new industry to promote. The new industries are not ready to
compete against foreign firms and need government assistance and support to
continue their operations. Without the governmentÊs help, they could face strong
competition and may even have to be shut down if they fail to survive the
competition.
For instance, in the mid 1980s, the automobile industry in Malaysia was still new
and needed government assistance. This industry was in its infancy stage and was
not ready to compete with giant foreign firms such as Ford and Honda. In the
beginning, the industry was not competitive in many aspects such as price, cost of
production and product quality.

8.7.2 Improve National Security

Certain goods consumed by citizens have to be produced by the individual
countries themselves. These countries cannot depend on other countries to
produce such goods. This could be due to security reasons. For instance, if
Malaysia is completely dependent on Thailand for its supply of rice and if war
breaks out between Malaysia and Thailand, it could affect our national security as
Thailand can restrict the supply of rice to Malaysia.
8.7.3 Diversify Local Economic Activities

It is necessary to diversify a countryÊs economic activities, which will contribute
towards national income through foreign exchange. If a country depends a lot on
a specific export industry, it can cause a decrease in national income if the industry
deteriorates.
For example, Malaysia exports its palm oil. If the price of palm oil in the
international market drops suddenly and Malaysia does not have another source
of income, then Malaysia will have no choice but to solely depend on the export of
palm oil. Therefore, protection is required for other industries to diversify the
countryÊs economic activities.
8.7.4 Protect Resources

Protectionism can also be used to protect local industries and their resources.
When consumers start depending on imported goods, it will not encourage
domestic economic activities. This will affect the demand for local sources of
production including labour. As a result, unemployment rate will go up. Other
related social problems such as robberies, thefts and political instability will also
emerge.

8.7.5 Act as Anti-dumping Measure

What does dumping refer to?
Dumping refers to the activity of foreign firms that have excess production to
sell the excess products to other countries for a much cheaper price compared
to the price sold in their own country.
This situation will encourage imports. If this continues, it will seriously affect the
local industry. Therefore, protection policies act as anti-dumping measures and
are needed to look after the welfare of the local industries because they contribute
towards the countryÊs economy.
EXERCISE 8.4
1. What is the meaning of terms of trade?
2. Why are protection policies needed?
 International trade is a process of exchanging goods or sale-purchase

transaction for goods and services between two or more countries.
 Factors that encourage countries to trade with one another are the possession
of different production factors, climate, labour skills and consumption
patterns.
 Absolute advantage is a countryÊs ability to produce more of the product than

another country can, with the same amount of resources.

 Comparative advantage refers to a countryÊs ability to produce a product with

lower relative cost compared to other countries.
 Benefits of international trade include acquiring modern technology, widen

the market for local products, acquiring goods that cannot be produced locally
and increasing the efficiency in the usage of factors of production.
 Several trade barriers that are commonly used in international trade are tariff
and non-tariff barriers such as quota, subsidy, voluntary export restraint (VER)
and foreign currency control. These barriers are used to protect new industries,
protect national security, diversify a countryÊs economic activities and avoid
dumping.
 Terms of trade can be measured either in price or goods.
Absolute advantage Protection policies

Anti-dumping Quota
Barriers Subsidy
Comparative advantage Tariff
Goods terms of trade Terms of trade
Price terms of trade

Finance
9
LEARNING OUTCOMES
1. Explain the meaning of foreign exchange rate and show how it is
determined;
2. Explain factors that influence the foreign exchange rate;
3. Describe the use of balance of payments and its components; and
4. Discuss strategies to reduce the balance of payments deficit.
 INTRODUCTION
Import and export are important activities for an open economy. Besides these,
other international transactions are also equally important to the economy such as
purchase of bonds, shares and other foreign financial assets.
Most international transactions involve the payment flow between countries. For
this purpose, the mechanism to determine the value of foreign currency is
required. The value of currency is very important to determine exports, imports
and a countryÊs foreign investment. For instance, the value of the Ringgit
compared with American Dollar, Japanese Yen and Euro is important for
MalaysiaÊs international transactions.

220  TOPIC 9 INTERNATIONAL FINANCE
This topic is divided into two parts. The first part focuses on the foreign exchange
rate. It covers the process of determining the foreign exchange rate and the factors
that influence it. The second part explains how each international transaction
influences the payment flow between countries. The classification of these
transactions will also be explained. This second part specifically discusses the
balance of payments accounts, issues and concepts related to it. Let us continue the
lesson!
9.1 FOREIGN EXCHANGE RATE

Almost all countries have their own currency. In order to carry out international
trade involving different currencies, one currency has to be exchanged with
another currency.
Before we proceed further, what does foreign exchange rate refer to?
Foreign exchange rate refers to the rate at which one currency may be
converted into another.
For example, Proton company agrees to sell a car for RM30,000 to a dealer in
America. If the foreign exchange rate between the American Dollar and the Ringgit
is RM2.50 to USD1, then the dealer in America has to pay USD12,000 to purchase
a Proton Wira car.
Since trade is carried out with countries using different currencies, the foreign
exchange rate plays a vital role in influencing international trade.
If the foreign exchange rate increases from RM2.50 to RM2.60 for USD1, that means
the value of the Dollar has increased compared to the Ringgit. In other words, the
value of the Ringgit has depreciated. This is because with USD1, the holder can
now get more Ringgit. On the other hand, if the foreign exchange rate drops from
RM2.50 to RM2.40 for USD1, then the value of the Dollar has depreciated
compared to the ringgit. In other words, the value of the Ringgit has increased
compared to the Dollar because USD1 can now be purchased with just RM2.40.

TOPIC 9 INTERNATIONAL FINANCE  221
In this topic, the foreign exchange rate is stated in Ringgit for every unit of Dollar,
for example, RM2.50 for USD1. Actually, the foreign exchange rate can also be
stated in Dollar for every Ringgit, that is, USD0.40 for every RM1. This means that
USD0.40 can be exchanged for RM1. This figure is obtained by dividing USD1 with
RM2.50, which equals to USD0.40.
ACTIVITY 9.1
In your opinion, how important is the foreign exchange rate to a
government that sponsors its studentsÊ costs of education to overseas
countries? Share your opinion with your coursemates in myINSPIRE
online forum.
9.2 HOW IS THE FOREIGN EXCHANGE RATE

DETERMINED?
The foreign exchange rate is determined in the currency market. In order to
understand the determination of the foreign exchange rate, we can look at the
demand and supply models. Figure 9.1 shows the demand and supply for the
Dollar compared with Ringgit.
Figure 9.1: Determinants of foreign exchange rate
The vertical axis represents the foreign exchange rate that is stated in Ringgit for
every Dollar. The supply curve shows the quantity of Dollars supplied to be
converted into Ringgit. Americans have to get Ringgit in order to purchase goods
from Malaysia. Similarly, if firms from the United States want to make investments
in Malaysia or to make transfer payments to residents in Malaysia, they will
supply the US Dollar to get Malaysian Ringgit.

The demand curve shows the quantity of Dollars that is demanded in exchange for
Ringgit. If an individual or firm from Malaysia wants to buy a product made in
America, he will have to get Dollars and exchange it to Ringgit. Similarly, if firms
from Malaysia want to make investments in the United States or to make transfer
payments to residents in the United States, they will demand US Dollars and
exchange with the Malaysian Ringgit.
The equilibrium value is RM2.50 for USD1. If the exchange rate increases to
RM3.00 for USD1, then the value of Dollar has appreciated compared with Ringgit
because every USD1 can get RM3.00. In reverse, if the exchange rate drops to
RM2.00 for USD1, then the value of Ringgit has increased compared to the Dollar.
EXERCISE 9.1
1. Provide the definition of foreign exchange rate.
2. How does the market mechanism determine the foreign exchange

rate?
9.3 CHANGES IN DEMAND OR SUPPLY

Changes in demand or supply will cause changes in the equilibrium of foreign
exchange rate. Figure 9.2 shows an increased demand for the Dollar.
Figure 9.2: Increase in demand for the Dollar

Notice that the original demand curve D moved to the right to DÊ. This increases
the equilibrium of foreign exchange rate from RM2.50/USD1 to RM2.75/USD1
(now USD1 equals to RM2.75). An increase in demand pushes up the value of the
Dollar because more Ringgit can be obtained with USD1. In other words, the value
of the Ringgit depreciated in comparison to the Dollar.
Let us look at another illustration in Figure 9.3.
Figure 9.3: Increase in supply of the Dollar
Figure 9.3 shows the effect of an increase in supply of the Dollar compared to
the Ringgit. This increase causes the original supply curve S to move to SÊ and
achieve a new equilibrium rate at RM2.25/USD1. At this level, USD1 can only be
exchanged with RM2.25. This rate is a little higher than the rate of RM2.50/USD1.
In other words, the value of the Dollar has depreciated compared to the Ringgit or
the value of the Ringgit has gone up compared to the Dollar.
ACTIVITY 9.2
Imagine that you are a money changer in Kuala Lumpur. Discuss how
international trade activities in Malaysia can influence your business.
Post your answer in myINSPIRE online forum.

9.4 FACTORS THAT INFLUENCE THE FOREIGN

EXCHANGE RATE
The equilibrium of foreign exchange rate will change if demand or supply changes.
There are four factors that can influence the supply and demand of any currency.
Do you know what are they? Let us refer to Figure 9.4 to identify the four factors
that influence the foreign exchange rate.
Figure 9.4: Four factors that influence the foreign exchange rate
The explanation for each factor is as follows.
9.4.1 Price of Traded Goods

The price of traded goods is the main determining factor for demand and supply.
If local goods can be sold more cheaply than goods from other countries, it will
increase exports and will eventually cause a hike in the demand for the local
currency. This means the value of the local currency will increase compared to
other currencies.

On the other hand, if the price of imported goods is cheaper, it will encourage
demand for foreign currency with an increase in imports. This will cause the value
of foreign currency to go up and the value of the local currency to drop.
9.4.2 Inflation Level

There are two reasons why the value of currency can drop. Firstly, a high inflation
level will make local products more expensive compared to imported goods. The
difference in price will encourage consumers to purchase imported goods, which
will directly increase the value and demand for foreign currency.
Secondly, inflation not only affects the price of goods sold domestically but also
the price of goods exported. Exported goods will become more expensive and this
will cause a decline in the demand for local currency. Eventually, the value of the
local currency will decrease.
9.4.3 Interest Rate

Among the important factors that influence the movement of capital is the interest
rate. What is this so? This is because,
The interest rate reflects the rate of returns on the investment made.
High interest rate shows profitable investment returns and this increases the
capital inflow. An increase in capital inflow will cause an increase in demand for
local currency and this will eventually increase the value of local currency
compared with foreign currency.
On the other hand, low interest rate compared with that of other countries will
encourage capital outflow. This will reduce demand and subsequently, the value
of the local currency. Demand for foreign currency will increase because investors
will invest in countries that offer a higher interest rate.

9.4.4 Income of the People in a Country

The average income of the people in a country influences their expenditure
pattern. Those who have high incomes prefer to import goods from overseas
because they have a higher purchasing power. This will increase the demand for
foreign currency. On the other hand, low income encourages people to buy only
locally produced goods.
EXERCISE 9.2
Discuss four factors that influence foreign exchange rates.
ACTIVITY 9.3
There are many interesting articles for you to read which provide
additional information on consumerism in Malaysia.
Visit the website of the Ministry of Domestic Trade, Co-Operatives and

Consumerism at http://www.kpdnkk.gov.my
Discuss the price trends of imported goods and services in Malaysia over
the last ten years. Why is it so?
9.5 BALANCE OF PAYMENTS

Have you heard of balance of payments? What does this term stand for?
The balance of payments is a systematic record of a nationÊs total payments to

foreign countries including the payments for imports and the outflow of
capital and gold along with the total receipts from abroad, payments for
exports and the inflow of capital and gold.

What about a countryÊs balance of payments? A countryÊs balance of payments

refers to balance of financial records showing the total inflow of money into the
country and the total money outflow paid to other countries.
The financial records can be classified either as credit or debit depending on the
type of international transactions that are carried out.
Credit transactions record the receipts of money from other countries. On the
other hand, debit transactions record payments made to other countries.
The credit transactions will be marked positive (+) in the balance of payments
account. Credit transactions include exports of goods and services, receipts of
transfer payment or gifts, and any capital inflow. Debit transactions will be marked
negative (ă) in the balance of payments account. Among the debit transactions are
the imports of goods and services, giving of gifts to other countries and capital
outflow.
Figure 9.5 shows the categories of balance of payments.
Figure 9.5: Categories of balance of payments
Let us look at each of the accounts in more detail in the following subtopics.

9.5.1 Current Account

The current account records all transactions on exports and imports of goods and
services plus net international transfers (public or private gifts or donations). The
current account is divided into three smaller accounts, namely the trade account,
services account and the transfer of payments account. This is shown in Figure 9.6.
Figure 9.6: Three types of accounts in current account
Table 9.1 gives the description of the three types of accounts in the current account.
Table 9.1: Types of Accounts in Current Account
Type of Current
Description
Account
Trade Account The trade account records the total exports and imports for the
production of agriculture, mining and various other traded goods.
The difference between export value and import value is known as

the balance of trade. A positive balance of trade is known as a trade
surplus and occurs when exports exceed imports. On the other
hand, a negative balance of trade is known as a trade deficit or
informally as a trade gap.
Services Account The services account records the total exports and imports for
services that include payments for transportation, insurance, tourist
expenditure and investment income.
The difference between the export value and import value of

services is called the balance of services. A positive balance is
known as a services surplus and occurs when exports exceed
imports. A negative balance is known as a services deficit, which
means imports exceed exports.

Transfer of The transfer of payments account records all transfer payments

Payments made or received by the government and the private sector.
Account
Transfer payments include giving (receiving) assistance and gifts to
(from) other countries. Transfer payments do not get any payments
in return, whether in cash or in kind. For example, the humanitarian
channel given by Malaysia to Afghanistan is a transfer of payment.
These three transactions, when placed together, form the current balance, as given
in the following formula:
Trade account + Services account + Transfer of payments account =

CURRENT BALANCE
9.5.2 Capital Account

What does capital account record? The capital account records the net result of
public and private international investments flowing in and out of a country.
Investments and loans from overseas are recorded as credits in a countryÊs capital
account. Investments and loans given to other countries are recorded as debits.
As shown in Figure 9.7, the capital account is divided into two smaller accounts,
namely, long-term capital account and short-term capital account.
Figure 9.7: Types of capital accounts

(a) Long-term Capital Account

The long-term capital account covers all forms of capital inflow and outflow
in a country that has the maturity date of more than one year. It includes
official long-term capital and private long-term capital. Let us refer to
Table 9.2 for the explanation.
Table 9.2: Types of Long-term Capital Accounts
Type of Long-term
Explanation
Capital Account
Official Long-term The movement of official long-term capital comprises the
Capital loans and payments between the government of one
country and that of another, or international financial
bodies. Some examples are loans taken by the Malaysian
government from Japan and the World Bank.
Private Long-term The movement of private long-term capital can be divided
Capital into two types, namely direct investment and portfolio
investment. Direct investment means investing in asset
ownership such as building new firms in other countries
together with the ownership control.
Portfolio investment is the purchase of shares and bonds.

However, the government guarantee letter does not
include ownership control.
When the current balance is added to the long-term capital account, they
form the basic balance as shown here:
Current balance + Long-term capital account = BASIC BALANCE
(b) Short-term Capital Account

The short-term capital account covers all types of capital inflow and outflow
in a country with a maturity date of less than year. The short-term capital
account includes official and private short-term capital. Let us refer to
Table 9.3 for the explanation of these two types of short-term capital
accounts.

Table 9.3: Types of Short-term Capital Accounts
Type of Short-term
Explanation
Capital Account
Official Short-term The movement of official short-term capital is the payments
Capital of interest on loans taken from other countries or
international financial institutions. For example, payment
of interest by the Malaysian government on loans taken
from the World Bank.
Private Short-term The movement of private short-term capital includes bank
Capital loans, trade credits and such for a short period. For
instance, short-term investments made by foreign investors
in the country to earn profits in the short-run.
(c) Mistakes and Omissions

Mistakes and omissions are movements of short-term capital that cannot be
determined or classified as either official or private. They also include capital
flows which cannot be traced or recorded.
9.5.3 Official Settlement Account

What does this type of account record? The official settlement account records the
net change of foreign currency reserves and gold reserves in a country. This change
is due to an imbalance in the balance of payments. When there is an excess balance
of payments, foreign currency and gold will increase.
In addition, if there is a deficit balance of payments, the foreign currency and gold
reserves will decrease as well. This clearly shows that surplus or deficit balance of
payments will be balanced by changes in the official settlement account.
When the basic balance (current balance + long-term capital account) is added to
short-term capital account and the official settlement account, the total obtained is
called the balance of payments.
CURRENT BALANCE + CAPITAL ACCOUNT + OFFICIAL SETTLEMENT

ACCOUNT = BALANCE OF PAYMENTS

SELF-CHECK 9.1
Are these statements True or False? Mark  in the appropriate column.
You can check your answers based on the topics you have studied.
No. Statement True False

1 Capital account records all transactions related to
the export and import of goods and services plus net
international transfers (public or private gifts or
donations).
2 Current account records the flow of public and
private capital or international investments flowing
in and out of a country.
3 Current account is classified into three smaller
accounts, namely trade account, services account
and transfer of payments account.
4 All forms of capital inflow and outflow in a country
that have a maturity date of more than one year are
known as short-term capital account.
5 All forms of capital inflow and outflow in a country
that have a maturity date of less than one year are
known as long-term capital account.
6 Current balance added to the long-term capital
account is known as the balance.
7 Trade account added to the net capital services
account is known as the current balance.
8 Three types of long-term capital account are official
long-term capital, private long-term capital and
government long-term capital.
9 There are two types of short-term capital account,
namely official short-term capital and private short-
term capital.

ACTIVITY 9.4
Find articles on balance of payments and the accounts that you have
studied in this topic from the Malaysian Department of StatisticsÊ website
(www.statistics.gov.my).
Extract the important points from the articles and share with your
coursemates in the myINSPIRE online forum.
9.6 STRATEGIES TO REDUCE BALANCE OF

PAYMENTS DEFICIT
Several strategies can be used by the government to reduce deficits in the balance
of payments. Do you know what are they? They are exchange rate devaluation,
demand management and supply-side policy.
9.6.1 Exchange Rate Devaluation

If one country devalues its exchange rate, foreigners will buy more of the countryÊs
exports and less of their own products. At the same time, domestic producers will
buy fewer imports and more domestically-produced goods. This will eventually
help to improve the balance of payments. However, the extent to which exchange
rates affect exports and imports will also depend upon the elasticity of demand for
the products.
9.6.2 Demand Management

This is an expenditure reducing policy where fewer imports will be demanded as
aggregate demand falls. This can be done by using either fiscal or monetary
policies. Fiscal policy can be carried out through higher direct taxes and this causes
the disposable income to fall and reduces the demand for imports. In addition,
lower government spending will also reduce the demand for imports. Monetary
policy through higher interest rates will reduce the aggregate demand in several
ways such as discouraging borrowing by households and firms and business
investments may also fall since the cost of borrowing funds will increase. Planned
investments may prove to be unprofitable and consequently, the aggregate
demand will fall. These policies will reduce the demand for imports by households
and firms.

9.6.3 Supply-side Policy

Supply-side policy leads to increase in exports and decrease in imports as the
quality of one countryÊs product improves whilst cost decreases. Supply-side
policies include technological progress and the impact of innovation, changes in
factor production in labour and capital, changes in unit wage cost and changes in
size and quality of capital stock through investment.
Balance of payment is needed in every country to record all economic transactions

between the people in a country with the rest of the world within a time period.
Deficit in balance of payment needs necessary action taken by the policy makers
to stabilise the economy.
 Foreign exchange rate refers to the rate at which one currency may be
 The foreign exchange determinant process is based on the power of supply and
demand.
 Factors such as prices of goods, inflation levels, interest rates and peopleÊs
income influence the foreign exchange rate.
 The balance of payments is a systematic record of a nationÊs total payments to

foreign countries including the price of imports and the outflow of capital and
gold, along with the total receipts from abroad and including the price of
exports and the inflow of capital and gold.
 Three main components of a balance of payments account are the current

account, the capital account and the official settlement account.
 There are a number of policy options available to reduce the balance of

payments deficit. They include the use of exchange rate devaluation or
demand management policy through either fiscal or monetary policies that
will reduce the demand for imports. The reduction of the balance of payments
deficit can also be done through supply-side policies that will lead to an
increase in exports and a decrease in imports.

Balance of payments Determinants

Capital account Foreign exchange rate
Credit transactions Interest rate
Current account Trade account
Debit transactions

Trade and
10 Finance:
Problems and
Policies
LEARNING OUTCOMES
1. Explain the Gold Standard and its limitations;
2. Describe the Bretton Woods system and its limitations; and
3. Discuss the flexible exchange rate system.
 INTRODUCTION
Since the beginning of the 20th century, the world has operated under a number
of different monetary systems. In this topic, we will learn about the history of the
most widely used international monetary system, namely the Gold Standard and
the Bretton Woods system. The Gold Standard, which was in use up until 1914,
had its own weaknesses and was eventually replaced by the Bretton Woods system
in the 1940s after an international conference in Bretton Woods.
We will also discuss the managed floating exchange rate system, which has
evolved over the past few decades. In addition, the advantages and disadvantages
of both flexible and fixed exchange rates will also be examined at the end of this
topic. Let us begin the lesson!

TOPIC 10 INTERNATIONAL TRADE AND FINANCE: PROBLEMS AND POLICIES  237
10.1 GOLD STANDARD

Have you ever heard about this standard? What is the Gold Standard?
The Gold Standard was formerly used as an international monetary system

where the value of each currency was fixed in terms of gold.
Under the Gold Standard, which operated from 1870 to 1914, the external value of
all currencies was maintained by fixing their prices in terms of gold. The Gold
Standard was the major system of exchange rate determination at that time. This
means that all currencies were exchanged at fixed ratios to gold and, therefore, the
exchange rate could be determined easily. To understand more clearly, let us look
at this example:
One ounce of gold is worth USD40. The same ounce of gold is also worth £5.
This means that the same ounce of gold can be exchanged for USD40 or £5.
Based on this, the exchange rate between dollars and pounds was USD40/£5 or
simply USD8 to £1.
However, in order for the system to be effective, the country had to be willing to
buy and sell gold at the determined price. In other words, the countryÊs central
bank had to preserve the official parity between its currency and gold by buying
and/or selling gold at the official parity price, which was the price of each
countryÊs currency in terms of gold. Since the gold content of each countryÊs
currency was known and fixed, the exchange rates between the countries were also
fixed.
As long as a countryÊs balance of payments remained in balance, the economy

would be in equilibrium as no gold would enter or leave the country. What
happens when citizens in Country A bought more from Country B? In this case,
Country AÊs balance of payments would be in deficit and its stock of gold would
decrease. On the other hand, Country B would start to accumulate gold as exports
would be greater than imports.

238  TOPIC 10 INTERNATIONAL TRADE AND FINANCE: PROBLEMS AND POLICIES
The Gold Standard was not only a means of fixing exchange rates between
countries but it also automatically managed the countryÊs money supply. This is
because an inflow of gold into the country would cause the countryÊs money
supply to expand and conversely, an outflow of gold would cause the countryÊs
money supply to contract. If gold were flowing from Country A to Country B,
Country BÊs money supply would increase and Country AÊs money supply would
decrease. When this happens, an increase in Country BÊs money supply would
lower its interest rate and therefore stimulate aggregate demand. Consequently,
the aggregate output and the price level would also increase. Higher prices in
Country B would discourage citizens in Country A from buying goods from
Country B. Meanwhile, citizens in Country B would import more goods from
Country A as they would have more income and face relatively lower import
prices. In the end, the changes in relative prices and income, which resulted from
the inflow and outflow of gold, would automatically revert back into balance.
ACTIVITY 10.1
Visit this website to gather more information on the Gold Standard at:
http://www.britannica.com/EBchecked/topic/237431/gold-standard
Discuss why the Gold Standard is no longer used today. Share your
opinion with your coursemates in myINSPIRE online forum.
10.2 PROBLEMS WITH THE GOLD STANDARD

What are the limitations of the Gold Standard system? As stated by Case and Fair
(1996), there are several problems with the Gold Standard because a country had
little control over its money supply. As mentioned earlier, an inflow of gold would
turn the balance of payments into a surplus and the money supply would expand.
A country with a balance of payments deficit would then correct the problem by
contracting its money supply.

However, this would affect the economy as income and employment would
decrease. In other words, a country could act to protect its gold reserves and this
action would eventually prevent the adjustment mechanism from correcting the
deficit. Besides that, the money supply of a country depends on the amount of
available gold. Therefore, when major new gold mines are discovered, the worldÊs
supply of gold would increase, and in turn would cause the price level and income
to increase. On the other hand, when no new gold mine is discovered, the price
level and income would decrease.
EXERCISE 10.1
1. Discuss the role of the government in making the Gold Standard

system effective.
2. Explain the problems of the Gold Standard system.
10.3 BRETTON WOODS SYSTEM AND THE

FIXED EXCHANGE RATES
Firstly, let us look at the definition of the Bretton Woods system.
The Bretton Woods system is a system in which currencies are pegged to the
US dollar and the dollar was fixed at the rate of USD35 per ounce of gold.
In July 1944, a group of economists met in Bretton Woods, New Hampshire to

formulate a new exchange rate determination that could avoid the problems that
emerged from the Gold Standard system. From this meeting, an adjustable peg
system of exchange rate ă called the Bretton Woods system ă was chosen. Under
this system, the US dollar was pegged to gold but all other currencies were pegged
to the dollar. Instead of pegging each currency directly to gold, all other currencies
were fixed in terms of US dollar, which was fixed at USD35 per ounce of gold.

It was also agreed that a new international monetary institution known as the
International Monetary Fund (IMF) be created to play an important role in the
operation of the international monetary system. As stated earlier, the Gold
Standard gave rise to the problem of a countryÊs control over its money supply.
The Bretton Woods system was developed to link an imbalance in the balance of
payments to a countryÊs money supply. In other words, to reduce the role of gold
in determining a countryÊs money supply.
Under a pure fixed exchange rate system, the government would set a fixed rate
at which its currency will be exchanged for and then commit to maintaining that
rate. The government will then has to intervene, by buying or selling foreign
exchange to manipulate the exchange rate and to keep its currency aligned to its
established value.
10.4 COLLAPSE OF THE BRETTON WOODS

SYSTEM
The Bretton Woods system operated fairly well during the 1950s and 1960s.
However, over time problems emerged. One of the problems was that the system
was not symmetrical. This means a country with a chronic balance of payments
deficit would be obliged to devalue its currency and to cut its deficit by contracting
its economy. By taking such actions, prices and employment would increase. This
would also mean that the country was losing its stock of foreign currencies and,
therefore, had to change its exchange rate.
On the other hand, what would happen to countries which have a balance of
payments surplus? Under the Bretton Woods system, countries with a balance of
payment surplus were allowed to accumulate reserves through intervention.
These countries are supposed to stimulate their economies and/or revalue their
currencies to restore balance to their balance of payments, however, they are not
obliged to do so. The fixed exchange rate could be maintained easily as the
countries could buy any excess supply of foreign exchange with their own
currency.

Another problem with the Bretton Woods system was that all currencies were
fixed to the US dollar and the US government was obligated to exchange the
dollars for gold at a fixed price. This implies that as long as the USÊ balance of
payments was balanced in the long run, the system would operate well. However,
what happened in the mid 1960s? The US balance of payments was in deficit. Since
all countries demanded for dollars to be used for intervention, the US was not
obligated to correct the imbalances. Therefore, no action was taken, that is, there
were no adjustments to the fiscal policy or monetary policy in order to correct the
external imbalance.
Over time, foreign central banks were holding an increasing amount of dollars.
Countries with balance of payments surplus had to buy US dollars and sell their
domestic currency to prevent their currency from appreciating. Problems started
to occur at the end of the 1960s where foreign central banks were holding a large
amount of US dollars compared to the US stock of gold at the official price of
USD35 per ounce.
In general, the collapse of the Bretton Woods system in the early 1970s was linked
to the US balance of payments deficit. The announcement made by the US in
August 1971 stated that it would no longer redeem dollars for gold. This marked
the end of the Bretton Woods system.
EXERCISE 10.2
Discuss the main problems of the Bretton Woods system which led to the
breakdown of the system.
10.5 FLEXIBLE EXCHANGE RATE SYSTEM

Next we come to the flexible exchange rate system. What is flexible exchange rate?
The flexible exchange rate is an exchange rate in which the value is determined
by market forces, without any intervention from the central bank.

The flexible exchange rate period officially began in 1973 after the breakdown of
the Bretton Woods system. Under this system, demand and supply determine the
exchange rates without any government intervention. The foreign exchange
market will always clear itself and the government can turn its attention to
domestic problems such as inflation and unemployment while leaving the balance
of payments to adjust itself.
With this movement from fixed or stable exchange rate to flexible exchange rate, it
has been argued that the flexible exchange rates was able to offer a superior
alternative to fixed exchange rates in correcting the balance of payments
disequilibrium. Theoretically, this system allows a nation to achieve internal
balance easily and automatically. However, the degree of exchange rate volatility
has been associated with high absolute levels of, and great movements in, other
economic parameters such as inflation rate and interest rate.
As such, there are also arguments against the flexible exchange rate system. One
of argument is that volatility in the foreign exchange market imposes a really high
economic cost and this reduces real international trade. Besides the volatility
problem, the most important problem is misalignment, which undermines
economic performance in several ways including generated austerity, adjustment
costs, recession, deindustrialisation, inflation and protectionism.
10.5.1 Managed Floating Exchange Rate

With a managed floating exchange rate system, the central bank plays an
important role in the foreign exchange market. The central bank does not have an
explicit set value for the currency like in the fixed exchange rate system. However,
at the same time, the central bank does not allow the market to freely determine
the value of the currency like in the flexible exchange rate system. The central bank
does not have to publicly announce the value of exchange rates that it has
committed in advance to defend. Therefore, the central bank is free to adjust its
exchange rate target as circumstances change. Sometimes the central bank can
leave the rate to fluctuate freely but at other times it intervenes to alter the
exchange rate from its free market value.

10.6 ADVANTAGES AND DISADVANTAGES OF

FLEXIBLE EXCHANGE RATE SYSTEM
What are the advantages and disadvantages of the flexible exchange rate system?
Let us find out the answers in the following subtopics.
10.6.1 Advantages of the Flexible Exchange Rate

As argued by the proponents of the flexible exchange rate system, there are four
advantages:
(a) Under the flexible exchange rate system, a deficit or surplus in the nationÊs
balance of payments is automatically corrected by a depreciation or an
appreciation of that nationÊs currency. Therefore, no policy decisions or
government interventions are needed to bring about adjustment in the
balance of payments disequilibrium. This system can be derived
fundamentally from the laws of supply and demand, where the competitive
market establishes the price that equates quantity demanded with quantity
supplied, and thus clears the market.
(b) Under the flexible exchange rate system, the balance of payments
disequilibrium is theoretically corrected in a smooth and continuous manner.
This is in contrast to the sudden erratic jumps under the Bretton Woods
system. As the exchange rate moves in a smooth fashion, this would result in
stabilising speculation, which prevents the exchange rate from overshooting
the fundamental equilibrium value. The movement of the exchange rate is
facilitated and made smoother by the actions of private speculators based on
their reading of current and prospective economic and policy developments.
As a result of these actions, overvalued currencies will then be sold, thus
reducing their values while undervalued currencies will be bought, thus
pushing up their values. In any case, flexible exchange rates will eliminate
the principle case of speculation, for example, major delayed discrete
changes in exchange rate.

(c) The flexible exchange rate system overcomes the problem of asymmetrical
adjustment since not only will the overvalued currencies depreciate but the
undervalued currencies will also appreciate. Therefore, the deflationary bias
in the world economy could disappear.
(d) The flexible exchange rate system reduces and removes the need for payment
policies such as protectionism. As a result, the full employment of the
worldÊs resources will be used efficiently.
It has been argued that the flexible exchange rates would lead to market efficiency.
In contrast, the fixed exchange rate system is inefficient as it may lead to policy
mistakes. Therefore, in flexible exchange rate system, purely internal economic
objectives would be achieved.
10.6.2 Policy Advantages of the Flexible Exchange

Rate System
It is argued that the flexible exchange rate system provides greater autonomy of
monetary policy whereby a nation is free to apply monetary policy for its domestic
stabilisation purposes in order to achieve internal macroeconomic goals of
employment, output, price stability and economic growth.
The balance of payments may adjust either through fluctuations in the exchange
rate as discussed earlier, or through changes in internal economic variables and
policies. Here, the fluctuation in the exchange rates is regarded as a substitute for
unacceptable economic adjustments in the international adjustment process. A
country can avoid the necessity of exposing domestic economic variables and
policies to external influences by allowing the exchange rate itself to bear the
burden of the international adjustment.
For example, suppose that a foreign recession threatens the domestic economy
through a fall in export demand. Under the flexible exchange rate regime, the
exchange rate depreciates and this prevents the balance of trade from worsening
by encouraging an increase in exports and a decrease in imports. Therefore, the
monetary authorities are free from the balance of payments constraint and are able
to pursue the goals of domestic stabilisation policies.

The biggest contribution of the flexible exchange rate system is that it provides
discretionary monetary independence rather than automatic insulation. It also
gives freedom to policymakers to set discretionary domestic policies without
explicit concern over balance of payments. In other words, under flexible exchange
rates, a nation can let the exchange rate take care of the external balance while it
directs its macroeconomic policies towards internal balance problems.
In the case of using the fiscal policy to achieve internal balance under the flexible
exchange rate, the fiscal policy affects the exchange rate in two ways. When a
nation expands its fiscal policy through increasing government spending or
reducing the tax rates, the aggregate spending and national income would
increase. As a result, imports increase and this worsens the trade balance and
weakens the domestic currency. At the same time, fiscal expansion increases the
interest rates and the government borrows more.
In the short run, high domestic interest rates attract capital from abroad. As a
result, two opposing tendencies might emerge, that is, an aggregate demand rise
that weakens the domestic currency versus a capital inflow that strengthens it for
a while. It would be more likely that the first effect would be stronger and longer
lasting, since the second effect might be offset by later outflows of interest and
principle repayments on the attracted capital. The overall result would probably
see the fiscal policy causing the currency to depreciate and, therefore, provides an
extra trade base for domestic production.
From the previous arguments, we can conclude that this system is generally more
efficient and gives countries more flexibility in pursuing their own stabilisation
policies. It also gives monetary authorities a greater control over the countriesÊ
money supply for their domestic stabilisation purposes in trying to achieve
internal macroeconomic goals of employment, output, price stability and
economic growth.

10.6.3 Disadvantages of Flexible Exchange Rate

System
How about its disadvantages? The advantages of flexible exchange rates discussed
earlier are based on theory. However, advocates of flexible exchange rates expect
these advantages to occur in the real economy. After adopting the flexible
exchange rate system, the outcome was different from what was expected. The
experience faced by the world was not the same as predicted by the theories of
flexible exchange rate system. When we examined the worldÊs economic
performance during the period from 1962 to 1972 (when the Bretton Woods system
was in operation), and compare the performance with the performance under
the flexible exchange rates since 1973, we would realised that the economic
performance had been almost unambiguously inferior under the flexible exchange
rate regime.
Some of the serious problems with the flexible exchange rates are as follows:
(a) It was argued that the flexible exchange rate system is associated with
volatility and misalignment. Opponents of flexible exchange rates claimed
that the worldÊs economic performance had worsened because of the
adoption of this system. In the case of volatility, two things can be inferred.
Firstly, the volatility might mean that the fundamental equilibrium exchange
rates are in themselves volatile and that the nominal rates are not equal to
the fundamental equilibrium exchange rate. It was also argued that, in
general, factors that determine the fundamental equilibrium exchange rates
such as productivity growth, terms of trade movement and changes in
savings-investment do not normally alter as quickly and as dramatically.
While these factors can explain the slow movements in exchange rates, it is
difficult to see how they are able to explain the high degree of volatility.
Therefore, it can be concluded that for much of the time since 1973, there has
been considerable misalignment of currencies.
(b) The flexible exchange rate system also causes uncertainty for both investors
and traders. Uncertainty caused by currency fluctuations discourages
international trade and investment.

SELF-CHECK 10.1
How would a country with a flexible exchange rate system be protected

from world economic fluctuations?
10.7 ADVANTAGES AND DISADVANTAGES OF

THE FIXED EXCHANGE RATE SYSTEM
In the following subtopics, we will learn about the advantages and disadvantages
of the fixed exchange rate system.
10.7.1 Advantages of the Fixed Exchange Rate

System
There are two advantages of the fixed exchange rate system. They are:
(a) Certainty is an advantage in the fixed exchange rate system. Under the fixed
exchange rate system, international trade and investment becomes much less
risky. Firms can forecast correctly and, therefore, make profits. This in turn
encourages international trade. Foreign investment is also encouraged, as
firms are more willing to set up factories overseas when there is less
uncertainty about exchange rate fluctuations.
(b) Fixed exchange rates would also eliminate destabilising speculation. If the
exchange rate is fixed, there is no point in speculating. Since there is no
speculative pressure on the currency, the central bank would have less to
intervene in order to maintain the rate.
10.7.2 Disadvantages of the Fixed Exchange Rate

System
There are four disadvantages of fixed exchange rate are as follows:
(a) There is no automatic adjustment in the balance of payments. With a fixed

rate, the problem of disequilibrium in the balance of payments would have
to be resolved through a reduction in the level of aggregate demand. When
demand falls, people consume fewer imports and the price level would fall,
making the country more competitive.

(b) A large holding of foreign exchange reserves is required in a fixed exchange

rate system. With fixed exchange rates, a government must hold large scale
reserves of foreign currency to maintain the fixed exchange rate resulting in
high opportunity cost.
(c) Loss of freedom in internal policy of a country. The needs of the exchange
rate can dominate policy and this may not be best for the economy at that
point. Interest rates and other policies may be set according to the value of
the exchange rate rather than the more important macro objectives of
inflation and unemployment.
(d) Fixed exchange rates are fundamentally unstable. Countries with a fixed
exchange rate mechanism often follow different economic policies, the result
of which tends to be differing rates of inflation. This means that some
countries will have low inflation and be very competitive while others will
have high inflation and not be very competitive. The uncompetitive countries
will be under severe pressure continually and may, ultimately, have to
devalue their currency.
Each exchange rate system has its own advantages and disadvantages and each
country would adopt the exchange rate system that deemed necessary for the
country.
 The Gold Standard was the main system of exchange rate determination before
1914.
 The Bretton Woods system was used in 1931 after the collapse of the Gold
Standard, which applied the fixed exchange rate system.
 After the breakdown of the Bretton Woods system in 1971, a flexible exchange
rate system officially begun in 1973, where demand and supply were used to
determine the exchange rates without any government intervention.
 Under the managed floating exchange rates, the government intervenes when
foreign exchange rates fluctuate more than the governmentÊs desired rates.
 The advantages of the flexible exchange rate system include the following:
ă It allows a nation to achieve internal balance easily and automatically;

ă It corrects the balance of payments disequilibrium smoothly and

continuously;
ă It overcomes the problem of asymmetrical adjustments; and
ă It provides greater autonomy of monetary policy.
 The disadvantages of the flexible exchange rate system are its volatility,
misalignment and uncertainty.
 The advantages of the fixed exchange rate system are that it is less risky and
less volatile which encourages trade and investment and no speculation.
 The disadvantages of the fixed exchange rate system include no automatic

balance of payments adjustment, large holdings of foreign exchange reserves
required to maintain the fixed exchange rates and loss of freedom in internal
policy.
Bretton Woods system Gold Standard system

Fixed exchange rate International monetary fund (IMF)
Flexible exchange rate Managed floating exchange rates
Case, K. E., & Fair, R. C. (1996). Principles of microeconomics. Prentice Hall.

Answers
TOPIC 1: INTRODUCTION TO
MACROECONOMICS
Exercise 1.1
1. Inflation is an increase in the general price level and usually measured by
looking at changes in the customer price note.
2. The unemployment rate in Malaysia was at approximately 3.3% as of 2018.

MalaysiaÊs unemployment is relatively approximately at 3%. The country
reached its lowest level of unemployment in 2014 with the unemployment
rate of approximately 2.85%.
Exercise 1.2
1. Business cycle refers to short-term movements (economic growth and
recession) of economic activities.
2. The rate of unemployment will increase when there is a recession and it will
decrease when there is economic growth.
3. The rate of unemployment will not become zero even when there is economic
growth because there will be some unemployment, for example, when there
is a change of jobs or while workers wait for better job opportunities.
Exercise 1.3
Macroeconomists are involved in macroeconomic forecasting, macroeconomic
analysis, macroeconomic research, developing and testing economic theories, and
collecting data. Macroeconomic research is beneficial in testing models to increase
the precision of the forecast. It provides information on how economic research
can help in the macroeconomic analysis and on the types of data that need to be
collected.

ANSWERS  251
Exercise 1.4
The classical view states that wages and prices will change rapidly whereas the
Keynesian view states that wages and prices change rather slowly when the
economy is imbalanced. According to the classical theory, high unemployment
rate will not last long and change in wages and prices will help the economy
achieve market equilibrium. However, if the Keynesian theory is true, then the
slow change in wages and prices would mean that unemployment rate will remain
high for a longer period of time unless there is government intervention.
TOPIC 2: NATIONAL PRODUCTION
Exercise 2.1
TRUE (T)/FALSE (F) Statements
1. T 2. F 3. F 4. T 5. T
Exercise 2.2
1. The difference between GDP and GNP is the net income from overseas.
GNP = GDP + Net foreign factor income.
2. The goods are included in the calculations for 2018 because GDP measures
the output value of goods produced, and not that of goods sold.
3. For developing countries, the value of GDP is usually higher than the value
of GNP. This is because the foreign investment in the country is higher than
the investments made by the locals in foreign countries.
Exercise 2.3
1. Methods of calculating GDP:
(a) Expenditure approach;
(b) Production approach; and
(c) Income approach.

252  ANSWERS
2. The value of factor cost is adjusted to market prices using the following
formula:
Market prices = Factor cost + Indirect taxes ă Subsidies
Exercise 2.4
1. Activities that are not included are:
(a) Traditional farming activities;
(b) Illegal activities;
(c) Unpaid productive activities; and
(d) Non-cash rewards.
2. Real GDP is calculated based on fixed yearly prices. Basically, the GDP value
does not have any element of price change in its calculation. Only the
quantity of the goods produced changes. Meanwhile, nominal GDP is
measured using current prices for the year.
Exercise 2.5
1. National production data is used:
(a) To measure economic performance;
(b) To facilitate policy-makersÊ planning;
(c) To show or indicate the success or failure of government policies;
(d) To measure the peopleÊs standard of living; and
(e) To evaluate the contributions of economic sectors towards the
countryÊs economy.

ANSWERS  253
2. There are two types of factors that will affect the national income level,
namely internal factors and external factors.
(a) Internal Factors

One of the internal factors that affects the level of national production
is the availability of natural resources such as petroleum or gas.
Countries that are rich in natural resources are bound to have a higher
national production level compared to countries that have no natural
resources at all.
The energy or labour factor plays an important role in contributing

towards national production. Countries that have hardworking and
capable employees like Japan will definitely have a higher national
production level compared to countries with lazy and unproductive
labourers.
Total capital owned by a country also affects the level of national

production. Countries that have less capital cannot afford to produce
large outputs compared to countries that have more capital.
Besides these, the level of technology also determines the national

production level. Countries that have knowledge and technological
advancement are able to produce goods and services using a fast and
efficient method.
(b) External Factors

Foreign investment is an external factor. It plays an important part in
increasing the national income and economic growth of a country.
Foreign investment, whether direct or indirect, contributes towards a
countryÊs economic growth and income level.
Terms of trade also affects the income of a country. Terms of trade

refers to the ratio of price that a country receives for its export
commodity to the price that it pays for its import commodity.

254  ANSWERS
The terms of trade is considered good if it shows that a countryÊs import

quantity is higher than its export quantity.
Receiving assistance from other countries can also improve the

standard of living in the recipient country. For example, assistance
provided by international organisations and developed nations can
help reduce the rate of poverty in poor countries. The national
production of developing countries can be improved with the help of
other countries.
Exercise 2.6
1. Problems in calculating national production are as follows:
(a) Gathering Information

Gathering of information or data is difficult as there are some parties
such as small-time businessmen and farmers who do not keep detailed
records of their economic activities. The production value obtained
from them is usually an estimated figure. Mistakes happen when
classifying this information, which could cause some confusions in the
calculating process.
(b) Counting Twice or Double Counting

The difficulty in identifying final goods and intermediate goods might
lead to the problem of double counting. A product can be classified
as either a final or an intermediate goods depending on its usage.
For example, flour purchased by a homemaker is considered a final
product. However, flour purchased by a baker is considered an
intermediate product.
(c) Determining the Price of Goods

Prices of goods usually differ from area to area. In addition, prices of
certain goods are always changing. An example is the price of palm oil,
which changes everyday. Thus, the difficulty arises in determining the
price that should be taken into account in calculating the national
production.

ANSWERS  255
(d) Measuring Devaluation

It is difficult to measure devaluation because there are no detailed
records about devaluation for some economic activities. Moreover,
there are many different methods of calculating devaluation and each
method gives a different figure.
2. The business cycle refers to the periodic fluctuations in the rate of economic
activity, as measured by levels of employment, prices and production.
There are five phases in a business cycle, namely peaks, troughs, recovery,
growth (expansion) and recession (contraction). The points between the
phases are indicated by peaks and troughs. The most important phases in a
business cycle are growth (expansion) and recession (contraction). An
economy is said to have achieved a full cycle when the economy has gone
through the five phasess. For example, a business cycle that starts at the peak
is complete when it ends at the next peak.
Recession starts at the peak and ends at the trough. Recession occurs when
the value of real national production drops continuously for two quarters of
a year. The main characteristics of a recession include a decrease in demand
for labour and a reduction in spending by the consumers. Recession is also
reflected in the drop in firmsÊ profits. Since consumer spending decreases
during recession, all the firmsÊ unsold products increase and this will raise
the firmsÊ inventories.
Expansion, on the other hand, begins at the trough and ends at the peak. The
early stage of expansion is called recovery. This happens when national
production actually increases continuously for six months. A growth in
the economy reflects the increase in business sector confidence, hike in
investment and a demand for labour. As income increases, the spending
power of the people also increases and this in turn causes firmsÊ profits to go
up and inventories to reduce.

256  ANSWERS
TOPIC 3: DETERMINANTS OF EQUILIBRIUM

INCOME THEORY
Exercise 3.1
1. Disposable income = Consumption + Savings
2. Multiplier is a ratio between changes in national income and changes in

aggregate expenditure multiplier value = 1/MPS
3. If C = 100 + 0.8Y and I = 50, at equilibrium level:
Y = C+I
Y = 100 + 0.8Y + 50
0.2Y = 150
Y = 750.
4. Because MPC + MPS = 1, then MPS = 0.25
5. Above
6. Marginal propensity to consume (MPC)
7. When the leakage is bigger than injection, the national income level
decreases. It also creates deflation.
Exercise 3.2
1. Please refer to the discussion on taxes and government expenditure for the
answer.
2. Savings + Taxes = Investment + Government expenditure
3. Government expenditure multiplier = 1/MPS

= 1/0.4 = 2.5
4. If MPC = 0.4, the government expenditure multiplier = 1/0.6 = 1.67
Therefore, if government increases its expenditure by RM2 million, the

equilibrium income level will increase by RM2  1.67 = RM3.33 million.

ANSWERS  257
Exercise 3.3
1. Players in the four-sector economy are:
(a) Households;
(b) Firms;
(c) Government; and
(d) Foreign countries.
Two additional concepts for a four-sector economy are import and export.
2. Equilibrium condition:
Y = C + I + G + (X ă M ) or S + T + M = I + G + X
3. Increases, decreases
4. Export multiplier = 1/MPS = 1/0.1 = 10

Change in income = 10 change in export
Change in export = 200/10 = 20
Therefore, export will have to be increased by 20.
Exercise 3.4
1. Fiscal policy is a government policy that is used to achieve government
objectives or economic goals such as higher employment rate, stable inflation
rate and encouraging economic growth. The fiscal policy consists of two
main tools, namely government expenditure and taxes.
2. Discretionary fiscal policy refers to a situation when the government makes

changes to the taxes and government expenditure in order to overcome
economic problems that cannot be handled through automatic fiscal policy.
3. Similarity:
It happens when the aggregate supply differs from the aggregate demand.
Difference:
Inflationary gap happens when the aggregate demand is more than the
aggregate supply. Deflationary gap happens when the aggregate demand is
less than the aggregate supply.

258  ANSWERS
TOPIC 4: MONEY AND THE BANKING SYSTEM

Exercise 4.1
1. Money can be defined as something that is universally accepted as a mode
of exchange. Features of money:
(a) Legal tender;
(b) Durability;
(c) Divisibility;
(d) Portability;
(e) Homogeneity; and
(f) Acceptability.
2. Four functions of money are as follows:
(a) Medium of Exchange

Money is very important for purchasing goods and services. With
money, the buying and selling of goods and services becomes easy
as a price system can be formed. Retailers can conduct business with
wholesalers of sugar, rice, flour, canned food, cooking oil and the
likes with great ease because of the existence of money. Similarly,
with money, consumers can purchase what they need easily from
businesspersons. This situation is completely different from the barter
system because in a barter system, you have to be sure that the other
party wants what you have to offer. For example, if someone has flour
and wants rice, he has to find someone else who has rice and wants the
flour. This makes it difficult to conduct business.
(b) Unit of Account

Money is used as the common benchmark to designate the prices of
goods throughout the economy. Unit of account, or measure of value,
means money is functioning as the measuring unit for prices. In other
words, prices of goods are stated in terms of the monetary unit. Just as
weight is measured in kilograms and distance in kilometres, we can use
Ringgit Malaysia (RM) to measure the value of goods and services. This
makes the accounting system much simpler. The measurement of
goods, services and wealth can also be done using the same measuring
unit, which is money.

ANSWERS  259
(c) Store of Value

As money is an easily exchangeable asset, it is easily stored for future
use. Thus, economic sectors such as households, firms, government and
overseas sectors are willing to save and borrow money.
(d) Standard of Deferred Payment

Money is used as a standard benchmark for specifying future payments
for current purchases, that is, buying now and paying later. Similarly,
loans from financial institutions can be quantified using the rate of
money.
Exercise 4.2
1. Bank Negara Malaysia (BNM) has to ensure that the banking system is
operating properly and smoothly because that is a necessity for good
economic growth. Therefore, BNM has to control the activities of financial
institutions so that they are in line with the government's objectives.
2. Three deposits that are received by commercial banks are:
(a) Savings deposit ă Does not have chequing facilities and the savings
earn interest as returns.
(b) Fixed deposit ă Savings for a fixed time period and interest is paid. No
chequing facilities.
(c) Current deposit ă Interest is not paid but depositors are given chequing
facilities.
Exercise 4.3
(a) Deposit multiplier = 1/RR = 1/0.25 = 4
(b) Total money supply = Multiplier value  Deposit

= 4  RM2,000
= RM8,000

260  ANSWERS
Exercise 4.4
1. Money creation does not refer to the activity of printing money. It refers to
the multiplier process that happens each time credit is given to the customer
because the giving of new credit will add the total money supply (M1, M2
and M3) in the market. This process of adding money supply is called money
creation or credit creation.
2. Industries based on agriculture can be expanded and developed through

financial policies by imposing low interest rates on farmers. This will
encourage and increase activities in the agricultural sector and eventually
help in boosting production from this sector.
Exercise 4.5
1. Money demand for precautionary purposes refers to money demand needed
to face unforeseen events like accidents, death and such. In life, we usually
face unforeseen events. These unexpected events usually make it difficult for
us to plan our expenses. An example is when you are retrenched because the
company has suffered losses due to recession. While looking for a new job,
you will probably have to use up your savings for your daily expenditure.
Therefore, you should keep aside a portion of your income or salary for
unforeseen expenditures.
2. The main factor that influences money demand for precautionary purposes
is the level of income. The higher the income, the more money will be saved
for this purpose.
Exercise 4.6
1. Current deposit refers to savings in a bank that do not earn interest but the
depositor is provided with the facility to withdraw money by issuing a
cheque.
2. When money supply exceeds money demand, there will be excess money in
the market. To use up the excess money, people will buy bonds. This
continuous process will cause the price of bonds to rise, whereas interest rate
will drop until it reaches the equilibrium level.

ANSWERS  261
3. (a) Money demand reduces from Md to Md1 and interest rate drops to R1.
(b) In order to maintain the interest rate, the central bank will have to cut
down the money supply in the market.
(c) Reducing the money supply in the market is a contractionary financial

policy.
TOPIC 5: MONEY, INTEREST RATE AND

INCOME: POLICY ANALYSIS
Exercise 5.1
1. An increase in government spending might cause a reduction in private
investment spending. If the money supply does not expand to accommodate
the rise in income and therefore an increase in money demand, planned
investment spending will be partially crowded out by the higher interest
rate. Although income still increases, the multiplier effect of the rise in
government spending (G) is lessened as the higher interest rate has a
negative effect on planned investment.
2. The crowding out effect depends on the sensitivity of planned investment

spending to changes in the interest rate. If the planned investment is
insensitive to changes in interest rate, any changes to the interest rate will not
have an impact on the planned investment. This means that there is no
crowding out effect. However, if the planned investment is very sensitive to
changes in interest rate, the crowding out effect will be larger. A small change
in interest rate will cause a bigger effect on the planned investment and
therefore the income level.

262  ANSWERS
TOPIC 6: AGGREGATE DEMAND AND SUPPLY
Exercise 6.1
1. Aggregate demand curve slopes negatively to show the negative relationship
between price and production level, assuming that all other factors are fixed.
2. Four factors that change the aggregate demand curve are as follows:
(a) Consumption Expenditures (C)

Consumption expenditures are usually associated to households.
Among the factors that influence consumption and cause the AD curve
to shift either to the left or right are the consumersÊ wealth, consumer
expectations, household debts and taxes.
(b) Investment Expenditures (I)

Investment expenditures are usually incurred by firms. The changes in
purchasing capital goods and other investments will cause the AD
curve to move either to the left or to the right. The change in investment
can be caused by interest rates, expected returns from investment
projects, business taxes, the level of excess capacity and technology.
(c) Government Purchases (G)

If the government increases its expenses in providing infrastructure
through an expansionary budget policy, the AD curve will shift to the
right. On the other hand, if the government practises a contractionary
budget policy, the AD curve will move to the left.
(d) Net Exports (X ă M)

The changes in exports associated to the movements of the AD curve
are influenced by factors other than price, namely:
(i) Foreign Income

When the income of foreigners is high, their demand will be
relatively high as well, regardless for domestic or foreign goods.
The demand for foreign goods will increase the exports of the
exporter country (assuming that exporter country imports less).
The increase in net exports is shown in the shift of the AD curve
to the right. If the income in foreign countries is low, then the net
exports will decrease and the AD curve will move to the left.

ANSWERS  263
(ii) Foreign Currency Exchange Rate

The change in foreign currency exchange rate also influences net
exports and aggregate demand (AD), for example, the exchange
rate between Ringgit Malaysia and American Dollar (exchange
rate E = RM/Dollar). If the value of the Ringgit deteriorates, the
rate of exchange will increase. Americans can get more Ringgit
whereas Malaysians will get fewer Dollars. The deterioration in
the value of Ringgit will make Malaysian goods relatively
cheaper compared to American goods. Therefore, MalaysiaÊs net
exports will increase (assuming that our imports are less than the
exports). This phenomenon will move the AD curve to the right.
The reverse situation will cause the curve to move the other way.
3. Macroeconomic equilibrium in the short run refers to a situation where firms

and resource suppliers are unaware of the full market conditions. It does not
happen at full employment level.
4. Changes in government expenditure is a fiscal budget policy because

government expenditure is a tool that is usually used by the government to
carry out its budget policies.
5. The long-run aggregate supply curve is vertical because the produced output
is the potential output. Costs and prices increase at the same time.
TOPIC 7: UNEMPLOYMENT AND INFLATION
Exercise 7.1
1. Unemployment refers to the labour force that does not work. They refer to a
working age group aged above 16 years old who do not work but who are
actively looking for jobs.
2. An unemployment rate of 4 per cent means 4 per cent of the labour force in
the country is currently not working.

264  ANSWERS
Exercise 7.2
1. Both unemployed persons and discouraged workers do not have jobs. The
difference between these two is that an unemployed person is actively
looking for a job while a discouraged worker does not show any interest or
make any efforts to find a job.
2. Full-time workers are those who work 35 hours or more in a week. Part-time
workers only work less than 35 hours a week.
Exercise 7.3
1. Types of unemployment:
(a) Frictional
Frictional unemployment or normal unemployment exists only for a
short period. It happens when individuals are moving between jobs,
careers and locations.
Sometimes people are willing to be unemployed while waiting to

accept another job and not because they are unable to find a job.
Frictional unemployment exists at all times, especially when the

economy is experiencing continuous rapid growth. This unemployment
even exists when the economy is at full employment.
However, since this type of unemployment is short term, it is not a

serious problem.
(b) Structural
Structural unemployment happens because workers do not have the
expertise and the ability to work in a new sector. It usually exists for a
longer period of time and a government policy has to be implemented
to overcome this problem.
Economic growth of a country is usually followed by structural

changes and changes in economic activities. For example, beginning
in the early 1980s, the Malaysian industrial sector became more
prominent compared to the agricultural sector. This caused some
workers to be laid off because the skills possessed by farmers could not
be utilised in the industrial sector.

ANSWERS  265
(c) Cyclical
Cyclical unemployment is caused by economic conditions that go up
and down. It occurs when the unemployment rate moves in the
opposite direction to the GDP growth rate. Therefore, when GDP
growth is small (or negative) unemployment is high. When there is
recession, demand for goods and services drop. This will force firms
to reduce their production and thus, cut down on their labour
requirements.
2. Natural unemployment rate equals the structural unemployment rate plus

frictional unemployment rate. It exists when the cyclical unemployment rate
is zero.
3. Jobs for all who want to work. Full employment means that everyone who
wants work and is willing to work at the market wage is at work. In a larger
context, it refers to a situation whereby production resources are used fully
without any wastage. It can also be defined as production level where the
real unemployment rate equals the natural unemployment rate.
Exercise 7.4
1. Reasons of unemployment:
(a) Job Losers

A job loser is someone who has been involuntarily terminated or laid
off from a job, regardless temporarily or permanently. There are many
reasons for this. For example, failure of the worker to fulfil his work
requirements or conditions, or the firmÊs failure to fulfil its employeesÊ
needs.
Those who have lost their jobs have two choices ă either to look for a
new job or leave the labour force. Those who leave the labour force are
not considered unemployed.
(b) Job Leavers

There are some who voluntarily leave their jobs and not necessarily
because they were laid off. If they left their job because they want to
accept another offer, then it does not contribute towards the increase in
the unemployment rate. Unemployment rate will only increase if these
job leavers are still in the process of looking for a new job.

266  ANSWERS
(c) New Entrants and Re-entrants

New entrants are those who have just completed their studies and are
ready to join the workforce. They have never been employed and are
actively seeking employment for the first time. However, while looking
for a suitable job, they will be referred to as unemployed.
Re-entrants are those who have previously been classified as employed

but have been out of the labour force for a period of time before actively
seeking employment once again. Usually, they will be unemployed
while trying for a new job.
2. The negative effects of unemployment towards the economy:

Unemployment does High unemployment rates will ruin economic growth and
not encourage performance. There will also be excess capacity from the
economic growth industrial production factor such as machinery. This will
indirectly cause a drop in investment levels.
Drop in government When people are unemployed, tax collection is also
revenue reduced. Subsequently, the government has to reduce its
expenditure to boost economic growth.
Wastage of High rate of unemployment forces the economy to
production resources operate at a level below maximum. The wastage of
resources brings about output production that is far lower
than the potential output.
Exercise 7.5
1. A continued increase in general price level is known as inflation.
2. The main component of the consumer basket for Malaysian CPI is the
expenses for food, which represents 34 per cent of the total expenditure.

ANSWERS  267
Exercise 7.6
1. There are three main steps in the calculation of CPI:
(a) Calculate the cost of CPI consumer basket at base year price;
(b) Calculate the cost of CPI consumer basket at current year price; and
(c) Calculate the CPI for base year and current year.
( New CPI  Old CPI)

2. Inflation Rate =  100.
Old CPI
TOPIC 8: INTERNATIONAL TRADE
Exercise 8.1
1. International trade is the process of exchanging or selling and purchasing of
goods and services between two or more countries.
2. Main factors that encourage international trade:
(a) Possession of Different Factors fo Production

Each country has its own factors of production and differences in type,
quality and quantity of goods produced. This difference is the main
factor why countries conduct trade with one another. Different factors
of production cause each country to focus on different types of
production.
(b) Different Climate

Differences in climate causes countries to concentrate on producing
different types of products. For instance, hot and wet climate in most
Southeast Asian countries like Malaysia, Indonesia and Thailand
encourages them to focus on rubber plantation. The cold climate in
Australia and New Zealand allow these countries to focus on the
production of fruits such as apples and oranges. As you can see,
different climate results in the production of different goods. The
differences in agricultural produce encourage countries to trade with
one another.

268  ANSWERS
(c) Different Labour Skills

Every country has its own level of labour skills. For instance, countries
like Japan, United States of America and Singapore have skilled labour
force in the industrial sector. Therefore, these countries focus on the
production of industrial goods. Other countries like New Zealand,
Australia, China and Malaysia have skilled labour force in the
agricultural sector. The difference in labour skills leads to the production
of different types of goods and this encourages international trade.
(d) Different Consumption Patterns

Different societies have different tastes, preferences and spending
patterns. This situation leads to the production of goods in accordance
with the societyÊs needs and preferences. Therefore, each country will
produce different types of goods. The different types of goods
produced encourage international trade.
Exercise 8.2
1. Absolute advantage is defined as a countryÊs ability to produce more of a
product than another country can, with the same amount of resources.
Comparative advantage refers to a countryÊs ability to produce a product
with relatively lower cost compared to other countries.
2. Absolute advantage looks at the efficiency of absolute production, taking

into account the output quantity that can be produced using total input.
Comparative advantage looks at relative efficiency, taking into account the
production with the lowest opportunity cost.

ANSWERS  269
Exercise 8.3
1. Four benefits of international trade:
The Benefits of
Description
International Trade
Acquire goods that The people in every country need a variety of goods.
cannot be produced However, the country is unable to produce all the goods
locally that are wanted or needed. Therefore, trade between
countries is carried out to acquire goods that cannot be
produced locally.
For instance, Malaysia specialises in the production of

palm oil, rubber and other plantation products which are
to be exported to other countries. In contrast, Malaysia
obtains goods that cannot be produced in the country such
as aeroplanes, apples and oranges.
Widen the market A countryÊs production can be marketed widely through
for local products international trade. Goods that are locally made can be
exported to other countries. Higher production quantity
will help to efficiently utilise the factors of production.
This will reduce the cost of production and the price. In
turn, it will increase the welfare and living conditions of
the people
Increase efficiency International trade encourages specialisation.
in the usage of Specialisation means each country specialises in
factors of producing a particular product that it can produce
production efficiently. This will ensure efficiency in usage of the
factors of production.
Acquire modern International trade allows modern technology to be
technology imported from developed countries to developing
nations. Modern technology will enable developing
countries to increase their production capabilities.
International trade also allows developing countries to
enjoy the usage of high technology products such as
computer, digital camera and the like.

270  ANSWERS
2. Methods to restrict free trade:
(a) Tariff
A tariff is a tax on foreign goods upon importation. Tariffs can be
divided into three types:
(i) Ad valorem tariff ă An import tax that is calculated based on the

percentage of the value of the imported goods;
(ii) Specific tariff ă A fixed tax figure that does not depend on the
value of the imported goods;
(iii) Compound tariff ă A combination of ad
(iv) valorem tariff and specific tariff.
(b) Quota
A quota is the maximum limit set on the quantity of a good that can be
imported into a country in a given period of time. Implementation of
quotas will not influence government revenue. In fact, quotas provide
protection for local firms. There is no more competition from foreign
firms once the quota is fulfilled. The main effect of a quota is that it
increases the prices of the imported goods. However, because of the
limited quantity of goods, consumers are willing to spend a lot of
money to get these products.
(c) Subsidy
The government grants subsidies to the producers to improve their
market position. With subsidies, producers can market their products
at prices that are lower than their actual cost. Subsidies can be in
various forms such as outright cash disbursements, tax concessions,
loans at below market interest rates and others. Two types of subsidies
that are usually used are domestic production subsidy, which is
granted to producers of import-competing goods and export subsidy,
which is granted to producers of goods that are exported to foreign
countries.

ANSWERS  271
(d) Voluntary Export Restraint (VER)

VER makes it possible to moderate the intensity of international
competition by allowing less efficient domestic producers to
participate in markets that would otherwise be controlled by foreign
producers who might sell products at a lower price.
(e) Foreign Currency Exchange Control

The government can also control the foreign currency used for import.
The government can impose various forms of control to influence
international trade activities such as imports. Among the methods used
to control the quantity of goods imported is by controlling the total
foreign currency needed to import these goods. Another alternative is
to sell the foreign currency at a higher rate compared to the market rate.
(f) Other Restrictions

The government can also use other methods to reduce importation of
goods. For example, the government can direct all government
departments to use only locally made products, for example, the
national car Proton. The government can also direct financial
institutions such as banks to reduce the giving of loans to support the
purchase of imported goods.
Exercise 8.4
1. Terms of trade can be defined as the ratio of the price or quantity of an export
commodity to the price or quantity of an import commodity.
2. Protectionism is needed to:
(a) Protect New Industries

Each country has new industries to promote. A new industry is not
ready to compete with foreign firms and, therefore, needs government
assistance and support to continue its operations. Without government
help, it could face strong competition and may even have to be shut
down if it fails to survive the competition.

272  ANSWERS
(b) Protect National Security

Certain goods have to be produced by the country itself. The country
cannot depend on another country to produce such goods. This is for
security reasons. For instance, if Malaysia depends on Thailand to fully
get its supply of rice, and if a war takes place between Malaysia and
Thailand, then this could possibly affect national security as Thailand
could restrict the supply of rice to Malaysia.
(c) Diversify Economic Activities

Trade restrictions are also necessary to diversify a countryÊs economic
activities that contribute towards national income through foreign
exchange. If a country depends a lot on a specific export industry, it can
cause a decrease in national income if the industry deteriorates.
(d) Protect Resources

Protectionism can also be used to protect local industries and their
resources. When consumers start depending on imported goods, it will
not encourage domestic economic activities. This will affect the
demand for local sources of production including labour force. This
will cause the unemployment rate to go up. Other related social
problems will appear such as robbery, theft and political instability.
(e) Perform Anti-dumping Measures

Anti-dumping refers to the activities of foreign firms that have excess
production and sell the goods to other countries at a much lower price
compared to the price sold in its own country. This situation will
encourage imports. However, if this continues, it will seriously affect
the local industrt. Therefore, protection policies are needed to look after
the welfare of the local industries because they contribute towards a
countryÊs economy.
TOPIC 9: INTERNATIONAL FINANCE
Exercise 9.1
1. Foreign exchange rate refers to the rate at which one currency may be
2. Foreign exchange rate is determined based on the interaction between money

demand and supply. Equilibrium is achieved when the demand and supply
for a currency is the same. When factors that influence the demand or supply
change, the equilibrium foreign exchange rate also changes.

ANSWERS  273
Exercise 9.2
Four factors that influence foreign exchange rate:
(a) Price of Traded Goods

The price of traded goods is the main determining factor for demand and
supply. If local goods can be sold more cheaply than goods from other
countries, it will increase exports and eventually cause a hike in the demand
for local currency. This means the value of local currency will increase
compared to other currencies. On the other hand, if the price of imported
goods is cheaper, it will encourage the demand for foreign currency through
increase in imports. This will cause the value of the foreign currency go up
and the value of local currency to drop.
(b) Inflation Level

There are two reasons why the value of currency can drop. Firstly, high
inflation level will cause the local products to be more expensive than
imported goods. The difference in price will encourage consumers to
purchase imported goods, which will directly increase the value and demand
for foreign currency. Secondly, inflation not only affects the price of goods
sold domestically but also the price of goods exported. Exported goods will
become more expensive and this will cause a decline in the demand for local
currency. Eventually, the value of local currency will deteriorate.
(c) Interest Rate

Among the important factors that influence the movement of capital is
interest rate. Interest rate reflects the rate of return on investments made.
High interest rate show will show profitable investment returns and this
increases the capital inflow. Increase in capital inflow will cause an increase
in demand for local currency and this will eventually increase the value of
local currency compared with foreign currency. In contrast, low interest rate
when compared to other countries will encourage capital outflow. This will
reduce demand and subsequently, the value of the local currency. Demand
for foreign currency will increase because investors will invest in countries
that offer high interest rates.
(d) Income of the People in a Country

The average income of people in a country will influence their expenditure
pattern. Those who have high incomes prefer to import goods from overseas
because they have higher purchasing power. This will increase the demand
for foreign currency. Conversely, low income will encourage people to buy
only locally-produced goods.

274  ANSWERS
TOPIC 10: INTERNATIONAL TRADE AND

FINANCE: PROBLEMS AND POLICIES
Exercise 10.1
1. In order for the Gold Standard system to be effective, countries should be
willing to buy and sell gold at the determined price. In other words, the
countryÊs central bank must preserve the official parity between its currency
and gold by buying and/or selling gold at the official parity price, which is
the price of each countryÊs currency in terms of gold.
2. Under the Gold Standard system, a country had little control over its money
supply. An inflow of gold would turn the balance of payments into a surplus
and the money supply would expand. A country with a balance of payments
deficit would then correct the problem by contracting its money supply.
However, this would affect the economy, whereby income and employment
would decrease. In other words, a country could act to protect its gold
reserves but this action would eventually prevent the adjustment
mechanism from correcting the deficit.
Besides that, the money supply of a country depended on the amount of

available gold. When a major new gold mine is discovered, the worldÊs
supply of gold increased, along with price level and income. However, when
no new gold mine is discovered, the price level and income decreased.
Exercise 10.2
One of the problems with the Bretton Woods system was that it was not
symmetrical. Countries with a chronic balance of payments deficit were obliged to
devalue their currencies and to cut their deficits by contracting their economies.
By taking these actions, prices and employment would increase. This means that a
country was losing its stock of foreign currencies and therefore had to change its
exchange rate. However, countries with balance of payments surplus were not
obliged to revalue their currencies. They could buy any excess supply of foreign
exchange with their own currency in an effort to maintain the fixed exchange rate.
Another problem of the Bretton Woods system was that all countriesÊ currencies
were fixed to the US Dollar and the US government was obligated to exchange the
Dollars for gold at a fixed price. This means that as long as the USÊ balance of
payments was balanced in the long run, the system would operate well. However,
in the mid 1960s, the US balance of payments was in deficit. When all countries

ANSWERS  275
demanded for the Dollars tbe used for intervention, the US was not obligated to
correct the imbalances. Therefore, no action was taken to adjust the fiscal policy or
monetary policy in order to correct the external imbalance. Over time, the foreign
central banks were holding an increased amount of Dollars. Countries with
balance of payments surplus had to buy US Dollars and sell their domestic
currencies to prevent their currencies from appreciating. Problems started to occur
at the end of the 1960s when foreign central banks were holding a large amount of
US dollars compared to the USÊ stock of gold at the official price of USD35 per
ounce.

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Copyright © Open University Malaysia (OUM)

Module Writers: Munzarina Ahmad Samidi

Co-Writers: Wan Azman Saini Wan Ngah

Moderators: Lilian Kek Siew Yick

Enhancer: Khu Bee Kiaw

Developed by: Centre for Instructional Design and Technology

First Edition, August 2011

Copyright © Open University Malaysia (OUM)

Topic 1 Introduction to Macroeconomics 1

Topic 2 National Production 19

Copyright © Open University Malaysia (OUM)

2.7 Real GDP and Nominal GDP 36

Topic 3 Determinants of Equilibrium Income Theory 47

Copyright © Open University Malaysia (OUM)

Topic 4 Money and the Banking System 90

Topic 5 Money, Interest Rate and Income: Policy Analysis 121

Copyright © Open University Malaysia (OUM)

Topic 6 Aggregate Demand and Aggregate Supply 135

Topic 7 Unemployment and Inflation 168

Copyright © Open University Malaysia (OUM)

7.10 Inflation 184

Topic 8 International Trade 198

Copyright © Open University Malaysia (OUM)

8.6 Terms of Trade 213

Topic 9 International Finance 219

Topic 10 International Trade and Finance: Problems and Policies 236

Copyright © Open University Malaysia (OUM)

10.6 Advantages and Disadvantages of Flexible Exchange 243

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

COURSE GUIDE DESCRIPTION

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Table 1: Estimation of Time Accumulation of Study Hours

COURSE LEARNING OUTCOMES

1. Apply the concepts of macroeconomics in economic perspectives;

2. Interpret the macroeconomics information using visual data/articles; and

3. Analyse the effects of various macroeconomics policies to the growth of a

Copyright © Open University Malaysia (OUM)

Topic 2 introduces one of the important concepts in macroeconomics, which is

Topic 3 focuses on the determinant of national income equilibrium in a two-

Copyright © Open University Malaysia (OUM)

Topic 6 focuses on aggregate demand and supply. From the aspect of

Topic 7 discusses two important variables in the economy, namely

Copyright © Open University Malaysia (OUM)

Topic 9 focuses on international finance. Learners will be introduced to the

TEXT ARRANGEMENT GUIDE

Self-Check: This component of the module is inserted at strategic locations

Copyright © Open University Malaysia (OUM)

Activity: Like Self-Check, the Activity component is also placed at various

References: The References section is where a list of relevant and useful

Copyright © Open University Malaysia (OUM)

Mankiw, N. G. (2018). Principles of economics (8th ed). Boston, MA: Cengage

McEachern, W. (2017). Economics: A contemporary introduction (11th ed.).

Statista. (2018). Retrieved from https://www.statista.com/

Trading Economics. (2018). Retrieved from

TAN SRI DR ABDULLAH SANUSI (TSDAS)

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)