BHM 101 Principles of economics

NATIONAL OPEN UNIVERSITY OF NIGERIA
SCHOOL OF MANAGEMENT SCIENCES
COURSE CODE: BHM 101
COURSE TITLE: PRINCIPLES OF ECONOMICS
Unit 1: Money, Types and Functions
Contents
Page
1.0 Introduction ........................................................................................................................................ 2
2.0 Objectives .......................................................................................................................................... 2
3.0 Meaning/Definitions ............................................................................................................................ 2
3.1 What is Money? ................................................................................................................................. 2
3.2 Trade by Barter .................................................................................................................................. 2
3.3 Types of Money ................................................................................................................................. 3
3.4 Qualities of Money .............................................................................................................................. 3
3.5 Functions of Money ............................................................................................................................ 4
4.0 Conclusion .......................................................................................................................................... 4
5.0 Summary ............................................................................................................................................ 4
6.0 Tutor-marked Assignments ................................................................................................................. 5
7.0 References/Further Reading ............................................................................................................... 5
1

2 Principles of Economics
1.0 Introduction
In this unit, you will learn that the wealth of a community exists in the goods and services it produces and that
money is merely a convenient way of measuring wealth. We must now investigate money more closely and
determine what it does, and what problems it creates. Market economy or Money economy should be
compared with the subsistence economy. Subsistence economy means that people consume what they have
themselves produced and exchange nothing. In a market economy, exchange may take two forms: direct
exchange (barter) or indirect exchange using money as a “means of payment” or “medium of exchange”. It
should be noted that barter involves such inconveniences at a comparatively early stage. In the development
of an economy, we should expect a medium of exchange; money comes into use.
In every economic system, whether dominated by private interest as in capitalism or government interest
as in communism and socialism, or mixed economy having a blend of capitalism and communism, money has
very crucial roles to play. Its roles in the economy is pervasive, touching every aspect of the economy.
A special attention is given to money because the use of monetary policy as a stabilisation tool by the
government is based on the role of money in the economy. We cannot have a proper grasp of monetary
theories and policies without first of all understanding money.
2.0 Objectives
It is hoped that by the end of this unit, you will be able to:
(i) understand the meaning of money and how it evolved.
(ii) show the various types of money and the functions that money performs in every economy.
3.0 Meaning/Definitions
3.1 What is Money?
Everybody who has reached the age of Kindergarten knows what money is. You possibly have touched
money today. However, the term ‘money’ means different things to the ordinary man in the street. It is often
used to describe wealth and financial resources, credit and income. When we say “the man has money or the
man is in money”, we are referring to money as wealth or financial resources. It differs from the way an
economist uses the term ‘money’.
Economists see money as anything that serves as a medium of exchange in a given society. Chandler and
Goldfield (1997) defined money as “anything that is generally acceptable as a medium of exchange”. Amacher
and Ulbrich (1986:239) defined it as “an item that people accept as payment for goods or services.” Cox
(1983) defined it as “anything which passes freely from hand to hand and is generally acceptable in settlement
of debt and other financial obligation is money.” From these definitions, we have two things to note. The
first is that whatever serves as money has to be generally acceptable in settling financial obligations. The
second thing is that anything whatsoever can serve as money provided it is acceptable as money within a
given community. The legal tender approach to defining money brings to fore the point that the law can help
a commodity to achieve general acceptability.
3.2 Trade by Barter
It is the direct system and practice of exchanging goods and services for goods or services. The best way to
understand the importance of money in any economy is to look at an economy that does not use money.
When there is no generally accepted medium of exchange, individuals engage in barter. The problem or
difficulties of Trade by Barter includes:
· The difficulty of double co-incidence of wants;
· It wastes time and energy;
Money, Types and Functions 3
· Difficulty in assessing the value of the commodities;
· The exchange always becomes uninteresting;
· It does not encourage deferred payments;
· It does not encourage the system of division of labour and specialisation;
· There is no lending and borrowing;
· It discourages large-scale production.
Students Assessment Exercise
How did Trade by Barter encourage the introduction of money?
3.3 Types of Money
(i) Coins:They are metal money with definite amount.
(ii) Paper Money: It is in form of paper notes which originated from the receipts that the Goldsmiths
issued to people.
(iii) Bank Money: It is deposit in both Savings Account, Current Account and Fixed Deposit Account.
(iv) Foreign Money: It is the money of other countries and it serves as money in the foreign exchange
market.
(v) Legal Tender: It is money backed by the force of law in a country which is generally acceptable as a
medium of exchange.
(vi) Gold Backed Money: It is money that can easily be converted or changed into gold by the central
authority that issues money.
(vii) Commodity Money: It is commodity used as money in the old days, e.g. cowries, shart teeth manilla
etc.
(viii) Token Money: This is money whose intrinsic worth is less than its normal or face value.
(ix) Representative Money: It is a document or lieu of legal tender but not fully and freely acceptable
e.g. cheques, postal and money order bills, etc.
(x) Fiduciary Note Issue: This is the type of money that are not backed by either gold or any foreign
currency.
3.4 Qualities of Money
This is also known as the characteristics of money.
(a) Homogeneity: Each unit of money must be homogenous, that is, each unit held by different individuals
must be identical;
(b) General Acceptability: Each unit of money must be generally acceptable in exchange for goods and
services purchased;
(c) Portability: Each money unit must be easily carried about. In other words, it must be easily transmissible;
(d) Divisibility: Money must be capable of being divided into small units;
(e) Recognisibility: Money must be easily recognisable by all and sundry in order to detect any counterfeit;
(f) Relative Scarcity: Money must be relatively scarce in order to maintain its value;
(g) Stability in Value: There should be absence of inflation and deflation to make money stable in value as
well as enable it serve some useful functions such as the store of value and means of deferred payment;
4 Principles of Economics
(h) Durability: Money must be capable of staying long without spoiling or going bad.
3.5 Functions of Money
(a) Money serves as a medium of exchange. With the introduction of money, goods and services are
exchanged with money and thus exchange is facilitated. With money as a mean of exchange, the
problems of barter are bye-passed.
(b) Money serves as a store of value. In-so-far as there is no inflation and deflation in the economy,
money serves as a store of value since money would not lose its value any period it is kept.
(c) Money serves as a unit of account. All business transactions are accounted in money units.
Whether it is payments, debts or costs, it is made in money units. This facilitates exchange or
transactions.
(d) Money serves as a measure of value. With money, one can measure the quality or value of goods,
services or different occupations.
Thus money is used to measure and compare the value of goods and services.
(e) Money serves as a standard for deferred payments – With the use of money, one can postpone or
defer the payment for goods and services purchased. This function is important these days when
business transactions are carried out mostly on credit basis.
4.0 Conclusion
Money has a very crucial role to play in every economy. One good way to understand the importance of
money to any society is to imagine a situation where there is no money in an economy. All the problems
associated with the barter system will become very prominent in such economy.
In every economy, money performs four major functions. The first two can be classified as primary or basic
function while the last two are secondary functions. They are said to be secondary because they are derived
from the first two. Any commodity that can perform the primary function can automatically perform the
secondary functions, but not all commodities that perform the secondary functions can perform the primary
functions.
The primary functions of money are:
(a) Money as a medium of exchange.
(b) Money as a unit of value.
The secondary functions are:
(a) Money as a standard for deferred payment.
(b) Money as a store of value.
5.0 Summary
In this unit, it is clear that money plays a vital role in the economic system of any country. Modern economic
activity is based on specialisation and exchange. Money is a device for promoting specialisation and exchange.
Specialisation and exchange would revert to the barter system of money that have ceased to exist.
We are living in an economy based on money. Government development programmes as well as individual
enterprise activities are calculated in terms of money as a unit of account. The existence of a unit of account
permits the growth of a price system and this in turn promotes growth of markets. By serving as a medium of
exchange, money facilitates the exchange of goods and services among specialists.
Money, Types and Functions 5
6.0 Tutor-Marked Assignments
(1) (a) In your own words, give a functional definition of money.
(b) Discuss the various types of money. Which of them is currently in use in Nigeria.
(2) What are the functions of money?
Describe clearly how money performs these functions.
(3) What are its main characteristics and major roles in the economy of a nation.
(4) The inadequacies of Trade by Barter as an Exchange Mechanism gave birth to money. Name
and explain these inadequacies.
7.0 References/Further Reading
1. Ade, T. O et al. Banking and Finance in Nigeria. Bedforshire: Graham Burn, 1962.
2. Adekanye, F. The Elements of Banking in Nigeria. Bedforshire: Graham Burn, 1991.
3. Afolabi, L. Monetary Economics. Lagos: Inner Ways Publishers Limited, 1991
4. Ajayi, S. I. et al. Money and Banking. London: George Allen and Unwin Limited, 1981.
5. Anyanwu, J. C. Monetary Economics. Onitsha: Hybrids Publishers Limited, 1993.
6. Nwankwo, G. O. The Nigerian Financial System. London: Macmillan Publishers, 1980.
7. Umole, J. A. Monetary and Banking Systems in Nigeria. Benin City: Adi Publishers, 1985.
8. Chandler, L. V. et al. The Economics of Money and Banking. 1977
9. Checkley, P. Monetary Economics. Worcestershire: Peter Andrew Publishing Company, 1980.
10. Cox D. Success in Elements of Banking 2nd (ed). London: John Murray (Publishers), Limited, 1983.
11. Culbertson, M. Money and Banking. New Delhi: Mc. Graw – Hill Publishing Co. Limited. 1972.
6 Principles of Economics
Unit 2: Demand for Money
Contents
Page
1.0 Introduction ....................................................................................................................................... 7
2.0 Objectives ......................................................................................................................................... 7
3.0 Meaning/Definitions ........................................................................................................................... 7
3.1 Demand for Money ............................................................................................................................ 7
3.2 The Liquidity Preference Theory ....................................................................................................... 7
3.3 Motives for Holding Money (DD for Money) ................................................................................... 8
3.4 Determinants of Money Demand ...................................................................................................... 9
3.5 Quantity Theory of Money ................................................................................................................. 9
3.6 Criticisms of Quantity Theory of Money ........................................................................................... 10
4.0 Conclusion ......................................................................................................................................... 10
5.0 Summary ........................................................................................................................................... 10
6.0 Tutor-Marked Assignments ............................................................................................................... 11
7.0 References/Further Reading .................................................................................................... 11
6
Demand for Money 7
1.0 Introduction
Money just like every other commodity has its own demand and supply. However, money has certain qualities,
or characteristics, or attributes, which distinguishes it from other commodities. Money does not need to
be converted to any other thing before it is used to pay for other goods and services. It is the most liquid of
all commodities. Money confers to the holder a general purchasing power. Once you hold money, you can get
other commodities. The most distinguishing feature of money is that it is a medium of exchange. It is generally
accepted in settlement of financial obligations. Now, we know that money serves as a medium of exchange
and a store of value. People, therefore, demand to hold money in order to utilise these services.
Broadly speaking, there are three motives or reasons why people prefer to hold money instead of other
assets. They are the Transactionary Motive, the Precautionary Motive and the Speculative Motive. This unit,
therefore, presents a detailed discussion of the demand for money.
2.0 Objectives
At the end of this unit, you should be able to:
(i) understand the meaning of liquidity preference and the various reasons why people demand for money
to hold as idle cash balances.
(ii) comprehend what is Quantity Theory of Money and the criticisms associated with it.
(iii) define the “Demand for Money”.
3.0 Meaning/Definitions
3.1 Demand for Money
Each individual or person tries to hold his wealth in any of two broad forms. It is either held as idle cash
balances which yield no income or held as non-cash assets such as securities, houses, bags of rice, vehicles
and other commodities. These other commodities yield some income, appreciate or depreciate in value over
time. Wealth held as idle cash balances guarantees no income, instead it reduces in value during inflation. The
decision to hold money as cash balances instead of spending it immediately in buying other assets is called the
demand for money. Demand for money, therefore, refers to the total amount of money balances that people
want to hold for certain purposes.
Students Assessment Exercise
(i) Explain the term “Demand for Money”
Solution
Demand for money means the demand to hold money, that is, to keep one’s resources in liquid form
instead of in some form of investment. OR it means the desire to hold money in liquid cash as against
spending the money.
3.2 The Liquidity Preference Theory
If an individual decides to hold all his wealth in the form of other wealth-creating or financial assets, he faces
the danger of illiquidity (that is, having no cash to settle his immediate illiquidity obligations). To avoid the
danger of illiquidity, he may prefer to hold money instead of other assets. This is what Lord J. M. Keynes
called Liquidity Preference. Liquidity Preference is the extent to which a person prefers to hold cash balances
instead of parting with it or keeping his wealth as other assets. Keynes propounded the Liquidity
Preference theory, which states that “the stock of money held by the public will vary inversely with the rate
8 Principles of Economics
of interest (price of money).” The higher the return on income-yielding assets, the less likely it is that cash
will be held (Leiter, 1968:55). There is a level to which interest rate will reach and people will no longer be
willing to invest at all. This level is called the Liquidity trap level.
Apart from the level of income and rate of interest generated by other assets, there are other determinants
of how much a person will be willing to hold as cash. These other factors include interval between pay days,
general price level, level of expenditure, and availability of credit. These factors are, however, influenced by
the level of income. Other factors such as a person’s attitude towards risks and expectations are equally
influenced by the rate of return (or Interest Rate). When interest rates are high, more people will be willing
to take risk.
Students Assessment Exercise
i “The Demand for Money is a function of the rate of interest real income and the price
level.” Discuss.
3.3 Motives for Holding Money (DD for money)
Whoever is holding money is holding it to enable him get something else. Each person has his own reasons for
holding money, and not because he wants to chew the paper called money. The demand for money is,
therefore, said to be a derived demand.
Lord John Maynard Keynes who propounded the Keynesian theory identified three reasons that prompt
people to hold money. These reasons are transactions, precautionary and speculative.
i Transactions Motive
The first reason people hold money balances is to enable them pay for their normal day-to-day transactions.
People hold money as a medium of exchange. It is generally accepted by individuals and firms in payment for
goods and services.
Keynes observed that the level of transaction undertaken by individuals and society as a whole has a
stable relationship with the level of income. Keynes, therefore, confirmed that “the demand for money for
transactionary purposes was proportional to the level of income”. This means that the higher the income
level, the larger the amount held for transaction purpose. The Monetarists led by Milton Friedman also agreed
that “the demand for money will be proportional to the level of income for each individual and hence for the
aggregate economy. Therefore, money is held for the purchase of goods and services because of the nonsynchronisation
of the periods of income receipts and their disbursements. This is determined directly by the
level of income.
ii Precautionary Motive
The term “Precautionary Motives” refers to the desire to hold cash balances in order to meet expenditures
which may arise due to unforeseen circumstances such as sickness and accidents. Uncertainties are a reality
of life. We can never be quite certain what payments we have to make in the future. Lacking certainty we,
therefore, arm ourselves with money against emergencies. Like the transaction motive, it is relatively interest-
inelastic unless the rate of interest is really very high.
As the case of transactions motive, the amount of money an individual holds for precautionary purposes is
also dependent on the level of Income. The higher the level of income, the more the amount held for precautionary
purposes. Both Keynesians and monetarists agree on this point.
iii Speculative Motive
The third reason why people hold money is to enable them speculate on the possible outcome of business
events. If people expect prices to fall in the near future, for instance, they can suspend further purchase now,
Demand for Money 9
and hold more money waiting to buy when prices will fall. In the same way, if people think that prices are
relatively low now and expect prices to rise in the near future they will use their money to buy financial
assets which they will sell later when prices will rise. The amount of money for speculative purpose is not
based on the level of income. It is determined by what people expect to gain or to lose by holding other
assets. This expected gain or loss depends on the interest rate.
Lord Keynes used movement in bond prices to illustrate the speculative motive for holding money and how
this is influenced by interest rates.
Students Assessment Exercise
(iii) Discuss the motive for holding money?
Solution
Reasons or motive for demand for money includes
(i) Transaction Motive: The desire to keep or hold money for the day-to-day transactions;
(ii) The Precautionary Motive: Necessary in order to meet up with unforeseen circumstances or
unexpected expenditure;
(iii) Speculative Motive: People also keep money with the hope of using such money kept in making
quick money.
3.4 Determinants of Money Demand
Apart from the factors identified by Keynes, other factors were later identified by Professor Milton Friedman
in his modern quantity Theory of Money. These include the price level, the rate of change of prices or
inflation real permanent income or wealth and return on bonds and equities. Therefore, the determinants of
money could be seen as
(a) Income
Demand for money varies directly with the level of income, that is, the higher the level of income,
the higher the level of income, the higher the level of money demand.
(b) Interest Rate
Demand for money varies inversely with the interest rate.
(c) Price level
There is direct positive relationship between money demand and the price level.
(d) The Rate of Price Changes
Inflation rate varies inversely with money demand. This is a weak determinant of money.
(e) Real Permanent Income
Real permanent income or wealth varies directly with money demand.
(f) Return on Bonds and Equities
The higher the return on bonds and equities the lower the demand for money.
3.5 Quantity Theory of Money
The classical quantity theory of money was developed by Irwin Fisher in 1911 and was generally accepted
view until the 1930’s about the relationship between the amount of money in economy or circulation and the
level of prices. It is a theory about how much money supply is needed to enable the economy to function.
The quantity theory took the view that money was used only as a medium of exchange to settle
transactions involving the demand and supply for goods and services. The theory is based on the simple
10 Principles of Economics
identity between total money spend and the price level in the economy. This is illustrated with an equation.
Where M – is the money supply
MV = PT
V – is the velocity of circulation i.e. the rate at which money changed hands in the society.
P – is the Price level
T – rate of Transaction
Given the assumption that ‘V’ and ‘T’ are constant, the price level ‘P’ varies directly with the amount of
change in money supply i.e. P = MV
T
3.6 Criticisms of Quantity Theory of Money
Today, no one accepts that the influence which money has on the economy can be explained in terms of a
simple quantity theory. To a lesser or greater extent, they would question the three key assumptions necessary
to convert the equation of exchange into a theory of the determination of prices. As we have seen, these
three key assumptions were:
· the velocity of circulation of money is constant.
· the stock of money is an instrument which can be controlled.
· Say’s Law (supply creates its own demand) will operate.
The validity of these three assumptions is critically on the grounds that
(a) prices cannot respond quickly to changes in money supply;
(b) an increase in the distribution of wealth might result from an increase in the money supply and
price levels;
(c) if people expect price to rise, they might decide to hold more of their wealth in physical asset and
less in money and so the velocity of circulation will fall;
(d) people must be fooled by inflation.
Students Assessment Exercise
(iv) Examine the quantity theory of money.
Does it offer an adequate explanation of inflation?
4.0 Conclusion
Money is such an important asset in the asset market and this is why people choose to hold it. A person’s
decision about how much money to hold (his or her money demand) is part of a broader decision about how
to allocate wealth among the various assets that are available. This analysis demonstrate that the price level
in an economy is closely related to the amount of money in the economy.
5.0 Summary
In this unit, we have succeeded in stating that The Demand for Money is the total amount of money that
people choose to hold in their portfolios. The principal macro-economic variables that affect money demand
are the price level, real income and interest rates. The Quantity Theory of Money is an early theory of money
demand that assumes that velocity is constant, so that money demand is proportional to income.
The motive for holding money can be divided into three motives namely: Transactional motives, Precautionary
motives and the Speculative Motives.
Demand for Money 11
6.0 Tutor-Marked
Assignments
Q1. Explain in details, the reason why an individual may decide to hold part of his money wealth as
money balances pointing out the factors that can influence the amount he decides to hold.
Q2 (a) Explain the Liquidity Preference theory
(b) Define velocity. Discuss the role of velocity in the quantity theory of money.
7.0 References/Further Reading
(1) Leither, R. D. New Economics. New York: Borives and Noble College, Outline Series, 1968.
(2) Lipsey, R. G. An Introduction to Positive Economics. London: English Language Book
Society/ Werdenfield & Nicolson, 1983.
12 Principles of Economics
Unit 3: Supply of Money
Contents
Page
1.0 Introduction ....................................................................................................................... 13
2.0 Objectives ......................................................................................................................... 13
3.0 Meaning/Definitions ............................................................................................................ 13
3.1 Supply of Money – Meaning .............................................................................................. 13
3.2 Determinants of Money Supply .......................................................................................... 13
3.3 Money Stock Composition – (Measuring Money) .............................................................. 14
3.4 Factors that affect Money Supply ....................................................................................... 14
3.5 Problems in defining Money Supply .................................................................................... 15
4.0 Conclusion ......................................................................................................................... 15
5.0 Summary ........................................................................................................................... 16
6.0 Tutor-marked Assignments ................................................................................................. 16
7.0 References / Further Reading ............................................................................................. 16
12
Supply of Money 13
1.0 Introduction
A type of financial asset that has long been believed to have special macro-economic significance is money.
Money is the economist’s term for assets that can be used in making payments such as cash and cheque
accounts. One reason that money is important is that most prices are expressed in units of money used in the
three markets in our model of the macro-economy. The three markets are the labour market, the goods
market and the asset market. By asset market we mean the entire set of markets in which people buy and sell
real and financial assets, money just like every other commodity or financial asset has its own demand and
supply. In this unit, we shall consider the Supply of Money, in the asset market.
2.0 Objectives
At the end of the unit, you should be able to:
(i) define the Supply of Money.
(ii) understand the determinants of Money Supply.
(iii) estimate the money stock.
(iv) highlights the problems in defining the supply of money.
3.0 Meaning / Definitions
3.1 Supply of Money
The supply of money in any economy at any particular period is the total sum of all money held by all
members of the society. Generally, money supply is taken as the total amount of money in circulation at any
given time e.g. notes and coins and demand deposits in commercial banks.
Afolabi (1991) explained “Supply of Money” as the amount of money which is available in an economy in
sufficiently liquid and spendable form. “What constitutes the components of this supply of money depends on
what has been officially accepted as the constitutes of Money Supply for that country”. Thus, each country’s
money supply definition may be unique.
Ajayi and Ojo (1981) defined money supply in Nigeria as the total sum of currency outside the banks,
demand deposit at Commercial Banks, domestic deposits with the Central Bank less Federal and State
Government’s demand deposits with the Central Banks. They proved that the preponderance of the money
supply in Nigeria consisted of currency outside banks and this probably still applies.
Bowden (1986:114) an American author simply defined it as the actual number of “spendable dollars” in
existence. At first instance, his definition appears to refer only to the physical dollar in circulation. But notice
that he put the “spendable dollars” in quotes. He used this term to include money created by the banking
system such as demand deposits, which can be used to pay for debts by the issuance of cheques. Money
supply is, therefore, the quantity of money available for spending at each point in time.
3.2 Determinants of Money Supply
It is normally assumed that the nominal money supply is exogenously determined i.e. it is supplied by the
monetary authority or Central Bank. But the real money supply is endogenously determined since the price
level variation cannot be fixed.
Ajayi and Ojo (1981) have also established that the following three economic factors determine the supply
of money or the quantity of money in the economy.
(a) The behaviour of banks concerning the amount of reserves that they want to hold. This decision on
reserves is a function of the profit maximising behaviour of banks and the expectation of the managers
with respect to economic environment
14 Principles of Economics
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(b) The behaviour of the non-bank public with respect to the way they divide their wealth or money holdings
between cash and demand deposits (i.e. the proportion of total wealth that people want to hold in
cash).
(c) The behaviour of the Monetary authorities with regards to the decisions about the size of the monetary
base, Legal reserve ratio, and the discount rate. (The monetary base is the currency in circulation plus
all the assets that banks are allowed to count while computing their legal reserve ratio).
In determining the level of money through the exogenous factors, the government increases or reduces the
supply in accordance with the desired economic target they want to achieve.
Ojo, M. O. (1993) puts it this way “a Monetary Control framework begins by establishing a link between
the monetary control instruments and the ultimate target for output, growth, inflation and the balance of
payments”.
Students Assessment Exercise
What are the determinants of money supply?
3.3 Money Stock Composition (Measuring Money)
Another important disagreement among economist is what to include or exclude in measuring the money
stock. This disagreement, as Checkley P. (1980) explained arises because assets fulfill some of the functions
of money but not all.
Focusing only on those assets that serve directly as a medium of exchange and are generally acceptable in
setting financial obligations, we get the M definition of money stock. The M definition comprises currency
in circulation and demand deposits.
The monetarists led by Professor Milton Friedman of University of Chicago argue that savings and demand
deposits should be included in money supply because they constitute “temporary abode of purchasing
power”. This definition of money stock as M plus savings and Time deposits is called M . This also agree
with Keynesian interest sensitive demand for money.
These two definitions M and M were the only ones existing until 1970s. With new developments in the
banking system, two economists Gurley and Shaw quoted in Checkley (1980) argued that quasi-money
should be included because they serve as good substitute for money. This led to M definition of money stock
as M plus deposits held in non-bank financial institutions. Money stock was later expanded to include investments
in government securities because they are easily cashable. This led to M definition of money as M 4 3
plus investment in government securities. In definition of money stock in Nigeria, the Central Bank of Nigeria
focuses on M and M .
Students Assessment Exercise
Examine the Composition of Money Stock.
3.4 Factors that affect Money Supply
The general belief is that the Central Bank of Nigeria issues notes and coins on behalf of the Federal
Government, it must be the Central Bank that determines the stock of money supply, this may not be entirely
true.
Afolabi (1991) has given five factors that could affect money as follows:
(i) Monetary base or High Powered Money: The money supply will naturally increase if the Central
Bank expands the monetary base. The monetary base or high powered money is the total of bank
reserves plus currency in the hand of the public.
(ii) Credit Creation: When banks create credit, the credit will in turn lead to demand deposit and so on.
Supply of Money 15
The extent to which commercial banks are allowed to create credit will therefore affect the extent of
money supply.
(iii) Portfolio behaviour of the Public: If most people keep their money in the bank, the banking system
will have Liquid reserves to lend out and create derivative deposit which is the deposit created through
lending. If the marginal propensity to hold currency increase, the Liquidity of commercial bank will go
down and money supply will similarly fall.
(iv) Reaction policies of the Central Bank: Monetary policies of the CBN applied in reaction to the
dictates of the economy will have effects on money supply.
(v) Foreign Exchange Transactions: Domestication of Foreign Exchange will have the tendency to
increase domestic money supply.
Specifically, money supply is also influenced by the other following factors:
(a) Total reserves supplied by the Central Bank: If the total reserves supplied by the Central Bank is
high, money supply will be high.
(b) Reserve Requirements: If the reserve requirement – percentage of commercial banks deposits
legally required to be kept with the Central Bank is high money supply will be low.
(c) If the non-bank public increases its demand for time deposits, money supply will increase.
(d) Demand for Currency: If the non-bank public increases its demand for currency, money supply will
increase.
(e) Demand for excused reserves: If commercial banks demand for excess reserves increases, money
supply increases.
(f) Interest Rates: There is a positive relationship between money and interest rate. That is, the higher
the interest rate the higher the money supply.
(g) The Bank Rate: If the rate at which commercial banks borrow from the Central Bank or discount bill
rises, money supply falls.
Students Assessment Exercise
Analyse the factors that affect money supply in the Nigerian Economy.
3.5 Problems in Defining Money Supply
There were difficulties with the monetarist thesis, neither of which was satisfactorily resolved.
First, in an advanced and more important an evolving-financial system, it was not possible to define the
stock of Money in an unambiguous way, or at least there were a number of different but equally valid
definitions of the money supply and there was no strong reason for choosing one in preference to any other.
As we have seen, money can be defined either narrowly or broadly. However, there are or have been within
the Nigerian institutional context a number of different definitions of the money supply. The definitions change
frequently as does the popularity of one measure over another which partly illustrates the difficulty in trying
to pin down the concept.
Students Assessment Exercise
Examine the problems in defining money supply.
4.0 Conclusion
Money supply represents the total amount of money in the circulation of a given country. It comprises all
those things which possess the characteristics of money. In Nigeria, money supply are broadly classified into
two: (i) Narrow Money Supply (M1) and (ii) Broad Money supply (M2).
16 Principles of Economics
In Modern economics, the money supply is determined by the Central Bank such as Bank of
England, CBN.
The terms ‘money supply and ‘money stock’ are used inter-changeably. The problem of defining
money supply is still associated with a considerable degree of controversy.
5.0
Summary
In this unit, we have tried to examine fully, the concept of money supply. In concluding our discussion
of money supply, let us make few observations about the supply of money. First, is that, it affects the price
level and hence other economic variables. The next observation is that, it expands as economics
activities grow. Furthermore, as money stock increases, total spending increases. The money supply in an
economy is influ- enced by internal and external factors.
6.0 Tutor-Marked Assignments
Q1 -What comprises the supply of money in
Nigeria?
Pinpoint the problems in defining the money supply.
Q2 -Discuss the factors that help to determine the supply of money in
Nigeria.
7.0 References / Further
Reading
1. Ade, T. O. et al. Banking and Finance in Nigeria. Bedfordshire: Graham Burn,
1982.
2. Afolabi, L. Monetary Economics. Lagos: Inner Ways Publishers Limited,
1991.
3. Ajayi, S. I. et al. Money and Banking; London, George Allen and Unwin Limited,
1981
4. Umole, J. A. Monetary and Banking Systems in Nigeria. Benin City: Adi Publishers,
1985.
5. Bowden, E. V. Economics: The Science of Common Sense. Gncinnati: South-Western
Publishing
Company, 1986.
6. Checkley, P. Monetary Economics. Worcestershire: Peter Andrew Publishing Company,
1980.
7. Cox, D. Success in Elements of Banking 2nd (Ed). London: John Murray (Publishers) Limited,
1983.
Supply of Money 17
Unit 4: Types of Financial Institutions
Contents
Page
1.0 Introduction ...................................................................................................................... 18
2.0 Objectives ........................................................................................................................ 18
3.0 Definitions ........................................................................................................................ 18
3.1 Financial Institutions .......................................................................................................... 18
3.2 Types of Financial Institutions ............................................................................................ 18
3.3 Bank Financial Institutions ................................................................................................. 19
3.4 Non-Bank Financial Institutions ......................................................................................... 19
4.0 Conclusion ....................................................................................................................... 19
5.0 Summary .......................................................................................................................... 20
6.0 Tutor-Marked Assignments ............................................................................................... 20
7.0 References/Further Reading .............................................................................................. 20
17
18 Principles of Economics
18 Principles of Economics
1.0 Introduction
In the last unit, we discussed exhaustively the supply of money and now we want to focus on the Financial
Institutions that are responsible for the supply of money. The Financial Institutions operate and function in
an economic system. In its ordinary usage, the word “System” can be used to refer to “a group of related
parts working together”. This is the sense in which it is used here – the financial institutions working
together to provide the financial services required in an economy. The Nigerian Financial System comprises
the banking system (all the banks) the non-bank financial institutions, the regulatory bodies, and other
financial market participants, that play the role of financial intermediation in the Nigerian economy. The
Central Bank of Nigeria Briefs (1996) defined a financial system as “a conglomerate of various
institutions, markets, instru- ments, and operators that interact within an economy to provide financial
services. Such services may in- clude resource mobilisation and allocation of financial intermediation and
facilitation of foreign exchange transactions to enhance international trade.
2.0 Objectives
At the end of this unit, you should be able to:
(i) define Financial Institutions fully.
(ii) recognise the various types of Financial Institutions.
(iii) arrange Financial Institutions into bank and non-bank financial institutions.
3.0 Definitions
3.1 Financial Institutions
Financial institutions are institutions which serve the purpose of channelling funds from lenders to borrowers.
They hold money balance of, or borrow from individuals and other institutions, in order to make loan or other
investments. Finance has to do with money. It is an organised system of managing money i.e. a system of
lending and borrowing money.
A Financial Institution acts as an intermediary between those individuals or firms who wish to lend and
those who wish to borrow. The existence of financial intermediaries reduces the risks by allowing specialist
institutions to evaluate the credit worthiness of borrowers. The risk reduction may encourage lending and
thus reduces the interest rate of most individuals and risk averters.
Institutionally, it is common to distinguish between banks and non-bank financial institutions. The importance
of the former is that their liabilities enter the common definitions of the money supply. The liabilities of
non-bank financial institution may enter some money supply definitions or they may be classed as “near
money” depending on their liquidity. Examples of non-bank intermediaries/ institutions listed in terms of
decreasing liquidity are: Building societies, Savings banks, Hire purchase, Insurance companies, Pension
funds and Investment trusts
3.2 Types of Financial Institutions
Financial Institutions can be broadly classified into two: banks or bank financial institutions in the banking
sector and non-bank financial institutions.
Commercial, Central, Merchant and Development banks are in the banking sector while Building Societies,
Hire Purchase Companies, Insurance Companies, Pension Funds and Investment Trust are non-bank
financial institutions.
While liabilities of banks form part of the money supply, the liabilities of non-bank financial institutions do
not for they are referred to as “near money”.
In Nigeria, the following types of financial institutions can be identified.
Types of FinaSnucipapll Iyn ostfi Mtutoinoenys 19
- Traditional Financial Institutions
- Commercial Banks
- Central Banks
- Development Banks
- Insurance Companies
- The Federal Savings Banks
- The People’s Bank
- Community Banks
- Savings and Loan Associations
- Investment and Unit Trusts
- Credit and Cooperative Societies
- Pension Scheme (NPF), (NSITF)
- Financial Companies
Students Assessment Exercise
- List exhaustively the types of Financial Institutions in Nigeria.
3.3 Bank Financial Institutions
Structurally, the bank-financial institution is made up of:
(a) The Supervisory and Regulatory Authorities: They comprise the Central Bank of Nigeria which is
the Principal regulatory body, Federal Ministry of Finance. The Securities and Exchange Commission,
Nigerian Deposit Insurance Corporation, Nigerian Insurance Supervisory Board (Now renamed National
Insurance Commission) and to a lower extent the Federal Mortgage Bank and National Board for
Community Banks. These Supervisory bodies are also referred to as monetary authorities.
(b) The Banking System (Banks): The banking system comprises all the banks that operate within the
economy. This includes commercial banks, merchants banks, development banks and other specialised
banks, such as the Community Banks and People’s Bank of Nigeria. Apart from few development
banks, all these banks collect deposits, and give out loans. They are key actors in performing the role of
financial intermediation.
3.4 Non-Bank Financial Institutions
Apart from banks, there are other institutions that perform the role of financial intermediation. These other
institutions are called non-bank financial institutions. At times, they are simply referred to as other financial
institutions. These institutions include finance house, savings and loan institutions, insurance companies, the
discount houses, Bureau de Change, Pension and other trust funds. There are also informal savings and loan
associations like cooperative societies, ESUSU or Isusu groups known as “Ajo” and Alashie in Hausa language.
An Isusu group is an association of like-minded individuals who contribute a pre-determined amount
of money which is given to each member of the group one after the other after each collection. The amount
may be contributed on weekly or monthly basis.
4.0 Conclusion
Financial Institutions are establishments that issue financial obligations such as demand deposits in order to
acquire funds from the public. The institutions then pool these funds and provide them in larger amounts to
businesses, governments or individuals. Examples are commercial banks, insurance companies, savings and
loan associations. In some countries, financial institutions are also known as “Financial Intermediaries”.
20 Principles of Economics
20 Principles of Economics
Financial Institutions can be classified into bank and non-bank Financial institutions. Bank Financial Institutions
include the central banks, the commercial banks and the development banks. Non-bank financial
institutions include discount houses, issuing houses, insurance companies, building societies and the stock
exchange. These institutions operate in markets with instruments to acquire funds from the public for investment.
5.0 Summary
What you have learned in this unit concerns the definitions/meanings of financial institutions and the various
types of Financial Institutions grouped into bank and non-bank financial institutions. It has served to
introduce the functions and control of financial institutions. The two units that follow shall build upon this
introduction.
6.0 Tutor-Marked Assignments
Q1 - What is a financial system? Discuss the various categories of institutions that make up the
structure of The Nigerian Financial System.
7.0 References/Further Reading
- Gupta, S. B. Monetary Economics, Institutions Theory and Policy. New Delhi, India: S Chand and
Company Limited, 1982.
- Okigbo, P.N.C. Nigerian Financial System Structure and Growth. Essev; Longman Publishing Co.,
1981.
- Osubor, J. U. Business Finance and Banking in Nigeria. Owerri: New African Publishing Co., 1981.
Supply of Money 21
Unit 5: Functions of Financial Institutions
Contents
Page
1.0 Introduction ....................................................................................................................... 22
2.0 Objectives ......................................................................................................................... 22
3.0 Definitions ......................................................................................................................... 22
3.1 Banks Financial Institutions ................................................................................................ 22
3.1.1 Central Bank of Nigeria ..................................................................................................... 22
3.1.2. Commercial Banks ............................................................................................................ 22
3.1.3 Merchant Banks ................................................................................................................ 23
3.1.4 Development Banks ........................................................................................................... 24
3.2 Other (Non-Bank) Financial Institutions ............................................................................. 26
3.2.1 Insurance Companies ......................................................................................................... 26
3.2.2 Finance Companies ........................................................................................................... 26
3.2.3 Primary Mortgage Institutions ............................................................................................. 27
3.2.4 National Economic Reconstructions Fund ........................................................................... 27
3.2.5 Traditional Financial Institutions .......................................................................................... 27
3.2.6 Discount Houses ................................................................................................................ 28
3.2.7 Nigerian Social Insurance Trust Fund ................................................................................. 28
3.2.8 Thrift and Credit and Co-Operative Societies ..................................................................... 28
3.2.9 Investment and Unit Trusts ................................................................................................. 28
3.2.10 Savings and Loans Associations ......................................................................................... 29
3.3 Specialised Banks (Non-Conventional Banks) .................................................................... 29
3.3.1 People’s Bank of Nigeria (PBN) ........................................................................................ 29
3.3.2 Community Banks ............................................................................................................. 29
3.3.3 Federal Savings Bank ........................................................................................................ 30
4.0 Conclusion ........................................................................................................................ 30
5.0 Summary ........................................................................................................................... 31
6.0 Tutor-Marked Assignments (TMA) .................................................................................... 31
7.0 References/Further Reading ............................................................................................... 31
21
22 Principles of Economics
1.0 Introduction
In the last unit, we have been able to compose and specify what financial institutions are. This will help to
assemble the functions of the various financial institutions in this unit. Having defined what financial institutions
are legally, the laws also establishes different types of financial institutions. The types of financial
institution depends on the law establishing it and its functions. Depending on the stage of economic political
and technological developments in a nation, each nation has the authority to grant licences to various types
of financial institutions.
2.0 Objectives
It is hoped that by the end of this unit, you will be able to:
(i) recognise the functions of banks financial institutions like CBN, Commercial Banks, Merchant Banks,
and Development Banks,
(ii) recall the functions of non-bank financial institutions like the insurance companies, Finance Companies,
Primary Mortgage Institutions, NERFUND, Discount Houses, NSITF, etc., and
(iii) define the functions of specialised banks – Non-Conventional Banks.
3.0 Definitions
3.1 Banks Financial Institutions
3.1.1 Central Bank of Nigeria
The Central Bank of Nigeria stands as the apex of the banking system. It licenses, supervises and regulates
the banks within the banking system. It is owned by the Federal Government.
The CBN was established in 1959. It goes ahead to perform the following functions:
Currency issue and circulation
Promotion of monetary stability through the formation and implementation of government monetary
policies.
Acting as banker and financial adviser to the government.
Encouragement of the growth and development of financial institutions.
Supervision and regulation of banks and other financial institutions.
Development of the money and capital markets through the creation of local government outlets.
Helping in the clearing and collection of cheques by banks by providing the clearing house.
Penalising of non-complying financial institutions to ensure compliance and help achieve government
objectives.
Undertake research and publications of a country
Maintains close contact with other international financial institutions. The CBN safeguards the International
value of the currency of the nation.
The CBN mobilises capital resources for economic development.
Students Assessment Exercise
List the functions of Central Bank of Nigeria.
3.1.2 Commercial Banks
The Banks and other financial institutions Decree No 25 of 1991 defined a commercial bank as “any bank in
Functions of Financial Institutions 23
Nigeria whose business includes the acceptance of deposits withdrawable by cheques. This definition presents
the major distinguishing functions of commercial banks from other banks. According to Osumbor (1984) in
his book Business Finance and Banking in Nigeria, commercial banks are unique in their performance of
services and are distinguished from other forms of financial institutions or intermediaries because of the
following functions:
Accept deposits from customers i.e. savings, current or demand deposit, fixed deposit or time deposit.
Lend money to approved customers i.e. overdraft, loan.
Allow the use of cheque
Safe-keep valuable assets for customer.
Provision of standing order facilities.
Give business advice to their customers.
Agents of government for monetary policy.
Assists customers for acquisition and sales of shares.
Issue of discount bills of exchange i.e. payment on behalf of customer.
Commercial bank creates money, this is done through deposits.
Money created = Original Deposits.
Cash ratio or reserve requirements.
They involve in agricultural financing.
They offer employment opportunities.
They act as guarantors to their customers.
They solve problem of foreign exchange.
They issue traveller’s cheques.
Their activities accelerate the economic development of a nation since they act as intermediaries
between large number of depositors and borrowers.
These banks could assume the responsibility of carrying out the duties of attorney, executor and
trustee.
Students Assessment Exercise
Restate the Statutory functions of Commercial Banks.
3.1.3 Merchant Banks
According to the Nigerian Banking Amendment Decree (No. 88) of 1979, Merchant Bank means any person
in Nigeria who is engaged in wholesale banking, medium and long-term financing equipment leasing, debt
factoring, investment management issue and acceptance of bills and the management of unit trust. They are
also called Acceptance Houses or Discount Houses.
Functions or services of merchant banks are often divided into two classes – banking and corporate
finance services.
Banking Services / Functions:
- Acceptances of Merchant Banks (MB) accept bills of exchange from importers and exporters which
are easily rediscountable.
24 Principles of Economics
- Loans and Advances – MB provides loans and advances of short, medium and long term nature
- Deposits – MD accepts the following deposits- current account deposits for corporate clients, fixedterm
deposits accounts for both corporate and non-corporate clients and Negotiable Certificates of
Deposits.
- Equipment leasing – MDs lease equipment, machine, tools, motor vehicles to farmers and industrialists.
- Foreign Exchange Services: MBs as authorised dealers performing foreign exchange services: Corporate
Finance Services.
- Project Financing: MBs finance the construction of new projects or ventures.
- Issuing House Services or Public Issue – MBs provide services to clients who want to raise money
from the public through the offer for subscription of shares/ securities.
- Investment and financial advisory services.
- Portfolio management.
- Money Market Services.
- Help to finance international trade
- Debt factoring – Taking over the debts of a firm and thereafter provides her with the amount to finance
the businesses.
Students Assessment Exercise
Compare functions of Merchant Banks with that of Commercial Banks.
3.1.4 Development Banks
Development banks are financial institutions which are set up to provide banking services that will help in the
development of a particular sector or aspect of the economy. They are normally government owned institutions
set up for the sole purpose of enhancing economic development rather than for profit motives. The
major reason for the introduction of development banks is to bridge the gap in the provision of long-term
finance for individuals. The existing Commercial and Merchant banks specialise in the provision of short term
and medium-term finance because of their deposit structure. They could provide the much needed long-term
finance. Another reason is the exigency of providing credit facilities to the priority sector of the economy.
Other banks are reluctant to give such credit facilities because of the high-risk involved. Instances of such
sectors are Agriculture, Commerce, Cooperatives, and small scale industries. This is what Professor G. O.
Nwankwo (1980) called the “gap thesis” and “exigency thesis”.
Currently, there are six development banks operating in Nigeria. Each is set up to perform specific developmental
role as discussed below.
(1) The Nigerian Industrial Development Bank Limited (NIDB)
The bank which was established in 1964 has the main function of encouraging the establishment and
growth of medium and large-scale industries in Nigeria. This is done through the provision of medium
and long-term finance for the private and public sectors, promoting and development of projects and
provision of financial, technical and managerial assistance to indigenous enterprises among other functions.
It provides finance mainly for large scale industries but recently some small scale industries have
benefited from NIDB loans.
(2) The Nigerian Bank for Commerce and Industry (NBCI)
The need to encourage the establishment and ownership of small scale industries and other business
ventures by indigenous Nigerian Investors after the promulgation of the Nigerian Enterprises Promulgation
Decree of 1972 (also known as indigenisation Decree) led to the establishment of this bank in
1973. Its main functions were to assist indigenous business through share underwriting, identification of
Functions of Financial Institutions 25
viable projects, preparation of feasibility studies, offering of managerial and technical advice. It was
therefore set up to provide the much needed capital for the implementation of the objectives of the
Nigerian enterprises promotion. Thus, Nigerians were given ready sums of capital for the purchase of
foreign business as provided for by the act.
(3) Nigerian Agricultural and Cooperative Bank (NACB)
As a step towards encouraging agricultural production, the NACB was established in 1973 mainly to
provide the needed finance for agricultural development projects and allied industries including poultry,
farming, pig-breeding, fisheries, forestry and timber production, animal husbandry and any other type of
Farming, as well as storage, and marketing of such production in Nigeria.
Its principal function is to promote agricultural assistance to interested individuals, Cooperative societies,
companies and government agencies throughout Nigeria. It also offers technical assistance including
advice and preparation of feasibility studies.
(4) Federal Mortgage Bank (FMB)
The Nigerian Building Society (NBS) was established in 1957 with the main aim of providing loanable
funds to Nigerians who were keen on investing in real estate. The NBS later in 1977, under Decree No.
7 of the Federal Military Government of Nigeria, metamorphosed into what is today known as the
Federal Mortgage Bank of Nigeria (FMBN). The Decree establishing FMBN assigned to it the responsibility
of performing the following functions:
(i) The provision of long-term credit facilities to mortgage institutions in Nigerian at such rates and
upon such terms as they may be determined by the Federal Government being rates and terms
designed to enable the mortgage institutions to grant comparable credit facilities to Nigerian individuals
desiring to acquire houses of their own.
(ii) The encouragement and promotion of mortgage institutional development at State and National
levels.
(iii) The supervision and control of the activities of mortgage institutions in Nigeria in accordance with
the policy directed by the Federal Government.
(iv) The provision of long-term credit facilities directly to Nigerian individuals at such rates and upon
such terms as may be determined by the Board in accordance with the policy directed by the
Federal Government.
(v) The provision of credit facilities with the approval of the Government, at competitive commercial
rates of interest to commercial property developers, estate developers and developers of officers
and other specialised types of buildings.
(vi) The Decree also allowed the banks to accept term deposits and savings from mortgage institutions
trust funds, the post-office and private individuals as the board may determine and to promote
the mobilisation of savings from the public.
(5) Urban Development Bank (UDB)
The Urban Development Bank was established by Decree 51 on 1992 mainly to take care of the
problems of inadequate housing, transportation, electricity and water supply that have posed serious
concern in most Nigerian Urban areas. The bank’s main function is to provide financial resources to
both the public and private sectors of the economy for the development of urban dwellings, mass
transportation and public utilities.
(6) Nigerian Export-Import Bank
The sharp decline in the prices of petroleum products in the international market during the late 1970s
brought to fore the need to encourage non-oil export so as to ensure that Nigeria does not remain a
mono-cultural economy. This and the need for financial import and exports generally led to the estab26
Principles of Economics
lishment of NEXIM in 1991. The bank is charged with the responsibility of helping the nation to attain
increased export growth as well as a structured balance and diversification on the product composition
and destination of Nigerian products. Its functions include the provision of export credit guarantee and
export credit insurance functions, provisions of credit in support of support establishment and management
of export funds and other related services.
Students Assessment Exercise
Examine the main functions of the various types of Development Banks.
3.2 Other Non-Banks Financial Institutions
3.2.1 Insurance Companies
Primarily, insurance companies provide against the various risks that often arise within the economy. They do
these by spreading the losses to the unfortunate few over many people. In performing these functions, they
collect premiums from several insured. This role is similar to the mobilisation of savings by banks in the sense
that a large amount of money is pooled together as premium. The amount so collected by the government
securities, public sector enterprises, and shares of private companies. By doing this, they have performed the
role of financial intermediation, Insurance companies in turn insure the Nigerian reinsurance corporation
which was established in 1977, and supervised by the Nigerian Insurance Supervisory Board (Okonkwo,
1998).
Functions/Roles of Insurance Companies
* Insurance companies provide the most effective method of handling many of the pure risks encountered
by individuals and firms.
* Insurance companies facilitates risk transfer.
* They accumulate substantial funds which are used for long-term investment.
* Through their life and pension businesses they help to develop the financial markets
* They help to mobilise national resource by encouraging individuals to save.
* They operate pension scheme on behalf of companies.
* They grant loans to mortgages.
* They act as underwriters in the capital market.
* Insurance policies are used as collateral securities for bank loans.
* They help to improve the balance of payments position of the country by insuring imports and exports
and through reinsurance, Marine Insurance facilities international trade.
* It promotes bilateral and multi lateral trade.
* Insurance gives the entrepreneur the confidence and provides him the security needed to venture into
uncertain areas. It reduces the burden of losses of the entrepreneur.
* Information released by insurers on incidence of certain risks enable people to take more measures to
avoid such loss.
* It provides employment opportunities to people.
3.2.2 Finance Companies
Finance Houses mobilise funds from the public mainly through the issuance of money market instruments
like certificates of deposits, and other commercial papers. They provide these funds to investors in the
form of
Functions of Financial Institutions 27
short-term and medium-term finance such as local purchase order (LPO) financing, leasing, hire purchase,
debt factorising and investment in securities. These assets being financed by them often act as a security for
their lending.
These are sometimes referred to as Hire Purchase Companies.
3.2.3 Primary Mortgage Institutions
These are institutions involved in mortgage financing apart from the Federal Mortgage Bank. They are
referred to as primary because they deal directly with individuals and firms, while the Federal Mortgage
Bank serves as a supervisory body. These institutions are also involved in the financial intermediation process.
They mobilise savings from savers and borrow from other institutions to finance the development of the
housing sector.
A mortgage bank is a financial institution established for the acceptance of fixed deposits from members
of the public with the aim of encouraging them to build their own house by offering them long-term loans.
They are also known as building societies.
Functions of Mortgage Banks
* They accept fixed deposits from members of the public.
* They encourage members of the public to save money.
* The construct and provide houses to low group.
3.2.4 National Economic Reconstruction Fund (NERFUND)
As part of the economic reconstruction under the Structural Adjustment Programme, the NERFUND was
established by Decree No. 25 of 1988. The primary aim of this fund is to provide soft Medium and Long-term
finance to small and medium scale enterprises that are 100 per cent owned by Nigerians. As a financial
intermediary, NERFUND sources its funds through the Federal Government, the Central Bank of Nigeria
and Foreign Government, The Central Bank of Nigeria and Foreign Government and International Development
Finance Institutions like the African Development Bank. The fund so mobilised both from local and
foreign sources are made available to small and medium scale industries provided they are 100% Nigerian
owned.
3.2.5 Traditional Financial Institutions
Traditional financial institutions are traditional credit groups such as “Esusu” which were originally the
insti- tutional agencies for credit supply to members and Esusu or Nsusu or Asuu. It is a kind of cooperative
which consists of people who agree to contribute a certain sum of money and hand it over to a member of the
group. They take the form of associations of people in the same place of work who matually agree to come
together in order to encourage one another to save, lend and manage money.
Functions of Traditional Financial Institutions
* They encourage their members to form the habit of saving money.
* They encourage their members to invest the money they have saved.
* They lend money to their members.
* They save their members the pains of going to banks to borrow.
* They inculcate the principles of democracy in their members.
* They discourage their members from being extravagant.
28 Principles of Economics
3.2.6 Discount Houses
Discount houses are institutions that specialise in the provision of discounting and discounting facilities, buying
and selling of securities, especially government securities. They act as financial intermediaries. They also
issue their own securities to banks as a mean of raising funds.
There are four Discount houses in Nigeria operating presently. Banks in need of funds approach them
instead of going to discount their bills with the CBN.
3.2.7 Nigerian Social Insurance Trust Fund
The Nigeria Social Insurance Trust Fund (NSITF) was established in 1993 by Decree No 7. It replaced the
National Provident Fund which was established in 1961. Its main function is to provide a more comprehensive
social security scheme for Nigerian private sector employees. It raises funds through a compulsory
contribution to the fund by private and public sector employees and employers. The funds so mobilised are
used to provide pension benefits to contributors. But, before it is time to pay the contributions, these funds are
invested by the fund managers or given out as loans. These investments, apart from serving as a source of
credit to investors earn some dividends or interests which help to ensure that the contributor are paid more
than their contributions.
Pensions are often the only form of savings for retirement which a person will make. They are a part of
the remuneration of the employee, deferred until he has finished active work, to which he has right. Thus
pension fund constitute another reliable source of funds for investment in commerce and industry and for
financing the economy.
3.2.8 Thrift and Credit and Co-operative Societies
The main functions of Thrift, Credit and loans Cooperative societies is to raise investment finance. Members
pays an agreed sum of money every month into a common fund. The members borrow at a certain interest
rate. This type of Co-operative society is a savings club and is popular amongst traders, artisans and peasant
farmers.
Functions
- It is a valuable means of mobilising some capital for investment.
- Members obtain loans easily from their society and there is no requirement for a collateral. The only
condition required is an approved project plant for which the loan is required.
- Members form the habit of saving a little of their income, especially in the rural areas, where banking
facilities are scarce.
- Exposure of monthly meetings and regular co-operative education means greater enlightment for members.
3.2.9 Investment and Unit Trusts
Many investment companies were established in Nigeria to complement the rapid industrial development
efforts of both the Federal Government and the State/Regional Government. Most investment companies
have common objectives bordering on developmental functions.
These companies mainly finance and complement Government efforts in developing industrial and commercial
ventures in those states.
The function of investment and unit trusts is to raise collective capital from the public and to direct such
funds into profitable investment channels. The two different types of organisation enable the small investors
with limited capital to spread his risks over a wide range of securities under full time specialist management.
A unit trust on the other hand, is a method of investment whereby money subscribed by many people is
pooled in a fund, the investment and management of which is subject to the legal provisions of a trust deed.
Functions of Financial Institutions 29
3.2.10 Savings and Loans Associations
These are said to be the best known non-bank intermediaries. These associations were originally organised
to make mortgage loans to their own members, but they have increasingly emphasised theirs as savings
institu- tions, catering to small investors and local governments and even state government.
The principal asset of these associations is conventional mortgage loans for family dwellers while their
liabilities consist of depositors funds, principally from the government and share accounts savers. The associations
normally in good time pay interest which is usually higher than that paid by commercial banks on their
savings deposits. They are also allowed to issue large denomination of certificates of deposits.
Students Assessment Exercise
Assemble all the functions of Non-bank Finance Institutions.
3.3 Specialised Bank (Non-Conventional Banks)
3.3.1 People’s Bank of Nigeria (PBN)
The People’s Bank of Nigeria (PBN) was established in October, 1989 but was given Legal Status by
Decree No. 22 of 1990. The Decree specified its functions as
(i) the provision of basic credit requirements of under-privileged who are involved in legitimate economic
activities in both urban and rural areas and who cannot normally benefit from the service of the orthodox
banking system due to their inability to provide collateral security.
(ii) the acceptance of savings from the same group of customers and making repayments of such saving
together with any interest thereon after placing the money in bulk sums on short-term deposits with
commercial and merchant banks.
People’s Bank of Nigeria (PBN) is a non-conventional bank established to provide specialised services
and grant credit facilities to the urban and rural poor masses who cannot satisfy the stringent collateral
requirements normally demanded by conventional banks. Those served by the bank include the poor roadside
hawkers, mechanics, vulcanizers, plumbers, electrician, food seller, truck pusher, hair dressers, dress makers,
etc.
Therefore, from the foregoing, People’s Bank of Nigeria has the following aims:
(a) Increasing investment and savings;
(b) Raising per capital income and PNG;
(c) Halting rural urban migration;
(d) Bridging the gap between the rich and the poor;
(e) Increase productivity, and
(f) Providing credit facilities to the disadvantaged classes who could not have ordinarily benefited from
credit facilities in conventional banks.
3.3.2 Community Bank
The Bank and other Financial Institutions Decree 1991 defined a community bank as “a bank whose
business is restricted to a specified geographical area in Nigeria. Operationally, it is also defined as a self
sustaining bank owned and managed by a community or a group of communities to provide financial
services to that community or communities. A community bank may be owned by Community
Development Associations (CDAS), Cooperative Societies, farmers groups, clubs, trade groups and their
similar groups or by indigenous businessmen or individuals within a community. Community Banks operate
basically like commercial banks, except that they are prohibited from engaging in “sophisticated banking
services” like foreign exchange transactions and export financing. Again, their operations are restricted to
a specified geographical area like
30 Principles of Economics
a unit bank. Thirdly, they are not members of the cleaning house. As such, their cheques are cleared through
commercial banks.
Functions of Community Banks
* Accept various types of deposits including savings, time and target deposits from individuals, groups and
other organisations.
* Issue redeemable debentures to interested parties to raise funds from members of the public.
* Receive money or collect proceeds of banking instruments on behalf of its customers.
* Provide ancillary banking services to its customers such as remittance of funds.
* Maintain and operate various types of accounts with or for other banks in Nigeria.
* Invest surplus funds of the bank in suitable instruments including placing such funds with other banks.
* Pay and receive interests as may be agreed between Community Banks and their clients in accordance
with public policy.
* Provide credit to its customers, especially small and medium scale enterprises based in its area of
operation.
* Operate equipment leasing facilities.
3.3.3. Federal Savings Bank
The Post Office Savings Bank established in 1889 was later rebaptised in 1974 to be known as the Federal
Savings Bank (FSB). The FSB even though carries out certain commercial banking functions still has as its
objectives, as was stipulated in its parent bank act – the Post-Office Savings Act, 1958, has the following:
(i) to provide a ready means for the deposit of savings, especially in the rural areas, and
(ii) to encourage thrift and the mobilisation of savings, also, especially in the rural areas.
These special savings scheme were at that time designed to mobilise funds for national development,
especially at rural levels.
Students Assessment Exercise
Analyse the functions of Community Banks
4.0 Conclusion
The banks Financial Institutions is the most important component of the Nigerian Financial System. The same
applies to other countries of the World. It is the heart of the Financial System. This is because apart from
being the key operators in the Financial markets, monetary policies of the government are implemented
through the banking system. Moreover, the banks Financial Institutions creates money, and by doing this,
influences the economy of a country in no small measure. These are in addition to the traditional roles of
savings mobilisation, and financial intermediation, and provision of settlement mechanism. Banks constitute
the major source of credit to the economy.
The Bank Financial Institutions comprises all Banks that operate within the boundaries of Nigeria by
whatever name they are called and their branches. These include the Central Bank of Nigeria, which stands
at the apex of the system, commercial banks, merchants banks, development banks, community banks and
the People’s Bank of Nigeria.
The non-bank financial institutions also known as other financial institutions are those institutions, apart
from banks, that help to perform the role of financial intermediation. They collect funds from the surplus unit
under various titles, and go ahead to make the funds available to the investors who have need for such funds.
Development banks are specialised in lending to different sectors of the economy depending on government
priorities.
Functions of Financial Institutions 31
Insurance and Pension Schemes aim to return the money borrowed to the policy
holder. Investment and Unit trusts buy shares and keep them for the benefit of the
members.
For credit and co-operatives societies, they on-lend the money they get from their members to
various other members for various purposes.
Finance companies use the money they get to lend to people wanting to buy capital goods over a period.
5.0 Summary
In this unit, we have been able to compose all the functions of financial institutions of various types.
There- fore, the institutions in the world has made possible, and of course, efficiently and effectively, a
situation where the surplus money of savers could be mobilised to finance the worthy needs of reliable
borrowers through these Financial Institutions discussed thus far.
6.0 Tutor-Marked Assignments
(TMA)
Q1 -Discuss the various roles that Commercial Banks play in the Nigerian
Economy. Q2 -In which ways does a Merchant Bank differ from a commercial
bank?
Q3 -What reasons justify the establishment of Development Banks in
Nigeria?
Q4 -How many development banks do we have in Nigeria? Mention them and briefly discuss the
major reasons for the establishment of each.
Q5 -Discuss the difference between the People’s Bank of Nigeria and Community Banks in terms
of ownership, geographical spread and customers served.
Q6 -Explain how the following institutions perform the role of the financial
Intermediation. (a) Insurance Companies
(b) Finance
Companies
(c) Discount
Houses
(d)
NERFUN
D
7:0 References/Further
Reading
1. Uzoaga, W. O. Money and Banking in Nigeria. Enugu: Fourth Dimension Publishing Co,
1981.
2. Osubor, J. U. Business Finance and Banking in Nigeria. Owerri: New African Publishing Co.
Ltd.
3. Nwankwo, G. O. The Nigerian Financial System. London: Macmillan Publishers Limited,
London,
1985.
4. Okigbo, P.N.C. The Nigerian Financial System, Structure and Growth. Essex: Longman
Publishing
Company Limited, 1981.
5. Onuigbo, O. Elements of Banking and Economics. Aba: Esquire Press and Books Enterprises
32 Principles of Economics
1992.
6. Jihingam, M. L. Money, Banking, and International Trad.e New Delhi: Vani Educational
Books,
1984.
Functions of Financial Institutions 33
Unit 6: The Control of Financial Institutions
Contents
Page
1.0. Introduction ....................................................................................................................... 33
2.0. Objectives ......................................................................................................................... 33
3.0. Definitions ......................................................................................................................... 33
3.1 Central Bank of Nigeria ..................................................................................................... 33
3.2 The Nigerian Deposit Insurance Corporation (NDIC) ......................................................... 34
3.3 The Federal Ministry of Finance ......................................................................................... 34
3.4 The Securities and Exchange Commission .......................................................................... 34
3.5 The National Insurance Commission ................................................................................... 35
3.6 The Federal Mortgage Bank of Nigeria .............................................................................. 35
3.7 The National Board for Community Bank ........................................................................... 36
4.0 Conclusion ........................................................................................................................ 36
5.0 Summary ........................................................................................................................... 36
6.0 Tutor-Marked Assignments ................................................................................................ 36
7.0 References/Further Reading ............................................................................................... 36
32

The Control of Financial Institutions 33
1.0 Introduction
In the last unit, we have examined fully the functions of financial institutions. Now we have to look at the
control of financial institutions in this unit. To ensure that good standards are maintained by the various
operators within the financial system to check any excesses of these operators, and ensure a well functioning
and safety of the system, certain institutions are created by the Federal Government to regulate and oversee
their activities. These institutions are the regulatory and supervisory authorities. The specific roles of these
authorities will be discussed in this unit.
2.0 Objectives
At the end of this unit, we shall be able to:
(i) identify the regulatory and supervisory authorities of the various Financial Institutions.
(ii) examine how Central Bank of Nigeria controls the various Financial Institutions.
(iii) specify the role of the Nigerian Deposit Insurance Corporation.
(iv) assess the importance of the Federal Ministry of Finance incorporated.
(v) explain the activities of the Securities and Exchange Commission (SEC).
(vi) appreciate the role of the National Insurance Commission.
(vii) illustrate the impact of the Federal Mortgage Bank of Nigeria.
(viii) categorise the very essence of the National Board for Community Banks.
3.0 Definitions
3.1 Central Bank of Nigeria
The Central Bank of Nigeria is the principal regulator and supervisor of the entire Nigerian Financial Institutions.
The Central Bank of Nigeria stands at the apex of the banking system. It licenses, supervises and
regulates the banks within the system in order to pursue an effective monetary policy and to control credit in
the economy, the Central Bank uses the following weapons:
* Open Market Operations
* The Bank Rate
* Moral Suasion
* Special Directives
The CBN is charged with the responsibility for promoting a sound financial structure in Nigeria. To this end,
the Bank acts as a banker to and supervisor of banks and other financial institutions by providing the
following:
* Bankers’ Clearance
* Banks’ Examination
* Foreign Exchange Monitoring
* Prudential Guidelines
* Acts as lender of the last Resort
* Reserve Requirements
* Cash Reserve Requirement
* The stabilisation Securities
* Interest Rate Policy
* Capital Funds Adequacy
34 Principles of Economics
Students Assessment Exercise
How does the CBN Control the Financial Institutions?
3.2 The Nigerian Deposit Insurance Corporation (NDIC)
The NDIC was established by Decree No. 27 of 19 June 1988. Although it is a special type of insurance
company, it complements the efforts of the Central Bank in the regulation and supervision of banks. Specifically,
NDIC performs the following functions:
1. Provision of deposit insurance of related services for banks.
2. Examination of the books and affair of insured banks and other deposit taking institutions to ensure a
healthy operation.
3. Identification and restructuring of acting banks to avoid bank failures.
4. Settlement of the depositors of failed banks up to a maximum indemnity of N50,000. Deposits in excess
of this amount are to be settled along with other creditors as part of the bank liquidation process in the
event of bank failure.
5. Resolution of the problem of distress in the Nigerian Financial system.
In performing the above functions, the NDIC works hand-in-hand with the CBN. This regulatory body is
meant to insure all deposit liabilities of licensed banks and other financial institutions.
Students Assessment Exercise
“It has been said that the existence of Nigeria Deposit Insurance Co-operation serves in itself to reduce
the frequency of loss by depositors” Develop arguments to support this position and then examine the basic
reasons behind the adoption of an insurance plan in Nigeria.
3.3 The Federal Ministry of Finance
This ministry acts as an agent of the government in the financial system. Its functions are:
(1) Advising the government on its monetary and fiscal operations after consultations with the Central
Bank of Nigeria.
(2) Preparation of the Federal Government Budget and its break-down.
(3) Licensing of bureau de change. It was also involved in the licensing of banks until 1991 when it
became the sole responsibility of the Central Bank of Nigeria.
(4) Carrying out related financial institutions as directed by the Presidency. Before the CBN was given
more autonomy, the CBN was reporting to the Ministry of Finance.
3.4 The Securities and Exchange Commission (SEC)
This body is responsible for the regulation of capital market operations in Nigeria. It was established in 1979
by the SEC Act of 27 September 1979 to replace the capital issues Commission that existed before then. The
SEC Decree of 1988 further strengthened its activities. Its functions among others are as follows:
* Promotion of an orderly and active Capital Market.
* Determination of the amount and timing of securities to be offered privately with intent to transfer them
later.
* Registering and supervising stock exchange and branches stock brokers issuing houses investment
advisers and other bodies involved in securities trading.
* Approval of companies to be listed in the capital market.
* Creating the necessary atmosphere for orderly growth and development of the capital market.
The Control of Financial Institutions 35
* Approval and regulation of mergers and acquisitions vide the companies and Allied matters Decree
1990.
* Issuance of guidelines on foreign investments, in the Nigerian Capital Market.
* Maintenance of Surveillance over the Capital Market.
Students Assessment Exercise
In Nigeria, apart from the CBN, the financial system consists of bank financial institutions and non-bank
financial institutions. Name the institutions in these groups and discuss the differences between them as well
as their importance to the society.
3.5 The National Insurance Commission
The National Insurance Commission (NIC) was established in 1997. This body which was established by the
president in his 1997 annual budget speech took over the Supervision and control of the business of insurance
in Nigeria from the National Insurance Supervisory Board which was established by the Insurance Special
Supervision Fund (Amendment) Decree No. 62 of 1992. This commission is the apex institution in the insurance
industry. However, it collaborates with the Central Bank of Nigeria in performing its (NIC) functions.
Prior to 1992, the insurance department of the Federal Ministry of Finance carried out the supervision of
insurance companies and their operations.
The functions of the Nigerian Insurance Commission include among other things:
(a) The supervision and control of insurance business in Nigeria.
(b) Settings of standards for the conduct of insurance business.
(c) Establishment of a bureau to receive and resolve public complaints against insurance companies and
intermediaries.
(d) Consideration and approval of insurance premium rites applicable to various classes of insurance.
Now that the distress syndrome is affecting the insurance industry, this commission is expected to be involved
in the resolution of distress in the industry.
3.6 The Federal Mortgage Bank of Nigeria
To help tackle the problem of housing which has been an issue of serious concern in most Nigeria cities, the
Federal Mortgage Bank was established by Decree No. 7 of 1997. This new body took over the assets and
liabilities of the Nigerian Building Society which was established in 1956. From inception, the bank has
been functioning as one of the development banks. It provided both finance and advisory services in the
area of housing. The regulatory and supervisory role of this institution became prominent from 1991. To
help imple- menting the National Housing policy which was adopted in 1990 by the government, Decree
No. 3 of 1991 gave more powers to the Federal Mortgage Bank of Nigeria to act as the apex
Mortgage institution in Nigeria.
Furthermore, in 1993, the finance functions of this institution were transferred to a new institution known
as Federal Mortgage Finance Limited which was carved out of the bank. This is to enable the bank concentrate
on its regulatory role.
In this new position, the functions of the bank include:
- The Licensing supervision and regulation of primary Mortgage Institutions.
- Management of the National Housing Fund.
- Acting as a banker and adviser to other mortgage finance institutions who retail functions to
individuals, organisations and estate developers.
- Carrying out researches aimed at improving housing patterns and standards in both urban and
rural areas.
36 Principles of Economics
- Encouragement and promotion of the development of mortgage institution at states and
national levels and provision of long-term finance for them (Ugwuanyi 1997).
3.7 The National Board for Community
Banks
Following the introduction of a new set of self-sustaining banks called Community Banks in 1990,
the National Board for Community Banks was established to serve as an apex institution for Community
Banks. Like other supervisory bodies, its roles are performed in collaboration with the Central Bank
of Nigeria. Specifically, the functions of the Board are:
(i) To receive and process application for the establishment for Community Banks and issuance of
provi- sional license to Community Banks before their formal licensing by the Central Bank of
Nigeria.
(ii) To supervise and control the activities of Community Banks, provide them with long-term finance
and set standards to ensure the safety of Community Banks
Students Assessment
Exercise
(i) What is a Community
Bank?
(ii) What are the aims and objectives of Community Bank in
Nigeria?
(iii) Propose some operational strategies for Community Bank in
Nigeria.
4.0
Conclusio
n
A Central Bank is the government’s representatives in the financial system. It has a very close
association with both the government and the financial sector of any Nigerian economy, advising the
government on monetary policies and implementing the policies on behalf of the government. A Central
Bank helps to control the Commercial Banks, Merchant Banks, Development Banks, Community Banks,
Peoples’ Bank, Finance Companies, Insurance Companies, etc. The effective implementation of
regulatory measures will likely give earlier warning about the potential problems of Financial Institutions
and hence provide financial regulations with more time to prevent failures.
5.0
Summary
In this unit, we have succeeded in focusing exhaustively on the controls of Financial Institutions. This is
very necessary for greater efficiency and effectiveness of the Financial Institutions.
6.0 Tutor-Marked Assignments
Q.1 Certain institutions are created by the Government to ensure that good standards are maintained by
the various operators within the Nigerian Financial System. Mention these institutions and briefly
discuss how they maintain such standards.
Q.2 As a supervisor in the Nigerian Financial System, what are the roles of the Nigerian Deposit
Insurance
Corporation (NDIC) and the Federal Ministry of Finance?
Q.3 (a) What led to the establishment of National Board for Community
The Control of Financial Institutions 37
Board? (b) Discuss the role of the National Insurance Commission.
7.0 References/Further
Reading
- Ugwanyi W. The Nigeria Finance System: A systematic Approach, Lagos: Johnkens and
Willy
Nigeria Limited,
1997.
- Olashore, O. Finance, Banking and Economic Policy. Ibadan: Heinemann Educational Books,
1982.
- Anyanwaokoro, M. Banking Methods and Processes. Enugu: Hosanna Publications,
1996.
38 Principles of Economics
Unit 7: Inflation
Contents
Page
1.0 Introduction ........................................................................................................................ 38
2.0 Objectives .......................................................................................................................... 38
3.0 Meaning/Definitions of Inflation ........................................................................................... 38
3.1 Types of Inflation ................................................................................................................ 39
3.2 Causes of Inflation in Nigeria .............................................................................................. 39
3.3 Effects of Inflation (Problems) ............................................................................................. 41
3.4 General Ways of Controlling Inflation in Nigeria ................................................................... 42
4.0 Conclusion ......................................................................................................................... 43
5.0 Summary ............................................................................................................................ 43
6.0 Tutors Marked Assignments ............................................................................................... 43
7.0 References/Further Reading ................................................................................................ 44
37

38 Principles of Economics
1.0 Introduction
In the last unit, we examined the control of financial institutions and the consequent role that the various
supervisory and regulatory authorities play in the determination of money supply. In this unit, we shall review
inflation.
The economic spectre of the Nigerian Inter Civil War period was the demoralising level of unemployment.
The implementation of economic policies following the war allowed over 30 years of unemployment problems.
The worry of unemployment has given way to a concern over inflation, the condition of generally rising
prices and the bulk of post-war Nigerian economic policies may be seen as a continuing fight to restrain price
increases and the distortions created by them.
In a very general sort of way, inflation simply means rising prices. Although prices do not always change
together, the interdependence of different parts of the economy does tend to punch up all prices together.
The main purpose of this chapter is to examine some of the causes/theories of inflation and to see if they are
applicable in Nigerian situation. In earlier units, the causes of inflation have already been considered implicitly.
Firstly, an excess of aggregate demand over aggregate supply when output cannot increase will cause a
rise in prices. This sort of inflation is called “demand inflation” (sometimes also demand-pull-for some obvious
reasons). For these reasons inflation is usually an important element in an excess demand situation. The
second type of inflation already considered is what might be called “monetary inflation”, that is rising prices
caused by increases in the money supply.
2.0 Objectives
At the end of this unit, you should be able to:
(i) define inflation.
(ii) specify the types of inflation.
(iii) know the causes of inflation in Nigeria.
(iv) appreciate the effects of inflation.
(v) recall the various ways of controlling inflation.
3.0 Meaning/Definitions of Inflation
Inflation has become a household word in Nigeria. It is no longer a strange economic jargon to any student.
There is hardly any Nigerian citizen who does not worry about rising prices and the high cost of living.
In the ordinary sense, inflation is seen as an increase in the average level of prices. In economics, it is
defined as a condition in which supply persistently fails to keep pace with the expansion of demand. It is a
state of disequilibrium in which too much money is chasing too few goods.
The literature is full of plethora of definitions of inflation. Selow (1979) for instance, see inflation as going
on when one needs more and more money to buy some representative bundle of goods and services or a
sustained fall in the purchasing power of money. As Johnson (1972) notes, and for most purposes, inflation is
generally and conveniently defined as a sustained rising trend in the general price level.
Inflation is a period of general increases in the price of goods and services in an economy.
Inflation can be measured using the following methods.
(a) Consumer Price Index - It measures inflation at the price where goods are consumed.
(b) Wholesale Price Index - In this, inflation is measured at the wholesale stage.
(c) Gross Development Product Deflator - More often this is used to measure variations in the computation
of economic activity in developing countries.
None of these indices will give an unbiased result because at any point in time, there is a new product being
introduced in the economy.
Inflation 39
Students Assessment Exercise
What is Inflation? or Define the term “Inflation”.
3.1 Types of Inflation
(a) Demand-Pull Inflation: This is induced by excessive demand not matched with increase in supply.
Here, too much money is chasing too few goods. Give a fixed stock of goods, any increase in demand
brought about by increase in people’s disposable income will force prices up in the market. This was the
situation during the Biafran-Nigerian War and after the Udoji Salary Awards in 1974 when wages
extensively increased. Higher wages increased the purchasing power of consumers thus leading to
increased demand. The pressure on commodities therefore led to increase in their prices.
(b) Cost-Push Inflation: This is induced by rising cost of production, particularly rising wages. If we take
the four factor rewards/wages, profit, interest and rent, we would note that only wages could be influenced
considerably by human factors. The trade union could be very vocal and militant and this may
lead to increase in wages without corresponding increase in productivity. This wage-price spiral inflation
is such that the increase in wage, which is a production cost will lead to price rise and the price rise
is another argument by labour unions for higher wages and therefore, higher prices will once again set
in and so on. The problem is more pronounced when such wage increase is well anticipated by sellers
such that prices may actually rise in anticipation of pay rise. In fact, the cycle continues and prices
continue to rise, hence the name wage-price spiral.
(c) Hyper-Inflation: This occurs when the level rises at a very rapid rate. In this case, money loses its
function as a store of value and its medium of exchange function may be affected if people are unwilling
to receive it, preferring trade by barter. This was the situation in Germany after World War II in 1945
when people preferred cigarette to money.
The main cause of hyper-inflation is an enormous expansion of the money supply.
Students Assessment Exercise
(i) Distinguish between the various kinds of inflation relating yours to the Nigerian Economy.
(ii) “Trade Union cause Inflation”. Comment.
3.2 Causes of Inflation in Nigeria
Generally, the following could be said to be the causes of inflation.
(1) Excessive Money Supply: Excessive money supply through poor monetary policy or other methods
invariably lead to inflation in Nigeria, the 1974 Udoji Salary Award and the 1981 Minimum Wage Act
injected a lot of money in the economy thus causing inflation. Expansionary monetary policy is also a
contributory factor.
(2) Fall in the Supply of Goods and Services: Agriculture is virtually abandoned in Nigeria. It is only left
to the aged in the remote villages who practice subsistent farming using out-dated or archaic methods.
This shortage of commodities has been one of the most influential causes of inflation in Nigeria today.
Rising wages also increase production costs. This, thus, leads to decreased supply of commodities
thereby causing rise in prices.
There were marked shortages in the supply of essential commodities. This became particularly noticeable
when the country could not obtain necessary foreign exchange to pay for the expanding imports.
Thus, the prices of few commodities that found their ways into the country and those produced locally
were soaring.
40 Principles of Economics
(3) Budget Deficits or Government Expenditure Programme: Almost all the governments of West
African countries have been experiencing budget deficits since the 1970s. There is also enormous
increase in government expenditure on development programme and other capital projects or expenditures.
These have contributed greatly to inflationary trends.
(4) Imported Inflation: Almost all our manufactured goods in Nigeria are imported from the advanced
nations of the world who are currently experiencing inflation. This means a direct importation of these
higher prices to West African nations. Importation of goods from countries suffering from inflation
could lead to imported inflation into the country which also increase domestic price.
(5) Rural-Urban Drift/Migration: The mass drift to urban areas has left the Agricultural sector unattended
to. Moreover, the little goods and services in the urban areas are grossly inadequate hence
inflation results.
(6) Increase in population Explosion: There is enormous increase in the population of West African
nations in particular and the whole world in general. For Nigeria, her estimated population increased
from about 55m in 1963 to more than 88.5m in 1991. The situation is worsened by the fact that majority
of the population are children who fall under the unproductive sector of the society. They are, therefore,
dependent on the working population hence they put pressure on the little goods and services available.
(7) Activities of Middlemen and Monopolistic Tendencies: There are too many middlemen in the
chain of distribution of goods and services in Nigeria. These people are very exploitative hence they
hoard available goods in order to sell at higher prices in “Black Markets”. Many others who have the
influence from government quarters monopolise the supply of certain essential commodities thereby
charging higher prices than hitherto or what ought to be. Therefore, large scale hoarding in the hands of
the major and minor distribution, particularly the lucky few that had access to import license contributed
in a very large way to the severity of inflation in Nigeria.
(8) Excessive Demand by Consumers: Increase in the purchasing power of consumers leads to higher
demands and thus inflation. This is the case in Nigeria due to higher wages resulting from frequent
upward salary adjustments and revisions.
The inflation we have in Nigeria can be rightly described as demand-pull because there has been an
upward trend in demand for goods and services for the past thirty years which may be the result of a
rising standard of living of many Nigerians. The oil boom further increased and aggregated demand
with no corresponding increase in supply most especially essential goods and food stuffs, hence persistent
rise in their prices.
(9) Higher Production Costs: Higher wages, as is the case in Nigeria are higher costs of production.
They may hinder increased productivity, thereby resulting to inflation or the higher production costs are
passed onto consumers in the form of higher prices on commodities.
(10) War-Caused Inflation: During wars like Nigerian/Biafran War, efforts were directed to production of
war equipment or armaments. Labour which could have produced foods was deployed to the war
fronts. Hence, demand could not equate supply. Inflation therefore resulted.
(11) Wage Increase Unrelated to Production: Since there have been general wage increases, the most
notorious was the Udoji wage review reports, the implementation of which almost troubled the wage
levels of most of the working groups. The most recent of this wage increase in the country is the SAP
relief and 45% wage increase. These wage increases were unrelated to increases in productivity of
workers. Hence high wages means high prices.
Inflation 41
(12) Bad Management of Resources: The large-scale fraud and corruption which has started since the
oil boom era of early 1970s has been increasing the tempo of inflation in Nigeria. Contracts most of
which were not executed, were unbelievably inflated. Large sum of money were siphoned into private
pockets, some particular individuals become richer than the states. Thus, money lost its traditional
value. In pursuit of Naira, most people abandoned productive employment to become sales agents,
contractors, importers and exporters. The effects of all these were the disappearance of many essential
and other goods from the Nigerian Market, coupled with usually rising prices.
Students Assessment Exercise
(i) To what extent is it possible to regard inflation as a purely monetary phenomenon?
(ii) Examine the quantity theory of money. Does it offer an adequate explanation of inflation?
3.3 Effects of Inflation (Problems)
(i) Distributive Injustice: Inflation imposes a lot of distributive injustice on the society by re-distributing
income in favour of one group to the disadvantage of the other groups. Examples are discussed below:
(a) People on fixed income suffer: Such people like pensioners, fixed salary earners etc, because
there is no in-built flexibility in their income to make their income adjust in line with the continuous
rise in the prices of goods and services they buy. Thus the quantity of good and services that their
money income can buy will be diminishing progressively until they succeed in improving their lot
through bargaining for higher wages. On the other hand, those whose income are flexible will
benefit from inflation because they can always increase their income ahead of price increase.
Business men and other profit earners thus benefit from inflation
(b) Inflation imposes adverse effects on savings: This is because real value of savings cannot be
maintained. By discouraging savings, inflation could be perpetuated because people will want to
keep their wealth in real assets as opposed to money. The Central Bank can, however, maintain
the real level of savings by adjusting interest rates but this will be an extra cost to the economy.
(c) Inflation Reverses the Position of Debtors and Creditors: Debtors gain while creditor lose.
The only way which the creditor could be saved is by imposing an interest rate which should
reflect the inflation rate; otherwise he will get cheap money back for dear money lent out.
(ii) Loss of Confidence in Money: At the extreme case of Hyper-inflation, there would be economic
depression such that business men may not know what to charge for their products like the 1930s
inflation in Germany when a packet of cigarette sold for millions of German marks and buyers too will
not know what to pay. In such severe cases, money virtually become worthless. Suppliers of productive
factors want to be paid in kind and not in cash, and creditors will keep away from debtors as they do not
want to obtain such cheap money from debtors. Money will be deprived of its functions as an exchange
medium and as a standard for deferred payment. We have seen above that because of inflation, savings
will fall thus money will cease to be a store of value. As a measure of value or unit of account, money
will also fail because the instability of its own value will make it difficult for it to measure other values.
With all these developments, money will become virtually useless and this may bring a tendency for the
society to go back to barter exchange and subsistent production.
(iii) Expectation Effects: As a buyer, if I expect that price will rise tomorrow, I will want to buy today so
as to avoid paying higher price tomorrow whereas as a seller, I would wish to withhold stock until the
price rises tomorrow.
A situation of scarcity will, therefore, arise today and the current high demand will create inflation
today. This makes economist believe that “inflation will occur if people expect it to occur”.
(iv) Wrong Investment Priorities: Inflation will precipitate wrong investment because it is only those
items whose prices are rising that people will concentrate production upon whereas they may not be
42 Principles of Economics
actually important. It follows in real life that ostentatious goods and such goods like beer will attract
more attention than essential items like agricultural products.
(v) Inefficiency and Poor Quality: In an inflationary period, goods will no longer be of the required
standard because of the haste to make profit. Emergency contractors and innumerable unskilled people
will go into contract jobs and such jobs as distributorship, increasing distribution cost which is an aid of
inflation.
(vi) Distortion of Government Development Plans: the costs of major investments are disturbed by
inflation such that government development plans are severely distorted. This may lead to re-appraisal
and deficit financing and some projects might be dropped out of the plan for reason of prohibitive cost.
During inflation, new plans become difficult to formulate because the planner will not know the prices
to use.
(vii) Distortions in Accounting Reports
(viii) Balance of Payment Effect: Because domestic prices are higher, home made goods would become
more expensive relative to those in other countries. The country, therefore, becomes a dumping ground
for foreign goods, a good place to sell but a bad place to buy from and this will have significant impact
on foreign exchange earnings and on the balance of payment situation.
Students Assessment Exercise
(i) Consider carefully the economic effects of inflation.
(ii) “Those who cause inflation are rarely those who suffer its effect” Comment.
(iii) What is inflation and what are its causes?
(iv) Describe three different types of inflation you know.
3.4 General Ways of Controlling Inflation in Nigeria
(1) Price Control Measure: This involves the setting up of Price Control Board by the government
which fixes maximum prices charged for certain commodities experiencing inflation. Experience, however,
has shown that this system bedeviled with a myriad of problems does not work. The Nigerian case
is typical example. What usually results are hoarding, profiteering and black-marketing, thus negating
the initial aims.
(2) Wage Control or Wage Freeze: Most of governments place freezes on wage increases as a measure
to combat inflation but this policy does not work or is ineffective since workers have deviced
methods of making the government or employers of labour dance to their tune. These ways include goslow,
work-to-rule, industrial actions, etc. These are most often used in democratic nations/societies.
(3) Monetary Policy: This involves the use of traditional monetary instruments to reduce the quantity of
money in circulation. These include increase in the Bank or Discount Rate, increase in the Liquidity
ratio, use of open market operation – contractionary monetary policy in this case, sectoral allocation or
special directives, etc., however, the experience in the developing world has shown that these traditional
instruments of monetary policy have a lot of deficiencies hence their effectiveness.
(4) Fiscal Policy: A combination of increase in personal income tax and reduction in government expenditure
may prove effective especially when inflation is demand-pull in nature. These reduce the purchasing
power of consumers thus reducing demand and prices of commodities.
(5) Total Ban on the importation of certain items : Especially when inflation is imported, the government
is strongly tempted to place total ban on the importation of certain non-essential items. However,
Inflation 43
retaliation by other nations and political pressure lead to the lifting of the ban no sooner than it was
placed hence the ineffectiveness of such a policy.
(6) Increase in the Production of Goods and Services: Increase in the production of goods and services
is the most effective measure to inflation. Increase in the supply of products will naturally force
prices down. In Nigeria, concrete efforts should be made to increase production of essential but scarce
commodities.
(7) Over-hauling of the entire Distribution Network: Only genuine distributors should be appointed
and any one found hoarding and profiteering should be prosecuted to serve as a deterrent to others.
Students Assessment Exercise
(i) What are your suggestions for control of inflation in Nigeria today?
(ii) Discuss three types of inflation in Nigeria and the methods of control of each type.
(iii) Why have the efforts being made for some years proved unsuccessful in curbing inflationary problems
in Nigeria?
(iv) To what extent is a formal prices and incomes policy likely to control the rate of inflation?
(v) For what reasons do government set to control inflation?
4.0 Conclusion
The tendency of prices to rise and the value of money to fall is known as inflation. One of the main aims of
government is to control the rate of inflation because of its undesirable effect on the economy. For a full
understanding of inflation, it is important to realise the relationship between the supply of money and the rate
at which prices are rising for the supply of money is important consideration in the question of inflation. This
leads many people to regard inflation as a condition of excess Aggregate Monetary Demand (AMD) over
Aggregate Supply in conditions of full employment. The importance of this definition of inflation lies in the
fact that it draws attention to Aggregate Monetary Demand and consequently to the supply of money.
While acknowledging the importance of the money supply to the inflationary process, it is useful to consider
other powerful forces which make their contribution to rising prices. The standard distraction is between
“Cost-Push inflation” and “demand-pull” inflation. The names indicate the main causes of the particular
inflation although it is usual for one kind of inflation to lead to the other kind in a particularly unpleasant
circle.
Cost-push inflation occurs when prices rise as a result of the costs of production increasing more rapidly
than output. When cost inflation of this kind is widespread, it necessarily leads to demand inflation as the
recipients of extra income want to increase their purchases. Once an inflationary atmosphere is established,
the process is in danger of becoming not only self-perpetuating but self-accelerating.
While there is a minority view that a degree of inflation is a necessary stimulant to the economy slightly
rising prices encouraging investment, the strenuous efforts of governments to restrain its pace suggest that it
produces many undesirable side effects.
5.0 Summary
In the unit, we have successfully defined inflation and were able to recognise the different types of inflation,
analyse the causes and effects of inflation. Reasonable suggestions on the various ways of controlling inflation
was also reproduced.
6.0 Tutor-Marked Assignments
Q.1 What is inflation and what are its causes?
44 Principles of Economics
Q.2 What problems are created in the economy by inflation?
Q.3 What are your suggestions for control of inflation in Nigeria today?
Q.4 Discuss three types of inflation in Nigeria and the methods of control of each type.
7.0 References / Further Reading
1. Hacche, J. The Economics of money and Income. London: Heinemann, 1970.
2 Ajayi, S.I. et al. Money and Banking. London: George Allen and Union Limited, 1981.
3. Afolabi, L. Monetary Economics. Lagos: Inner Ways Publications, 1991.
4. Anyanwa, J.C. Monetary Economics. Onitsha: Hybrid Publishers Ltd, 1993.
5. Johnson, H.G. Further Essays in Monetary Economics. London: George Allen and Union, 1973.
6. Solow, R.M. “What we know and Don’t know About Inflation, “Economic impact, Quarterly
Review of World Economics. Vol.4, No. 28, pp 37-43.
Inflation 45
Unit 8: Deflation
Contents
Page
1.0 Introduction ....................................................................................................................... 46
2.0 Objectives ......................................................................................................................... 46
3.0 Meaning/Definitions and Causes of Deflation ...................................................................... 46
3.1 Effects of Deflation ............................................................................................................ 47
3.2 Control of Deflation ........................................................................................................... 47
4.0 Conclusion ........................................................................................................................ 48
5.0 Tutor-Marked Assignments ................................................................................................ 49
6.0 References/ Further Reading .............................................................................................. 49
45
46 Principles of Economics
1.0 Introduction
The last unit was dominated by the discussion on inflation. In this unit, we shall concentrate on deflation in
order to be able to distinguish between two of them.
When the prices of most goods and services are rising over time, the economy is said to be experiencing
inflation. Prior, to 1950, several European countries including Germany, France and Italy had periods when
prices rose very rapidly. This usually occurred during wartime and in the years of rationing that followed.
These wartime periods of inflation were often followed by periods of deflation, during which the prices of
most goods and services fell. In some countries, such as Sweden, the Netherlands and the U.K., the result of
these offsetting periods of inflation and deflation was that over the long run, the level of prices was fairly
constant. The last significant deflation in Europe occurred during 1929 – 33, the initial phase of the Great
Depression. Since then, inflation without offsetting deflation has become the normal state of affairs. Deflation
is a situation in which the prices of most goods and services are falling over time.
2.0 Objectives
At the end of this unit, you should be able to:
a. define deflation.
b. determine the effects of deflation.
c. suggest the various ways of controlling deflation.
3.0 Meaning/Definitions and Causes of Deflation
Deflation is a reduction in the general price level due to a decrease in the economic activity of a nation. The
price levels as well as national income; output and employment will all fall. During the twentieth century, the
only sustained period of deflation in the U.K. existed between 1920 and 1938 when the general prices level
fell by almost 50%. Government introduced deflationary policies for several reasons to decrease the rate of
inflation, to cut the volume of import or to prevent the economy from becoming “overhead.” Among the
deflationary policies available to the government are increases in level of taxation, and “credit sequences.”
Deflation is also the conversion of a factor such as a wage, the cost of raw materials, etc, from a nominal
to a real amount, when measured in monetary terms. For example, the nominal increase in the price of
consumer durables must be divided by the rate of inflation to arrive at the real increase in the price. Also,
Deflationary Gap is the difference between the amount that is actually spent in an economy and the amount
that would have to be spent in order to maintain output at a level corresponding to employment.
Furthermore, Deflation refers to a persistent fall in general price level due to a reduction in the amount of
money in circulation. It is the opposite of inflation.
It is a continuous fall in the price level of goods and service in a country as a result of decrease in the
volume of money in circulation used in the exchange of large available goods and service.
From the foregoing, the cause of Deflation is summarised below.
· Under population
· Increase in production
· Increase in taxation
· Increase in bank rate
· Compulsory bank savings
· Executive price control
· Surplus budget or reduction in government expenditure.
Students Assessment Exercise
(i) Explain the term Deflation and examine its causes.
(ii) Distinguish between Deflation and Inflation.
Deflation 47
3. 1 Effects of Deflation
Since deflation is the opposite of inflation, its effects are the opposite of the effects of inflation already
discussed in Unit Seven.
(a) Effects on Incomes
People with fixed incomes – salary earners, pensioners benefit from the fall in price level while people
whose income are not fixed lose. Income of businessmen, manufactures, shareholders fall because of
fall in profits. The real value of fixed income earners rise when prices fall.
(b) Fall in investment and employment: Fall in profits leads to decline in investment and consequently
in employment. The total output (or national income) working through the multiplier process also falls.
(c) Borrowers lose while lenders gain, since the repaid debts can buy more because of falling prices
(d) Exports are encouraged while consumption of imported goods fall because their prices are relatively
dearer than domestic projects.
(e) Due to falling imports and rising exports, foreign exchange rises while balance of payments problems or
deficits are eliminated or corrected.
The effects of deflation are further summarised as follows:
* Money gains more value
* It encourages export
* It discourages imports
* Decrease in investment
* It encourages savings
* Reduction in profit
* Fall in prices of goods and services
* It causes unemployment
* Money lenders gain at the expense of borrowers
* Improvement in the balance of payments
* Fixed income earners will gain
* It will instill sense of hardwork on the people.
Students Assessment Exercise
Discuss the effect of Deflation.
3.2 Control of Deflation
Earlier, we explained that economic theory distinguishes two “types” of Inflation – demand-pull inflation and
cost-push inflation. In practice, demand-pull and cost-push inflation tend to co-exist, though it is possible in
theory at least to distinguish “demand pull” and cost-push” inflation.
If demand-pull inflation is diagnosed, the appropriate policy is one which reduces the level of demand –
what is called deflationary policy – if on the other hand, cost-push inflation is diagnosed, deflation would not
be appropriate. Rather a policy to restrain cost increases is necessary. In practice, the appropriate policy
would depend upon the nature and source of the cost increases.
The terms deflation, reflation “both refer to demand. Deflation means a reduction in demand. Reflation is
the opposite – an increase in demand. The odd one out is inflation, since it refers to prices. Curiously or
perhaps not so curiously, there is no single word, which is the opposite to inflation – we have to use a phrase
such as “ a fall in the price level.”
Deflation can be checked by reversing those measures for checking inflation: Specifically, these measures
are as follows:
48 Principles of Economics
(a) Government should encourage investment by reducing the bank rate thus making it cheaper for investors,
businessmen and consumers to borrow money. That is, expansionary monetary policy that liberalises
credit facilities can remedy deflation.
(b) Reduction of Taxes
The government should also reduce taxes (particularly income taxes) to increase people’s disposable
income and thus purchasing powers.
(c) Increase in Government Expenditure
The Government expenditure should rise in order to increase employment and personal income of
consumers.
(d) Increase in Salaries and Wages
There should be a general increase in salaries and wages so as to raise consumers’ purchasing power
and push up prices to acceptable levels (stable prices).
The control of Deflation is further summarised as follows:-
(i) Deficit budget
(ii) Increase in wages
(iii) Reduction in bank rate
(iv) Reduction in income tax
(v) The use of Open Market Operation
Students Assessment Exercise
Deflation, Reflation and inflation.
Which is the odd one out?
4.0 Conclusion
Deflation is almost the opposite of Inflation. This is experienced when the amount of money in circulation is
not sufficient. In other words, the total demand for money is greater than the available amount. This may be
due to the contraction of money supply with a view to raising the value of the national currency.
Volume of goods and services in the economy is expanding without corresponding increase in the supply of
money. OR the same volume of goods and services. But part of money circulating over them have been
withdrawn as indicated above leaving more goods and services with little amount of money.
The general result is the appreciation of money value. This leads to a fall in the general level of prices.
With the little amount of the money in your possession, you can purchase as many goods and service as
possible. This is deflation. It reduces the National Income as it reduces personal income. This is general
distress resulting from jungle economic activities. Its effects could be more caustic than inflation both in the
short-run and in the long-run.
By deflation; we mean a time when most prices and costs are falling. The effect of deflation is the
opposite of inflation. During the period of deflation, the entrepreneurs lose because of the declining profit of
their investment. The creditors and fixed receivers tend to gain at the expense of debtors. Wage earners and
pensioners obtain increased purchasing power for their income. Debtors gain at the expense of the creditors.
In terms of production, profit margin decline, entrepreneurs are less inclined to expand their operation.
This decline in production leads to growing unemployment to labour and capital.
The standard of living falls. When an economy faces this type of depression, private and public spending
has to be stimulated to encourage and accelerate production, which creates more job and more real income.
Deflation 49
5.0 Tutor-Marked Assignments (TMA)
Q1. Discuss Deflation under the following
headings. (i) Meaning/Definitions
(ii)
Cause
s (iii)
Effects (iv)
Control
6.0 References/Further Reading
1. Anyamu, J. C. Monetary Economics, Theory, Policy and Institutions. Onitsha: Hybrid Publisher
Ltd., 1993.
2. Lipsey, R. G. An Introduction to positive Economics. London: English Language Book Society/
Weidenfied & Nicolson, 1983.
3. Vaish, M. C. Money: Banking and International Trade. Sahibabad: Vikas Publishing House, PVT
ltd., 1980.
4. Pearce, D. W. The Dictionary of Modern Economics. London: Macmillan Press,
1983.
50 Principles of Economics
Unit 9: Tools of Monetary Policies
Contents
Page
1.0 Introduction ........................................................................................................................ 51
2.0 Objectives .......................................................................................................................... 51
3.0 What is Monetary Policy? ................................................................................................... 51
3.1 Objectives of Monetary Policy ........................................................................................... 52
3.2 Stance of Monetary Policy .................................................................................................. 53
3.3 Monetary Policy Instruments/Weapons/Tools ....................................................................... 54
3.4 Phases of Monetary Policy in Nigeria .................................................................................. 56
3.5 Formulation and Administration of Monetary Policy in Nigeria .............................................. 56
3.6 Lags in Monetary Policy ...................................................................................................... 58
3.7 Conflicts and Achievements of Monetary Policy Objectives ................................................. 58
3.8 Limitations of Monetary Policy in Nigeria ............................................................................. 59
4.0 Conclusion .......................................................................................................................... 60
5.0 Summary ............................................................................................................................ 60
6.0 Tutor-Marked Assignments ................................................................................................. 60
7.0 References/Further Reading ................................................................................................ 61
50
Tools of Monetary Policies 51
1.0 Introduction
In this unit, we will focus our attention on the effectiveness of monetary policies in changing the level of real
income. We will attempt to delineate the conditions that are favourable and those that are unfavourable for
the successful operation of the respective policies. We will also resort to the findings of empirical research to
see the impacts of the policies.
As we have seen, in the previous units from our study of financial institutions, the Government needs to
influence the level of employment, the rate of inflation or economic growth, or the balance of payments, it will
implement some kind of monetary policy. Such a policy is designed to influence both the supply of money and
its price. If the volume of money circulating in the economy is increased, the level of Aggregate Monetary
Demand (AMD) is likely to rise. If the price is the money, that is the rate of interest payable for its use, is
reduced, the level of AMD is again likely to be stimulated.
The onus of formulating monetary policies in Nigeria rests on the Central Bank of Nigeria. In this unit,
therefore, we shall specifically take a look into the techniques and instruments of monetary policies. We shall
also look at the procedure for the formulation and administration of monetary policies and how to minimise
lags in monetary policy formulation and implementation.
2.0 Objectives
At the end of this unit, you should be able to:
(i) present an introduction of the meaning, objectives and stance of monetary policy.
(ii) discuss in brief the various tools and techniques of monetary policy.
(iii) show the administrative, procedure of formulation and monetary policy and the lags that often occur.
3.0 What Is Monetary Policy? – The concept of Monetary policy
Simply put, monetary policy is a government policy about money. It is a deliberate manipulation of cost and
availability of money and credit by the government as a means of achieving the desired level prices, employment
output and other economic objectives. The government of each country of the world embarks upon
policies that increase or reduce the supply of money because of the knowledge that money supply and the
cost of money affect every aspect of economy. By affecting the aggregate demand, money supply affects
the level of prices and employment. It also affects investment levels, consumption, and the rate of economic
growth. An increase or reduction in the cost of money (interest rate) affects all these variables.
Monetary policy is defined in the Central Banks of Nigeria Brief as “the combination of measures designed
to regulate the value, supply and cost of money in an economy, in consonance with the expected level
of economic activity.” (CBN) Brief 1996/03.
One idea is central in this and other definitions given above – that monetary policy focuses on money
supply as a means of achieving economic objectives. If the government thinks that economic activity is very
low, it can stimulate activities again by increasing the money supply. But when the economy is becoming so
much that the rate of inflation is high, it will reduce the supply of money. This will reduce aggregate demand
in and the general price level. However, it can also lead to unemployment and stunted economic growth. As
you will see later, there is often a conflict between the objectives of monetary policy. It is difficult to achieve
all the objectives simultaneously.
Monetary policy is a major economic stabilisation weapon which involves measures designed to regulate
and control the volume, cost of availability and direction of money and credit in an economy to achieve some
specified macroeconomic policy objectives.
That is, it is a deliberate effort by the monetary authorities (the Central Bank) to control the money supply
and credit conditions for the purpose of achieving certain broad economic objectives (Wrightsonan, 1976).
Monetary policy is administered by the Central Bank of Nigeria, in some cases with degree of political/
Government Interference. As a watchdog of the economy, the Central Bank has the duty of ensuring that
52 Principles of Economics
policies are set in motion to ensure that the monetary system is directed towards achieving national objectives.
Monetary policy is the control of the supply of money and liquidity by the Central Bank through “open
market” operations and changes in the “minimum lending rate” to achieve the government’s objectives of
general economic policy.
The control of the money supply allows the Central Bank to choose between “a tight money” and “easy
money” policy and thus in the short to medium-run to affect the fluctuation in output in the economy.
Monetary policy could, therefore, generally be defined as follows:
(a) As an attempt to influence the economy by operating on such monetary variables as the quantity of
money and the rate of interest; OR
(b) As a policy which deals with the discretionary control of money supply by the monetary authorities in
order to achieve stated or desires economic goals; OR
(c) As steps taken by the banking system to accomplish, through the monetary mechanism a specific
purpose believed to be in the general public interest; OR
(d) The use of devices to control the supply of money and credit in the economy. It has to do with the
controls that are used by the banking system.
Students Assessment Exercise
(i) What is monetary policy?
(ii) Who carries out monetary policy in Nigeria?
(iii) Distinguish between contraditionary and monetary policy.
3.1 Objectives of Monetary Policy
Generally, the objectives of monetary policy in various countries are the same as the economic objectives of
the government.
In Nigeria, the objectives of monetary policy as explained by the government of Central Bank of Nigeria
are as follows:
(i) Promotion of price stability
(ii) Stimulation of economic growth
(iii) Creation of employment
(iv) Reduction of pressures on the external sectors, and
(v) Stabilisation of the Naira exchange rate (ogwuma 1997:3).
These are discussed briefly in turns:
(i) Promotion of Price Stability
This involves avoiding wide fluctuation of prices which are highly upsetting to the economy. Not only do
such wide prices gyrations produce windfall profits and losses, but they also introduce uncertainties
into the market that make it difficult for business to plan ahead. They therefore, reduced the total level
of economic activity. This objective of avoiding inflation is desirable since rising and falling prices are
both bad, bringing unnecessary losses to some and necessary undue advantages to others. Prices
stability is also necessary to maintain international competitiveness.
(ii) Slowly rising prices, slowly falling prices and constant prices (though the last option is rather unrealistic
in the world).
(ii) Stimulation of economic Growth i.e. – Achievement of a High, Rapid and Sustainable Economic
Growth: This mean maximum sustainable high level of output, that is, the most possible output
with all resources employed to the greatest possible extent, given the general society and organisational
structure of the society at any given time. This highly desirable economic growth implies raising peoTools
of Monetary Policies 53
ple’s standard of living. The growth of the economy is the wish of every government and monetary
authorities. Therefore, when growth is achieved, it should be sustained.
(iii) Creation of Employment: Attainment of High rate or Full Employment: This does not mean Zero
unemployment since there is always a certain amount of frictional voluntary or seasonal unemployment
(Acklay, 1978). Thus, what most policy makers aim is actually minimum unemployment and the percentage
that varies among countries.
The monetary policy should always aim at reducing the level of unemployment in the economy. Unemployment
is a social ill which should not be allowed to exist in the economy. The effects of unemployment
to individuals as well as the society as a whole is so enormous that if left unchecked it will spell
doom for both individuals and society.
(iv) Reduction of pressures on the external sectors - i.e. Maintenance of balances of payments
Equilibrium: This involves keeping international payments of receipts in equilibrium, that is, avoiding
fundamental or persistent disequilibrium in the balance of payments positions. Usually, however, nations
worry about persistent balance of payments deficits. The pursuit of this objective, arises from the
realisation that deficit in the balance of payments will retard the attainment of the other objective of
other objectives, especially the objective of rapid economic growth. Deficit balance of payment is not
healthy and therefore the monetary authorities should try to achieve healthy balance of payment.
(v) Stabilisation of Naira Exchange Rate – This involves avoiding wide swings (undue and unnecessary
fluctuations) in the currency exchange rate. This is meant to help in protecting foreign trade.
Instability in the economy creates an atmosphere of uncertainty for the investors and discourages them
from investing while stability encourages investment. Monetary policy will, therefore, endeavour to achieve
economic stability so as to encourage both local and foreign investors to invest in the economy.
The above discussed objectives of monetary policy are achieved through the manipulation of the monetary
policy tools by the Central Bank of Nigeria (CBN).
Students Assessment Exercise
Examine fully the objectives of monetary policy in Nigeria.
3.2 Stance of Monetary Policy
The stance of monetary policy refers to the position taken by (CBN) – the monetary authorities about
whether to increase or reduce the supply of money in the economy during a policy period, usually one year.
this gives rise to two types of monetary policies, namely expansionary or a monetary ease policy, and
contractionary or stringent or tight monetary policy.
Monetary policy is said to be an expansionary or a monetary ease policy when the monetary authorities
decides to increase the supply of money or reduce the cost of money in the economy so as to stimulate an
increase in economic activities. This can be accomplished through the buying of securities in the open market,
a reduction in interest and discount rates, a reduction in reserve requirements, and relaxing of credit controls,
among others. The overall effect of expansionary monetary policy is to have more money in the hands of the
public. This will lead to an increase in aggregate demand, investment, savings, employment, output and
economic growth, while at the same time increasing the rate of inflation.
A contractionary stringent or tight monetary policy does the opposite of an expansionary policy. Monetary
policy is said to be contractionary, stringent, or tight when the monetary authorities embark on policies that
will reduce the supply of money or increase the cost of money in economy, in other to generate a contraction
in economic activities. The effect of contractionary policies is to reduce the general price level and curb
inflation. However, it will equally lead to a reduction in the level of investment, employment, output and
economic growth.
The government switches from contractionary to expansionary policies as the need arises depending on
the economic objectives, which she is giving priority. In Nigeria, the stance of monetary policy adopted has
54 Principles of Economics
been varying from one regime to another.
Students Assessment Exercise
Differentiate between Expansionary and Contractionary monetary policy. Examine/ discuss why both are
necessary.
3.3 Monetary Policy Instruments/Weapons/Tools
Instruments of monetary policy are many and varied. Their respective effects on the economy also vary in
terms of where they start and transmission route. Sometimes, some tools are not compatible with others i.e.
in which case, the adoption of one set instruments will negate or be at cross purposes with the effects of
others. That is why monetary authorities usually consider the operational efficiency, the technical features,
the lags and other effects of any given instruments before it can be used.
Apart from minor variations based on level of economic development of each country, the tools used to
attain the monetary objectives of various countries of the world are virtually the same. In discharging its
obligations, the Central Bank of Nigeria has at its disposal a number of control mechanism usually referred to
also as tools of monetary policy.
Instruments or tools of monetary policy can be classified into two:-
(a) Quantitative Instruments (Traditional and Non-Traditional).
(b) Qualitative Instruments (Ranlett, 1977).
A. Qualitative Instruments
These are “impartial or impersonal” tools which operate primarily by influencing the cost, volume, and
availability of bank reserves. They lead to the regulation of the supply of credit and cannot be used
effectively to regulate the use of credit in particular areas or sectors of the credit market.
Quantitative tools are further classified into traditional or market weapons and nontraditional tools or
credit direct control of bank liquidity.
1 . Traditional or market weapons.
This are called market weapon because they rely on market forces to transmit their effects to the
economy. Specifically, these tools include Open Market Operations (OMO), Discount Rate Policy and
Reserve Requirements.
(i) Open Market Operations
This is the buying and selling of securities by the monetary authorities in the open market. Securities
are sold to reduce money supply and bought to increase money supply.
(ii) Discount Rate Policy or the Rediscount Rate Policy or Bank Rate
Discount rates are interest rates paid in advance based on the amount of credit extended by
increasing the rediscount rates that Central banks charges from borrowing for the Central Bank
and makes banks to increase their own discount rates and interest rates. This discourages banks
lending and reduces money supply. A reduction in rediscount rates increases the supply of money.
Interest rates is the cost of borrowed money. An increase in interest rates discourages people
from borrowing from banks. This reduces money supply. A reduction in interest rate does the
opposite.
(iii) Reserve Requirements/ Required Reserve Ratios
The monetary authorities set a minimum level of reserves that will be maintained by banks. In
Nigeria, banks maintain two types of reserve – Cash Ratio, and Liquidity Ratio. An increase in
bank reserves reduces money supply by reducing bank loanable funds, while a decrease in reserves
increases the supply of money.
Tools of Monetary Policies 55
(a) Non-traditional Instruments or Direct Control of Bank Liquidity: These tools are non- market
tools that strike directly at bank’s Liquidity. They include supplementary reserve requirements and
variable Liquidity ratios.
(b) Supplementary reserve requirements or special deposits: The Central Bank here requires
banks to hold over and above the legal minimum cash reserves, a specified percentage of their
deposits in government securities such as stabilisation securities issued by the Central Bank,
hence it is also called special deposits policy. The main objective is to influence banks’ lending by
freezing a certain percentage of their assets.
Stabilisation securities which the Central Bank of Nigeria is authorised by law to issue and sell to banks
compulsorily at any rate they may fix and redeem them at any time they may fix. It is used to mop up excess
liquidity to reduce money supply.
It is important to understand how this works. Assuming that the Central Bank wants to reduce the money
supply in the economy, it may impose a special deposit of say 5% on banks and this will force the banks to
deposit 5% of their total deposits liquidity with the Central Bank on a special account. The special deposit is
mainly used when other instrument fail to achieve their objectives or targets. This is, therefore, regarded as
instrument of the last resort.
(2) Variable Liquid Assets Ratio
Here, Banks are required to diversify their portfolio of liquid assets holding.
These means that banks are required to redefine the composition of their Liquid assets portfolios at
different times to reduce or increase their credit base.
B . Qualitative or Selective Controls or Instruments
These confer on the monetary authorities the power to regulate the terms on which credit is granted in
specific sectors. These powers or control seek typically to regulate the demand for credit for specific
uses by determining minimum down payments and regulating the period of time over which the loan is
to be repaid. In other words, they involve official interference with the volume and direction of credit
into those sectors of the economy which planners believe are a crucial importance to economic development.
These tools include moral suasion and selective credit controls or guidelines.
(1) Moral Suasion
Moral suasion is an appeal of persuasion from the Central Bank to other banks to take certain actions in line
with government economic objectives. Unlike directives, no penalty is attached to non-compliance to moral
suasion. Banks have the freedom not to comply, but they often comply so as to have a good relationship with
the Central Bank.
This involves the employment of persuasions or friendly persuasive statements, public pronouncements or
outright appeal on the part of monetary authorities to the banks requesting them to operate in a particular
direction for the realisation of specified government objectives. For example, the Central Bank or the government
may appeal to the banks to exercise restraint in credit expansion by explaining to them how excess
expansion of credit might involve serious consequences for both the banking system and the economy as a
whole. Moral suasion is supposed to work, through appeal and voluntary action rather than the regulation and
authority.
(2) Selective Credit Controls and Guideline
These are specific instructions given by the Central Bank to other banks which they must comply with. Such
directives come in the form of credit ceilings, special deposits and sectoral allocations of credits, among
others. This can be used to increase or reduce money supply.
Selective credit controls or guidelines involve administrative orders whereby the Central Bank, using
guidelines, instructs banks on the cost and volume of credit to specified sectors depending on the degree of
56 Principles of Economics
priority of each sectors. Thus, selective credit controls are examples of the use of monetary policy to
influence directly the allocation of resources indicating a lack of faith in the working of the free market.
Apart from the quantitative control which regulates the amount of money in circulation, the Central Bank
can monitor the economy by giving directives to banks in all areas of operation. The selective control or
directives can be in form of:
(a) Credit Ceiling: Every year the Central Bank dictates the rate of credit expansion in the economy.
(b) Sectorial Allocation of Credit: The Central Bank divided economic activities in the country into
sectoral allocations. The divisions are agriculture, forestry, fishing, mining, quarrying, manufacturing
and real estate.
(c) Interest Rate Ceiling: The interest rate may be controlled to favour particular sectors.
(d) Loans to Rural Borrower: This is aimed at improving investment in the rural areas.
(e) Grace Period on Loans: Longer period may be granted to some important sector like agriculture.
(f) Refinancing Facilities
(g) Indigenisation of Credit
Students Assessment Exercise
(1) “ If you control the supply of money you control the economy.” Comment.
(2) Explain the monetary steps that should be taken to induce conditions of full employment.
(3) What effects does a rise in interest rate have on the price of gilt-edged securities?
3.4 Phases of Monetary Policy in Nigeria
The Central Bank of Nigeria from its inception had various instruments of monetary control at its disposal.
However, the extent to which each of the monetary policy instruments has been changing from time to time.
In this regard, it has become usual to classify monetary policy in Nigeria into two phases based on the typed
instruments been emphasised by the bank, during each phase. They are the era of direct monetary control
(1958 to 1986) and the era of indirect or market-based monetary control.
During the first phase covering 1958 to 1985, the emphasis of the Central Bank was on the use of those
tools which directly affect the price of money and the flow of bank credit such as interest rates policy,
directives or direct controls, moral suasion, and stabilisation securities. The Central Bank had direct control
on the maximum amount of credit to be allocated by each bank and the sector to which the credit would go.
Apart from giving specific directives, although the use of indirect tools like reserve requirements, Open
Market Operation, and Discount Rates were attempted during this period, the emphasis on their use was not
much.
The second phase of the administration of monetary policy in Nigeria began in 1986 when the Babangida
administration began a gradual deregulation of the economy under the Structural Adjustment Programme
(SAP) introduced in that year. This phase placed much emphasis on the use of market oriented instruments
to achieve monetary policy objectives. The determination of interest rates which is the price of money the
ceiling on banks credits and its allocation to the various sectors of the economy were left to be determined by
the market mechanism. Rather than fixing rates and the flow of bank credit, the Central Bank controlled the
monetary base or its components which are intermediate variables and left the market forces of demand and
supply to determine interest rates, credit ceilings and credit allocations.
3.5 Formulation and Administration of Monetary Policy in Nigeria
The monetary policy for each fiscal year is contained in a circular currently titled the monetary, credit, foreign
trade and exchange policy for a given year. This circular which is released by the Central Bank of Nigeria at
the beginning of each year comes after the annual Presidential Budget speech and its break down have been
announced.
Tools of Monetary Policies 57
Although this circular is a publication of the Central Bank of Nigeria, inputs are made into it by various
sectors of the economy through a comprehensive administrative process. This administrative process involves
five stages: preparation of policy disposals, review by the committee of Governors approval by the
Board of Directors, review and approval by the government, and publication by the Central Bank Governor.
(a) Preparation of Proposal Memorandum
The first stage in the administrative process is the preparation of policy proposals. This stage is coordinated
by the Research Department of the bank, which collect inputs from the various policy departments
of the bank and tries to reflect the views of the financial and non-financial sectors of the economy
about the prevailing economic conditions. These inputs along with suggestions are complied as a memorandum
usually captioned “Monetary, Credit, Foreign Trade Exchange Policy Proposals” for a particular
year and forwarded to the committee of Governors.
(b) Review of Proposals by Governors Committee
The next stage is the review and amendment of the policy proposals by the committee of Governors.
The committee is the highest management body responsible for the day-to-day administration of the
Central Bank of Nigeria. The committee made up of the Central Bank Governors and the five Deputy
Governors discuss the proposals and make amendments and new inputs where necessary. The amended
copy of the memorandum is then forwarded to the board of Governors for approval.
(c) Approval of Proposals by Board of Governors
The third stage is the approval of the policy proposals by the Board of Governors. This board which is
chairmaned by the Governor is the body directly responsible for the formulation of monetary banking
and exchange rate policies. The Board discusses the memorandum extensively if they are satisfied
with it, they add their approval to it. Despite the approval of the board of Governors, the memorandum
remains the proposal until it receives the approval of government.
(d) Securing the Government Approval
The next thing required after approval by the Board of Governors is, therefore, government approval.
To get this approval, the memorandum is forwarded to the President (Head of State) for consideration.
According to the Governor of the Central Bank of Nigeria, this is “for all government economic policies
to be co-ordinated and harmonised for internal consistency” (Ogwuma, 1997.6) the policy proposals
are usually referred to various committees and councils of the government before final approval by the
senate and signed by the Head of State.
(e) Publication of policy by CBN Governor
This is the final approved copy of the memorandum that is published by the Governor of the Central
Bank of Nigeria as the Monetary, Credit, Foreign Trade and Exchange Rate Policy of the Central Bank
for the particular year. Apart from publishing the circular, the Central Bank sees to the monitoring and
implementation of the policies contained therein (CBN Briefs 1996. vol 3).
Specifically, the issues covered in the formulating of monetary policy and published in the circular are as
follows:
- Review of Macro economic Problem
- Setting of Objectives
- Monetary and Credit Policy Measures
- General guidelines on banking practices
- Foreign Trade and Exchange Policy Measures
- Guidelines for other Financial Institutions
58 Principles of Economics
Students Assessment Exercise
Analyse the formulation of Monetary policy in Nigeria.
3.6 Lags in Monetary Policy
Monetary policy affects the economy in two major ways – the magnitudinal (size) dimension and the time
dimension. Here we are concerned with the time dimension which measures the lag in the effect of monetary
policy. (Friedman 1961, Cultertson, 1960, 1961; Ando et al, 1963, Ranlet 1977 and Willes, 1968).
Lags occur because of the time lapse before changes in Monetary variables have effect on the economy.
The need to formulate monetary policy arises as a result of existing economic problems. It is only when
the monetary authorities recognise the existing problems and the need to take action about it that they will
adopt appropriate monetary policy measures. This may take some time even after they have taken action, it
may take another period of time before the effect of their action is felt in the economy. The time that elapses
between when the economic problems arose and when the effect of the action of the monetary authorities is
felt in the economy is the monetary policy.
Lags in the Monetary Policy affect its effectiveness. In Nigeria, for instance, the Central Bank Monetary
Policy circular is released at the beginning of each year. Assuming an inflationary pressure arises in the
economy in August, 1998, if it took six months for the Central Bank to notice the problems, they will only
become aware of it in February, 1990 after the monetary policy for 1999 has already been released. The
monetary authorities may then include anti-inflationary measures to be felt in their monetary policy circular
for the year 2000. By then, 14 months have elapsed. It may take another 6 months for the impact of that
anti-inflationary measures to be felt in the economy. This gives a total lag of 20 months.
It is possible that during the 20 months lag, the level of inflation may have been reduced already by market
forces. The anti-inflationary measures may end up pushing the economy to deflation and economic depression.
Even if the inflationary pressure is still present and unreduced, the lag of 20 months means that the
effect of the policy is 20 months late. Thus, the shorter the lag the more effective and appropriate the
monetary policy would be.
Students Assessment Exercise
Write a short notes on
(i) Objectives of monetary policy;
(ii) Monetary policy Lags.
3.7 Conflicts in Achievements of Monetary Policies Objectives
A look at the objectives of monetary policy shows that these multiple objectives are not compatible at all. In
some cases, they are not achieved simultaneously but rather the achievement of one objective may take the
economy further away from the other objective. This actually means that the attainment of one objective
may preclude the attainment of another or even in other word there is existence of trade-offs in the attainment
of objectives. Authorities have identified two types of conflicts in the attainment of monetary objectives.
These are necessary conflict and policy conflict.
The relevant questions here are:
(1) Are the multiple objectives of monetary policy compatible?
(2) Can they be achieved simultaneously?
(3) Or thus the pursuit of one objective lead us further away from another?
Two types of conflicts in the attainment of policy objectives exist.
(i) Necessary Conflict
The necessary conflicts exist whenever the attainment of one objective precludes the attainment of the other.
In other words, this is a situation where the said objectives are inherently incompatible with each other. In
fact, a good example will make the understanding of this clearer. Let us look at the twin objectives of
Tools of Monetary Policies 59
attaining full employment and price stability. The full employment in this context means unemployment rate
of between 3% and 5% or employment rate of between 95% and 97%.
Experience has shown that the pursuance of the objectives of full employment normally works against
price stability. Full employment situation means that almost anybody who wants to work is able to find job at
the existing wage rate. The fact that almost everybody is working makes individuals to have high purchasing
power and the economic activities will be high indeed. This situation will induce inflation which will eliminate
price stability in the economy.
Philip’s curve is used to demonstrate the trade off that exists between unemployment and inflation or the
relationship between them. It shows that whenever unemployment rate is very low, inflation rate will be
very high and vice-versal. This means that there is a trade off between unemployment and inflation.
(ii) Policy Conflict
The policy conflict exists when government takes a measure that would jeopardise the simultaneous
achievement of two objectives. In other words, policy conflict exist when monetary policy has difficulty
in pursuing or achieving both monetary and fiscal policy objectives simultaneously. Take for example,
during an inflationary period, a tight monetary policy may be embarked upon to fight inflation. This
policy may reduce the rate of investment and affect growth adversely. On the other hand, an easy
monetary policy designed to stimulate economic growth will definitely lower the rate of interest and this
will generate higher rate of inflation.
Students Assessment Exercise
(i) Distinguish between necessary conflict and policy conflicts in monetary policy.
3.4 Limitations of Monetary Policy in Nigeria
When monetary policy is used to influence the level of income, its potential effect is lessened because of the
lack of consumer and investor responses to interest rates changes. Other things may occur to dampen the
effect of monetary policy on the level of income and keep spending from rising or falling when the Central
Bank engages in activities such as open market purchases.
Most economists are of the view that monetary policy plays a limited role in a developing economy like
Nigeria’s as a result of the following reasons:
(a) There is the existence of a largely non-monetised sectors which hinders the success of monetary
policy. Most of the people live in the rural areas where there is absence of financial institutions
and knowledge. Thus, monetary policy fails to effect the lives and activities of this bulk of the
people of these economies.
(b) The money and capital markets are both inadequate and undeveloped. These markets lack in
securities (shares, stocks, and bonds and bills which limit the success of monetary policy.)
(c) Most of the banks in the banking system possess high liquidity so that they are not affected by the
credit and hence monetary policies of the monetary authorities.
(d) There is the large-scale operation of non-bank financial intermediaries, most of which are not
under the control of the Central Banks.
Commercial banks are just only one of many types of financial intermediaries that exist in
money using economies. In Nigeria today, there are many savings and loans Associations, Insurance
Companies and Finance Companies that handle huge sum of money. The activities of these
non-bank financial intermediaries if not checked may render Central Bank’s expansionary or
contractionary policies ineffective.
(e) In addition, bank money or demand deposits comprise a small proportion of the total money supply
in these countries, rendering the monetary authorities ineffective in monetary control.
(f) monetary policy is hindered by time lags (recognition, administrative and result lags).
60 Principles of Economics
(g) It conflicts with government policies.
(h) Monetary policy is influenced by politics and hence it is an attempt to fulfill political ambitions of
parties in office.
(i) There is the problem of inability to predict how people will react to any monetary policy measure.
It is unable to deal with the business cycle.
Students Assessment Exercise
What are the constraints on effective monetary policy? Or what are the weaknesses of monetary policies in
Nigeria?
4.0 Conclusion
In general, monetary policy refers to the combination of measures designd to regulate the value, supply and
cost of money in an economy in consonance with the level of economic activity.
In a nutshell, the objectives or aims of monetary policy are basically to control inflation, maintain a healthybalance
of payments position for the country in order to safeguard the external value of the national currency
and promote an adequate and sustainable level of economic growth and development.
However, monetary authorities are not free to deal with these objectives separately but are required to
pursue them simultaneously. This makes their tasks very difficult because of the constraints to manipulate a
set of policies to achieve sometimes incompatible objectives.
One of the principal functions of the Central Bank of Nigeria (CBN) is to formulate and execute monetary
policy to promote monetary stability and sound financial system in Nigeria. the CBN carries out this responsibility
on behalf of the Federal Government of Nigeria through a process outlined in the Central Bank of
Nigeria Decree 24, 1991 and the Banks and other Financial Institutions Decree 25, 1991. In formulating and
executing monetary policy, the Governor of Central Bank of Nigeria is required to make proposals to the
resident of the Federal Republic of Nigeria who has power to accept or amend such proposals. Thereafter,
the CBN is obliged to implement the monetary policy approved by the President. The CBN is also empowered
to direct the banks and other financial institutions to carry out certain duties in pursuit of the approved
monetary policy. Usually, the monetary policy to be pursued is detailed out in the form of guidelines to all
banks and other financial institutions. The guidelines generally operate within a fiscal year. Penalties are
normally prescribed for operators that fail to comply with specific provisions of the guidelines.
The techniques/tools/instruments by which the monetary authority tries to achieve the objectives of monetary
policy can be classified into two categories – the direct control approach and indirect market approach.
The indirect/portfolio control instruments place restrictions on a particular group of institutions, especially
deposit banks by limiting their freedom to acquire assets and liabilities. Examples of such instruments for
indirect control are quantitative ceilings on bank credit, selective credit controls and administered interest and
exchange rate.
The indirect method of control relies on the power of the monetary authority as a dealer in the financial
markets to influence the availability and the rate of return on financial assets, thus affecting both the desire of
the public to hold money balances and the willingness of financial agents to accept deposits and lend them to
users. Examples of such instruments are reserve requirements discount rate and open market operations.
5.0 Summary
This unit enlightens the reader/student on monetary management in Nigeria with specific focus on the concept,
objectives, tools/techniques of monetary policy, its administration and general direction in Nigeria.
6.0 Tutor-marked Assignments (TMA)
Q1 - Examine the objectives of monetary policy of the Federal Government. Access its ability to achieve its
goals.
Tools of Monetary Policies 61
Q2 - Briefly discuss the various tools that the Central Bank of Nigeria can use to influence the flow of
money and credit in Nigeria in order to achieve government economic objectives.
Q3(a) Identify and discuss the various stages the Central Bank of Nigeria goes through in the process
of formulating its annual monetary policy circular.
(b) What crucial issues are normally covered in such circulars?
7.0 References/Further Reading
- Ackley, G. Macro-Economic Theories and Policy. Hong Kong: Macmillan, 1978.
- Ando, A. et al. “Lags in Fiscal and Monetary Policy,” in Commission on Money and Credit Stabilisation
policies, Prentice Hall Inc., Englewood Cliffs 1963 p.2..
- Culbertson, T. M. “The Lag in the Effect of Monetary Policy: Reply”, Journal of Political Economy.
1961.
- Freedman, M. “The Role of Monetary Policy”, American Economic Review. March 1968, pp 1-17.
- Friedman and Shwartz, A. T. A. Monetary History of U.S. 1867 – 1960. Princeton: Princeton University
Press, 1963.
- Ranlett, J. G. Money and Banking: An Introduction to Analysis and Policy. Sanka Barbara: John
Wiley and Sons, 1977 P. 425.
- Willes, M.H. “Lags in Monetary and Fiscal Policy,” Federal Reserve Bank of Philadelphia, Business
Review,” March, 1968, p.3.
- Wrightsman, D. An Introduction to Monetary Theory and Policy. New York: The Free Press, 1976.
- Anyafo, Aiafo, M.O. (1966). “Public Finance in a Developing Economy: The Nigerian Case,” Department
of Banking and Finance, University of Nigeria, Enugu Campus.
- Central Bank of Nigeria (CBN) (1996): CBN Briefs, CBN Publications, Lagos.
- Ogwuwa, P. (1997), “An Effective Monetary Policy for Nation Building”, Bullion Vol. 21 Central
Bank of Nigeria Publications, Lagos.
- Anyanwu, J. C. Monetary Economics. Onitsha: Hybrid Publishers Limited, 1993.
- Afolabi, L. Onetary Economics, Lagos: Inner Ways Publications, 1991.
- Adekanye, F. The Elements of Banking in Nigeria. Bedfordshire: Graham Burn, 1986.
62 Principles of Economics
Unit 10: The Nigerian Capital and Money Markets
Contents
Page
1.0 Introduction .......................................................................................................................... 63
2.0 Objectives ............................................................................................................................ 63
3.0 Meaning of Money Market ................................................................................................... 63
3.1 Money Market Operators and Methods of Sourcing for Funds .............................................. 64
3.2 Money Market Instruments ................................................................................................... 64
3.3 Features/Characteristics of a Developed Money Market ....................................................... 66
3.4 Reasons for the Establishment of the Nigerian Money Market ................................................ 66
3.5 Functions of the Nigerian Money Market .............................................................................. 67
3.6 Meaning of the Capital Market ............................................................................................. 67
3.7 Reasons for the Establishment of Nigerian Capital Market ..................................................... 68
3.8 Capital Market Institutions (ORGANS) ................................................................................ 68
3.9 Capital Market Instruments ................................................................................................... 71
3.10 Problems of the Nigerian Capital Market .............................................................................. 71
4.0 Conclusion ........................................................................................................................... 71
5.0 Summary .............................................................................................................................. 72
6.0 Tutor-Marked Assignments .................................................................................................. 72
7.0 References/Further Reading .................................................................................................. 72
62
The Nigeria Capital and Money Markets 63
1.0 Introduction
To the ordinary man in the street, a market is a place where goods and services are sold and bought like the
Alaba International Market at Lagos and the Central Market at Kaduna.
Just as people go to such market to sell what they have, and others go there to buy what they need but do
not have, so do firms and individuals who need money (Finance) but do not have money go to a financial
market to buy money (long-term and short-term finance) from those who have it and want to sell. The buyer
pays a price for such money known as interest dividend or discount.
A financial market is a market where long-term and short-term funds are bought and sold. And as Nwanke
(1980) puts it “money like any other commodity, is bought and sold in a market”.
Financial markets are traditionally classified into two broad classes based on maturity funds traded in the
market. The market for short-term funds is known as money market while the market for long-term funds is
known as capital market. The institutions and instruments traded in each market will be discussed in this
unit.
2.0 Objectives
At the end of this unit, you should be able to:
(i) understand the meaning of financial market money market, and capital, market.
(ii) know the money market operators and methods of sourcing for funds.
(iii) identify the money market instrument and institutions.
(iv) recognise the feature of a Developed Money Market.
(v) recall the reasons for the establishment of the Nigerian Money Market
(vi) tell the functions of the Nigerian Money Market.
(vii) define the meaning of capital market.
(viii) explain the reasons for the establishment of Nigerian Capital Market.
(ix) discover the capital market institutions/ organs in Nigeria.
(x) produce the capital market instruments.
(xi) estimate the problems of the Nigerian Capital Market.
3.0 Meaning of Money Market
The money market is a market for short-term funds. Funds obtainable from this market usually include
working capital loans production cycle loans and other funds that are repayable within short period of about
one to three years. Those who need funds for longer period have to go to the capital market.
Or the money market deals in short-term instruments that are readily convertible into cash, and whose
maturity range between a few days to the two years.
Or the money market refers or a group of financial institutions or exchange system set up for dealing in
short-term credit instruments of high quality, such as treasury bills, treasury certificates, call money, commercial
paper Bankers’ Unit Fund, Certificates advance, as well as the dealing in gold and foreign exchange.
Or while denoting trading in money and other short-term financial assets, the money market comprises all
the facilities of the country for the purchase and sale of money for intermediate and deferred delivery and for
the borrowing and lending of money for short period of time.
Or it is a manifestation of dealing in short-term financial instruments (their sale and purchase as also
borrowing and lending for short periods) on the one hand and a collection of the dealers in these assets on the
other hand.
Or it is thus a collection of financial institutions set up for the granting of short-term loans and dealing in
short-term securities gold and foreign exchange.
64 Principles of Economics
Students Assessment Exercises
Arrange for the definitions/meaning of Money Market.
3.1 Money Market Operators and Methods of Sourcing for Funds
Key operators in the Nigeria Money Market are Commercial Banks, Merchant Banks, Community Banks,
People’s Bank of Nigeria, the Central Bank, Discount houses and other non-bank financial institutions that
provide short-term finance. Since we have discussed the activities of these institutions in the preceeding
units, it is no use repeating them here.
When sourcing funds through the money market, two approaches are adopted, namely the use of securities
and private negotiation. A borrower can approach lender and negotiate for short-term funds privately
without the issue of securities. Funds obtainable in this manner include overdraft facilities and short-term
loans and advances.
The market for securities is further segmented into the market for newly issued securities and the market
for old and existing securities
3.2 Money Market Instruments
Money Market instruments are mainly short term securities that are used to obtain money from the money
market. The borrower issues (or sell) the instruments which in fact is piece of paper to the lender who buys
and holds them as an evidence of the debt. He can decide to hold it until maturity or re-sell to another person
usually at a discount (i.e. below the actual price) if he needs his money before the maturity date. The major
instruments currently used to evidence debts are treasury bills, treasury certificates, certificates of deposit,
money at call commercial papers, and stabilisation securities. The features of these instruments are as
follows:
(a) Treasury Bills: Treasury Bills are money market (short-term) securities issued by the Federal Government
of Nigeria, they are sold at a discount (rather than paying coupon), interest matures within 91
days of the date of issue and are default-free. These instruments are promissory notes to be paid to the
bearer 90 days from the date of issue. They provide the government with a highly flexible and relatively
cheap means of borrowing cash. They also provide a sound security for dealings in the money market
and the Central Bank of Nigeria in particular, can operate on that market by dealing in Treasury Bills.
The first money market instrument to be issued in Nigeria was the Treasury bill. It was first issued by
the Federal Government of Nigeria through the Central Bank of Nigeria in April 1960. The issue for the
first time in Nigeria (in April, 1960) was provided for under the Treasury Bill ordinance of 1956.
(b) Treasury Certificates (TCs): The second money market instruments to appear in the Nigerian money
market was treasury Certificates. It was first issued in 1968. Treasury certificates, just like Treasury
Bills are short-term government securities designated as Treasury Certificates by which the government
borrows from the public for periods ranging from one to two years. The major difference between
Treasury bills and Treasury Certificates is that Treasury Certificate has longer maturities than Treasury
Bills.
The reason for the issue of Treasury Bills and the issue of Treasury Certificates are the same,
namely for development of the money market, government borrowings and for open market operations.
(c) Certificate of Deposit: These are inter-bank debt instrument meant to provide outlet for the commercial
bank surplus funds. It was introduced in Nigeria by the CBN in 1975. It was also meant to open up
a new source of funds for the merchant banks who are the major issuers. Two types of certificate of
deposit are the negotiable and the non-negotiable certificate of Deposits.
These are short-term debt instruments issued by banks evidencing that the issuing bank has received
an amount certain of money from a named person on deposit which the issuing bank undertakes to
The Nigeria Capital and Money Markets 65
repay on a given date with interest to the named person or to a bonafide holder. It is in fact a form of
fixed deposit receipt. Certificates of deposits are issued for various maturities ranging from 3 months to
36 months. The certificate may be designated as negotiable or non-negotiable by the issuer. Negotiable
certificate can be transferred from one person to another by endorsement.
(d) Call Money: This instrument is the most liquid money market instruments next only to cash. It is an
inter-bank arrangement whereby banks in need of immediate cash can borrow from the participating
banks on overnight basis on the conditions that the funds so borrowed are repayable on demand.
Initially, the placing of money at call was arranged by banks themselves. By 1962, the Central Bank
instituted the call money scheme. Under that arrangement, participating banks that maintained a minimum
balance with the CBN which banks that have immediate liquidity requirements, can borrow on call
basis. This arrangement was later changed. Banks now carry out the arrangements themselves.
(e) Commercial Papers (CP): CP are documents that are issued in the normal course of business as
evidence of debt. Examples of such papers are commercial bills of exchange, letters of credit and
promissory notes. These debt instruments often have maturities ranging from 330 days to 180 days.
Commercial Papers used in the money market are often bills of exchange that carry the acceptable or
confirmation of a reputable bank. Such bills can be discounted easily with by the holder. Banks who hold
such discounted bill can further rediscount them with the discount houses or the central bank if they
have immediate need for liquidity.
CP may also be sold by major companies (blue-chips-large, old safe well-known national companies)
to obtain a loan. Here, such notes are not backed by any collateral rather; they rely on the high
credit rating of the issuing companies.
(f) Stabilisation Security: These are special securities which the law authorises the CBN to issue and
sell compulsorily to banks at any interest rate and such conditions as the CBN may deem fit for the
purpose of moping up the excess liquidity of banks. These instruments are not an instrument of the
government but that of the CBN.
The use of stabilisation security was introduced in 1976 but was later phased out. It was reintroduced
again in1993 but by 1998 further issue was stopped.
The issue of this type of security is usually made when banks in the system are perceived to hold
excess liquidity. Banks that hold such securities can discount it if they have immediate liquidity need.
(g) Bankers Unit Fund (BUF): This was introduced by the CBN in 1975 and initially meant to mop up
excess liquidity in the banking system. It was also designed to sweeten the market for the Federal
Government stock. To this end, Commercial banks’ holdings of the stock are accepted as a part of their
specified liquid assets and are repayable on demand. Under the BUF Federal Government stocks of not
more than 3 years to maturity were thus designated Eligible Development Stock’s (EDS) for the purpose
of meeting the bank’s specified liquid assets requirements. This placed banks in position to earn
long-term rates of interest on what is essentially a short-term investment. Though, initially designed to
mop up excess liquidity in the banking system by conferring on instrument cash substitute status repayable
on demand acceptable in meeting reserve requirements, the capability of the banks for credit
expansion was unaffected. In effect, the BUF was intended to provide avenue for the commercial and
merchant bank and other financial institutions to invest part of their liquid funds in a money market asset
linked to Federal Government Stocks.
(h) Ways and Means Advances Section 34 of the CBN Act 1958 (Cap 30 as amended 1962 –1969)
empowers the CBN to grant temporary advances in the form of “Ways and means” to the Federal
Government to 25 per cent of estimated recurrent budget revenue.
66 Principles of Economics
Students Assessment Exercise
(i) Although money Market instruments are mere pieces of paper, they are used to obtain money. Discuss
in details five of such instruments, showing how they can be used to obtain money.
3.3 Features/Characteristics of a Developed Money Market
A developed money market refer to one which is comparatively efficient in the sense that it is responsive to
changes in demand and supply of funds in any of its segments and effects initiated in any part of it quickly
spread to others without significant time lag.
To meet the definition, a money market should possess these features:
(a) Presence of a Central Bank
A Central Bank with adequate legal power, sufficient relevant information and the expertise, must
exist as a lender of last resort and as the initiator and executor of monetary policy as a whole.
(b) Presence of a Developed Commercial Banking System, Development banking System
and Merchant Banking System
A well developed money market should be characterised by the presence of a developed Commercial
Banking System, Merchant Banking System and Development Banking System along
with a wide spread banking habit on the part of the public.
(c) Adequate Supply of a Variety and Quantity of Financial Assets
In a well developed money market, there should be an adequate supply of a variety and quantity of
short-term financial assets or instruments such as Trade Bills, Treasury Bills, Treasury Certificates,
Commercial Papers, etc.
(d) Presence of well-developed sub-market
The existence of well-developed sub-markets and their adequate responsiveness to small changes
in interest and discount rates make room for a well developed money market. If the demand and
supply of certain instruments dominate, the interaction between different interest rates will be
limited.
(e) Existence of Specialised Institutions
For competitiveness and efficiency, there must exist specialised institutions, in particular, types of
assets e.g. specialised discount houses, acceptance houses, specialising in accepting bills or Specialised
dealers in government securities.
(f) Existence of Contributory Legal and Economic Factors
For the money to be well-developed, there must exist appropriate legal provisions to reduce transaction
costs, protect against default in payment while prerequisite economic forces such as speedy
and cheap transmission of information, cheap fund remittance and adequate volume of Trade and
Commerce must exist.
Students Assessment Exercise
What are the basis features of money market?
3.4 Reasons for the Establishment of the Nigerian Money Market
(a) To provide the machinery needed for government short-term financing requirements.
(b) As an essential step on the path to independent nationhood, hence it was part of a modern financial and
monetary system, which was to enable the nation to establish the monetary autonomy which is part and
parcel of the working of an independent, modern state.
The Nigeria Capital and Money Markets 67
(c) To Nigerianise the credit base by providing local investment outlets for the retention of funds in
Nigeria and for the investment of funds repatriated from abroad as a result of government
persuasions to that effects.
(d) To perform for the country all the functions which money market traditionally performs, such as the
provisions of the basis for operating and executing an effective monetary policy.
(e) To effectively mobilise resource for investment purpose.
3.5 Functions of the Nigerian Money Market
(a) It provides the basis for operating and executing an effective monetary.
(b) To provide an orderly flow of short-term funds
(c) To ensure supply of the necessary means of expanding and contracting credit.
(d) It is a Central Pool of liquid financial resources upon which the banking system can draw upon when it
is in need of additional funds and into which it can make payments when it holds funds surplus to its
needs.
(e) It provides the mechanism through which the liquidity of the banking is maintained at the desired level.
(f) To provide banks the basic financial instruments for effective management of their resources. It thus
helps them to diversify their assets holding by providing them with a forum for investment of their
surplus cash.
(g) To provide the machinery needed for the government short-term financial requirement – hence achieving
even seasonal variation in the normal flow of revenue.
(h) Mobilisation of funds from savers (lenders) and the transmission of such funds to borrowers (Investor).
(i) It provides a channel for the injection of Central Bank cash into the system or the economy.
(j) To maintain stable cash and liquidity ratios as a base for the operation of the open market operation.
Students Assessment Exercise
Why is a Money Market necessary in Nigeria?
3.6 Meaning of the Capital market
While short-term funds are traded in the money market, the capital market is the financial market for longterm
funds. Those who need long-term capital for projects of long gestation to be repaid after five years, ten
years or more go to the capital market to source such funds. The Capital Market for securities is further subdivided
into two: the primary and secondary market. When new securities like shares, stocks and bonds are
issued, they are sold initially in the primary market. But when the holders of these securities want to re-sell
them, the securities are re-sold in the secondary market. Thus, the primary market is a market for initial issue
while the secondary market is a market for subsequent trading in securities.
The Capital Market refers to a collection of financial institutions set up for the granting of medium and
long-term loans. It is a market for long-term instruments which included market for the government securities,
market for corporate bonds, market for corporate shares (stocks) and market for mortgage loans. That
is a market for the mobilisation and utilisation of long-term end of the financial system. Thus, it is the mechanism
whereby economic units desirous to invest their surplus funds, interact directly or through financial
intermediaries with those who wish to procure funds for their business (Phillips, 1985). In the Nigerian
context, participants include the Nigerian Stock Exchange, Discount Houses, Development Banks, Investment
Banks, Building Societies, Stockbroking Firms, Insurance and Pension Organisation, Quoted Companies,
the government, individuals and the Nigerian Securities and Exchange Commission (NSEC)
Students Assessment Exercise
Define or explain the term Capital Market.
68 Principles of Economics
3.7 Reason for the Establishment of Nigerian Capital Market
1. To introduce a code of Conduct check, abuses and regulate the activities of operators in the market.
2. To provide local opportunities for borrowing and lending for long-term purposes.
3. To enable the authorities to mobilise long-term capital for the economic development of the country.
4. To provide facilities for the quotation and ready marketability of shares and stocks and opportunities and
facilities to raise fresh capital in the market.
5. To provide foreign business with the facility to offer their shares and the Nigerian public an opportunity
to invest and participate in the shares and ownership of foreign businesses.
6. Through participation and ownership to provide a healthy and mutually acceptable environment for
participation and cooperation of indigenous and expatriate capital in the joint effort to develop the
Nigerian economy to the mutual advantage of both parties.
The following are the functions of an active capital market.
* The promotion of rapid capital.
* The provision of sufficient liquidity for any investor or group of investors.
* The creation of a built-in operational and allocational efficiency within the financial system to ensure
that resources are optimally utilised at relatively little costs.
* The mobilisation of savings from numerous economic units for growth and development.
* The encouragement of a more efficient allocation of new investment through the pricing mechanism.
* The provision of an alternative source of fund other than taxation for government.
* The broadening of the ownership base of assets and the creation of a healthy private sector.
* The encouragement of a more efficient allocation of a given amount of tangible wealth through changes
in wealth ownership and composition.
* Provision of an efficient mechanism for the allocation of savings among competing productive investment
projects.
* It is machinery for mobilising long-term financial resources for industrial development.
* It is a necessary liquidity mechanism for investors through a formal market for debt and equity securities.
* It is an avenue for effecting payments on debt.
Students Assessment Exercise
i. Examine fully why the establishment of a capital market is inevitable in Nigeria.
3.8 Capital Market Institutions (ORGANS)
Generally, any person who provides long-term capital fund is a participant in the capital market. However in
the organised market as Nigerian Capital Market, participating institutions are as follows:-
(a) The Nigerian Securities and exchange Commission
(b) The Nigerian Stock Exchange
(c) Issuing Houses
(d) Merchant Banks
(e) Central Bank of Nigeria
(f) Commercial Banks
(g) Development Banks
(h) Non-bank Financial Institutions
The Nigeria Capital and Money Markets 69
Having discussed the activities of most of these institutions in the proceeding units, we shall briefly discuss
the activities of the Securities and Exchange Commission, and the Nigerian Stock Exchange.
(a) The Nigeria Securities and Exchange Commission
The Securities and Exchange Commission (NSEC) is the apex institution for the regulation and
monitor- ing of the Nigerian capital market. The commission was established under the security and
Exchange Commission Decree 1979, operating retrospectively from 1st April 1978.
Prior to the SEC, two bodies had in succession been responsible for the monitoring of capital market
activities in Nigeria. The first was the capital issues committee, which operated between 1962 and
1972. It could not bee seen as the superintendent of the capital market because its functions were more
or less advisory without the force of instruction even though its functions included the co-ordination of
capital market activities. The next body was the Capital Issues Commission (CIC), which came into
being in March 1973. The CIC, unlike its predecessor, had full powers to determine the price, timing and
volume of security to be issued. Despite these wider powers, the CIC could not be seen as the apex of
the Capital Market because it concerned itself with public companies alone and its activities did not
cover the stock exchange and government securities.
The enabling Act of the Securities and Exchange Commission specifies its overriding objectives as
“investors protection and development while its functions were divided into two: regulatory and Developmental.
To the extent that it combines developmental functions with regulatory matters, it could be
seen to be fully established as the apex of the Capital Market. Its functions, as contained in SEC
Quarterly Journal Vol. No 1 December, 1984 are as follows:-
(1) to determine the price, amount and time at which security of the company are to be sold either
through offer for sale or subscription companies within the grip of the Commission’s functions are:
(a) all public companies and
(b) all enterprises with foreign interest.
(2) to determine the basis of allotment of Security of a public offering to ensure wider spread of share
ownership,
(3) to monitor the activities of the Nigerian Stock Exchange trading floors in order to ensure orderly,
smooth and equitable dealings in securities to forestall illegal deals by privileged insiders at the
expense of the innocent and often ignorant investors,
(4) to register:
(a) all securities proposed to be offered for sale to or subscription by the public or offered
privately
(b) stock exchange and its branches.
(c) person/instruction involved in securities dealings in stock and securities, registrars, security,
brokers and their agents, issuing house, fund managers, etc.
(d) securities to be traded or being traded (share, debentures)
(5) though the above, to sustain and uplift the integrity and ethical standard of the security market and
enhance the public confidence and mass participation in Capital Market activities.
(6) to create the necessary atmosphere for orderly growth and development of the capital market
through public enlightenment processes, seminars, workshops, publicity, etc., stimulating ideas,
initiating policy and programmes and innovation for the growth of security market.
(7) to protect investors against misleading or inadequate information, fraud, deceit on the part of
securities offered for sale hence acting as the watch dog of the public.
(8) to remove all bottlenecks which may hinder easy transfer of shares
(a) to provide avenue for wider spread in ownership this avoiding monopolistic tendencies or
concentration of shares in few but influential hands.
70 Principles of Economics
(b) The Nigerian Stock Exchange (NSE)
Formation of NSE
Following the favourable report of the Barback Committee (Set up in May, 1958) the Lagos Stock Exchanges
was established. It was granted certificate of registration of business name on 1 March 1959 and incorporated
on 15 September 1960 commencing business on the 5 June 1961.
This exchange is the key player in the Nigeria Capital Market. Although the activities of the exchange is
regulated by the Securities and Exchange Commission, it is privately owned. The exchange has three categories
of membership. These are the foundation members, the ordinary members and the dealing members.
The foundation members are the seven members that signed the memorandum of association on inception:
Shehu Baker, Theophilus B. Doherty, Sir Odumegwu Ojukwu, Akintola Williams, C.T. Boweighs and Co.
(Nig) Limited, Investment Company of Nigeria and John Holt Nigeria Limited. The ordinary members are
shareholders of the Register of members. This category of members are those who share any profit or loss
made by the exchange.
The dealing members are those ordinary members who are licensed by the council to trade in the floors of
the exchange. They act as intermediaries between buyers and sellers of securities. In doing this, they advise
their clients on lasting procedures, act as their agents when they want to buy or sell securities and also offer
professional advise on portfolio selection.
In order to meet the aspirations of the users of its services, the Lagos Stock Exchange was transformed by
the Federal Government on 2 December 1977 into the Nigerian Stock Exchange (NSE) with additional
branches at Lagos, Kaduna, Port Harcourt, Kano, Onitsha, Ibadan.
A new Stock Exchange is also to be opened at Abuja known as Abuja Stock Exchange as contained in the
1998 Presidential Budget Speech.
Functions of NSE
(a) To provide appropriate machinery to facilitate further offerings of stocks and shares to the public.
(b) To promote increasing participation by the public in the private sector of the economy.
(c) To encourage the investment of savings as soon as it is clear that stocks and shares are readily available
as Professor G. O. Nwankwo (1980) noted other functions as in other economics books.
(d) To provide a central meeting place for members to buy and sell existing stocks and shares and for
granting quotations to new ones.
(e) To provide opportunities for raising new capital.
(f) To provide the machinery for mobilising private and public savings and making these available for
productive investment through stocks and shares. That is to assist in the mobilisation and allocation of
the nation’s capital resources among numerous competing alternative uses.
(g) To facilities dealings in Government securities and foreign investment in Nigeria Manufacturing since
Government goes into joint venture with foreign investor.
(h) To act as a channel for implementing the indigenisation policy by providing facilities to foreign business
to offer their shares to the Nigerian public for subscription.
(i) To reduce the risk of liquidity by facilitating the purchase and sale of securities.
(j) To protect the public from shady dealings and practices in quoted securities as to ensure fair trading
through its rules, regulations and operational codes.
Students Assessment Exercise
Discuss fully the main functions of the Nigerian Securities and Exchange Commission (NSEC) and The
Nigerian Stock Exchange (NSE).
The Nigeria Capital and Money Markets 71
3.9 Capital Market Instruments
This comprises long-term securities traded in the capital market. These instruments include the following:
(a) Shares: A share is a security evidencing part ownership in a company. According to Orji (1996), it is a
unit of ownership interest which a holder has in a business unit translated into financial terms. There
are two types of shares traded in the exchange – Ordinary Shares and Preference Shares.
(b) Debentures: These are long-term instruments evidencing the borrowing of funds by a company from
the holders measured in units with a financial value. They carry fixed interest charged. Debenture
holders are creditors to the company and are given preference on liquidation over all classes of shareholders.
(c) Government Stocks: These are long-term debt instruments evidencing that the government has borrowed
from the holder. It is similar to debentures, and carries a fixed amount of interest. Government
stocks are often issued for to raise development funds. They include treasury stocks, and development
stocks.
(d) Bond: A bond is a long-term debt instrument which carries a definite understanding of the (issuer or
borrower) to repay the amount so borrowed on a given date with interest. It carries a fixed interest.
3.10 Problems of the Nigerian Capital Market
The experience of our capital market will not be complete without recounting the challenges and problems
which are historical, institutional and structural.
Perhaps the most important single challenge that faces all those interested in the emergence of an active
capital market is the problem of impacting depth and breath to the market. By breadth is meant the number
and range of securities, which are available for trading, and by depth is meant the volume and the value of
such securities. The market has not succeeded in generating sufficient securities from companies and institutions.
The number of equities is considered grossly inadequate. The situation has not encouraged active
buying and selling in the market.
Second as with the money market, the nation’s capital market is dominated by the government securities
in value terms.
Thirdly, the market is characterised by infrastructural inadequacies. There are delays in effecting transactions
between issuing houses broker – dealers, registrars, investors and their banks due largely to the inadequacy
of postal and telegraphic services. The drag in the delivery services discourages many investors who
sometimes view with distrust their registrars and brokers when shares certificates are undelivered or proceeds
of shares are not received promptly. Infrastructural limitations insulate many investors, especially
those in the rural areas from broker-dealers, thereby restricting trading in securities.
Other problems of this market have to do with ignorance on the part of most members of the Nigerian
Public as to the meaning of shares and stocks as well as benefits derivable from market operations and the
reluctance of the Nigerian businessman to go public for fear of losing control of family business.
4.0 Conclusion
The financial market is segmented into two: the money market which deals in short- term funds and the
capital market for long-term dealings in loanable funds. The basis of distinction between the money market
and the capital market lies in the degree of liquidity of instruments bought and sold in each of these markets.
Suffice it to say, therefore, that both the Money and Capital Market exist to cater for the fund requirements
of both the public (government) and private sector of the economy. Through the Money Market, for
example, the government obtains some of its funds to bridge budgetary gaps and business enterprises to
realise cash for working capital purposes by issuing short-term debt instruments. The Capital Market makes
72 Principles of Economics
it possible for the government to raise long-term capital to execute its development programmes and
also facilitates the establishment, expansion and modernisation of businesses for increased output
employment and income.
In Nigeria, the debt instruments traded in the money market include treasury bills, treasury
certificates, commercial papers bankers’ acceptances, promissory notes, certificates of deposits
bankers unit fund and money at call.
Participants in the money markets include – the most dominant of the financial institutions in the
interme- diation of short-term funds, merchant banks, insurance companies and other savings type
institutions such as savings banks, individuals, and others. The Central Bank supports the market as
lender of last resort.
The financial instruments or securities traded in the market include equities or ordinary shares,
industrial loans and preference shares, Federal Government development stocks, state government
bonds, company bonds and debentures and mortgages. Participants include the commercial,
merchant and development or specialised banks finance and insurance companies, provident and
pension funds, other financial intermediar- ies like the Federal Savings Bank and individuals. The nonbank
financial institutions are dominant in this market just as commercial banks dominate the money
market. As with the Money Market, the CBN is a major participant in the Capital Market as it is
statutorily required to absorb unsubscribed portions of govern- ment debt issues into its portfolio.
5.0
Summary
In this unit, an attempt has been made to examine the structure and roles of the money and Capital
Markets in Nigeria, and the evolution of the markets including institutional developments in the
markets.
6.0 Tutor-Marked Assignments
Q.1 Distinguish between the Money Market and the Capital Market. Examine the various
instruments traded in each market.
Q.2 What are the objectives of the Nigerian Stock Exchange? What are the contribution of this body
to the economic development of Nigeria?
Q.3 What is a Capital Market? Discuss the role of the main institutions and participants in this
market in
Nigeria.
7.0 References/Further
Reading
- Phillips, T. “The role of the Capital Market in a Recessed Economy”, Bullion, Vol. 9. No 1,
January/ March, 1985 pp.219.
- Allile, H. J. et al, “The Nigerian Stock Market in Operation “, The Nigerian Stock Exchange,
Lagos.
- Ojo, A.T. et al. Banking and Finance in Nigeria. Bedfordshire: Graham Bum, 1982 p.
277.
- Oyido, B. C. “Promoting Money Market Development in Nigeria (1960 - 1985)” CBN Economic
and
Financial Review, Vol. 24 No.1 March 1986.
- Hache, J. The Economic of Money and Income. London: Heinemann,
1970
The Nigeria Capital and Money Markets 73
- Orji, J. Elements of Banking, Rock Communications. Enugu:
1960
- Nwankwo, G. O. The Nigerian Financial System. London: Macmillan Publishers Limited,
1980.
- Anyanwu, J.C. Monetary Economies: Theory, Policy and Institutions. Onitsha: Hybrid
Publishers
Limited, 1993.
74 Principles of Economics
Unit 11: International Trade
Contents Page
1.0 Introduction ................................................................................................................... 74
2.0 Objectives ..................................................................................................................... 74
3.0 Concepts, Reasons and Importance of International Trade .............................................. 74
3.1 Classical Theories of International Trade ......................................................................... 76
3.2 Advantages of International Trade .................................................................................. 77
3.3 Disadvantages of International Trade .............................................................................. 78
3.4 Restrictions to International Trade and Specialisation ...................................................... 78
3.5 Instruments of Foreign Trade Protection and Promotion .................................................. 80
4.0 Conclusion .................................................................................................................... 82
5.0 Summary ....................................................................................................................... 82
6.0 Tutor-Marked Assignments ............................................................................................ 82
7.0 References/Further Reading ........................................................................................... 82
73

74 Principles of Economics
1.0 Introduction
So far in the previous units, we have examined domestic economic problems and noted that the Government
has monetary and fiscal policies at its disposal for dealing with them. The technicalities of these policies have
been considered in the previous units, but the extent to which they are effective is frequently limited by the
repercussions they may have on the external trading position of the country.
Historically, International trade has been in existence since ancient times. Even in the Bible, references
were made to trading activities between different countries. Mention was made in the book of Genesis of
sons of Jacob who went to Egypt to buy grains. With increase in civilisation and travelling added to the known
benefits of specialisation and division of labour, International trade among countries of the world has even
increased tremendously.
Although early writers recognised the existence of International Trade they felt that it was not much
different from domestic trade to warrant the existence of a separate theory. The fist economist to propound
the classical theory of International Trade was Adam Smith in his much celebrated work published in 1776
and titled “An Inquiry into the Nature and causes of the wealth of Nation” other classical economists that
helped publicise the theory included David Ricado, John Stunt Mill, Alfred Marshall and others.
While trying to demolish the classical proposition for a separate theory, Ohlin (1933) argued that
“International Trade” should be regarded as a special case within the general concept of International Economies.
He further argued that nations engage in trading for the same reasons for which individuals or groups
within the country trade with each other instead of each one producing his own requirement. That reason is
that they are enabled to exploit the substantial advantages of division of labour to their mutual advantage.
Trade between different countries developed first where one country could produce something desirable
which others could not. International Trade, therefore, owes its origin to the varying resources of different
regions.
2.0 Objectives
The key object of this unit is to introduce the students to international arrangements for the movement of
money and goods across national boundaries. After reading this unit, you will be able to:
(i) learn the concept, reasons for and importance of International Trade,
(ii) quote the classical Theories of International Trade, especially the theory of comparative advantage
and other rationals for trade between nations.
(iii) outline the advantages and disadvantages of International Trade.
(iv) understand the various arguments presented for and against the idea of trade, and protectionism.
3.0 Concepts, Reasons and Importance of International Trade
International Trade refers to the buying and selling of goods and services between countries e.g. between
Nigeria and the United States of America, Ghana or Britain, etc.
In other words the term “International Trade” refers to the exchange of goods and services that take place
across International Boundaries.
International Trade also is simply defined as the trade across the borders of a country. This may be
between two countries, which is called bilateral trade or trade among many countries called multilateral
trade.
International Trade is also referred to as International specialisation or International division of labour.
The essence of International Trade is to enable countries obtain the greatest possible advantage from the
exchange of one kind of commodity or another.
International Trade 75
International Trade is across the borders involving different nationalities with different languages and
currency. e.g. Nigeria and England.
Vaish (1980:589-592) observed some distinguishing special features of International Trade. One of those
salient features according to Vaish (1980) is the immobility of factors of production. The fact remains that in
recent times, international movement of factors of production is subjected to much restriction while domestic
factor mobility has been on the increase with increase in means of transportation and communication. Thus,
this is a difference enough to indicate or distinguish between domestic and International Trade.
Another distinguishing feature is the presence of single currency in domestic trade and multiplicity of
currency in international trade.
The third feature of International Trade that makes it distinct is the controls and regulations inherent in the
existence of boundaries. Such controls take the form of import restrictions, protectionism, custom duties and
other controls, which do not exist, in domestic trade. Critics cannot disprove the fact that both the payment
and every aspect of international trade are highly controlled.
The next difference is the presence of linguistic, cultural and political differences between the people of
one country and those of another international trade. Although critics argue that language and cultural barriers
can still be present in domestic trade in a country with more than one official language and cultures, the
fact still holds that people from the same country tend to have a way of understanding themselves more even
when their cultures and languages differ. This makes the domestic trade to have less barriers than international
trade.
The fifth point to consider is the difference in geographical and transportation, more complex and costlier
whether by land, sea or air in international trade. The packaging, insurance, banking and other processes
involved in international trade do not apply in the national or domestic trade.
Other differences include differences in the legal systems of various countries, difference in customer
demands and also the issue of balance of payment.
From the foregoing, it becomes clear that even when there are some similarities in home and foreign trade
they are not exactly the same. It needs be stated, however, that both types of trade are not independent of
each other. Both domestic and foreign trade helps to satisfy the needs of the citizens of a country.
No country in the world produces all that her people need. Thus, International Trade is as important as
domestic trade if not more.
Nations trade with each other due to the following reasons:
(a) Necessity: - No country is self-sufficient which means that they have to buy from other countries
those things they cannot produce.
(b) Because of the uneven distribution of National resources: National resources are not distributed
evenly in all countries e.g. in Nigeria we have oil, tin, coal, etc., but Ghana has Gold, etc. Different
countries have different mineral resource endowment. Such mineral deposits include coal, tin ore, oil,
gold, lead, etc. A country largely supplies of one but with less of others, hence such a country will trade
with countries that have such so as to obtain the one she does not have.
(c) Differences in climate: Some crops can only do well under certain climatic conditions e.g. tropical
crops such as cotton, cocoa, etc., will not do well in Temperate zones and vice versa. Many commodities,
particularly agricultural products are produced under different climatic conditions. Tropical countries
produced Cocoa, palmoil products, rubber, etc., while variation of diary products are produced in
the temperate regions, hence the need to exchange.
(d) The existence of special skills in some countries: Some countries have acquired worldwide reputation
at making certain products e.g. Switzerland is known for making watches. Japan is known for
making electronics, etc.
The inhabitants of a region may develop a special skill for the production of a commodity, which in time
may acquire a special reputation for quality. Wines such as champagne sherry, port, chianti owe their
distinctive qualities partly to the special flavour of locally grown grapes and partly to the local method
of
76 Principles of Economics
manufacture, Scotch and Irish Whisky have similarly acquired distinction.
By exchanging some of its own products for those of other regions, a country can enjoy a much wider
range of commodities than otherwise would be open to it.
(e) Differences in tastes: Countries have to import different or some commodities required by citizens
which they cannot produce in great quantities e.g. manufactured goods, shoes, plastics.
(f) Differences in Industrial development and the level of Technology: The more advanced countries
are developed both industrially and technologically hence the developing nations have to import
most manufactured goods from them.
The advanced technology in most of the developed countries enable them to produce a good number of
machines and equipment, which the less developed countries could not produce. By trading they can
exchange.
(g) Access to Capital: International Trade enables countries with limited capital to either borrow from
capital rich countries or attract direct investment into the countries and thus enjoy the benefits of
imported capital and technology.
Students Assessment Exercise
1. What gives rise to international trade?
2. Are there any circumstance in which international trade should be discouraged by the government of a
country?
3. Explain carefully the circumstances in which nations find it beneficial to trade with each other.
3.1 Classical Theories of International Trade
The classical economists led by Adam Smith and David Ricardo presented two important explanation to
justify International Trade. One is the absolute cost difference in production of various commodities at different
countries. The other argument, which in fact incorporates the first, is the theory of comparative advantage.
Absolute Costs Differential Argument: This argument holds that where one country can produce a given
commodity at a lower absolute cost than another both countries will benefit more from international trade by
allowing the country that can produce it at a lower absolute cost to specialise in this production while the other
country buys from them.
According to Smith (1776), trade between two countries will take place if each of the two countries can
provide one commodity at an absolute lower cost of production than the other country because of the difference
in absolute cost and the absolute advantage that one has over the other.
Samuelson (1982:627) used the term “diversity in conditions of production” to present the argument for
absolute cost differential. In line with this, Vaish (1980) sees the superiority of one country in the production
of a commodity, as being also her comparative advantage in the production of that commodity.
Thee Theory of Comparative Advantage: Based on the absolute cost difference explanation, international
trade will only be beneficial when one country can produce a commodity at a lower absolute cost or
more efficiently than another. There may be a situation where one of two countries can produce all commodities
at a cheaper rate than the other. The theory of comparative cost also known as the theory of comparative
advantage, holds that as long as there is a variation in the degree of efficiency at which one country produces
various commodities as compared to another, both countries will benefit from engaging in international trade.
Samuelson (1982) explained this theory with the simple example. He likened that example to countries and
concluded that the key word “comparative” implies that each and every country has both definite “advantage”
in some goods and definite “disadvantage” in other goods. According to him, international trade is
mutually profitable even when one of the countries can produce every commodity more cheaply in terms of
labour or all resources than the other country.
International Trade 77
The theory of comparative advantage centers on international specialisation and international division of
labour, it was originally popularised by David Richardo.
Lepsey (1986) also agreed that specialisation will help people learn by doing which in turn leads to greater
efficiency in production.
The theory of comparative advantage supports the principle of free trade among nations. It is only on that
condition that Specialisation would be beneficial to a country. It only emphasises that those industries should
shift to the area where the country has a comparative advantage.
Students Assessment Exercise
What do you understand by the theory of comparative costs? Can it be applied to home trade?
3.2 Advantage of International Trade
Basically, trade between nations become necessary for the same reason that an individual engages in trade
with another. No nation is so independent that it produces within its borders all that her citizens need. Butressing
this point, Vaish (1981) observed that “since the creation of earth its inhabitants, natural resources and man’s
innate abilities were not uniformly apportioned by the Almighty God to all parts of the globe and to all persons
and since techniques of production do not advance at equal rates among all nations, regional specialisation in
production offers ample scope for international trade.
International trade is, therefore, of much benefit to both consumers in term of improved satisfaction and
living standards, the country and the word in general in terms of better utilisation of the world resources and
increased international understanding, which helps to promote world peace.
One of the outstanding benefits of international trade is that it encourages international division of labour
and specialisation, which in turn increases the wealth of the nation.
By encouraging specialisation, more goods and services are produced, and at reduced prices. This reduces
the monopolistic tendencies of local suppliers. International Trade also make it possible for each
county to have access to world’s raw materials and other resources, which the Almighty God had distributed
unevenly to various countries.
Ahukannah et al (1992:45) pointed out that foreign trade makes possible the importation of machinery and
spare parts needed for local production and for the operation of local industries.
Oyebola (1977:154) also added that “under international trade, there is a free movement of skilled labour
between different countries of the world”. As we know, in developing countries like Nigeria, local industries
still depend on technological transfer from the developed countries, without international trade, this will not be
possible. It, therefore, accelerates economic development, especially the developing world where modern
equipment can be used for industrial and agricultural purposes. The developing world gains in technical
knowledge from the more advanced world. International Trade attracts foreign investment to Nigeria.
International trade provides revenue for the countries concerned. In Nigeria for example, import and
export duties form a great percentage of the total revenue from taxes.
Another advantage of international trade is that it provides employment for many inhabitants of the countries
concerned. For example, many people in West Africa are engaged in importation and exportation of
goods.
Students Assessment Exercise
(i) Comment on the view that an extension of international trade will raise the living standards of all those
countries which engage in it.
(ii) Should two countries trade if one of them is more efficient at producing everything?
(iii) Why do countries trade with each other?
78 Principles of Economics
3.3 Disadvantage of International Trade
Despite all the advantages of trade between countries, it is criticised on the basis of some observed disadvantages.
1. Any nation that is solely dependent on the sale of a single major product is liable to adversities of a
decline in world demand for the product e.g. the monoeconomies of Nigeria and Ghana which depends
solely on crude oil and cocoa respectively.
2. Economically, weaker nations are likely to be dominated by the more advanced countries of the world.
West African nations are subjected to economic subservience by their former colonial masters.
3. International trade leads some nations not to make serious efforts to be self-reliant.
4. International trade can also lead to over-production of goods and services, which can rise to depression.
5. It breeds mistrust, suspicions, jealousies and unhealthy competition among countries and these have
often accounted for wars and other forms of unrests in the world.
6. Over-dependence of some countries on others for the supply of some products may result in lack of
development of knowledge and skill along the lines of the dependant nations. In times of war, dependent
nations economically can be at great disadvantage.
7. Some economies concentrate on the production of certain commodities at the expense of many essential
ones. It could be a source of handicap in times of war. This is because the other country can place
an embargo on these goods that the nation highly depended upon.
8. The next argument is that international trade can stifle local industries and cause unemployment to
result from such industries. It is also said to cause economic instability because the economic problems
of a supplier country may affect the buyer country. Moreover, goods that are currently imported at
lower prices can rise in prices in the future.
Students Assessment Exercise
Explain the disadvantages that can be experienced from foreign trade or international trade and the principal
difficulties, which can arise.
3.4 Restrictions to International Trade and Specialisation
Barriers to international trade could be both natural and artificial. These barriers include:
(a) Linguistic or Language Barrier: All over the countries of the world, different languages are spoken.
For instance, in France, they speak French, in Britain they speak English, in Spain they speak Spanish
while in Nigeria the official language is English in addition to numerous other local languages. The
problem of communication arises when different languages engage in trade. However with Western
education and the increased use of English Language all over the world, this natural barriers is being
broken.
(b) Distance Barrier: Nations are thousands and millions of kilometers apart. This delays messages or
goods involved in foreign trade. However, the development of modern communication system like the
telephone and modern transport systems has helped to minimise this natural barrier.
(c) Religious Barrier: Religion also poses a barrier in foreign trade. For instance, in West Africa, cow
meat is a good source of protein but in some parts of India and other Asian Countries, cow meat is
forbidden. This can go a long way in hindering the development of foreign trade, especially when people
are dogmatic and fanatical about their beliefs and religious practices.
(d) Communication Barrier: In many developing countries, telephone and the telex system are not
International Trade 79
developed while the existing ones are poor, inefficient and inadequate.
(e) Transport Barrier: Many developing nations have very poor and inadequate transport systems and
network such as inaccessible roads, under developed maritime system and poor airport services constituting
delays in international transactions.
(f) Currency differences Barrier: Each country uses its domestic currency in domestic trade. For instance,
in Nigeria, naira is used, in Ghana, cedi is used, in Britain the British sterling or pound is used
while in America, the American dollar is used. Most of these local currencies are not convertible
currencies and cannot be used in the settlement of international transactions. This poses the problem of
being involved in securing foreign exchange involving convertible currencies such as the US dollar,
the pound sterling.
(g) Measures and Weights Barriers: Technical problems arise since different countries use different
units of measures and weights. For instance, Nigeria has gone metric and hence uses metres, etc., as
well as grammes, kilogrammes, etc. However, some other nations she trades with still use yards, feet,
and inches as well as ounces and pounds.
(h) Traditional differences Barriers: The traditions and customs of different countries differ and these
may pose a problem to foreign trade.
(i) Ideological differences Barrier: The countries in the Western bloc practice capitalism while those in
Eastern bloc used to practice socialism, capitalism or mixed economies. Many a time, these ideological
differences pose a great obstacle to foreign trade since nations under different idealogical learnings
may refuse to trade with each other. Where they do trade at all, a lot of caution and restrictions are
adopted.
(j) Economic Independence/Self-reliance barrier: Many countries today want to be economically
independent and self-reliant so that they reduce their participation in foreign trade even when they do
not have comparative cost advantage in the goods they produce in as much as this is a good policy. It
can limit or hinder foreign trade.
(k) Protectionist Policy Barrier: Many countries take measures to protect their economies from dumping
from overseas or to protect strategic sectors of their economy such as agriculture. This limits the
extent of foreign trade.
(l) Trade Inbalance Barrier: When many developing nations experience continuous trade inbalance
with some advanced nations, there is the tendency to limit their imports from those nations so as to
improve their balance of trade and hence balance of payments.
(m) Foreign Exchange barrier: Many developing nations such as Nigeria lack enough foreign exchange
to purchase foreign goods. Such nations will thus reduce imports and hence their participation in foreign
trade.
(n) Credit Shortage barrier: In many countries, credit facilities are inadequate or lacking such that there
is not enough money to engage in external trade.
(o) Artificial Barriers: Government also takes measures to restrict foreign trade. Such measures include
the imposition of custom duties, import and export duties placing bans on some goods, placing quantitative
controls or quotes exchange controls, and non-tariff barriers, etc.
Factor Mobility: Factors of production, especially labour, are not mobile. Raw materials are subjected
to controls which include sanctions. If factors of production are not mobile, specialisation is limited to
the extent of international restrictions.
Imperfect competition between countries: Sometimes there is opposition from groups with vested
interest. This prevents free trade among nations and makes difficult the operation of the comparative
advantage principle.
Multi-lateralism: The theory of comparative costs assumes trade to be bilateral, that is between two
80 Principles of Economics
countries that specialise. The real world, however, is a system of multi-literalism in which many countries
trade with one another at the same time. Among countries that produce cheaply, some may have
greater advantage over others, while some countries may prefer to buy from one country rather than
from one another. This factor sometimes leads to an unfavourable balance of trade for countries that
import more than they export to other countries.
3.5 Instruments of Foreign Trade Protection and Promotion
In an ideal world in which the principle of comparative costs specialisation is practiced, there is free trade and
no duty is placed on traded goods. Almost all countries around the world impose some form of restrictions on
the flow of international trade. Despite the advantages of foreign trade, different governments place restrictions
on it. These restrictions take different forms as described below:
(a) Import Duties of Tariffs: These are charges or taxes levied by the government on goods imported
into the country. The major objective of imposing such duties is to raise revenue or to restrict the
importation of the concerned goods.
(b) Export Duties or Tariffs: These are charges of taxes levied by the government on goods exported out
of the country. It may be to raise revenue or to discourage the exportation of certain commodities that
are in short supply locally.
(c) Import Quotas or Quantitative Restrictions: These are direct restriction on the quantity of goods
that can be bought into the country. This limits importation. Embargo is also a form of quantitative
control.
(d) Exchange Control: This includes the rationing of foreign exchange available for purchases e.g. through
import licencing or through the foreign exchange market (FEM). Exchange control measures specify
the value of foreign exchange.
(e) Non-Tariff Barrier: This may take the form of administrative practices, such as deliberately channelling
government contracts to home companies even where their tenders are not competitive or insisting
on different technical standards.
(f) Total Ban: This involves placing total ban on the importation of certain commodities, especially harmful
and non-essential goods. It may also be to encourage the local production of such goods and save
foreign exchange e.g. Nigeria has placed total ban on the importation of wheat (before December,
1992) barley, vegetable oil, etc. Occasions may also arise when the government places total ban on the
exportation of certain commodities to meet local demand. For instance, in January, 1988. The Federal
Government of Nigeria banned the exportation of certain grains such as maize.
(g) Export Promotion Incentives/Subsidies: Nations such as Nigeria (since 1986) give export promotion
incentives in order to stimulate non-oil exports to earn longer foreign exchange. This reduces
hitherto imported items. Standards and complex customs regulations such as import deposit schemes
and pre-shipment inspections are trade protection measures.
The Case for Free Trade
Free trade on its own refers to an open door trade policy which encourages free flow of foreign goods and
services without any barrier. It is, therefore, the absence of protectionism. According to Adam Smith, free
trade policy is “ a system of commercial policy which draws no distinction between domestic and foreign
commodities and thus neither impose additional burden on the latter nor grants any special favour to the
former” Vaish (1980:644).
The major argument presented for free trade is that it will make the maximisation of world output possible
by encouraging each country of the world to specialise in the production of those commodities in which they
International Trade 81
have a comparative advantage.
Furthermore, such specialisation will lead to a more efficient utilisation of the world resources. This in turn
will lead to cheaper imports. It does this by encouraging perfect competition, which safeguards consumers
from monopolistic tendencies of local producers.
According to Haberler (19509:4-10) free trade encourages the economic development of under-developed
countries. It does this by enabling them to import capital goods machinery and essential raw materials,
and also to import the technical know-how managerial talents, and entrepreneurship from developed countries.
It also serves as a carrier for international capital movement and promotes free competition in those
countries.
The Case for Protection
Why Nations impose Restrictions on Foreign – International Trade.
(a) Infant Industry Argument: Nations impose restrictions in order to protect new or infant local industries
from foreign competition with respect to long-standing but similar large industries.
(b) Revenue Argument: Nations impose duties or restrictions in order to earn enough revenue to execute
other projects locally. This is particularly so in the case of the imposition of import duties.
(c) Balance of Payments Arguments: Some countries impose restrictions to improve their balance of
payments via import restrictions or to correct balance of payments deficits. Measures taken here
include those which restrict imports and stimulate.
(d) Anti-dumping Argument: Countries take measures to prevent the dumping of cheap commodities in
their countries.
(e) Employment Stimulation Argument: Restrictions are also used as a deliberate instrument of planning
to stimulate employment. This is done by encouraging local production of hitherto foreign imported
goods by businessmen.
(f) Changing Pattern of Consumption Argument: The government also imposes restriction to discourage
the consumption of some commodities which are either considered harmful or non-essential. Those
considered harmful are meant to protect the health of the nationals while the non-essential but expensive
ones are placed on restrictions to change consumption pattern while generating revenue to the
government as well as redistributing income.
(g) Bargaining Power Argument: Some countries also impose restrictions on foreign trade in order to
have bargaining power during negotiation at trade conferences.
(h) Self-Sufficiency Argument: Some countries impose restriction on certain goods to enable them to be
self sufficient in the production of those commodities. This helps to eliminate or reduce foreign domination
and neo-colonialism.
(i) Self-Reliance Argument: Some nations tend to rely on their abilities, initiatives and resources in the
production of certain commodities hence they impose restrictions on certain goods.
(j) Recovery from Depression Argument: During periods of economic depression when there is low
economic activity and rising unemployment, imports are usually restricted to stimulate the domestic
economy.
(k) Strategic Sectors Argument: Strategic tariff could be imposed to protect some strategic sectors of
the economy such as industries whose products may be essential in times of war or international crisis.
Also protection given to agriculture in most developing nations even when comparative costs are high
compared to other nations could be seen as a measure to protect a strategic sector of the economy.
82 Principles of Economics
Students Assessment Exercise
(i) Explain carefully the circumstances in which nations find it beneficial to trade with each other.
(ii) “Government can always justify the establishment of trade barriers”. Examine critically the arguments
in favour of trade barriers.
(iii) Describe and Comment on the significance of various forms of trade barriers to trade.
4.0 Conclusion
When trade takes place within the borders of a country, it is said to be home trade, domestic trade or internal
trade. But, when trade takes place beyond the boundaries of a country, it is said to be foreign, external or
international trade. International Trade is the trade between one country and another.
The most obvious reason for trading with other countries is to obtain goods which cannot be produced in
our country or can only be produced at great expense. Climatic and geological differences account for a
proportion of International Trade. Less obviously perhaps, differences in the skills of labour and in accumulation
of capital account for some of the exports of the wealthy countries. It was differences in factor
endowments that underlay the traditional pattern of world trade.
The basic explanation underlying International Trade is to be found in the “Law” of comparative costs.
This shows that trade will be beneficial to a country if it concentrates but not necessarily specialise entirely on
the production of those goods in which it has the greatest relative advantage over its trading partners.
Economists have frequently praised the virtues of free trade- trade unhampered by any artificial barriers
such as tariffs and they have seen it as a means of inducing the most economic allocation of resources.
Despite this, all Governments take steps to reduce the volume of imports entering their country, or exports
leaving their country. They do this for a variety of reasons and in the certain knowledge that they invite
retaliation from their trading partners. There are a number of ways of protecting the home economy from
overseas competition. Those most frequently used include the following: Tariffs, subsidies, Quantitative restrictions,
non-tariff barriers, exchange controls.
We may conclude that there are frequently important economic and social strategic reasons for the protection
of home industries.
5.0 Summary
In this unit, we have tried to look at the concept and importance of International Trade, the theories of
absolute and comparative advantages, the issues of protectionism and free trade, briefly.
6.0 Tutor-Marked Assignments (TMA)
Q.1 Explain the theory of Comparative Advantage in International Trade.
What makes international trade different from domestic trade?
Q.2 What arguments are often presented in support of protectionism?
Q.3 Why do countries trade with each other? Is it ever desirable for a country to restrict the amount of
international trade it permits its inhabitants to participate in?
Q.4 It is Comparative Advantage not Absolute Advantage, which determines the pattern of trade between
countries, elucidate and discuss.
International Trade 83
7.0 References/Further Reading
- Jhingan, M. L. Money Banking and International Trade. Newdelhi: Vani Educational Books, 1984.
- Lipsey, R. An Introduction of Positive Economies. English Language Book Society/WeidenField and
Nieolson, 1983.
- Samuelson, P. A. Economies, II Edition. Newyork: McGraw Hill Inc., 1980.
- Vaish, M.C. Money, Banking and International Trade. Sahibabah: Publishing House PVT Ltd, 1980.
- Ude, M.O. International Trade and Finance Theory and Applications. Enugu: John Jacob’s classic
Publisher Ltd, 1996.
- Sodersten, B. International Economics. Macmillan, 1970.
- Todaro, M. P. Economies for a Developing World. London: Longman, 1977- 332.
- Whale, P. B. International Trade
- Harrod, R. F. International Economics.
Unit 12: The Balance of Payments
Contents Page
1.0 Introduction ................................................................................................................... 85
2.0 Objectives ..................................................................................................................... 85
3.0 Balance of Trade – Meaning/Definitions .......................................................................... 85
3.1 Terms of Trade and Measurement .................................................................................. 85
3.2 The Concept of the Balance of Payments ....................................................................... 86
3.3 The Reasons for Measuring the Balance of Payments ...................................................... 87
3.4 The Components/Structure of the Balance of Payments .................................................. 88
3.5 Balance of Payments Disequilibrium ............................................................................... 89
3.6 Ways of Correcting Balance of Payments Disequilibrium Deficits ..................................... 90
4.0 Conclusion .................................................................................................................... 92
5.0 Summary ....................................................................................................................... 92
6.0 Tutor-Marked Assignments ............................................................................................ 92
7.0 References/Further Reading ........................................................................................... 92
84
The Balance of Payments 85
1.0 Introduction
In the analysis of comparative costs in Unit Eleven, we confined ourselves to trade by barter, deliberately
excluding any idea of money of currency. In practice, it is the use of different (token) currencies that causes
most of the problems associated with International Trade. This unit shows the need for careful recording of
international transactions, the nature of these transactions, recent changes in their structure as far as the
Nigerian economy is concerned, and the methods available for dealing with short-term Balance of Payments
difficulties.
2.0 Objectives
At the end of this unit, you should be able to:
(i) define Balance of Trade and Terms of Trade.
(ii) make clearer the meaning of Balance of Payments and its various items.
(iii) distinguish between the various parts of the current and capital accounts that constitute the component/
structure of the Balance of Payments.
(iv) evaluate the consequences of chronic balance of payment deficits.
(v) evaluate the merits of the policies that can be used to tackle a balance of payments deficit.
3.0 Balance of Trade – Meaning/Definitions
Foreign Trade is made up of Exports and Imports.
Exports are the goods and services which a country sends to other countries (abroad) in return for some
payment made in foreign exchange.
We have “visible exports” and “invisible exports”. Exports of goods refer to visible exports while exports
of services refer to invisible exports.
Imports are goods and services which are brought into a country from foreign nations for which the
receiving country pays for in foreign exchange. There are also “visible and invisible” imports. Imports of
goods are visible imports while imports of services are invisible imports.
Nigeria’s major imports include manufactured goods, machinery, transport, equipment, chemicals, foods
and live animals, etc.
Balance of Trade shows a country’s receipts and payments for goods and services, such as crude oil,
cocoa, machines, equipment, baking, etc. That is, it deals with exports and imports of goods and services
which may be visible or invisible. Visible trade is that concerned with buying and selling of goods.
Invisible trade consists of services provided to or by other nations, e. g. Insurance, Banking, etc. It can
also be called Balance of Current Accounts.
3.1 Terms of Trade and Measurement
Terms of Trade means the rate at which one country’s products exchange with those of another and this
depends on the countries’ prices of exports and imports. That is, it is the rate at which a nation’s exports
exchange for its imports.
To say that the terms of trade of a country is favourable means that the prices of its exports are higher
relative to the prices of its imports. Otherwise, it is unfavourable if the prices of imports are higher relative to
the prices of exports.
86 Principles of Economics
The measurement of TOT is given as follows:
TOT = Index of Export Prices x 100
Price Index of Import Duties 1
- Bilateral Trade – This means trade between two countries
- Multilateral Trade – This occurs when there are more than two (2) countries involved in trade.
Nigeria exports barrels of crude oil, Cocoa, tin and some other commodities to the rest of the world. At the
same time, Nigeria imports machinery, milk, ink, writing paper, services of exports and so on from other
countries. With the income earned from exports, Nigeria is able to buy a certain amount of imports. It follows
that a certain amount of exports has to be exported to the rest of the world before Nigeria can import a
certain quantity of import. This rate of exchange between Nigeria’s exports and imports it gets from the rest
of the world is Nigeria’s terms of “Trade”. In other words, the term of Trade of any country is the rate at
which its exports equates its imports at any given time.
The terms Trade change from time to time, following the prices of traded commodities. If the price of
motor cars rise in Japan, Nigeria will have to sell more barrel of crude oil assuming that there is no change in
the price of crude oil in order to buy the number of motor cars. In this case, the terms of trade are unfavourable
to Nigeria. If the price of oil rises in favour of Nigeria, Japan will have to sell more cars to buy the same
quantity of crude oil from Nigeria. In this case, we say that the terms of Trade are favourable to Nigeria as
its exports if it exports the same amount of crude oil but get more cars from Japan.
Briefly, if a country gets more imports for a given amount of exports, the term of trade are favourable to
the country. If on the other hand, the same country gets less imports for the same amount of exports the
terms of Trade are unfavourable to the country. The terms of Trade are important determinants of the
balance of payments.
The concepts of the terms of Trade is of great importance in the theory of International Trade since it
measures the terms on which a country’s exports are exchanged for its imports. It thus determines how much
a country gains from foreign trade. Because money is so important in foreign trade, the terms of Trade are
measured as a ratio of changes in exports and import prices.
Students Assessment Exercise
(i) How does changes in the terms of Trade effect the economies of trading nations?
(ii) How are the terms of Trade of a country measured? Is it important in the terms of trade bound to lead
an improvement in the balance of Trade?
(iii) How is a country affected by a change in its favour of the terms of Trade?
3.2 The Concept of the Balance of Payments
A country’s balance of payments refers to a systematic record of all economic transactions between the
residents of the reporting country and residents of foreign countries during a given period of time, usually a
year. An economic transaction, as used here, is an exchange of value, typically an act in which there is
transfer of title to an economic good, the rendering of services or the transfer of title to assets from one
country’s residents to another.
Thus, the balance of payments is a statistical record which summarises all transactions which take place
between the residents of a country and the rest of the world. It is a statement of a country’s economic
transaction with other countries and it shows, for that accounting period usually a year, total income (receipts)
and total expenditure (payments) and the balance of income over expenditure. The transactions include
The Balance of Payments 87
buying, selling, borrowing and lending, investment and disinvestment, income from investment and repatriation
of profits and dividends, in addition to gifts and grants, etc. All transactions which entail inflow of
payments are taken as credit plus entries while debit or minus entries are those transactions which generate
an outflow of payments.
Thus, a balance of payments account refers to a classified summary of the money value of all international
transactions of an economy, in some form of aggregation, pertaining to a given period of time, usually a year.
Both in the accounting and economic sense, a country’s balance of payments must always balance since
every purchase of goods and services by a country is recorded both as a credit item (the goods received and
as a debt item) (the debt owed by the purchasing country to the supplier). This is an accounting procedure
based on common sense rather than on mere fancy.
3.3 The Reasons for Measuring the Balance of Payments
(a) To measure performance
A country’s Balance of Payment may be likened to the annual income and expenditure of a household,
although the comparison must not be carried too far. The household receives income by supplying the
services of factors of production and spends that income on the purchase of goods and services it
requires. If the household spends all its income, no more and no less, it is in the same position as a
country whose Balance of Payments just balances, if it spends more than its income either by borrowing
or drawing on past savings, the household has a balance of payments deficit for the year, if its
expenditure falls short of income, it may regard itself as having a balance of payments surplus.
This illustrates one reason for assessing the Balance of Payments. It shows whether or not the country
as a whole is paying its way in the world. The Government needs an assessment of the Balance of
payment in order to check that the community is living within its means.
(b) To protect the foreign currency reserves
Goods imported from abroad have to be paid for in currency acceptable to the supplier. Individual
importers do not keep stocks of foreign currencies needed to buy goods overseas but they can acquire
them from the Central Bank of Nigeria (CBN). A second important reason for keeping track of the
Balance of Payments is that a deficit leads to the reduction in these reserves and prolonged deficits
force the Government (CBN) to take restrictive actions in order to preserve the currency for essential
purposes.
(c) To inform governmental authorities of the international position of the country.
(d) To aid governmental authorities in reaching decisions on monetary and fiscal policy on the one hand and
trade and payment questions on the other.
(e) They are used to measure the resource flows between one country and another.
(f) Information on payments and receipts in foreign exchange constituting a foreign exchange budget,
helps to assure monetary authorities that the country could go on buying foreign goods and meeting
payments in foreign currency when they become due.
(g) To measure the influence of foreign transactions on national income.
Students Assessment Exercise
(i) Define the terms “Balance of Payments” and Balance of Trade”
(ii) There is no reason to expect the balance of Trade to balance. But the balance of payment must always
balance. Discuss.
(iii) What are invisible exports and invisible imports? Give examples of both and discuss their relatives
88 Principles of Economics
importance for Nigeria.
(iv) Can a deterioration in a country’s international terms of Trade cause an improvement in that country’s
balance of Trade?
3.4 The Components/Structure of the Balance of Payments
Lipsey (1983), said that a more analytically convenient way to present a nation’s balance of payment is to
divide it into three components, viz Current Account, Capital Account, and Official Financing.
The Capital Account
These records transactions related to movement of long and short-time capital i. e. it shows the volume of
private foreign investment and public grants and loans from individual nations and multilateral donor agencies
such as UNDP and the World Bank. It includes direct investment, portfolio investment, long-term capital and
short-term capital. The capital account will be a deficit if payment exceed receipts but a surplus if receipts
exceed payments.
The capital account section records all capital movements. They do not consist of goods and services but
debts and paper claims such as long term and short term loans that government and private citizens make or
receive from foreign government and private citizens.
The capital account is very crucial because it is used to finance any deficit on the balance of trade (i. e.
current account deficit) and also used to finance a net flow of goods to the recipients country. This explains
why the balance of payments must always balance.
The Current Accounts
The account of import and export goods and services is known as the current account. This is the basic
component of the balance of payments. It equally has the largest entries. The current account is further
divided into two sections: merchandise trade items and service transaction items.
The merchandise items refer to the import and export of goods (merchandise). This is also known as
visible items or visible trade items. The service items are known as invisible items.
The difference between the debit and credit entries in the current account is known as balance of Trade.
The balance of Trade is said to b e “favourable” or surplus if exports (sources of foreign exchange) exceeds
imports (use of foreign exchange). It is also said to be “unfavourable” or “deficit” if the imports exceed
exports.
In most cases, when the balance of payment is said to be in deficit or in surplus, reference is being made
to the current account or one account heading not to the total of all balance of payment entries. This is
because, in totals the balance on the Capital Account normally offsets the balance on current account. An
excess of imports over exports (a debit balance on current account), creates an international debt obligation
which is an equivalent credit balance in the capital account.
Official Financing
After summation of the investment and capital flows, a balancing item is added in the Capital Account. This
has noting to do with the size of the Balance of Payments deficit or surplus but merely indicates the errors
and omissions which have occurred. That part of the accounts which we have so far overlooked is called
“Official Financing”. This records the changes that have occurred, in government holdings of foreign currency
of liquid claims to currency over the year.
The Balance of Payments 89
Official financing items or official settlements represent transactions involving the Central Bank of the
country whose balance of payment is being recorded and there are three ways in which credit items may
occur on the official financing account.
(a) The Central Bank may borrow, say from the IMF and this represents a capital inflow and is hence a
credit item on the balance of payment. Repayment of old IMF is a debit item.
(b) The Central Bank may run down its official reserves of gold and foreign exchange and this is a credit
item since it gives rise to a sale of foreign exchange and a purchase of naira.
(c) The Central Bank might borrow from other Central Banks though a network of arrangement and these
will be on the credit side of the BOPs account.
There is also a Cash Account showing how cash balances (foreign reserves) and short term claims have
changed in response to current and capital account transactions. Such a cash account is, thus, the balancing
items which is lowered (i. e. a net outflow of foreign exchange) whenever total disbursements on the current
and capital account exceed total receipts (Todaro, 1977).
Finally, actual recording of BOPs can rarely be quite complete and accurate, hence there are bound to be
certain omissions and error in some other entries in terms of their values. Some of the errors and omissions
on credit side might be compensated by errors and omissions on credit side. This, a balancing item of “errors
and omissions” is provided to equate the two sides of the account, and it could be positive or negative, and
hence might appear on the credit or the debit side of the balance. This entry does not violate the principle that
debits and credits will equal each other, but only reflects the reality that actual recording is bound to be
incomplete in more than one ways.
Students Assessment Exercise
What part do Capital Movement play in the Nigerian Balance of Payment?
3.5 Balance of Payments Disequilibrium
A state of disequilibrium occurs in the balance of payments when an adverse or unfavourable balance results
in movements in short-term capital and or adjustments to reserves. Disequilibrium has two aspects: surpluses
and deficits. A country is said to have a surplus in the balance of payments if its income flow exceeds its
expenditure flow. On the other hand, a deficit or debit in balance is of two kinds: temporary and
fundamental. A deficit is temporary, if it can be corrected or adjusted within a short-time. It is persistent,
if it is of long duration. If it is not corrected, reserves will run out and other countries will lose confidence in
the country. As a result, such a country will find it difficult in raising external loans for the development of
its economy.
The following are the causes of disequilibrium in the balance of payments.
(i) excessive importation of goods and services
(ii) deficiency in domestic output
(iii) inadequately patronage of home made goods which are regarded as inferior goods and
(iv) high-level of importation of technical know-how in developing countries,.
In an accounting sense, credit and debit side totals of the BOPs must balance. Therefore, an inherent
tendency for the balance of payments to balance refers to equilibrium in the balance of payments since when
there are variations in the balance, the surpluses tend to cancel out the deficits. However, the absence of an
inherent tendency for the balance of payments to balance refers to disequilibrium in the balance of payments
since when there are variations in the balance, the surpluses do not tend to cancel out the deficits. Then
disequilibrium or gap in the balance of payments generally refers to an inherent tendency of an absence of
90 Principles of Economics
balance the balance of payments “unfavourable or deficit balance is considered more undesirable than an
“active”, “positive”, favoruable or surplus one.
Such as disequilibrium may be due to factors which cause an imbalance in trade account and/or in capital
account. The factors include:
(a) Persistent inflationary pressures at home hence the nation’s cost-price structure makes it unprofitable
for foreigners to import from this country, but making imports to rise.
(b) Inflationary pressures in trading partners’ economies hence the country in question is forced to import
at higher prices and hence bear the burden of high wages and other types of exploitation by the richer
economies.
(c) Servicing of existing debts through fresh loans without generating an adequate export surplus.
(d) Political disturbance such as war of threat of war which result in large imports of arms, ammunitions,
food and strategic raw materials for stockpiling. This sudden spurt in imports and possibly a planned
reduction in exports result in a deficit in the trade and payments.
(e) Economic calamities such as drought, flood, earthquake or general crop failure which increase imports
reduce exports.
(f) Lacks of capacity to meet changing requirements of importers due to lack of resourcefulness, diversification
and resiliency. This exports lag behind imports more so when the latter is influenced by demonstration
effect, (Bhatia, 1984).
Students Assessment Exercise
(i) “Living beyond their means”. Does this well describe citizens in any country with a balance of payments
deficits?
(ii) How does inflation affect our export and import trade?
3.6 Ways of Correcting Balance of Payments Disequilibrium/Deficits
Thus, while a temporary balance of payments can be financed (official financing) by running down foreign
currency reserves and by foreign borrowing, these cannot go on indefinitely since such financing cannot
carry a persistent balance of payments deficit. This calls for corrective action/policy on the part of the
government. Government corrective action can be grouped into two broad categories: Expenditure Reducing
Policies and Expenditure Switching Policies.
(a) Expenditure Reducing Policies
These are meant to achieve a deflation of aggregate demand in the economy such that the demand for
imports will reduce. Also, it is expected that domestic industry, faced with a contraction of demand in the
domestic market, will attempt to export more aggressively.
Specific expenditure reducing policies include:
(i) Fiscal Policy: This involves increase in taxes and decrease in government expenditure. This is
expected to lower purchasing power in the domestic economy and hence lower imports of goods
and services, and therefore correct the persistent deficits in the BOPs.
(ii) Monetary Policy: This involves measures which include contraction for restrictions on money
supply, raising interest rates and restriction of credit. Again, this lower people’s purchasing power
and hence lower demand for imports.
The Balance of Payment 91
(b) Expenditure Switching Policies
These are meant to switch expenditure away from imported goods toward domestically produced
substitutes, as well as to stimulate the level of exports and hence export earnings. These policies can also be
categorised into two – Trade Policy and Exchange Rate Policy.
Trade Policy includes
(i) Control of imports or direct controls –Attempts to directly control imports of goods and services
can take the form of tariffs or import duties, quantitative restrictions (quotas) exchange control and
export schemes.
- Tariffs or import duties: The deficit nation can impose a tax on imports to increase their price
and reduce demand for them. The government might also change licence fees for the imports.
- Quantitative Restrictions or quatos or ban: These involves physical controls on the amount of
a good which are imported from a particular source in a given time period. At the extreme, it may
involve outright ban on the importation of certain items.
- Exchange Control: A country which has a balance of payments problem may restrict the supply
of foreign exchange. This is meant to regulate both the inflow and the outflow of foreign exchange
hence all transaction in foreign exchange pass through the hands of the authorities.
- Export Schemes: These involves scheme meant to increase exports to subsidise export industries
and for which might make exporting simpler to finance and less risky. For example, in Nigeria,
there is the export promotion strategy meant to encourage exports and generate foreign exchange
and enhance the nation’s BOPs position. It involves such measures as duty-free export of some
goods and services, tax holidays or elimination of export subsidy, retention of a percentage of the
foreign exchange earnings by the exporter, assistance on export costing and pricing, liberalised
export and the establishment of an Export Credit Guarantee and Insurance Scheme to provide
insurance risk of default by foreign buyers and cheap finance for exports.
- Exchange Rate Policy: In addition, to foreign exchange restriction, a country can intervene in the
foreign exchange market by fixing its own rate. This also essentially involves devaluation i. e.
reduction in the value of the home country in terms of one or more currencies or gold. This is a
deliberate measure of shifting the exchange rate against the home country. Devaluation means a
fall in the exchange value of a country’s currency in relation to the currencies of other countries.
Devaluation cheapens exports and makes imports clearer, thus improving the balance of payments.
For devaluation to be effective, the demand for the devalued exports should be elastic.
Apart from elasticities, the success of devaluation also depends on other factors including Retaliation
by Trading Partners. If the devaluating country’s trade partners retaliate by devaluing their
currencies then devaluation will have disruptive effects without improving the balance of Trade.
Students Assessment Exercise
(i) In what ways could a balance of payment deficit be corrected?
(ii) Define “Devaluation” and state briefly how devaluation of a country’s currency may reduce its imports.
(iii) Distinguish between a balance of payments surplus and a balance of payments deficit.
92 Principles of Economics
4.0 Conclusion
International Trade gives rise to indebtedness between countries. The BOPs shows the relation between a
country’s payments to other countries and its receipts from them, and thus a statement of income and
expenditure on international account. In other words, it is the country’s monetary and economic transactions
with the rest of the world over a period of time usually one calendar year.
Like the Balance Sheet of Income and Expenditure of a company or a person, the balance of international
payments or accounts shows credit (+) for payment received by the country and debit (-) for payment made
to other countries. The overall balance enables the government of a country to see its position in international
economic order and to take measures to improve correct or adjust its position.
There are three main accounts of the balance of payments into which all economic transactions between
a nation and the rest of the world are classified. They are (i) the current account, (ii) the capital account and
(iii) the official settlement account or financing.
When a country has an adverse or debit balance in its balance of payments, it regards it with serious
concern, when it has a favourbale or credit balance there is satisfaction.
A variety of instruments are available for correcting balance of payment deficits.
5.0 Summary
In this unit, we have succeeded in stating that all transactions between one country and the rest of the world
involving the exchange of currency are brought together annually under the heading of the Balance of
Payments. This effectually summarises the country’s economic relationships with the rest of the world during
the proceeding 12 months.
6.0 Tutor-Marked Assignments (TMA)
Q1 What is “Balance of Payments”? Explain the various components of the Balance of Payment
Q2 Why is it necessary to make an estimate/measure of the Balance of
Payment?
Q3 In what ways could a balance of payment deficit be corrected?
7.0 References/Further Reading
- Bhatia, H. L. Monetary Theory. New Dehhi: Vikas Publishing House PVT, 1984.
- Kanem, S. R. Principles of International Finance. London: Goom Helm, 1988.
- Lipsey, R. G. An Introduction to Positive Economics. London: English Language Book Society/
Weidenfeld and Nicolson, 1983; pp. 560-564.
- Sodersten, B. International Economics Macmillan. 1979.
- Todano, M. P. Economics for a Developing World. London: Longman, 1977, pp. 329-332.
- Ellsworths, P. T. The International Economy. New York: Macmillan International Edition, 1975.
- Anyawu, J. C. Monetary Economics, Theory Policy and Institutions. Onitsha: Hopbrid Publishers
Limited, 1993.
- Stern, R. M. The Balance of Payments: Theory and Economic Policy. Chicago: Aldine, 1973.
- Seamunell, W. M. International Trade and Payments. Toronto: Toronto University Press, 1974.
- Meade, J. E. The Balance of Payments. London: Oxford University Press, 1951.
- Caves, R. E. et al. World Trade and Payments. Boston: Little Brown, 1973. 8
Units 13: Scope of Public Finance
Contents Page
1.0 Introduction .................................................................................................................................... 94
2.0 Objectives ...................................................................................................................................... 94
3.0 Meaning of Public Finance .............................................................................................................. 94
3.1 Distinction between Public Sector and Private Sector of the Economy ......................................... 95
3.2 Objectives / Functions of Public Finance ........................................................................................ 96
3.3 Public and Private Goods ................................................................................................................ 96
3.4 Public Revenue and Public Expenditure ......................................................................................... 98
3.5 Factors Responsible for Increased Government Expenditure in Nigeria ........................................ 98
4.0 Conclusion .................................................................................................................................... 100
5.0 Summary ...................................................................................................................................... 100
6.0 Tutor-Marked Assignments .......................................................................................................... 100
7.0 References/Further Reading ......................................................................................................... 100
93
94 Principles of Economics
1.0 Introduction
Public finance is not a new field of study. It dates from emergence of governments which means that it is not
as old as governments. From time immaterial, governments imposed taxes to raise enough revenue only to
cover the cost of administration and defence. The state is supposed to provide security and prohibit or
regulate those activities by individuals or by groups within the society which might injure the community as a
whole. To provide for these necessary services, government began to raise money in form of taxes. This is
why taxes were regarded as payment for services rendered by the government. Today, the number of
services which the governments provide have increased tremendously. Government development expenditure,
roads and equipment required to provide government social and economic services.
Since independence in 1960, the government has sought to control the level of economic activity by
alterations in fiscal policy, and it has used monetary policy mainly to create the general economic atmosphere.
“Public Finance” is the term applied to the study of the methods employed by the government to raise
revenue, and the principles underlying Government expenditure.
It is important to understand that Government expenditure is just as much as part of public finance as
adjustments to taxation.
In order to emphasise this, we shall in this unit examine the expenditure side of government before investigating
the main sources of revenue and later examine the role of fiscal policy in the next unit.
2.0 Objectives
At the end of this unit, you should be able to:
(i) specify the meaning of Public Finance.
(ii) differentiates between Public Sector, and Private Sector of the economy.
(iii) examine the objectives of Public Finance.
(iv) define what are Public goods and Private goods.
(v) analyse the differences between Public Revenue and Public Expenditure.
(vi) discuss the factors responsible for the increased government expenditure in Nigeria.
3.0 Meaning of Public Finance
Public Finance refers to that branch of economics that is concerned with the revenue, expenditure and debt
operations of the government and the impact of these measures. It identifies and assesses the effects of
governmental financial policies. That is it tries to analyse the effects of government taxation and other
sources of revenue and expenditure on the economic situations of individuals, institutions and the economy as
a whole. It develops techniques and procedures to increase that effective in effect, it looks into the financial
problems and policies of the government at different levels and studies the inter-government financial relations.
Public finance can be defined from two major perspectives. Firstly, Public Finance can be defined from
the perspective in which finance is defined as money. If this view is held, then Public Finance as a technical
term would refer to the pool of resources (borrowed or earned) available to government for the satisfaction
of public wants. As a course of study, public finance can be defined as that part of economics that deal with
the economic behaviour of governments. It discusses the various ways by which the government carries out
its allocative, redistributive and stabilisation functions in the economy. This will include government taxing,
spending, borrowing, transfers, aids subsidy and other operations that pertain to the use of scarce resources
of government.
In common usage, the term public finance means the financing of the government including the economics
Scope of Public Finance 95
of finance as well as the social effect and consequences of government policies. Public Finance can equally
be called the study of public sector economics. It is an aspect of economics which deals with government
revenue and expenditure.
The study of public finance involves a detailed analysis of the various sources from which the government
derives its income, the items on which the government spends its money and the impact of such government
revenue sources and government expenditure on different aspects of the economy.
Students Assessment Exercise
In a broad sence, explain the term Public Finance
3.1 Distinguish between Public Sector and Private Sector of the Economy
It is usually necessary to look at the economy from the point of view of the degree of influence and economic
resources of the government and of individuals. In this context, we are talking of public and private sectors of
the economy.
Public Finance is described as that branch of economics which studies the economic bahaviour of governments.
Economics itself is the study of man making decision in a world where scarcity of resources relative
to human wants makes choice a necessity. Economists have broadly divided the economy into two related
sectors. i.e.
(a) Private Sector and
(b) Public Sector
Though the end problem in both sectors are the same, that is, the satisfaction of human wants, their
behaviour and decision making processes vary. Hence their separate treatment in economic analysis.
The public sector refers to all production that is in public hands. That is, in public sector, the organisation
that produces goods and services is owned by the state. It is thus a combination of control, government, state
government, local authorities, the nationalised industries, public corporations, government administration, defence
and similar public service, including commercial and non-commercial undertakings of the government.
Some public sector activities are in the form of “nationalised industries” put differently, this sector is that
portion of the economy whose activities (economic and non-economic) are under the control and direction
of the Federal/State/Local Government.
The private sector refers to that part of the economy not under direct government control. It entails all
production that is in private hands. There, the organisation that carries out the production is owned by households
or other firm. Beyond the productive activities of private enterprises (the sole Proprietorship, Partnership,
Private Limited Liability Company, Public Limited Company and Cooperative Societies), the private
sector also includes the economic activities of non-profit-making organisation and private individuals. Put
differently, this sector is that part of an economy whose activities are under the control and direction of nongovernmental
economic unit such as households and firms.
Modern private economy is market oriented and operates on the principles of economic efficiency consumer
preference and market exclusion. This implies that resources should flow to where they are most
economically efficient and are appropriately rewarded. Price mechanism rations the scarce goods to the
consumers whose preferences are expressed through the market forces of demand and supply. Thus the
problem of relative scarcity is solved by excluding buyers who cannot buy and sellers who cannot sell at the
market price.
Modern public economy on the other hand organises its own want satisfying activities on the budget
instead of the market. Though the budget contains the priority list of public goods, the solution to the problem
of scarcity is determined by the political system.
96 Principles of Economics
Students Assessment Exercise
Differentiate the “Private” from the “Public” Sector.
3.2 Objectives /Functions of Public Finance
Traditionally, public finance serves three major functions: Allocation, Stabilisation and Distribution functions.
(a) Allocation function of Public Finance
Public Finance, traditionally ensures the provision of special goods as well as ensures that total resources
use is divided between social and private goods. It also ensures a proper mix of social goods
provision.
Through its Public Finance activities, government allocates the productive resources of government
to their optimal use. It determines for instance how much of the resources should go to the production
of consumer or producer goods. Besides and very importantly, the government ensures that resources
are allocated to the production of public goods (social goods) which otherwise would be neglected by
the market system.
(b) Stabilisation function of Public Finance
Public Finance is a means traditionally used to maintain price stability, high employment, high and
sustainable economic growth and favourable balance of payments.
Government through its public finance activities aim at removing or reducing such fluctuations so that
growth can be achieved without serious unemployment and inflation. Every government wants to have
a stable economy. Stability here implies stable prices at full employment. Inherent in the economy are
forces which could cause fluctuations and thus engender unemployment and stagnation on one hand
and inflation and balance of payments disequilibria on the other.
(c) Distribution Function of Public Finance
Public Finance was also used traditionally to promote equality in income and wealth distribution.
This was to ensure the attainment of what society see as a “just or fair” state of distribution in (Musgrave
and Musgrave 1989).
The market system guided by the principle of economic efficiency equates the price of a factor with
the value of its marginal product. This system breeds in equalities in income distribution. Through its
public finance activities, government tries to change the market distribution so that a higher level of
equality can be achieved e. g. Government can also use tax revenue to finance the provision of the
social goods free of charge. Examples include free Primary Education, free Primary Health-Care
delivery, etc., which usually benefit the lower income earners.
3.3 Public and Private Goods
A proper understanding of the meaning and scope of public finance will benefit greatly from the knowledge
of the existence of public and private goods, the difference thereof, and the corresponding roles of private
and public institutions in supplying them. Broadly, goods and services consumed in a given economy are
divided into two viz:
(i) Public Goods
(ii) Private Goods
Scope of Public Finance 97
Goods are said to be o f a public nature if they have the following characteristics:
(1) Indivisibility: The use of such commodities is not divisible in the sense that each individual has access
to the entire amount of the commodity under consideration, and the enjoyment of that commodity under
consideration by one person does not diminish its availability to other persons. For instance, several
persons tune into a particular radio programme without reducing the availability of the programme to
several other persons.
The major problem associated with indivisible goods is that the cost of producing or supplying them
cannot be met voluntarily through the price mechanism. Since the financing of such goods/services is
by public expenditure and not through price mechanism, their production supply must be in the hands of
the public sector.
(2) Neighbourhood Effects: This is variously reffered to as spillover effects, third party effects of externalities
constitute an integral part of the qualities of pure public goods. By neighbourhood effects, we
mean the economic effects on other parties arising from production use of the good. These externalities
can be either positive or negative i. e. economic gain or economic loss.
(a) Non Market externalities and
(b) Market externalities
For instance, the benefits of a new Federal highway cannot easily be proportioned. Also the economic
hazards associated with the environmental pollution which results from locomotive aim service
cannot easily be apportioned.
(3) Zero Marginal Cost: The Marginal cost of a pure public goods tends to analysis of almost zero. This
means that the inclusion of one more members of the society as a beneficiary of the said good does not
appreciably increase the total cost.
(4) Decreasing Average Cost: A pure public good is expected to be subject to the law of decreasing
average costs. By this, we mean that as more of a given public goods is provided, the average limit cost
decreased because of the economics of scale.
Private Goods are said to be purely private if they have the following characteristics:
1 . Product Divisibility
This characteristic requires that the availability and use of this good can be decided on a discriminatory
manner through the price mechanism. This means only those who can afford the price and are willing
to pay can have use of the commodity. Others who cannot pay the price or who are not willing to pay
the price are excluded from using the product/service. In this way, the product/service is divisible as far
as its use is concerned. Hence everybody does not have equal access to the use of the goods. The
essential elements of this characteristic are:
(i) The ability to price the good
(ii) The divisibility of the good
(iii) The exclusion principle
The presence of all these elements in a good/service makes it possible for one to voluntarily pay for
the supply of it because those who do not pay will not be supplied. Hence, through the market forces of
demand and supply, the consumers can determine the volume of any of the said goods that can be
produced.
2 . Economics of Scale
Pure Private goods yield favourably to the concept of large scale production. This will lead to decreasing
average cost.
98 Principles of Economics
3.4 Public Revenue and Public Expenditure
Public revenue or fund, it meant all moneys received for the interest of the whole economy. Every citizen has
right to it. Because government is the custodian of public wealth and welfare, it has the responsibility to
collect such revenues for the public. Generally public revenue is divided into two as follows:
(a) Revenue Receipts and
(b) Capital Receipts
(a) Revenue Receipts: This refers to all revenues accruing to the public through tax and non-tax sources
other than all forms of borrowing. Revenue receipts are therefore generally classified into two viz:
(i) Tax revenue and
(ii) Non-tax revenue
For tax revenue, government generates a large proportion of its revenue from tax. For non-tax revenue,
this is the collective name for the revenue generated from all non-tax sources of revenue other
than borrowing. This will include fees, fines and penalties as well as aids and grants, profits, interests
and dividends.
(b) Capital Receipts: This is the collective name for all resources of government arising from borrowings
and returns its own lending activities. Capital receipts include borrowing from certain statutory funds
and recoveries of loans given to state and local governments.
The term public expenditure is a collective name for all the monies spent by government to maintain
the machinery of government itself, for the benefit of the society, and the economy to meet its obligations to
external bodies as well as gratuitions assistance to other countries.
On the basis of their life span, expenditures are classified broadly into two viz,
(i) Recurrent expenditure
(ii) Capital expenditure
The term recurrent expenditures refer to those expenditures/spendings made by government for its dayby-
day operations. This will include salaries and other emolument of workers and other monies spent to
maintain current levels of government services such as health, education, communication, road maintenance,
defence and internal security. They also include transfer of payments like pensions and gratuities, internal and
external public debt charges. In Nigeria there have been a gradual but continuous increase in the recurrent
expenditure of the Federal Government.
The term capital expenditure refers to those spending that are investments in nature. In other words, they
are expenditure that add to or increase the existing stock of Wealth/Capital. They are spendings on the
provision of physical facilities like roads, bridges, hospitals, schools, construction of dams, communications,
mining and quarrying outfits. In Nigeria, the capital expenditure have gradually continued to increase perhaps
because of our development needs.
3.5 Factors Responsible for Increased Government Expenditure in Nigeria
It was mentioned in the last section that the size of public expenditure in Nigeria has continued to grow.
Several factors may be responsible for this continued rise. Among these factors are:
(1) Accelerated development of the new Federal capital Territory in Abuja: This monumental project
has gulped quite a lot of money. The speed with which it was pursued in the recent past also contributed
significantly to the increased pressure on government expenditure on both current and capital items.
The new Federal Capital has taken huge sums of money in terms of both capital and recurrent expenditure.
Scope of Public Finance 99
(2) Rising Population: Though accurate statistics are not available because the 1989 census figures are
yet subject to abjudication, the population of Nigeria has continued to grow at an increasing rate. In fact,
unconfirmed sources put the current figure at an average of eighty million persons. This has necessitated
increased government expenditure on all items necessary for the provision of economic, social
and health serviced to the teaming population.
(3) Infrastructural Development: As a developing country, the need for infrastructural development has
always been recognised as a catalyst to our economic and industrial development. Hence, so much
money has been spent on the provision of roads, bridges, electricity, communication facilities, portable
water, etc.
(4) Changes in Political and Bureaucratic Structure: In Nigeria certainly, the country’s political and
bureaucratic structure has undergone many changes over time. The change from a four regional structure
to twelve-state structure and then to nineteen, twenty one, thirty and lately thirty six has led to huge
increase in government spending during particular periods in which they took place. The cost of providing
physical facilities and other machineries for these governments at the various levels have contributed
in no small measure to the increasing size of the government expenditure.
(5) Campaign for Agriculture and Rural Development: The successive administrations of the Federal
Government have attempted to organise programme/directorates aimed at improving agriculture and
rural development. The expenditure of government on such programmes have been quite colossal,
some of such programme are the Operation Feed the Nation (OFN), the Green Revolution, Directorate
for Foods, Roads and Rural Infrastructural (DIFFRI), Better Life and currently Family Economic
Advancement Programmes (FEAP). The success or otherwise of these campaigns are not the subject
for our discussion here, the point being made is that these programmes have contributed significantly to
the increasing expenditures of the government.
(6) The various programmes and organisations set up by the Federal Government to mobilise popular
support for the programme and activities of the ruling government has taken quite a lot from the purse
of the government. These agencies include the Mass Mobilisation for Social and Economic Reform
(MAMSER) and the National Orientation Agency (NOA).
(7) Inflation: The increasing size of government expenditures can also be traced to the rising prices of
goods, labour and other services, indeed the inflation in Nigeria has the double digit level and by extension
affects the level of the public expenditure. The continuous increase in the price level means an
additional expenditure for individuals, households and the government. Government expenditure have to
reflect rise in prices of goods and services, wages and salaries.
(8) Debt Servicing: There was an extensive borrowing both internally and externally to pursue the development
programmes. Some of these debts have matured. The servicing of these debts (i. e. paying of
interest, due repaying the principal sum due) has continued to add to the size of the government expenditure.
(9) National Crises/Wars: Such crises and wars always necessitate huge government spending and
these partly account for the growth. In Nigeria, the civil war and the national reconstruction expenditure
which followed later, contributed significantly to the growth in public spending. Also the ECOMOG,
operation in Liberia in which Nigeria was reported to have contributed over seventy per cent of the total
budget is a significant factor in government expenditure growth.
(10) The idea of planning and economic growth are being increasingly accepted by the modern government
and this implies an increase in public expenditure with the growing awareness of its responsibilities to
the society. The government started to expand its activities in the field of various welfare measures.
100 Principles of Economics
4.0 Conclusion
Public Finance is regarded as a branch of economics concerned with the finance and economic activities of
the public sector. Three aspects of the subject matter of Public Finance have been emphasised. The three
aspects emphasised include the revenue aspect, the expenditure aspect and the public debt. The above
theory of public finance may be broken down into two. These are:
(a) The principle of Taxation and
(b) The principle of public expenditure
Leading authorities on the subject of public finance such as Musgrave and Prest tended to emphasise the
resources allocation, distribution and stabilisation functions of public finance.
5.0 Summary
In this unit, we have succeeded in establishing the fact that the theory of public finance is the theory of the
economic functions of government; why they are undertaken, how many should be undertaken, who should
perform them and how the resources should be provided. The classic work on this subject identifies three
main economic functions of government: the distribution of income, allocation of resources between private
and public sectors, and the stabilisation of national income. To these three functions, most people would now
add a fourth, which is the active promotion of economic development.
6.0 Tutor-Marked Assignments
Q1 Examine critically the main areas of Government expenditure.
Q2 In a broad sense, explain the term Public Finance.
Distinguish between public and private sector of the economy.
Q3 Is there any need for public sector in any economy?
7.0 References/Further Reading
- Anyanwu, J. C. Monetary Economics: Theory, Policy, and Institution. Onitsha: Hybrid Publishers
Limited, 1993.
- Bhatia, H. L. Public Finance. New Delhi: Nikas Publishing House PVT Limited, 1976.
- Buhari, E. L. ICAN/POLYTECHNIC, Public Finance. Lagos: Peat Marwick and Ogunde Consultants,
1993.
- Musgrave, R. et al. Public Finance, in Theory and Practice. Singapore: Mcgrawhill International
Editions.
- Due, F. Government Finances, An Economic Analysis. Homewood Illnois: Richard D. Irwin Inc.
1978.
- Herbert, P. Modern Public Finance. Homewood: Richard D. Irwin Inc., 1989.
- Johnson, L. Public Economics. Chicago: R and NC Nally & Company, 1975.
- Solomon, L. Economics. New York: Meredith Corporation, 1982.
- Stanford, C. T. Economic of Public Finance 2nd Edition. Oxford England: Pengamon Press Limited,
Headington Hill Hall, 1978.
- Taylor, P. E. The Economic of Public Finance. New York: The Macmillan Company, 1973.
Scope of Public Finance 101
- Anyafo, M. O. Public finance in Development Economy: The Nigerian case, Department of Banking
and Finance. Enugu: University of Nigeria, 1996.
- Wiseman, J. et al. The Growth of Public Expenditure in the United Kingdom. Princeton: Princeton
University Press, 1961.
Units 14: Taxation and Fiscal Policies
Contents Page
1.0 Introduction .................................................................................................................................. 103
2.0 Objectives .................................................................................................................................... 103
3.0 What is Tax? ................................................................................................................................ 103
3.1 Taxation Objectives – Reasons why Government Levy Tax ........................................................ 104
3.2 Principles of Taxation .................................................................................................................... 105
3.3 Types of Tax – Nigerian Tax Structure ........................................................................................ 106
3.4 Effects of Tax ............................................................................................................................... 107
3.5 The Goals of Fiscal Policy ............................................................................................................ 108
3.6 Types of Fiscal Policy ................................................................................................................... 109
3.7 The Instruments of Fiscal Policy .................................................................................................... 110
3.8 Limitations of Fiscal Policy ............................................................................................................ 111
4.0 Conclusion ..................................................................................................................................... 112
5.0 Summary ....................................................................................................................................... 113
6.0 Tutor-Marked Assignments ........................................................................................................... 113
7.0 References/Further Reading .......................................................................................................... 113
102
Taxation and Fiscal Policy 103
1.0 Introduction
We have made reference in earlier units to the division of the economy into various sectors, one of which is
the public sector. The principal feature of this part of the economy is that ownership and control are in the
hands of government in one form or another. Therefore the public sector consists of Federal or Central
government, state government authorities, and public corporations. However, public expenditure includes all
expenditure under the control of the public sector which has to be financed mainly by taxation or borrowing.
In unit thirteen (13), public finance is explained as that aspect of economics which deals with government
revenues and expenditure. Again it involves detailed analysis of the various sources from which the government
derives its income. Taxation is one of the major sources of the revenue to the government. This unit
looks at taxation in all aspects and effects of taxation in the economy.
Monetary policy is advocated by the monetarists as the most effective means of controlling economic
variables. However, Keynesian economists argue that monetary policy alone is not sufficiently powerful as a
stabilisation policy. To them, the most effective way of controlling the economy is the use of fiscal policy.
They see monetary policy as playing only a supportive role. The emphasis of our discussion in this unit is
fiscal policy. We shall, therefore, give attention to fiscal policy in this unit.
Fiscal policy is the influence of economic activities through variations in taxation and government expenditure
or public sector expenditure.
2.0 Objectives
At the end of this unit, you should be able to:
(i) specify what is tax.
(ii) state clearly the reasons why Government levy tax or tax objectives.
(iii) define the principles of taxation.
(iv) point out the characteristics or features of a good tax system.
(v) know the various types of tax.
(vi) appreciate the burden of taxation.
(vii) list the key effects to tax.
(viii) know the meaning of fiscal policy.
(ix) identify the goods of fiscal policy.
(x) list and explain the types of fiscal policy.
(xi) understand the various instruments of fiscal policy.
(xii) appreciate the limitations of fiscal policy.
3.0 What is Tax?
Several definitions of tax appear in the economy literature. These definitions do not really vary as the same
though/runs through all of them.
According to Dalton, tax is a compulsory contribution imposed by a public authority, irrespective of the
exact amount of service rendered to the tax payer in return. Elsewhere, tax described as a compulsory
contribution from a person to the government to defray the expenses incurred in the common interest of all,
without reference to the special benefits conferred. From these definitions, three principal features of tax can
be deduced as follows:
(i) It is a compulsory contribution imposed by government on private persons, groups and institutions within
104 Principles of Economics
the country. Since it is a compulsory payment, a person who refuses to pay a tax is liable to punishment.
(ii) A tax is a payment made by the tax payers which is used by the government for the benefit of all
citizens. The state uses the revenue collected from taxes for providing economic, social, educational,
health and general administrative services which benefit all people.
(iii) Tax is not levied in return for any specific or direct services rendered by the government to the payer.
In summary it can be said that tax is a compulsory payment of money to government by individuals, groups
and corporations. It can be levied on wealth income or as surcharged on prices. Or taxation can simply be
seen as compulsory transfer or payment of money from private, individuals, institutions or groups to the
government.
Students Assessment Exercise
Discuss the term “Tax”.
3.1 Taxation Objectives – Reasons why Government Levy Tax
(1) The primary objective of tax is to raise revenue for the government. Indeed, to the most economics, tax
constitute the major source of revenue for the treasury.
(2) To encourage even development: The tax proposals can be designed to push productive resources,
especially capital from relatively more developed areas to relatively less developed areas of the nation.
(3) To control and regulate the production of certain goods, taxes may be imposed on the production of
certain commodities considered harmful or injurious to either consumers or the workers.
(4) To check the cyclical fluctuations in income and employment: Tax system can be adjusted to
motivate saving and investment which through the multiplier can accelerate income and thus increase
employment.
(5) To redistribute Income: One way of achieving the government’s role of reducing the irregularity gap
is to operate a highly progressive income tax system. This will reduce the consumption and health
accumulation tendencies of the rich. Taxation is used to reduce the gap between the income of the rich
and the poor.
(6) To check Inflation: With reasonable level of economic growth and full employment, an increase in tax
unaccompanied by increase in government expenditure will reduce the purchasing power of consumers
and thus check demand-full inflation.
(7) To regulate the consumption of certain commodities. Taxes can be imposed to control the consumption
of certain commodities considered either harmful/injurious to consumer or non-essential and too luxurious.
(8) Taxes may be imposed to influence the method and kind of business. This may take the form of
encouragement in which a subsidy will be adopted. The underlying motive may be to protect or subsidise
the said business and commerce. This may take the form of agricultural price support tax reduction
or input subsidisation (e. g. fertiliser procurement and distribution in Nigeria).
(9) To prevent Dumping: There is a tendency for the industrialised world to dump their cheap products
on the developing countries where such products may not even be considered as necessaries heavier
tariffs can be imposed to prevent this act.
(10) To protect Infant Industries: Protective tariffs are also imposed to prevent the demise of infant local
industries as a result of foreign competition. Import duties are specifically designed to serve this purpose.
Taxation and Fiscal Policies 105
(11) To control Monopoly: Certain types of taxes may be anti-monopoly in purpose. Such taxes include
undistributed profits tax, excessive profits tax, intercorporate dividends tax and consolidate returns tax.
(12) To allocate resources: Taxation is also aimed at allocating resources between, for example, private
and public goods and between investment and consumption goods. It may also be aimed at correcting
deficiencies in the pricing mechanism resulting, for example, from monopoly elements, the existence of
external economics or diseconomics and in case where the social costs sharply diverge from private
costs.
(13) To maintain balance in the nation’s foreign accounts: Certain taxes may be imposed to reduce imports
and encourage exports such that balance of payments deficits are avoided, i. e. in Export Promotion.
Students Assessment Exercise
Mention and explain the reasons why governments levy taxes in any economy.
3.2 Principles of Taxation
Also called the cannons tax, the principles were enunciated by Adam Smith. These principles have largely
been accepted by subsequent writers who have also elongated the list. Some of the principles include:
1. The Cannon of Equity: This means that the tax payable by a tax payer should be based on the tax
payer’s ability to pay. This principle demands economic justice in which each person’s contribution to
the state should be as much as possible be proportionate to the person’s ability. In order words the rich
should pay or contribute more than the poor.
2. Cannon of Certainty: This principle holds that a tax payer should be made to know the exact amount
of tax he should pay and when. This is to avoid the tax payer being cheated by corrupt tax officials.
3. Cannon Convenience: This means that the amount of tax and the timing of tax payment should be
made to suit the tax payer. It should be related to the way he receives and spends his income.
4. Cannon of Economy: Proponents of this principle posit that the costs of assessment, administration
and collection of tax should as much as possible be small relative to the volume of revenue generated in
practice. The cannon requires that the tax structure should be such that it is economically correct.
5. The Principle of Flexibility: Proponents of this principle posit that the tax system should make room
for changes in the tax structure to meet the changing requirements of the economy and treasury. It
should not be too rigid.
6. Principle of Diversity: The sources of Tax revenue should be as diverse as possible to ensure the
certainty of some revenue to the treasury at all times. It is, however, noted that too much multiplicity of
taxes may negate the principles of economy.
7. The Principle of Buoyancy: The system should be such that tax revenue would have inherent tendency
to change with changes in the National Income level without any changes in the tax coverage
and rates.
8. Principle of Neutrality: The willingness of tax payers to work, invest or save must not be discouraged
by the tax system.
9. The Principle of Productivity of Fiscal Adequacy: It requires the tax system to yield so much
revenue that the government would not need to borrow or be forced to resort to deficit financing. It
should not be too high as to discourage productivity.
10. The Principle of Simplicity: This cannon holds that the tax system and laws should be clear and
simple enough for the tax payer to understand. The tax schedule should be simple and easy to calculate
by both the tax collector and the tax payer. If the tax system is complicated and difficult to administer
106 Principles of Economics
and understand, it breeds problems of differences in interpretation and legal tussles.
11. Cannon of Impartiality: This cannon advocates that no partiality should be shown in the distribution of
tax burden.
12. Cannon of Acceptability: This principle holds that the rate of taxation should be such that is politically
acceptable.
Students Assessment Exercise
Discuss the various principles that should guide the government in determining the level of taxation.
3.3 Types of Taxes – Nigerian Tax Structure
Two major groups of taxes can be identified. They are direct and indirect taxes.
Direct Taxes are levied on incomes and profits of firms. On the other hand, indirect taxes are levied on
goods and services. They can easily be avoided by not buying the goods to which they are attached to.
Direct Taxes
1 . Income Tax: This is the type of tax paid according to one’s income. Companies like human beings are
legal beings. Corporations, therefore, pay taxes on their income. Personal taxes are paid on total wages,
salaries, profits, interest and rent which a person receives with due allowances for family size, home
ownership, insurance contribution and other factors. Company or Corporate Income Tax is paid only on
corporate profit.
2 . Poll tax is imposed at a flat rate per head of population: It is a regressive tax because no matter
the size of a person’s income, everyone has to pay the same amount. Nigeria has a poll tax for people
with low incomes.
3 . Capital Tax: These are taxes imposed on property and other capital assets. For instance, when a
person dies his assets are subject to capital tax, in this case the term death duty or estate duty is used.
4 . Capital Gains Tax: This is paid on property, when you buy a property and over time it rises in value,
the amount by which it rises over what you paid is capital gain. The tax paid on this gain is called capital
gains tax.
5. Petroleum Profit Tax: In Nigeria, a tax is charged, assessed and payable upon the profits of each
accounting period of any company engaged in petroleum operations during any such accounting period,
usually one year.
Indirect Taxes
These are taxes levied upon persons or groups whom they are not intended to bear the burden or incidence,
but who will shift them to other people. They are normally levied on commodities or services hence their
services does not fall directly on the final payers. Ability to pay here is assessed indirectly.
Examples of Indirect are:
Custom Duties – Import and Export duties
Import duties are levied on goods coming into the country from abroad.
Taxation and Fiscal Policies 107
Export Duties: These are taxes levied on goods which are exported or sold to other countries by the home
country.
Excise Duties: These are levied on certain goods produced or manufactured locally.
Value – added – Tax (VAT) – This belongs to the family of sales taxes. The valued – added tax is not a tax
on the total value of the goods being sold but only on the value added (the difference between the value of
factor services and materials that the firm purchases as inputs and the value of its output) the value that a
firm adds by the virtue of its own activities to it by the last seller. Thus, the seller is liable to pay a tax on its
gross value but net value, that is the gross value minus the value of the services and materials purchased from
other firms, etc.
Sales Tax – These are taxes on selected sales transactions but applied at only one stage of business activity.
Stamp Duties: These are taxes on documentary evidence of particular transactions such as transfer or
property loans, bonds, mortgages, debentures, bills of exchange, promissory notes, cheques bills of lading,
letters of credit, policies of insurance, transfer of shares, proxies and receipts.
It is evidence and not the transactions itself that are taxed.
Inheritance Tax – This is tax payable by the recipient or beneficiary of a deceased property.
3.4 Effects of Tax
The question posed now is whether tax has other effects and the answer is yes. The imposition and payment
of taxes elicit some responses from the imposition of tax engenders distortions in the production, employment,
consumption, wealth distribution and other variables in the economy. These distortions which are collectively
called the effects of tax could be for good or for bad. We shall take a global look at these effects. For this
purpose, four groups of effects shall be considered. These are:-
1. Effects on Inflation
2. Effects on Wealth and Income distribution
3. Effects on Economic Stability
4. Effects on productive growth
Effects on Inflation
Inflationary pressures will be heightened if taxes are increased on commodities with high demand elasticity
and low supply elasticity. On the other hand, the pressure on prices may not be increased if there is an
increased tax on commodities with high supply and low demand elasticities.
Effects of Wealth and Income Distribution
Government assume the responsibility for reducing the inequality gap (in income and wealth) in the economy.
Under certain circumstances, taxation can be a potent tools for achieving this noble objective.
Market economics are characterised by great deal of income inequalities through the institutions of private
property and inheritance. Taxation has the egalitarian objective of reducing this income and wealth inequalities
which incidentally conflicts with increasing production and economic growth objectives.
108 Principles of Economics
Effect on Economic Stability
While some economist have faith in the inbuilt stabilisers that automatically adjust the economy if there is any
variation in one variable, others like Keynes opine that the economy is incapable of stabilising itself. Hence
government must intervene by way of tax and or expenditure adjustments. Progressive taxation is thus used
as an instrument to neutralise the fluctuations in output, employment, income, prices, etc.
Effect on Production and Growth
Tax can affect the production and growth of the economy in several ways. Indeed tax can influence the
supply of resources for production. High taxes, for instance, can reduce disposable income which will in turn
reduce savings and investment. If investors are taxed on their retained profits, they will resort to borrowing
since retained earnings will no longer be a sure way of getting finance. Even when resources are available,
their allocation to different areas of production can be influenced by tax. It is, therefore, necessary to be
careful and judicious in the choice of taxes as well as items and industries to be taxed. Taxes influence the
location of industries as well as the supply of labour, suppliers of labour must move to tax heavens from
areas of high tax.
Fiscal Policy works through and regulates the market mechanism without taking over the responsibility of
the market mechanism itself.
3.5 The Goals of Fiscal Policy
Fiscal policy, as an effective instrument of policy, may be used to accomplish the following goals:
(a) To increase employment opportunities or to attain full employment: The goal of fiscal policy is
the reduction of unemployment rate. Fiscal policy aims at achieving full employment in the economy
and at the same time ensure reasonable price stability. It is the wish of every government to reduce the
rate of unemployment to the lowest minimum.
High rate of unemployment requires expansionary fiscal policy but the government must also guard
against the inflationary impact of expansionary fiscal policy.
(b) Price Stability: Control of inflation fiscal policy aims at stabilisation of prices in the economy, that is
counteracting or avoiding inflation and deflation. Expansionary fiscal policy is used to fight deflation
while a contraction fiscal policy is used to fight inflation taking into cognizance the aims of attaining full
employment.
(c) To promote economic growth and development: One of the primary goals of fiscal policy is the
achievement of steady growth in national resources and in national output as well as structural and
attitudinal changes in the economy.
Economic growth here means continuing increase on the annual basis in production of goods and
services or a rise in per capital income made possible by continuing increasing in per capital productivity
where as economics development refers to the changes in economic growth and social structure that
always accompany economic growth.
(d) To achieve equity in income redistribution: Fiscal policy is used to redistribute income so as to
achieve equity and for the attainment of social and economic justice. In equities in income, distribution
is very high in the developing countries of the world. Progressive tax structure is one of the measures
taken by the government to arrest the issue of inequality in income distribution.
(e) To achieve a satisfactory or favoruable balance of payments: Fiscal policy is used to avoid and or
correct balance of payments deficits in the nation’s external trade relations. In such a situation, efforts
should be geared towards the reduction of importation by increasing import duties. Import substitution
Taxation and Fiscal Policies 109
industries should be established and exports should be given a big boost.
(f) To achieve a stable exchange rate: To avoid fluctuations in the nations external reserves and to
avoid fundamental disequilibrium in the nation’s balance of payments position, effective fiscal policy
measure are adopted. Stability in the price has great influence on the value of a country’s currency
which will equally affect the exchange rate between that currency and other currencies of the world.
(g) To increase the rate of investment, low rate of investment is not good for any economy. Low rate of
investment will lead to low rate of employment and eventually low income. Fiscal policy is employed to
generate revenues which should be used to increase investment in major sectors of the economy to
avoid recession. With government spending in the form of investment, the multiplier effect will help to
put back the economy on the right track.
The process will help to accelerate economic growth (National income via the multiplier process)
Students Assessment Exercise
(a) Distinguish between monetary and fiscal policies.
(b) Examine the various objectives/goals of fiscal policies.
3.6 Types of Fiscal Policy
There are basically two types or approaches to fiscal policy. These are compensary and counter cyclical
approaches and they deserve good treatment.
(1.) Compensatory Fiscal Policy: This refers to the management of government finance to compensate
for fluctuations in National income and employment. The compensatory fiscal policy which combines
deficit and surplus financing attempt to achieve high level of National Income. It uses taxation and
spending to produce the desired balance.
The point here is that the government budget should be used as the major instruments for achievement
of macro-economic objective and the budgetary changes should be made as often as desired and
in whatever magnitude desired. To maintain a desired level of income during a business decline, any
decrease in private spending or investment must be balanced by government policy of either increasing
government spending or raising total government purchases from private business or reducing taxes i.
e. increasing the income of consumers, business or both has to be noted that the reverse will be the case
during the inflationary period. To maintain a desired level of income during a period of over expansion
and inflation, government policy would comprise a reduction in the government spending, a possible
increase in tax or both steps.
(2.) Counter Cyclical Action: The counter cyclical fiscal policy is the government effort to combat the
cyclical instability of the private enterprise system. Such action take many counter cyclical forms,
including fiscal policy, monetary policy and transfer payments. The basic aim of all such actions is to
eliminate the effects of the periodic fluctuations of the economy and to stabilise national income and
production.
Under this countercyclical approach, the government plays the role of varying its expenditure policies
with the objective of moderating, fluctuations in income and employment over the business cycle, there,
the government is required to unbalance its budgets during deflationary and inflationary periods. This
means that the government will increase its expenditure and cut taxes when private spending declines.
110 Principles of Economics
Students Assessment Exercise
(i) Distinguish between the main forms of taxation in the Nigerian economy.
(ii) To what extent does the Nigerian fiscal system meet main principle of taxation?
3.7 The Instruments of Fiscal Policy
There are a number of instruments which the government employs in order to achieve its fiscal policy. Such
instrument include:
(1.) Government Expenditure: This is the total amount spent by the various three tiers of government
within a given period through governmental ministries, and departments including transfer payments.
According to Anyafo (1996:230), Transfer payments in the Nigerian content include “debt service i.e.
internal payment and capital repayments on internal and external debts, pensions and gratuities, external
financial obligations such as animal subscriptions to international bodies, and others”.
There are two types of government expenditure: Capital expenditure and Recurrent expenditure.
Capital expenditure are those expenditure made on items that can retain their value for more than one
year. Example of capital expenditure includes costs of constructing new roads and buildings, acquisition
of plant and machinery, and other fixed assets.
Recurrent expenditure are expenditure made on revenue items that will set up its value within one
year. Such expenditure is called recurrent expenditure because they are made repeatedly on a yearly
basis. They include salaries and other personnel costs, telephone services, stationeries and other running
costs of the various ministries and department of the government.
As a tool of fiscal policy, government expenditure can be used to influence the economy by influencing
aggregate demand.
The increase in government expenditure will make money available in the hands of the public. This
will increase aggregate demand which will make business of invest more and to employ more hands.
Moreover, the new government projects will create employment opportunities. Thus, the decline in the
economic activity will be reversed in government, expenditure may lead to an increase in the rate of
inflation.
During inflation, government can reduce the level of government spending and pursue a surplus
budget. The surplus fund is used in servicing public debts. The reduction in government expenditure will
reduce the spendable money in the hands of the public. This will lead to a reduction in aggregate
demand and general price level. Thus, the rate of inflation will be reduced, the negative aspect of a
reduction is the level of unemployment and level of economic growth.
(2.) Taxation: The second instruments of fiscal policy is taxation. Government can increase or reduce the
amount of tax payable by individuals and organisations as a means of influencing the macro-economy.
An increase in taxation reduces the spendable money in the hands of the public and hence the aggregate
demands. Such increase in taxation can, therefore, be used to reduce the rate of inflation in the
economy.
A reduction in taxation does the opposite. It leaves more money in the hands of the public since only
a small percentage of their income is paid back to the government. A reduction in taxation can be used
by the government to stimulate aggregate demand, investment spending and employment when there is
a slow down in the economy.
Note that there is an inter-relationship between the two tools of fiscal policy. A reduction in taxation
can be used to achieve a deficit budget even when the level of government expenditure remains unchanged.
In that same manner, an increase in taxation can also be used to achieve a budget surplus.
(3.) Subsidy: This is another instrument of fiscal policy. While high rate of taxation will reduce economic
activities of the firm and the purchasing power of individuals, subsidy to the business firm will help to
boost economic activities. Subsidy will help the business firms to produce at a very low cost and make
the product of the firms affordable by the customers. Subsidy is only useful, during depression and low
Taxation and Fiscal Policies 111
economic activities while taxation will be very useful during boom and high economic activities.
(4.) Budget Surplus and Budget Deficit: Tools/Instruments of fiscal policy are basically budgetary policy.
The Federal budget is a statement of planned revenue and expenditure of the government within a
fiscal period. It shows how the government intends to get money and how she intends to spend the
money got.
A budget is said to be a balanced budget when the planned expenditure of the government equals
expected budget. When government expenditure is more than government revenue the budget is said to
be a deficit budget. A simple budget or budget surplus, occurs when planned revenue is more than
planned expenditure.
Surplus budget and deficit budget are unbalanced budget. An unbalanced budget can be achieved in
any of two ways. First is by increasing or reducing government expenditure. Second by increasing or
reducing taxations. That is the reason why the tools of fiscal policy are said to be government expenditure
and taxation. State in another ways, the tools of fiscal policy are surplus and deficit budget. Either
way the tools are the same and they have been discussed as government expenditure and taxation.
Students Assessment Exercise
(i) Examine the case for raising an increasing proportion of government revenue through taxing expenditure.
(ii) Compare the economic effects of different kinds of expenditure taxes.
3.8 Limitations of Fiscal Policy
(a) There is the problem of how to make accurate short-run forecasts of the economic situation. Therefore,
fiscal policy action should be geared not to forecasts, but to actual situations since early solution to
the problem is unlikely. So long as a forecast is inaccurate, governmental action based upon it might be
harmful rather than remedial.
(b) There is the problem of how to appraise the effective force of the numerous techniques of fiscal policy.
The more tractable nature of this problem calls for the exploration of the issues by academic economists
to add to our knowledge of the force of specific measures of fiscal policy. This calls for speeding
up by governmental research in the CBN, the Ministry of Budget and planning, the Ministry of Finance
and Economic Development, etc.
(c) There are political obstacles in the way of a success fiscal policy, arising because the economy is
shaped to allow full expression of dissent which may be anti-thetical to execute parliamentary decisions
about debatable issues.
(d) There is also the problem of accurate data, which may become available only with a delay.
(e) The uncontrollable protions of the budget pose a problem in the use of fiscal policy.
(f) The use of fiscal policy is also limited by the time long involved.
(g) It is also discriminatory in effect since it is non-neutral not affecting the whole economy equally.
There are, however, a number of situation in which measures such as variations in government spending
and taxes may not have the desired effects on the level of economic activities.
Suppose the government in an attempt to stimulate growth, increases its expenditure. The resulting spending
on goods and services may be earned as income but people do not spend this income, it will constitute a
leakage out of the circular flow of income. The multiplier effect will therefore, be greatly reduced, and the
resulting effect on the level of output, income and employment may not be realised.
Again, people who earn the resulting income as a result of the government increased spending may not
spend these incomes on locally produced goods and services. They may decide to spend the incomes on
112 Principles of Economics
impacts of the particular economic exhibits, a high propensity to import as is the case with Nigeria. The
multiplier may be generated abroad and not in the domestic economy. Thus, the level of income, output and
employment may not change much as a result of the increased government spending.
Furthermore, it is argued that there are time lags between the time when fiscal policy is required and the
time it is actually implemented. This in turn may result in a situation in which by the time a particular fiscal
policy becomes operational, the result may be contrary to what was required originally. This particular criticism
applies as well to other economic policy measures, monetary policy and incomes policy.
From the foregoing above, there are broad limitations to the effectiveness of fiscal policy. These are (i)
Operational Limitations and (ii) Fundamental Limitations. The operational limitations to the effectiveness
of fiscal policy are usually associated with its timing and magnitude of the policy options, in terms of time,
there exist lags in the system. There is also the implementation or action lag. This is the length of time
between the realisation of the need for action and the implementation of new policy.
Before this time, however, the problem of determining the size of (or magnitude of the policy) government
spending and/or tax needed had to be contended with.
Fiscal policy is usually ineffective when the problem in the economy is fundamental, such fundamental
problems calls for basic adjustments in the economy. Examples include adjustment of production pattern to
changes in the pattern of demand and adjustment of wages to the productivity in various lines of economic
activity.
4.0 Conclusion
The problem of paying for government services is very much apart of the theory of public finance. There are
ways of meeting the cost of government services, most of them require a degree of compulsion. This is
taxation. Taxes are compulsory contribution from individuals and for business organisations for the purpose
of financing government expenditure.
Modern experts in public finance have argued that there are principles of taxation that sufficiently meet all
the purposes of modern economic policy which are partly achieved through budget.
There are two forms of taxes. These are (a) direct taxes and (b) indirect taxes.
Direct taxes, in very broad terms, are those taxes levied directly on individuals and business firms. Indirect
taxes on the other hand are taxes levied on goods and services.
Fiscal policy is concerned with deliberate actions which the government of a country take in the area of
spending money and/or levying taxes with the objectives of influencing macro-economic variables such as
the level of national income or output, the employment level aggregate demand level, the general level of
prices, etc., in a desired direction.
Generally, fiscal policy measures usually attempt to achieve one or some of the following objectives:
- influence the rate of the growth of the economy.
- raise the level of national income, output and employment.
- protect local industries from unfair competition from abroad.
- moderate inflationary pressure.
- improve the balance of payment.
The two key instruments of fiscal policy are:
- Government expenditure and
- Taxation
Taxation and Fiscal Policies 113
5.0 Summary
In this unit, we have succeeded in establishing that a modern economy, taxation is normally by far the most
important way of providing resources to the government, but other methods do exist. This unit dealt mainly
with the principles of taxation, different types of tax but also other ways of allocating resources from private
to the public sector, i.e. fiscal policy.
6.0 Tutor-Marked Assignments
Q1 (a) What do you understand by the “term of fiscal policy”?
(b) How does it differ from monetary policy?
Q2 Discuss in full types or approaches to fiscal policy
Discuss the goals of fiscal policy in modern economy.
Q3 Discuss in full types or approaches to fiscal policy.
Q4 List and explain five instruments of fiscal policy stating when each instrument will appropriately applied.
Q5 Mention and explain the reasons why government levy taxes in any economy.
Q6 What are the features of a good tax structures?
Q7 Distinguish between direct and indirect taxes.
Q8 Discuss the main cannons or principles of taxation.
7.0 References/Further Reading
- Anyanwu, J.C. Monetary Economics Theory, Policy and Institutions. Onitsha: Hybrids Publisher
Limited, 1997.
- Anyanwu, J.C. et al. The structure of the Nigeria Economic (1960-1977). Onitsha: JOANEE Educational
Publisher Limited, 1997.
- Musgrave, R. A. et al. Public Finance in Theory and Practise. New York: McGraw thill Book
Company, 1989.
- Anao, R. A. “The structure of the Nigerian Tax System” In Ndekwu E. C. (ed) Tax structure and
Administration. Ibadan: NISER, 1985. pp 51-60
- Kadlor, N. “Taxation within a Macro-economic framework for Development in Ndekwu E. C (ed).
1988.
- Anyanwu, J. C. “Monetary and Fiscal policy implications for full employment in Nigeria”, Annuals of
the Social Science councils of Nigeria, Vol. 6. January – December 1994. p1-16.
- Ndekwu, E. “An Analysis Review of Nigeria Tax System and Administration” paper presented at the
National Workshop, on the Review of the Nigeria Tax System and Administration, Lagos, May 15-17
1991.
- Phillips, D. “Formation of an effective Tax policy”, paper presented at the National Workshop on the
Review of the Nigeria Tax System and Administration, Lagos, May 15-17, 1991.
- Brown, C.V et al. Public Sector Economics. Oxford: Blackwell, 1992.
- Blejer, M. and Cheaity, A. “How to measure the Fiscal Deficit”, Finance and Development, Vol 29,
No 3, September, 40-42, 1992
- Due, F. I. Government Finance; Economic of the Public Sector. Illinois: Richard D, Irwin, Inc, 1993.
114 Principles of Economics
- Havemen, R. H. The Economics of the Public Sector. Sanita Barbers: John Wiley & Sons Inc., 1996.
- Jhingan, M. L. The Economics of Development and Planning. New Delhi: Vikos Publishing House
PVT Ltd, 1975.
- Seddon, E. Economics of Public Finance. Plymouth: Mcdonald & Evans Limited, 1997.
- Broadway, R. W. Public Sector Economic. Cambridge: Winthrop Publisher, Inc, 1979.
- Herber, P. B. Modern Public Finance. Illinois: D. Irwin, bc. Home worked, 1979.
Unit 15: Budgeting in the Nigerian Public Sector –
(Government Budgeting)
Contents Page
1.0. Introduction ............................................................................................................................. 116
2.0. Objectives ............................................................................................................................... 116
3.0. Budget Conceptual Issues ...................................................................................................... 116
3.1. The Government Budget ......................................................................................................... 117
3.2. Budget Preparation ................................................................................................................. 117
3.3. Budget Presentation ................................................................................................................ 117
3.4. Budget Deficit ......................................................................................................................... 118
3.5. Budget Surplus ........................................................................................................................ 118
3.6. Four Main Roles of the Budget ............................................................................................... 118
3.7. Steps in Presentation of National Budget ............................................................................... 119
3.8. State and Local Government Budget ...................................................................................... 119
3.9. The Budget as an Instrument of Economic Policy ................................................................. 120
3.10 Disposing of Surplus Revenue in the Budget .......................................................................... 121
3.11 Financing a Deficit in the Budget ............................................................................................ 122
4.0. Conclusion ............................................................................................................................... 122
5.0 Summary ................................................................................................................................ 123
6.0. Tutor-Marked Assignments .................................................................................................... 123
7.0. References/Further Reading ................................................................................................... 123
115
116 Principles of Economics
1.0 Introduction
In the proceeding/previous unit, fiscal policy was taken to refer to that part of government policy concerning
the raising of revenue through taxation and other means and deciding on the level and pattern of expenditure
for the purpose of attaining some desirable marco-economic goals. Such fiscal policy can be used for allocation
stabilisation and distribution.
In essence, a primary objective of official policy is to balance the use of resources of the public and private
sectors and by so doing to avoid inflation unemployment balance of payments presents and income inequality.
Budgeting can be seen as setting of expenditures priorities and the weighing of alternatives. It is a system
of resources allocation hence it implies looking ahead and planning since decisions involved in the process are
of future orientation. In this sense, budgeting involves the converting of the multi-year plan of operations into
more exact short-term installments of inputs and outputs usually for the year ahead. It is no wonder it is taken
a part of the managerial cycle of planning executing learning and applying the lessons to plan, execute, learn
an so on. The national Budget or Government budget itself is the financial statement of the government’s
proposed expenditure and expected revenue during a particular period of time, usually a year. Such budgets
are usually employed to attain the objectives of full employment in the economy, price stability, rising growth
in National output balance of payments equilibrium and equity in income distribution.
To attain these objectives, the budget must be seen as exhibiting certain features. It is a plan (a financial
plan) of Operation, it is for a fixed period, it must be an authorisation to collect revenue and incur expenditure.
It must be a mechanism of control of both revenue and expenditure and it must be objectives oriented.
On a broader basic, therefore, the budget is not only an instrument of economic and social policy but also
as planning tool instrument for co-ordination and an instrument for communication.
Therefore, a good budget requires comprehensiveness, a meaningful presentation of the state of budgetary
balance and an appropriate grouping of expenditure items
2.0 Objectives
At the end of this unit, you should be able to:
(i) define what a Budget is.
(ii) know how government prepares budget and presents it to the national assembly.
(iii) examine what is budget deficit and budget surplus.
(iv) appreciate the main roles of the budget.
(v) recognise the steps to be taken in the presentation of a National Budget.
(vi) distinquish between state and Local Government Budgets.
(vii) accept budget as an instrument of Economic Policy.
(viii) design how to finance a deficit in the Government Budget.
3.0 Budget Conceptual Issues
A budget is an estimate of the expected revenue and expenditure of individual, group, organisation or government
for a seated period of time, usually one year.
Put in another way, a budget is schedule of all the revenues and expenditures that an individual, group,
organisation or government expects to receive and plans to spend during some future time period, usually the
following year.
Budget ranges from very simple and casual one like the typical family budget, to extremely complex and
sophisticated one like the Federal Government Budget.
Budgeting in the Nigerian Public Sector – (Government Budgeting) 117
3.1 The Government Budget
The government budget shows clearly the expected incomes and proposal expenditure of the government for
the coming year. It contains estimates of anticipated revenues from sales, taxes, gifts and it specifies what
expenditures are planned during the time period. If revenues exceed expenditures, a budget surplus is expected.
If on the other hands, expenses are expected to be greater than revenues, a budget deficit must be
confronted and some methods of financing it must be planned.
A budget is usually used to control the allocation of revenues so that spending is rational. It is an
important instrument in the planning and control of the financial matters of a country.
The Federal Government’s budget is usually prepared by the ministry of finance. The Ministry of Finance
requires other ministries to submit their expenditure proposals to it before the budget is prepared. The expenditure
proposals by different ministries may be adjusted or pruned depending on government policy and
the resources available.
It is important to note the four stages that are involved in the budget of a Federal Government. The four
states are as follows:
(1) The formulation of the National Budget by the Director of Budget.
(2) The appraisal of the National Budget by the National assembly.
(3) The implementation of the content of the approved budget by the Executive arm of the government.
(4) The auditing of the budgeted revenue mapped out for expenditure in the process of the execution of the
content of the budget.
3.2 Budget Preparation
The preparation of the budget begins before the end of the present fiscal year. Each ministry sends its own
expenditure proposal to the Ministry of Finance and goes there to defend it. After each department of
ministry has successfully defended its proposals, the revised or amended proposals made in the budget are
presented to the National Assembly for deliberation. The debate on the budget is expected to be completed
before the end of the present fiscal year. After all the debates and amendments, the budget is finally sent to
the president for final approval and the remaining conflicts within the various departmental claims are to be
resolved by the president.
3.3 Budget Presentation
It is important to note that there are various forms of budget presentation today in Nigeria. Only two parts in
the presentation of the budget will be discussed here.
(a) The Presidential budget speech which is usually on the last day of the old fiscal year. In the Presidential
budget speech, the major points contained in the budget are summarised by the President.
(b) Analysis of some selected aspects by the Minister of Finance: The second part is the careful analysis of
some selected aspect of the budget. This is usually done by the Minister of Finance. During this analysis,
the general public, especially the business, the institution, the ministries and the parastalas are
invited and questions raised by them are responded by the minister.
It is important to emphasis again that in the budget, the means of raising revenue will be stated and any
new tax proposed or any loan expected will be clearly stated. Normally, a country will try to cover all the
items of the recurrent expenditure from revenues from taxation and other recurrent sources. If possible, it
will aim at a surplus of such revenue over recurrent expenditure in order to have fund available for the capital
projects.
118 Principles of Economics
A budget has two sides - the expenditure and the revenue. Every government tries to balance the two
sides. This means that the expected revenue income is made equal to proposed expenditure. In some cases,
the expenditure is greater than the revenue and in other cases, the revenue is greater. This is why the term
budget deficit and budget surplus are used.
3.4. Budget Deficit
In any budget whenever the expenditure of the government is greater than the revenue, it is usually referred
to as budget deficit. In most cases, the government spends more than what it collects in form of revenue. The
excess of expenditure over revenue can be covered by loans from outside the country. In most cases the
deficit is usually covered by government borrowing either from the public or financial institutions.
Although no individual or business firm can incure deficit over an indefinite period, some economists
believe that the Federal Government is in a different category and that budget deficits for some years are
acceptable and sometimes recommendable. They point out that a balance budget is instabilising in recession,
aggravating the effects of a drop in national income. They suggest instead a deliberate unbalancing of the
budget to create a deficit.
The deficit according to them will increase total spending, which in turn will increase national income.
Because of the operation of the national income multiplier, the increase in the income will be larger than the
deficit. The budget deficit can be achieved by lowering taxes, raising government expenditure or by
adopting both measures. Although an increase in government spending may be more effective in
raising national income. Since it has a higher income multiplier, a tax cut may be preferable, since it can
be made effective more quickly.
If the total revenue of the government in a fiscal year is N250 billion, and the expenditure for the same
period is N275 billion, then there is a deficit of N25 billion. Again, budget deficit is usually used to increase
government expenditure so as to generate more economic activities and increase employment.
3.5 Budget Surplus
Budget surplus occurs when the government revenue is greater than expenditure. This means that the government
collects more revenue than what it spends. Budget surplus can be used to reduce inflation because
the surplus may come from taxation which will reduce the disposable incomes of individuals and as a result
reduce their purchasing power. The use of the government budget surplus is an important part of countercyclical
fiscal policy. During periods of inflation, it is desirable to reduce total spending in the economy,
diminishing the excess demand which is forcing up prices. At such times, the government budget can be
adjusted to produce a surplus and achieve the desired lowering of income.
The budget surplus may be accomplished by lowering government expenditure, raising taxes or adopting
both measures. The reduction of government expenditures is more effective than a tax increase as an antiinflationary
measure, since its negative income multiplier is greater, but it is generally harder to put into
effect, especially when the budget consists of many large items. It has to be noted that for the budget
surplus to be effective, the surplus money must not find its way back into the spending stream. The surplus
funds may be used to retire part of the outstanding debt of the Federal Government or build up the balance
of the Treasury account. If debt retirement is undertaken, the purchase of government bonds held by
banks has a greater anti- inflationary effect than the refunding of bond held by citizens and non-financial
business firms. But budget surplus can lead to lower economic activities and increased unemployment.
3.6 Four Main Roles of the Budget
There are four main roles of the budget and these include:
Budgeting in the Nigerian Public Sector – (Government Budgeting) 119
(1) The Authorisation Function
As soon as the budget is approved, it constitutes an authority for implementation. The budget normally
contains a break down for the limit of expenditure that could be made on each expenditure head during
the budget period and once approved, it constitutes the authority limit within which expenditure could be
made. However, any required expenditure beyond such limit will require approval by higher authority.
(2) Directional Function
One of the roles of the budget is to provide a guide as to the intended direction of the economy during
the budget period in terms of priority, focus and attention. The budget is therefore expected to influence
individuals, organisations or institutions along the desired direction.
(3) Control Function
Control function is the most important role of the budget. This is the proper monitoring of the budget
and it helps to inject discipline in the Chief Executive of each unit as regards fund management. This
helps to ensure optimum use of resources.
(4) Development Function
The budget makes provision for development. The capital expenditure of the budget is, therefore, linked
to the development plan and integrates the budget with the plan. The budget then serves as the medium
for the actual implementation and actualisation of development plans.
3.7 Steps in Presentation of National Budget
In the present Nigeria, the government budget involves the following steps:
(1) An appraisal of the economy for the past budgeting period showing achievement, failures and things
that posed as problems during the period.
(2) The appraisal of the economy in the past budget period is followed by an analysis of the present day
situation in economy, stating problem and prospects in the present budget periods.
(3) The budget then specifies the national objectives in the budgeting period and the various policies
aimed at achieving them. In some of the budgets, specific targets are set and efforts are directed
toward achieving them.
(4) The budget then forecasts the future economic trend over the given period.
(5) Finally, the budget gives an outlay of expected revenue and intended expenditure over the budget
period. This involves an analysis of the expected government resources during the budget period and
the way the resources will be utilised to ensure justice and equity.
Note
In most cases, the government bases the current year budget on the figures in the previous year budget and
this system is normally referred to as incremental system of budgets.
3.8 State and Local Government Budget
Like the Federal Government, the state and local governments prepare and present their own budgets almost
in the same manner as the Federal government. The only difference is that each tier of the government
prepares its own budget according to its own resources
As already mentioned the Federal government presents its budget on the last day of previous fiscal year.
As the fiscal year in Nigeria runs from 1st of January to 31st of December, the Federal government budget is
120 Principles of Economics
usually presented on 31st day of December each year. This will be followed by presentation of budgets by
different state Governors. The presentation of State budget has no specific date like that of Federal Government.
In preparing the budget, each state takes into account its resources, peculiarities and priorities. The
revenues generated from the state are meant to urgument the state’s share of the ‘Federation Account’. The
presentation of the state budget is done by the state chief executives. This is followed by detailed analysis of
the budget by the Commissioner of Finance during which he answers questions from the general public.
It has to be noted that the implementation of the approved budget is usually carried out by the executive
arm of the government whether it is Federal or State. The budgeted revenue mapped out for expenditure in
the process of the execution of the content of the budget is later audited. This is to ensure that the approved
money is spent in the project for which it is meant or in other words to avoid the diversion of fund from the
project it is meant for to another and less important project.
The local government as the third-tier of the government presents its budget last after the State. The order
in the presentation is so because the local government that presents last expects some amount from both the
Federal and State Governments to make up what it will generate by herself. The expenditure of the local
government is mostly directed towards meeting the recurrent expenditure of the local government as well as
developing the resources of the local government.
3.9 The Budget as an Instrument of Economic Policy
The budget can be used as an instrument of economic policy. This is why we have balanced budget, budget
deficit or budget surplus. Each of these three type of budgets has its own advantages as well as disadvantages.
Each one plays a good role in the economy.
The classical economists believed that the budget must be balanced and they saw an unbalanced budget as
an unhealthy phenomenon. Much is sometimes made of the need for balanced budgets to ensure a healthy
economy even in the recent past. But even if optimum amount of government transfers and purchases occur,
balanced budgets do not necessarily prevent inflation or solve any other economic problem. Instead with a
balanced budget, total customer spending may be so high that inflation or shortages occur, or so low that there
is unemployment.
Budget deficits were no longer to be viewed as extraordinary and potentially dangerous acceptable only as
temporary expedient during recessions. Instead they were to be viewed as just another tool of economic
policy. Some economists at present argue that if budget deficit are needed to provide the additional spending
required to ensure a full employment economy, then such deficit should be encouraged in expansionary period
as well as in recessions. These economists suggest that annual deficits in most years might be required as the
price of economic growth.
The following are some of the main ways in which the budget can be used as an instrument of economic
policy.
1 . To Stimulate Recovery from a Recession
In the later years of the Great Depression, it was suggested that the budget should be deliberately
unbalanced, a policy known as deficit financing in order to promote recovery. This worked
successfully during the period and also during a period of serious slump, it is necessary, but in he case
of recession, it may be sufficient simply to reduce taxation.
2 . To Check Inflation
The aim of an anti-inflationary budget is to reduce the amount of purchasing power in the hands of the
consumers, and this is done by increasing the rate of taxation so that a substantial surplus is achieved.
So during the time of inflation, governments should increase tax rate so as to reduce the disposable
income of the consumers which will help to reduce the inflation rate.
Budgeting in the Nigerian Public Sector – (Government Budgeting) 121
3 . To Reduce Inequality of Incomes
In a country where great inequality of incomes exist, attempt should be made in the budget to introduce
progressive tax system. This will make the high income group to pay more proportion of their income or
wealth as tax than the low income group. Again inequality of incomes can still be reduced by the
provision of some social services which, though available to everybody are generally of most benefit to
people in the lower income group.
4 . To improve the Balance of Payment Position
Duties on particular imports may be imposed or increased for the purpose of curtailing the demand for
these goods, thereby reducing imports. Again duties on export goods can be reduced to encourage
export which will equally improve the balance of payment position.
5 . It is Used as a Means of Raising Revenue
This was the original role of the budget. Through the budget, the government plans to raise enough
money to finance the cost of national emergency such as war or disaster. It is also used as a means of
raising revenue for the various development projects of the government. This is true because in the
budget, the government sets out how it plans to raise its revenue.
6 . Budget is Used as a Tool of Economic Planning
Through the budget, the government assesses the economic performance of the various sectors of the
economy during the previous year. Sectors which require special attention i.e. priority areas are identified
and carefully enumerated.
3.10 Disposing of Surplus Revenue in the Budget
Whenever a budget is not a balanced one, it would either be budget surplus or a budget deficit. Care must,
therefore, be taken in handling either of the two. When there is a surplus budget giving rise to surplus revenue
due to increase in taxation or decrease in government expenditure, the government must be very careful to
handle this surplus in a way that will not offset the intended deflationary effect. The government must
withdraw the money form circular flow and not allow it to creep back into the circular flow.
One way by which to accomplish this goal is to actually destroy the money i.e. to burn the bills. An
alternative to this is to hold the money in idle treasury deposits. The third option is to use the money to retire
some portion of the public debt.
Ordinarily, when holders of government bonds cash in their holdings, the government simply issues new
bonds, selling the same amount of bonds to some different bondholders so that the amount of national debt
remains constant. But when the government has a surplus, it can elect to pay off the old bondholders without
selling new bonds thus retiring the debt.
However, there is a risk that some of this money will find its way back into the circular flow. But for the
most part, the money, that the households and business have invested in government bonds is intended to be
saved. Receivers of the money are, therefore, most likely to reinvest it in other form of saving-stocks in
private industry, savings account or other securities.
3.11 Financing a Deficit in the Budget
It has already been stated that whenever the government expenditure is greater then the revenue collected
deficit will accrue. How can this deficit be financed? There are many ways through which such deficit can
be financed.
In the first place, the government may choose to meet the deficit by increasing the supply of money; that
is the government will simply print up new bills in the amount equal to the deficit. Under certain circum122
Principles of Economics
stances, this is a satisfactory solution but in some cases it may be inflationary. The inflation which is the
reduction in the purchasing power of the currency may be acceptable or even beneficial with certain limits.
However it carries with it potential dangers for the economy.
Historically, many cases of hyperinflation were either started or fed by the printing of new money to meet
budget deficit. So in some cases, the governments are somehow hesitant about making extensive use of this
method of financing. But the introduction of certain amount of new money is often a sound economic policy.
In fact the relationship between the supply and value of money and the stability of the economy is an
important monetary policy, The other way that government can finance a budget deficit is by selling bonds i.e
borrowing money from households and businesses. One possible drawback to this method of financing deficit
is that it may take from households money that would otherwise be spent or from the business money that
would otherwise be invested in capital goods. Any such decline in spending or investment would of course
offset the basic goal of an expansionary fiscal policy.
Students Assessment Exercise
Q1 a. Explain what is meant by the term “Budget”.
b. Discuss how government budget can be used as an instrument of economic policy.
Q2 a. Distinguish between budget deficit and budget surplus.
b. Under what situations will each one be applied in the economy.
Q3. Write briefly on the following
a. Balanced budget
b. Budget deficit
c. Budget surplus
d. Budget presentation
4.0 Conclusion
A budget may be simply defined as a document indicating the total and composition of government expenditures
and the sources from which such expenditure are expected to be financed in the course of the year.
When a government plans its annual expenditure and revenue in such a way that both are equal, the budget
is said to be balanced. Where annual expenditures and tax revenues are planned in such a way that the
expected revenue exceed expenditure then the budget is referred to as a surplus budget, however, the total
intended expenditures for the year exceed the anticipated revenues, then the budget is referred to as a deficit
budget.
Essentially, the budget process in Nigeria involves the determination of the expenditure priorities of the
government together with the methods of applying the revenues from which these expenditures are met.
Although they may be variations among countries, the objectives and functions of a typical budget in
general include the following.
- The allocation function
- The distribution function
- The stabilisation function
- The control and management function
- Protection for local industries.
There are a number of ways in which the budget deficits may be financed. The popular ways include:
- Raising loans from members of the public
Budgeting in the Nigerian Public Sector – (Government Budgeting) 123
- Raising the level of taxation
- Borrowing from the commercial banks
- Printing of more currency notes.
A typical annual budget composition in terms of expenditure is made up of recurrent and capital expenditure.
The revenue items includes petroleum profit tax, mining company income tax, PAYE, import duties, export
duties, exercise duties, interest and repayment of loans, fines, penalties, sales of goods and services, rents,
fees and charges, etc.
5.0 Summary
In this unit, we have usefully interpreted the term budget in several ways thereby analysing in one conceptual
issues like objectives goods of national budget, functions of budget, kinds of budget, budgeting system,
deficit budget, financing, capital and recurrent expenditures.
6.0 Tutor-Marked Assignments
Question – What is “deficit budgeting”?
Examine four(4) ways the government can finance the deficit, explaining the most inflationary
and the reasons for thinking so.
7.0 References / Further Reading
- Anyanwu, J.C. Monetary Economic: Theory Policy and Institutions. Onisha: Hybrid Publishers
Ltd., 1993.
- Musgrave, R. et a.l Public Finance in Theory and Practice. Singapore: Macgrawthll International
Editions
- Wiseman, J. et al. The Growth of Public Expenditure in the United Kingdom. New Jersey: Princeton
University Press, 1961.
Unit 16: Public Debt
Contents Page
1.0 Introduction ............................................................................................................................... 125
2.0 Objectives ................................................................................................................................ 125
3.0 Meaning ................................................................................................................................... 126
3.1 The Meaning of Public Debt .................................................................................................... 126
3.2 The Reasons for Public Debt ................................................................................................... 126
3.3 The Effects of Public Debt on the Public and Economy .......................................................... 126
3.4 Limit to Rising Public Debt ....................................................................................................... 127
3.5 Public Debt and Inflation .......................................................................................................... 128
3.6 Management of Public Debt ..................................................................................................... 128
3.7 Public Debt and Fiscal Policy ................................................................................................... 128
3.8 Categories of Public Debts ....................................................................................................... 129
4.0 Conclusion ................................................................................................................................ 130
5.0 Summary .................................................................................................................................. 131
6.0 Tutor-Marked Assignments ...................................................................................................... 131
7.0 References/Further Reading .................................................................................................... 131
124
Public Debt 125
1.0 Introduction
The act of borrowing create debt. Debt, therefore, refers to the resources of money in use in an organisation
which is not contributed by its owners and does not in any other way belong to them (Oyejide et al 1985:9).
It is a liability represented by a financial instrument or other formal equivalent.
When a government borrows the debt in a public debt. Public debt, internal and external are debt incurred
by government through borrowing in the domestic and international markets in order to finance domestic
investment. Therefore, public debt is seen as all claims against the government held by the private sector of
the economy or by foreigners whether interest bearing or not (and including bank held debt and government
currency, if any), less any claims held by the government against the private sector and foreigners (see
Anygnwu, 1993). It is the obligation of a public debtor including the national government, a political subdivision
(or an agency of other) and autonomous public bodies (Klein, 1994).
In broad terms, all kinds of obligations of a government (including the currency obligations) are included in
the public debt such obligations include the currency short- term debt, floating debt, and funded debt and
unfunded debt.
Public debt can be internal or external gross or net, marketable or non- marketable, short-term, mediumterm
or long-term, interest bearing or non-interest bearing and/or project or jumbo loans (see Anyanwu,
1993).
The classical principles of loan finance rationalise loans to provide inter-generation equity pray as you use
capital formation, old-age insurance, self-liquidating projects, adjusting distribution, and reduction often friction.
Borrowing may be considered as a second-best alternative to money creation during periods of unemployment.
In this way, it is seen as an instrument of managing the economy.
Foreign loan, in particular is seen as a means of filling domestic savings gap, especially in the face of
dwindling government revenues from domestic sources. It is particularly so in the face of fluctuating prices of
primary commodity exports and hence dwindling foreign exchange earnings.
External borrowing is also seen as enabling a developing country increase its rate of real investment just as
it is seen as an engine of growth. In this sense, it increases per capital GNP or its component measures.
(Cairncross 1961). Thus, debt acts as a source of capital formation.
Public internal borrowing acts as an anti-inflationary measure by mobilising surplus money in people’s
hands.
2.0 Objectives
At the end of the unit, you should be able to:
(i) know the meaning of public debt.
(ii) analyse fully the rationale or reason for public debt.
(iii) appreciate the effects of public debt and or the public economy.
(iv) examine fully the limit to rising public debt.
(v) discuss the relationship between public debt and inflation.
(vi) assess the management of public debt.
(vii) evaluate the relationship between fiscal policy, public debt and the various types of debt.
126 Principles of Economics
3.0 Meaning
3.1 The Meaning of Public Debt
Public debt can be defined as the total indebtedness of the Federal government, state government and local
government in any country. This is quite different from national debt which is the total indebtedness of the
national or Federal government alone. From the above definitions, we can see that the national debt is smaller
than public debt.
In Nigeria, the national debt refers to the accumulated borrowing by the Federal government and it represents
the money owned by the Federal government to its citizens and the oversea governments and residents.
The Central Bank undertakes the administration of both national debt and public debt on behalf of the Federal
government.
The structure of the public debt needs to be looked into. As already stated, the public debt is made up of all
the total indebtedness of the Federal government, the total indebtedness of states as well as those of the local
government. So the three-tiers of the government contribute to the continuing growth of the public debt in our
country as well as other countries.
3.2 The Reasons for Public Debt
Infact, there are many reasons why some countries accumulated public debt. Some of the reasons are to be
discussed here. In the first place, the Federal government usually borrows from foreign countries, agencies
or individuals as well as from the public within the country in order to meet its expenditure plan. Although the
government can always increase the note issue to meet its own expenditure plan, such policy is likely to be
inflationary.
Some governments atimes engage in wars with other countries and this will necessitate an external loan.
Such governments cannot help going for such external loan or they will definitely pay the price of not getting
the loan which is losing the war.
There are some projects which are likely to yield revenue to the government when completed and the
government will like to borrow money to execute them. There is no doubt that some heads of government
involve themselves in an external borrowing for personal benefits and not necessarily to embark on a useful
venture.
It is important to realise that both the wealthy countries as well as the poor ones accumulate public debts.
In 1945, the national debt of the United States of America stood at $258.7 billion while the Gross National
Product figure stood at $258.9 billion.
Nigeria is one of the countries whose national debts figure is alarming. Nigeria’s national dept in 1966 was
N3,044.6 billion and N5,002.1 billion in 1977. This then means that the substantial part of Nigeria’s G.N.P. will
be used for the servicing of the national debt. It has to be noted that in each of the countries mentioned, the
public debt was greater than the quoted national debt figures of the mentioned years.
3.3. The Effects of Public Debt on the Public and Economy
Many countries are worried over the increasing size of their public debt because of many reasons. Some of
such reasons include:
1 . The increasing burden of public debt is being passed on in the future generation: There is no
doubt that the increasing burden is being passed on the future generation but if the government totally
avoids the public debt, it may distort the economic behaviour of the firms and individuals.
In most cases honest government increases the national debt in order to ensure proper public and
private spending. In order to avoid depression or recession, a lot of money is required to be pumped
into
Public Debt 127
the economy for greater economic activities.
2 . Interest Payment Continues of Increase: As the public debt or even the national debt gets higher,
there is tendency for more interest to be paid on it. The lender then gets more and more purcashing
power than the debtor. If the debt is allowed to grow very high, it may require more proportion of the
G.N.P. to pay the interest on the debt and this will affect both the people and economy.
3 . The Increasing public debt may lead to bankruptcy on the part of the government: This may
adversely affect the economy so much and the government may find it difficult to get future loan for
developmental projects.
4 . It may necessitate higher tax rate: In an attempt to pay the interest on the debt, there may be need
for higher interest rate which means more tax for the public. The higher tax will affect the disposable
income of the individuals and this will equally affect the standard of living of the people.
It has to be noted that in 1988 budget, the President of the Federal Republic of Nigera, General Ibrahim
Babangida stated that the sum of N3.915 billion is allocated for the payment of interest charges on external
loans while N3 billion is for the payment of interest on the domestic loans. This will give a clear idea of the
amount of money involved in payment of interest charges only and the impact of the huge amount of money
on the public.
The big question which many people usually ask is whether public debt can be avoided. The answer to that
question is that it is not really possible to avoid public debt. Every country of the world owes another or is
being owed. A country which always fears owing other countries will never take a bold step towards economic
development. It is not always bad if a country owes, provided the money borrowed was optimally
utilised.
The best thing the planners of the economy should do is not to avoid borrowing but to make sure that
borrowed money is invested in a viable projects that will be capable of generating enough fund for the
repayment of the debt.
3.4. Limit to Rising Public Debt
In most countries today, public debt has shown a continuous upward trend during the last few decades. There
have been various reasons or factors responsible for this mentioned above. But the question now is whether
there is a limit beyond which a government cannot increase its public debt.
In order to answer the question, we should distinguish between the will and capacity to raise loans on the
part of the government and both of them should be considered in the context of short-run and long-run
possibilities.
It has to be borne in mind that a modern government would not resort to borrowing for the sake of it. It
does not have a tendency to borrow and squander it away on wasteful consumption beneficial to the section
of the rulers. A reasonable government borrows for only such consumption purposes which are considered
absolutely necessary for the economy such as defense, protection against national calamities and some
important other welfare activities.
In a normal circumstance, the government of a country might borrow as a part of its anti-cyclical operations
i.e. for stabilisation purposes while in the developing countries, the government may borrow for capital
accumulation and economic growth and development. At times there is self imposed limitation by the government
which stipulates that the borrowing must be for public purposes. In some cases, specific legislature
provisions may prohibit the government from borrowing under certain circumstances or beyond certain limits.
Government borrowing reduces the supply of funds available to the authorities to borrow too much and
unnecessarily. Only short-term loan will attract low interest rate for the government.
In the long-run, however, the situation is different. Total volume of public debt can increase gradually in
128 Principles of Economics
harmony with the growth in the National income. Therefore, no definite limit may be stated to exist for the
volume of public debt in the long-term. Furthermore, the borrowing power of the government can be assumed
to be unlimited.
3.5 Public Debt and Inflation
Most government while raising loan for their investment and even for consumption purposes, will claim that
such activities will not be inflationary. They claim that such borrowing will divert funds from the market into
the hands of the government and that they are spent by the government instead of the market. This according
to the argument is only a diversion of demand but no net addition to it.
The logic is wrong since the economy’s resources will be divided from production of consumption goods
into those of capital goods, therefore, making the demand for consumer goods to be greater than supply,
thereby leading to inflation.
Whenever effort is made to increase economic activities so as to ensure greater employment opportunity
for the citizens, it is likely to be inflationary. In fact, inflation is the cost of full employment. It can, therefore,
be concluded that public debt if continuous will likely cause inflation but that will not make the government
avoid public debt but to guard against its adverse effect.
3.6. Management of Public Debt
The term debt management refers to the debt policy designed to achieve certain objectives and actual
implementation of the policy. According to the traditional philosophy, the debt management consisted of
raising the necessary debt at the cheapest interest cost and paying it off as early as possible. However, with
the development of the concept of welfare state, various objectives are being considered as the cornerstones
of a sound debt management policy.
There is no doubt that every government is still interested in keeping the interest cost of its debt at the
minimum possible, but when this objectives comes into conflict with other objectives, it may be sacrificed.
Other Important objectives attracting the attention of the government authorities include anti-cyclical measures
or stabilisation objectives, economic growth and development.
It is expected that debt management policy has to be in harmony with the monetary policy of any country.
They both should influence the stablisation and economic growth. Through general and selective credit
controls, monetary policy tries to influence the volume and the direction of the flow of funds and thereby
guide the working of the economy. The ways in which debt management can also contribute to the monetary
policy objective have been stressed. We cannot loose sight of the fact that the objective of reducing the
interest cost on debt can come into conflict with the stabilisation policy of the country.
It is important to bear in mind that the aggregate volume of debt is as a result of fiscal action, that is the
budgetary policy of the government. The volume of debt will increase or fall in line with the deficit or surplus
budgeting.
In monetary policy, there is no such limitation. The volume of money and credit in the market may be
regulated quite independently to a large extent. In the case of public debt, the management part would mainly
consist of changing the maturity composition so as to effect its yield structure and the liquidity content. But
the emphasis is still that the monetary policy and the public debt are closely linked.
3.7 Public Debt and Fiscal Policy
When the government finances a budget deficit by borrowing from the public, it creates a public debt. This
raises a fundamental macro-economic issue. What is the effect upon the economy of the existence of a large
public debt?
Public Debt 129
Classical economists believed that any amount of public debt was harmful to the economy. They insisted
that the government budget should always be balanced, implying that it was practically sinful for a country to
be in debt to its citizens. The balanced budget was considered to be a necessary right up till the 1930s.
The experiences of the depression and the conclusion drawn from them by Keynes changed economists
attitude toward the balanced budget. Economists began to see the difference between private and public
finance and to realise that the balanced budget that was desirable for a household was not necessarily
desirable as an annual practice for the government.
Keynes demonstrated that effort to balance the budget when NNP is changing rapidly in either direction
will intensify economic instability. According to him, if NNP is falling, government can balance the budget
only by increasing taxes or by reducing expenditure as either of them will lead to recession. If NNP is rising,
the government will have to cut taxes or increase spending to achieve a balanced budget as such a policy will
add to the inflationary pressures.
It is currently accepted that an annually balanced budget may do more harm than good to a dynamic
economy, depending on how close the economy is operating at full employment. While some economists are
of the opinion that long-term balance is necessary, others are of the view that any magnitude of national debt
is acceptable as long as the rate of growth of the debt is less than the rate of growth of Net National product.
3.8 Categories of Public Debts
Public debts are mostly of two kinds or types, depending on the purpose for which the money was borrowed.
(1) Reproductive Debt: In a situation where a particular loan has been obtained to enable the government
to purchase some real asset, the debt is said to be a reproductive one. A good example may make
this more understandable. Assuming that the Federal government embarks on natinalisation of industries
owned by private companies and some foreign nationals instead of the current privatisation excise,
the former owners may receive compensation in the form of government stock. In this example, the
Federal government has just inquired debt in order to acquire some real assets. In other words, the
Federal government has just increased its debt by the amount of compensation paid, but has acquired in
exchange of real assets in form of more industries.
(2) Deadweight Debt: The second type of public debt known as “deadweight debt” is public debt that is
not covered by any real asset. This is a situation where the government borrows money and spends it
in something that is not tangible. Greater proportion of many countries public debt is in this category and
this makes the burden of the debt much on the people.
Most countries borrowed huge sum of money in order to prosecute one war or the other. During the
Nigerian civil war of 1967-1970 the public debt of this country increased but after the war the then
Head of State, General Yakubu Gowon paid completely the national debt owed Britain against the
wishes of many people. Many countries of the world accumulated huge public debt in the way of the
deadweight debt.
Students Assessment Exercise (SAE)
(1) What is public debt and how does it differ from national debt?
(2) Discuss the effect of public debt on
(a) The people of a country
(b) The economy
(3) Explain how a government will figure public debt.
(4) Discuss some advantages and disadvantages of public debt.
130 Principles of Economics
(5) The public debt is inevitable. Discuss.
(6) List and discuss the reasons for public debt
(7) Mention and explain two categories of public debt showing how each affect the people in the economy.
4.0 Conclusion
Before analysing the issues involved in public or national debt, it is important to distinguish between a national
debt and a budget deficit. A budget deficit is the difference between a particular year’s total government
receipts and the year’s total government expenditure.
The national or public debt on the other hand is the accumulated total of past deficits less pass surpluses.
Public debt may also be categorised as to whether it is internal or external. In the case of internal public
debt, payment of interest or repayment of principal involves a transfer from tax payers to security holders.
External debts on the other hand are debts owed by a country to institutions or countries abroad. To the
extent that interest payments are made abroad and principal repaid, there are implications for the country’s
balance of payments.
There are a number of causes which has led Nigeria and other developing countries into the debt crisis
now facing them. These factors include the following:
- Huge Budget Deficits.
- Heavy Dependence on oil Revenue.
- Short-term loans being used in Financing long-term projects.
- Reckless contraction of loans.
- Rise in interest Rates on Commercial loans.
- Poor performance of Non-Oil Export.
- Structural in-balance in the Economy.
- The effects of the public debt depends on whether it is internal debt or external debt that we are talking
about.
The more important effects on the economy as far as internal debt is concerned include the following:
- Large internal debt tends to “crowd out private investment.
- Internal debt may create income Distribution problem.
- Internal debt may Aid Government stabilisation programme.
- Debt Financing may create inflationary Effects.
The effects of external debt on an economy shall be examined in the context of the Nigerian situation. The
effects of the debt and its financing continue to generate debate on the Nigerian economic scene. Although
people tend to concentrate on the negative effects of the debt in their discussion, there are positive consequences
as well. The more important positive effects include the following:
- External Debt has made the financing of certain projects possible.
- The Debt helped in Balance of payments support.
The negative effects includes:
(a) The debt and its servicing are draining away resources which could be used to finance development.
(b) The debt and difficulties being encountered by Nigeria in its servicing have created the problem of
Foreign Investors confidence in the Nigerian Economy.
Public Debt 131
(c) Greater control on the direction of the economy by foreign creditors
The question of the debt burden of the public debt is a complex one since it raises question about the nature
of the burden and its intertemporal incidence. That is which future generation that bears the burden.
The term debt management is used to describe strategies adopted by a government to minimise the
negative impact of debt on the economy as well as the burden of the interest charges. The methods used in
managing the internal debt are important since they have implications for both the money supply and the
structure of interest rates.
The policy aims of debt management strategies of government including the Nigerian government include
policies designed to regulate monetary variables maintenance of stable market in securities and minimisation
of debt service charges.
Debt management strategies being used to tackle Nigeria’s External debt obligation are a number of
policies put in place to tackle Nigeria’s external debt problems.
The policies includes:
- Debt rescheduling strategy
- Debt conversion strategy
- A lid on External Borrowing
- Economic Restructuring
- Brady plan
- Debt Repudiation
5.0 Summary
In this unit, we have succeeded in examining the meaning, nature, the structure, trend and consequences of
public debt in Nigeria including the debt management strategies.
6.0 Tutor-Marked Assignments
Question – One
(a) Define Public Debt.
(b) What is the rationale for external borrowing?
(c) What to you understand by “debt burden”?
(d) Examine Nigerians external debt strategy.
7.0 References/Further Reading
Ajayi, S.I. “Macro Economic Approach to External Debt: The case of Nigeria”. AERC, Research paper
Eight Narrobi December, 1991.
Anyanwu, J.C. Monetary Economies: Theory Policy and Institutions. Onitsha: Hybrid Publishers Ltd,
1993.
Anyanwu, J.C. et al. The structure of the Nigerian Economy (1960-1997). Onitsha: TO ANNE Educational
Publishers Ltd, 1997.
CBN “Management of Nigeria’s Public Debt”. CBN Briefs, series No 96/09, 1996.
Klein, T.M. External Debt Managemen:t An Introduction. World Bank Technical paper Number 245.
World Bank Washington, D.C. 1994.
132 Principles of Economics
Oyejide, T.A. et al. Nigeria and the IMF. Ibadan: Heineman Books (Nigeria) Limited, 1985.
Haveman, R.H. The Economics of the Public Sector. Canada: John Wiley and Sons, 1976.
Hockey, G.G. Public Finance: An Introduction. London: Routledge and Kegan Pavil, 1970.
Unit 17: National Income
Contents Page
1.0 Introduction ............................................................................................................................. 134
2.0 Objectives ............................................................................................................................... 134
3.0 Meaning of National Income, Personal Income, and Disposable Income ............................... 134
3.1 Measurement of National Income ........................................................................................... 135
3.2 The Need for Regular Measurement of National Income ...................................................... 137
3.3 Factors Determining the Size of National Income .................................................................. 137
3.4 Some Difficulties in Measuring National Income .................................................................... 138
3.5 Why West African Countries have Lower National Income Figures than
Developed Countries ............................................................................................................... 139
3.6 The Uses of National Income Statistics .................................................................................. 140
3.7 The Limitations of the Uses of National Income Statistics ..................................................... 140
4.0 Conclusion ............................................................................................................................... 141
5.0 Summary ................................................................................................................................ 142
6.0 Tutor-Marked Assignments ..................................................................................................... 143
7.0 References/Further Reading ................................................................................................... 143
133
134 Principles of Economics
1.0 Introduction
The purpose of economic activities is the production of goods and services and a look at a modern economy
will reveal that its output is an endless flow of goods and services. As a result of the cooperation of factors
of production during a particular period, a certain output of goods and services is achieved. It is common that
factors of production are generally paid for their services in money, these payments being variously known as
rent, wages, interest and profit. These four types of payment are income and all incomes are received by
someone.
The important thing in any economy is that the total income of a community or the economy depends on
the total volume of production. If people are to understand the behaviour of the modern economy, there is
then need to measure its performance. There are needs to measure the total output of goods and services and
also the total income received by all the people in the economy. This unit will look at the national income i.e.
the total income of a nation, the measurement of the national income of many nations, the problems encountered
in the measurement of national income as well as the uses of National income statistics.
2.0 Objectives
In this unit, you should be able to:
(i) know the meaning of National Income, Personal Income and Disposable Income,
(ii) arrange for the measurement of National Income.
(iii) recognise the need for regular measurement of National Income;
(iv) recall the factors determining the size of National Income;
(v) classify some difficulties in measuring National Income;
(vi) appreciate why West African Countries have lower National Income figures than developed Countries.
3.0 Meaning of National Income, Personal Income and Disposable Income
(1) National Income
National income means the total compensation of the elements used in production (land, labour, capital
and entrepreneurship) which comes from the current production of goods and services in the economy.
It is the income earned hut not necessarily by all persons in the country in a specific period. It consists
of wages, rents, interest, profits and the net income of the self-employed. In other words, national
income is the market value of all goods and services produced in a country over a specified period of
time usually one year. It is important to note that national income can be classified according to the
industry in which it originates, such as mining, manufacturing and construction.
(2) Personal Income
This is the amount of current income received by persons from all sources, including transfer payments
form government and business. It is the total income the people in an economy usually receive i.e. their
actual receipts from all sources. Personal income also includes the net incomes of unincorporated
business and non-profit institutions and non-monetary income such as the estimate of the value of
homes occupied by their owners. The major monetary components of personal income are labour
income, rental income, proprietors income, dividends, interest and transfer payments.
National Income 135
3. Disposable Income
The disposable income refers to the income that individuals retain after they have deducted personal
income taxes. Disposable income is the concept closets to what is commonly known as take-home pay.
It is the amount which individuals can use either to make personal outlays or to save. It is the amount of
income actually available for the individual in an economy to use in purchasing goods and services for
consumption. Disposal income tends to differ from personal income because of personal income taxes.
These taxes arbitrarily removed a portion of the personal income received by individual and thus leave
a smaller amount for disposal by the income recipients.
3.1. Measurement of National Income
The national income of any country can be measured in three different ways; the output method or G.N.P.
approach, the income method and expenditure method.
1. The Output Method or GNP Approach
In the output method or G.N.P. approach, the national income is arrived at by adding together the
market value of all the output of goods and services in a country and net income form abroad less
capital consumption allowance. In this method, the Gross Domestic Product (GDP) is first arrived, at
then the Gross National Product (GNP) and finally the national income.
The Gross Domestic Product (GDP) is the total value of all the goods and service produced in any
economy of country in a particular year. The Gross National Product (GNP) on the other hand is the
gross domestic product plus net income from abroad i.e. the value of exports less the value of imports.
When the capital consumption allowance is taken away from gross national products, what is left is the
national income. An illustration of this with some figures will help to make the explanation clearer.
3.1(a) Table 12.1: Gross National Product of a Hypothetical Country
1997
N
Product or Service
Goods and Services produced by:
Agriculture, forestry and fishing
Million
95,000
Manufacturing 45,000
Building and construction 30,000
Mining 20,000
Insurance, banking and finance 15,000
Other services 20,000
Gross domestic product 225,000
Net income from abroad 8,000
Gross national product 233,000
Less capital consumption allowance 10,000
National income 223,000
The table above shows that the national income for our hypothetical country is N223,000 million. It has to
be stated that in output method or GNP approach, there is every likelihood of double counting or repeating the
value of some items and therefore arriving at a wrong figure of national income.
In other to avoid double counting in the output method approach, the value of the finished product or the
136 Principles of Economics
value added is used for example.
3.1 (b) Table 12.2 Illustration to avoid double counting
Producers Cost of raw
Materials
Sales
Value
Valued
Added
Wool farmer 0 100 100
Wool comber 100 150 50
Wool spinner 150 210 60
Wool weaver 210 280 70
Wool traitor 280 340 60
Total 740 1080 340
In figure 12.2 above the figure that should be used for the purpose of the calculation of the national income is
the value of the final product which is N340 or the total value added, which is also 340. If all the sales values
are taken, it will mean double counting and the amount will be 1,080 which is wrong.
2. The Income Method
This is the method of calculating the national income by calculating the incomes of the four factors of
production. In the method, the total income earned by business organisations and individuals during a
period of one year are added up. The addition got is known as the national income at “factor cost”, the
total cost attributed to all factors of production employed. In other words, national income at “factor
cost” include the total of all wages, salaries, rents, dividends and interests received. It also includes
income in kind. The income of entrepreneurs and profits of companies before deduction of taxes. This
then means that adjustment has to be made.
ADJUSTMENT: In practice income figures are obtained from income tax figures. Therefore, an
adjustments to be made.
a . Transfer Income
Sometimes an income is received without any corresponding contribution to the output of goods and
services e.g. unemployment insurance benefits, retirement pensions, students grants included in the
national income figures should not be there because they do not add to the output of goods and services.
They only represent a redistribution of income within a nation. It has to be noted that the usefulness of
this method is limited in West African by the existence of tax evasion and the refusal of many individuals
and firms to make correct returns of their income.
3. The Expenditure Method
The third method of obtaining the national income is through the expenditure method. This is the calculation
of expenditure incurred by individuals and the public. In other words, this method measures the
total amount spend on consumer goods and services and net addition to capital and goods and stocks in
the course of the year which can be referred to as savings.
National Income 137
It is important to note that in theory, any of these methods used will give the same result. The reason is
that the expenditure on goods and services must equal the sales value of those goods and services. This
in turn must be equal to the amount of money paid by firms as wages, salaries, interests, dividends, rent
and undistribution profit. But in practice, measurement problem can result to differences in the figure
obtained from the three methods.
3.2 The Need for Regular Measurement of National Income
The fact that the measurement of national income is not a simple exercise makes some people ask why
nation should embark on such painstaking exercise. Nevertheless, there are many good reasons why the
national income of every country should be measured yearly. Some of the reasons include:
(1) The Volume of Production Determines a Nation’s Economic Well-being
The fact that the volume of production determines the economic well being of any nation makes it more
than necessary for any country to measure its national income. National income is a good indicator of
economic progress as well as good measure for a standard or living of people in a country.
(2) National Income is an Important Instrument of Economic Planning
A country needs to know the trend of business activity in the economy so as to make adjustments in its
planning. There is need to know the proportion of national agriculture, industry, mining, services, etc.
The knowledge of this will help to determine where greater efforts should be directed. This is based on
the fact that one year’s achievements will form the basis of plans for the following year.
(3) National Income helps to determine the Economic Strength of different Nations
Measurement of national income is very important because that helps to determine the economic strength
of different countries, and this again will help to find out the countries that may need economic assistance.
(4) National Income is Necessary to Determine Different Countries Contributions to International
Institution
The measurement of national income is very vital for equitable assessment of different nations. Contributions
to international institutions such as the United Nations Organisation, Organisation for African
Unity and Economic Organisation for West Africa States.
3.3 Factors Determining the Size of National Income
Some countries have larger national income than others. There are a number of factors that influence the
size of national income of any country. These factors are:
(1) The Stock of Factors of Production
One of the factors that influence the size of a country’s national income is the quality and quantity of the
factors of production. Land for an example may be fertile or infertile and this will greatly affect the
productivity and national income. The quality of labour will depend on education and training which will
equally affect the productivity. Equally the extent of a country’s stock of modern forms of capital
determines the total volume of production.
(2) The State of Technology
The second important factor in determining the size of a country’ national income is the state of tech138
Principles of Economics
nology. The national income of any country increases as the country’s state of technology improves.
For example, the national income of Great Britain increased tremendously after the Industrial Revolution
of the 18th century as a result of the introduction of new method of production both in industry and
in agriculture. Also the national income of some West African countries increased recently as a result
of the introduction of modern technology.
(3) Political Stability of Instability
Political stability is very essential if highest level of production is to be maintained. Political instability on
the other hand has been a great hindrance to the output and development of many countries of the
world, especially the countries of West Africa and South America who suffered setbacks in their
economic progress as a result of political instability.
(4) Natural Endowment
The gift of the nature is one of the things that make some countries to have greater national income than
others. For an example, Kuwait which is one of the smallest countries of the world has greater national
income than the majority of the countries of the world. This is as a result of huge, deposits of crude oil
in the country which is not the handiwork of any human being. Countries with huge deposits of important
mineral resources have far greater national income than other countries not having any of such
mineral resources.
(5) Willingness and Development to Duty
The willingness and devotion to duty of the people in a country will in no small way increase the national
income of that country. When people are willing to work and devote their entire energy in the production,
productivity will be increased and this will subsequently increase the size of national income. In the
past, the Nigerians looked at the civil service work as ‘Oyinbo’ work and as a result, productivity was
very low.
3.4 Some Difficulties in Measuring National Income
Certain difficulties are encountered in measuring the national income. These difficulties are of different
nature and they include:
(i) Information is not Always Available
While some agencies provide some figures and information needed for the calculation of national income,
others not available have to be estimated. Some people do refuse to give any information about
their income by refusing to fill the income tax form. Under such a situation, there is nothing to be done
than to base everything on some estimate. More estimate will never give an accurate measurement of
national income.
(ii) The Problem of Double Counting
This particular problem arises when the price of raw material is counted and at the same time the cost
of production and finished goods are included in the calculation. Care must be taken to avoid such
double counting so as to arrive at an accurate figure. In this case, only the price of the final product
should be taken, or the sum of the values added during the process of production.
(iii) Unpaid Services
In the process of the production of goods and services some services are not paid for. In measuring
national income, therefore, only those goods and services for which payment is made are taken into
National Income 139
account. Services which people for themselves; friends and neighbours are not included. This means
that where there is greater division of labour, national income will be greater even when there is no
increase in the actual out-put.
(iv) Foreign Payments
Income usually comes from abroad in the form of dividends, interest on foreign government stock and
payment from export and income also goes out to foreign countries in the same way. The different
between the foreign receipts and payments made to foreign countries which is called net income from
abroad must be added in other to get the national income. When this is ignored, wrong figure will be
arrived at.
(v) Changes in the Value of Money
The value of money is not steady and as a result of this, comparison between national income of one
year and another is difficult to make. If the prices of goods and services go up by 5%, the national
income will increase by the same percentage even if the same amount of goods and services produced
in the previous year is produced in the current year.
(vi) Depreciation
Depreciation means the reduction in the value of an asset through wear and tear. An allowance has to
be made for this in the calculation of national income. The main problem here is that sometimes, it is not
easy to calculate the exact amount of depreciation of some equipment and other assets due to the fact
that the rate of wear and tear is not the same throughout the life span of the asset.
(vii) Payment in Kind
There are some people who are paid in kind for their services. The value of such payments cannot be
calculated easily. Again in some places, farmers sometimes retain some of their products without
bringing them to the market. Usually no account is taken of such goods and this normally leads to
incorrect accounting of national income. The value of all payments in kind is supposed to be included in
the calculation of national income.
3.5 Why West African Countries have Lower National Income Figures than
Developed Countries
The national income figures of West African countries are very small when compared with those of the
developed countries of Western Europe and the United States of America. There are some reasons behind
this situation and then include the following:
(i) The Stage of Economic Development
The state of economic development is very important in determining the size of national income. The
countries of Western Europe and the United States are more developed and highly industrialised and
therefore, have more national income than the countries of West Africa.
(ii) Shortage of Capital Goods and Funds
The relative shortage of capital goods and funds in West African compared with the highly developed
countries accounts for lower than national income in West Africa. Capital is an important factor of
production which can raise both productivity and national income in any country.
(iii) Limited Exploitation of National Resources in West Africa
Most of natural resources in West Africa as well as other developing countries are not fully exploited as
in United States of America, Japan or Western Europe. As a result of this, some natural resources are
lying idle in some of these countries which if fully exploited could have helped to raise the national
140 Principles of Economics
income figures of such countries.
(iv) Labour in West Africa is not Highly Skilled
While many countries of West African have abundant supply of unskilled labour, some lack skilled
labour. This situation leads to lower national income because skilled and well-trained man-power enjoys
higher pay than unskilled man-power. But with the establishment of many secondary schools and institutions
of higher learning, reasonable proportion of West African labour force is now skilled.
(v) Political Instability in West Africa
Political instability which characterised West Africa for many years now does not create healthy climate
for foreign investments which are essential for increase in productive capacity and national income.
The fear of nationalisation of foreign owned businesses discourages foreign investors in West
Africa.
3.6 The Uses of National Income Statistics
The use of national income statistic are not unique for any particular type of economy or any region. They are
relevant to all countries both developed and undeveloped. Some of the uses of national income statistics are
as follows
(i) National Income Statistics are used for estimating per capital income of a country. They give us a
summary of appropriate changes overtime in the per capital income and overcall standard of living.
(ii) The national income statistics can give the structure of production at a glance, i.e. the items that make
up the national income are clearly shown. This will help to know the combination of each sector in the
economy to the national income of the country in question.
(iii) National income statistics are useful in the formulation of fiscal policy. The figure of the previous year
are compared with the current year and on the basis of this, a forecast on the state of the national
economy is made for the coming year.
(iv) The national income figures present the best method used in measuring economic growth. They show
the progress made in each sector of the economy by giving the clear picture of the anticipated and
realised rate of economic growth.
(v) The national income figures can be used in comparing the living standard in one country with that of
another, especially when the countries are in the same level of economic development.
(vi) National income figures can influence the decision of foreign investor, e.g. an investor may like to
establish an industry where there is high per capital income as that will induce greater demand for the
product of the industry.
3.7 The Limitations of the Uses of National Income Statistics
(i) For the domestic and international comparison, it is necessary to bear in mind that the standard of living
is not merely measured by the amount of material goods available in the economy or even available to
individual. There are other things that contribute to the standard of living of people in a country such as
the health condition of the people; the amount of leisure time for the average worker, political and
religious freedom.
(ii) There are some unnecessary assumption that should not be allowed to exist e.g. if there is a 10%
increase in the GNP of a country, there is always a tendency for people to think that the people’s wellbeing
or standard of living has increased by the same percentage. Economic growth may occur but it
may not lead to economic development of the country.
National Income 141
(iii) Specialisation may lead to higher national income figure when actually there is no increase in the output
of goods and services. Where there is no specialisation, people can do certain works for themselves
and no payment can be made so as to include it in the national income calculation. But with specialisation,
it will be difficult for one to do some other things for himself rather he will empty the services of a
specialist which will necessitate payment and inclusion in the national income figure.
(iv). In developing countries, most of the agricultural products are consumed by the producers and as such
their values are not known because they did not find their way to the market. In such a country, the
national income figure, is seen to be very low where as in actuality is not so. The value of national
income in such a country will be highly higher that what records show by the value of the amount of
goods consumed by the producers.
(v) When comparing the changes in the standards of living, the average income per head. i.e. per capital
income, may be a more valuable indicator than total national income. This is because the national
income figure may rise but the population may rise more in the percentage, increase in population may
be greater, making the per capital income to be lower and consequently the standard of living of people.
(vi) Finally, the basis of the statistics may vary from country to country. The proportion of goods and
services not reaching the market is likely to be much greater in a developing country than in a developed
country and again the transport expenditure in a place where there are no mass transit services will
definitely be higher than in a country where there is highly developed mass transit facilities. These
differences will make the use of national income figure for international comparison of the standard of
living useless.
Students Assessment Exercise (SAE)
Q1. Explain what you understand by the term national income.
Q2. Distinguish between the gross domestic product and gross national product.
Q3. Explain three major methods of measuring the national income of a country.
Q4. Discuss in details the factors that determine the size of a country’s national income.
Q5. Why is the national income figures of West African Countries far smaller than those of the developed
countries of Western and the United States?
Q6. Discuss the uses of national income statistics. What are the limitations of the uses of national income
statistics?
Q7. Explain the reasons for measuring the growth trends in national income
Q8. Comment on this statement and discuss the view that the natural income does not provide the best
single measure of a nation’s economic progress.
4.0 Conclusion
In the previous units, we learnt that the purpose of economic activity is the production of good and services
and the output of a modern economy is an endless flow of such utilities. As the creation of both goods and
services is counted as production by the economist then no distribution is made between the work of a farm
labourer, a skilled physician a shop girl or a lorry driver. Thus a manufactured commodity is “produced’ in the
economic sense at every stage of its journey from its basic ingredients to its sale across the counter. Potatoes,
wheat, fish, coal, natural gas, pig, iron sheet, steel, motor cars, tractors, roads, medical services and a
million other items as well as a host of services are produced in Nigeria in any year. It would be possible with
a great deal of effort to draw up an inventory of the goods and services produced in one actual year, but such
a list would be of little economic significant as it would be so complex that comparison with earlier years or
142 Principles of Economics
other economic would be impossible. If all the good and services produced in a given year were reduced to
their monetary value that they could be added to give the value of total output for that year, this is called the
gross national product (GNP). This concept is one of the most important economic indicators and is frequently
mentioned in parliament and the press. Its correct economic definition is the aggregate value of the
goods and services produced during the year by the factors of production within the economy plus the net
income from abroad. The GNP is more popularly known as the national income and it is occasionally called
the national expenditure.
Therefore, the national income of a country is the record of all economic activities during the course of a
year. In more specific terms, it is the market value of all goods and services produced in any economy during
a particular year.
There are three ways of measuring the national income. These are
(a) the product approach
(b) the income approach
(c) the expenditure approach
The expenditure have three approaches, they should normally give the same figure for national income;
There are a number of difficulties encountered in an attempt to measure the national income of a country.
Some of the problems are conceptual while other are practical resulting from the under developed nature
of the economy.
- The first problem is to decide on what to include in the calculation and what to exclude.
- A second difficulty with national income measurement rendered by consumer durable goods.
- Thirdly, there are some activities which produce goods and services and generate incomes but which
are excluded in national income calculation because they are illegal. Good examples are armed robbery
activities, gambling and prostitution.
- Fourthly, often inadequate information leads to errors in national income calculation.
- Fifthly, the way depreciation is treated constitutes another difficulty.
- Perhaps, the real difficulty in national income calculation is in the danger of double counting.
- In the seventh place, there is the problem of owner-occupied houses, an accurate data collection is a
difficult track, some production systems are subsistence, technical expertise for collecting, national
income data is lacking and this makes the publication fit an irregular affair and finally a significant
proportion of the Nigerian population are self-employed and they include traders and market women
who are illiterates. These people do not usually keep accounts of their businesses and this makes it
difficult to calculate their incomes.
The figures obtained from national income computations have a number of uses. The per capital income is
sometimes used in comparing the standard of living of countries. The national income show the contribution
made by various economy. National income estimates also enables economic plans to compare the performance
of the economy over the years. It is used in deciding how much revenue should go to particular states
or regions, and also enables a country to contribute to international organisations like United Nations, IMFS,
etc.
5.0 Summary
In this unit, we have succeeded in looking at the national income, i.e. the total income of a nation, the
measurement of the national income of many nation, the problems encountered in the measurement of
national income as well as the uses of national income statistics.
National Income 143
6.0 Tutor-Marked Assignments
What is the gross national product?
What are the main difficulties associated with its measurement?
7.0 References/Further Reading
- Hanson, J.L. A textbook of Economics. London: Macdonald and Evans, 1968.
- Harvey, I. Intermediate Economics. London: Macmillan, 1969.
- Beckerman, W. Introduction to National Income Analysis. London: Heinemann, 1970.
- Marshall, B.V. Comprehensive Economics. Harlow: Longman 1967.
- Admas, S. The Wealth of Nations. Penguin: 1970.
Unit 18: Economic Growth and Development
Contents Page
1.0 Introduction ............................................................................................................................. 145
2.0 Objectives ............................................................................................................................... 145
3.0 Contents ................................................................................................................................. 145
3.1 Economics Growth and Development (Conceptual Clarification) ........................................... 145
3.2 Factors that Inhibit Rapid Economic Development in Developing Countries .......................... 146
3.3 Privatisation of Public Enterprises ........................................................................................... 147
3.4 The Merits or Advantages of Privatisation ............................................................................. 147
3.5 Problems of Privatisation ........................................................................................................ 148
3.6 Sources of Government Revenue ........................................................................................... 149
3.7 The Relative Importance of the Source of Government Revenue .......................................... 151
4.0 Conclusion ............................................................................................................................... 152
5.0 Summary ................................................................................................................................ 153
6.0 Tutor-Marked Assignment ...................................................................................................... 153
7.0 References/Further Reading ................................................................................................... 153
144
Economic Growth and Development 145
1.0 Introduction
In recent time, the idea of economic development occupied the minds of the authorities in governments,
especially in the developing countries of the world. But no meaningful development can be properly achieved
without a good development plan. It is a common belief by economists that it is only through proper allocation
of resources that the developing countries can accelerate their pace of economic development.
In view, of this, emphasis must therefore be laid on the right priorities, and planning is essential in order to
obtain aid from developed countries, loan from the World Bank and other development agencies. It is quite
clear that a government without any development plan may not be considered for aid and loan by some
international organisations.
The approach to development differs from country to country. While some countries feel that development
can be easily and better achieved through industrialisation, others think that rapid development can only
be achieved through agriculture. Again, the role of the government in the economy is still a controversial
issue. There is no consensus of opinion among economists as to the extent to which governments should be
involved in the economy. But there is no doubt that there will be an agreement on that issue in the future.
2.0 Objectives
At the end of this unit, you should be able to:
(i) distinguish between Economic development and growth.
(ii) specify the factors that inhibit rapid economic development in developing countries.
(iii) define privatisation of public enterprises.
(iv) know the merits or advantages of privatisation.
(v) recognise the problems associated with Privatisation.
(vi) identify the sources of Government revenue.
(v) appreciate the relative importance of the various sources of Government Revenue.
3.0 Contents
3.1 Economics Growth and Development (Conceptual Clarification)
Economic development is not quite the same things as economic growth. It is, therefore, necessary to make
a clear distinction here.
Economic growth means a rise in average per capital income made possible by continuing increase in per
capital productivity (Hagen 1975). It also means a continuing increase on an annual basis in the production of
goods and services which will help to raise the living standard of the people of the country as a whole. The
growth rate is usually expressed in percentage and it shows the percentage by which a nation’s production
increases per year. Substantial growth can only be achieved through planning.
Economic development on the other hand refers to the changes in economic and social structure that
always accompany economic growth. The changes in economic and social structure can be in form of better
health services, better housing condition and improvement in sanitation. It is necessary to note that the United
Nations International Development Strategy for the 70s stated that the ultimate objective of development
must be to bring about sustained improvement in the well-being of individual and bestow benefit to all.
It has to be emphasised that planning is very important for economic growth and development of any
country. The objectives of the planning have to be clearly known and stated.
146 Principles of Economics
3.2 Factors that Inhibit Rapid Economic Development in Developing Countries
Rapid economic development in developing countries is faced with a number of obstacles. These include the
following:
(1) Inadequacy of Infrastructural Facilities
In order to attain a rapid development, a developing country needs a stock of public capital goods
usually called the infrastructure of an economy. Inadequacy of infrastructure facilities reduces the pace
of development and since this is the case of developing countries, the rate of development is usually
slow.
(2) Low Accumulation of Capital
One problem that all under-developed countries have in common is relatively low stock of capital. The
inadequacy of capital within the country or from outside makes acceleration in the tempo of development
very difficult.
(3) Political Instability
Political instability is another important factor inhibiting rapid economic development in many developing
countries, especially in West Africa. Some countries of West Africa changes government as people
change dresses. This does not only prevent foreign investors from investing in such countries but also
upsets the fulfillment of development programme.
(4) Persistent Deficit in the Balance of Payment
The continuous deficit in the balance of payment for most developing countries makes it difficult for
them to achieve economic development. The money which could have been used in acquiring materials
to promote rapid economic development is used to offset the balance of payment deficit.
(5) Population Problems
Public health revolution in many developing countries has made possible a fall in death rate and consequently
rapid population growth as the birth rate is still high. As a result of high population, more of the
available resources which could be used for capital formation necessary for development are used for
the production of consumer goods for the growing population.
(6) Unfavorable Cultural and Social Attitudes
Cultural and social attitudes play an important role in motivating people to do certain kinds of work and
accept certain working condition. It also affects attitudes to work and land tenure system in many West
African countries. An example of this can be found in most countries where women are not allowed to
work outside their homes and this will definitely reduce total production and consequently national
income.
(7) Lack of Entrepreneurs with Innovative Ideas
There are not sufficient entrepreneurs with innovative ideas in most developing countries. For rapid
economic development to take place, there should be enough entrepreneurs with innovative ideas as
well as high level man-power or skilled personnel.
Economic Growth and Development 147
(8) Dependence on One or Few Export Crops
Some countries depend on one or few export crops. This makes it difficult for such countries to earn
foreign exchange which is needed to buy equipment required in the development project. Again, if there
is a decline in demand for such product, the country concerned will suffer. This happened to Nigeria
with the oil glut of late 70s and early 80s.
Students Assessment Exercise
(i) What are some of the common characteristics of less developed countries? Can you think of others not
mentioned in this units
(ii) Briefly describe the definition of the meaning of Economic Development not mentioned in this unit
(iii) Why is a strictly economic definition of development inadequate?
3.3 Privatisation of Public Enterprises
Privatisation of the public enterprises is one of the features of Nigerian economy in the 1980’s and 1990’s.
One feature of public enterprises in the world over, but more particularly in developing countries is inefficiency
leading to waste, slow growth and unnecessary dependence on government support, even when the
business is a profitable one.
As a way of improving performance of public enterprise, countries the world over have embarked on
commercialisation of public enterprises and they have profit orientation as the main motive of these enterprises,
As one of the features under commercialisation, government retains ownership and control but subventions
do not continue and the institution is allowed to pursue their objectives in their own style, having
profit as their main target.
Privatisation which many people advocate for is a little different from commercialisation. Privatisation is a
complete take over of public enterprises by individuals or private sector by buying them and having the
ownership and control power in such companies. Privatisation, however, can imply commercialisation because
once an industry or enterprise is sold to the members of the public i.e. private individuals, the social
objectives will have to give way to profit motive.
3.4 The Merits or Advantages of Privatisation
Privatisation has numerous advantage over government ownership, and management of such enterprises.
The advantages include:
(i) Efficiency
Experience has shown that improved efficiency and effectiveness of enterprises emerge as a result of
privatisation. It has been mentioned earlier that profit is the main motive of the private sector and in
order to achieve this profit objective, the management of these enterprises must ensure efficiency.
(ii) Management Capability
There is improved management capabilities as the private sector is believed to have better management
capability that the public sector. Again, board of director membership will be appointed on the basis of
competence and not on political patronage.
148 Principles of Economics
(iii) Reduction on Subvention
Reduced dependence on the government and therefore, reduction in public expenditure is one of the
outcome of good management resulting from privatisation.
(iv) Reduction in Waste
The private sector is noted for employing resources only whey they are needed. This will, therefore,
prevent waste from occurring. Also over staffing will be avoided.
(v) Quick and Efficient Decision
Bureaucracy is one of the characteristic of civil service and public enterprise. This is not so in the
private sector where decision making is quick and efficient.
(vi) Profit Retention
It is clear that profits generated by public enterprises are usually transferred to the government. But
with privatisation, most of these profits are retained in the organisation for development.
(vii) Management Stability / Continuity
The board of public corporation usually changes any time. There is change of government and this leads
to management instability and absence of long-term corporate planning. This situation, will change
immediately the enterprise is privatised and board stability will prevail.
(viii) Attention of Government to its Real Objective
Privatisation will no doubt enable government focus more on its role as sustainer of peace and orderliness
and its supervisory roles in the economy.
(ix) Cash Flow Effect
It is believed that the sale of such enterprises to the private sector will have positive cash flow effect for
the government since the money so realised could be reinvested on other socially desirable ventures like
road maintenance, electricity and water.
(x) Flexibility
While the public sector is guided by rigidity, bureaucracy and general order which hinders flexibility, the
private sector is always flexible and makes changes as the condition requires.
3.5 Problems of Privatisation
The advantages of privatisation have already been made clear in the previous discussion. This does not mean
that privatisation is not with some problems. Privatisation of public enterprises may have the following problems.
Economic Growth and Development 149
(i) Unemployment
With privitsation, such enterprises would naturally trim down their staff and use small number of staff
more intensively. This will no doubt lead to unemployment and we are very much aware of the social
effect of unemployment.
(ii) Price Effect
It is quite clear that prices of services provided by such privatised enterprise will rise and this will have
substantial real income effect. Some essential items like electricity, telephone and postal services may
subsequently be outside the reach of the low income earners. NEPA is a typical example today.
(iii) Problem of Share Valuation
The actual, prices of which the shares are to be transferred may cause a lot of problems. Again, there
are fears that the share may be deliberately under-valued to favour the elitist group who will be in
position to buy them, this indirectly transferring national wealth to few individuals through under-pricing.
On the other hand, there are fears that government may over-value the shares to earn more revenues.
(iv) Problem of Fund to Pay for the Shares
Problem may arise as to the possibility of the availability of fund to pay for the shares. Sales of public
enterprises may, therefore, place the few rich in monopoly power. It may also be difficult to ensure
equitable distribution to the various income groups, occupational groups and the share may be undersubscribed
for, especially if large number of enterprises are involved.
(v) Externality
In a situation of privatisation, it may be difficult to control externalities. Externalities here refers to
spillovers or neighborhood effects. This also refers to the discrepancies between private and social
costs or private and social benefits. The key aspect of externalities is interdependence without compensation.
Here some individuals or firms benefit without paying anything or they cause others to have
higher costs without compensation.
Loss of Control
The control of public enterprises is usually achieved through the appointment of the board members. Under
privatisation, the control of these enterprises may be difficult as laws will have to be introduced and there will
be problems and cost of enforcing compliance.
3.6 Sources of Government Revenue
Revenue refers to money which comes in from any source. It is income which comes to individuals, group,
firms and government on the annual basis. This chapter will look at the sources of revenue to the government.
The sources of revenue to any government must be a great concern to such a government whether it
is federal, state or local government because without adequate revenue, no government can carry out its
programme successfully. In the light of this, efforts should be made by the government or its agency to
ensure that the expected revenue in the annual budget is realised for utilisation in the fiscal year.
150 Principles of Economics
The government derives its income or revenue from a number of sources. The main sources of revenue to
the government, especially in Nigeria include the following:
(i) Taxation
Taxation is one of the major sources of revenue to the Federal Government of Nigeria.
(a) Direct Taxes: The direct taxes comprise personal income tax, corporate or company profit tax,
capital gain tax, death or inheritance tax, and pool tax. Actually, these are taxes that are levied on
specific individuals or institutions and the burden of the tax falls on the individuals or institution
concerned. In the 1970s and 1980s, greater proportion of the government revenue came for direct
taxes.
(b) Indirect Taxes: Government also gets its revenue from indirect taxes. The indirect taxes include
import duty, export duty, excise duties, purchase or sales tax. These taxes are levied on goods and
services. In other words, they are levied on the activities of individuals and institutions and the
burden of the taxes can be shifted to the final consumer.
(ii) Court Fines
Part of the government revenue comes from court fines throughout the country. For the Federal Government,
this comes from Federal High court, Appeal Courts as well as Supreme Court while the states
get from the magistrate courts, as well as state high courts. This source contributes a little proportion of
the government revenue in this country.
(iii) Fees and Licenses
Other source of the government revenue are fees and licenses. These include vehicle license fees,
liquor license fees, postage charges, etc.
(iv) Royalties from Mining Sector
The major source of revenue to the Federal Government of Nigeria at this present time is royalties from
the mining sector. The declining of the agricultural sector of our economy and the importance of mineral
resources in Nigerian economy have made the mining sector to be the major source of revenue to the
Federal government. Mining sector contributes up to 70% of total revenue of Nigeria today.
(v) Borrowing
The government gets part of its revenue from borrowing. This involves domestic and foreign loans by
the government. Loans may be taken from individuals and institutions within the country by sale of
government security by the central bank. Equally, loans can be raised from foreign government and
from world financial institution like the World Bank and the International Monetary Fund (IMF). Nigeria
has got a number of loans from African Development Bank (ADB). It has to be borne in mind that
international loan always posses a great problem to any nation because of its conditionalities.
(vi) Grants, Aids and Gifts
The government also gets its revenue from grants, aids and gifts from private and public spirited individuals
and institutions within the country as well as friends and government agencies of foreign countries.
However, these sources cannot be relied upon as a source of revenue as they are limited.
Economic Growth and Development 151
(vii) Profit made by Government Corporations and Commodity Boards
Revenue also comes to the government from profit made by government corporation and the Commodity
Board. Commodity Boards have replaced the former Marketing Boards in this country.
3.7 The Relative Importance of the Source of Government Revenue
In the earlier section, the major sources of government revenue were discussed.
This section look at the relative importance of each source of revenue to the government.
(i) Indirect Taxes: Taking Indirect Taxes as one of the sources of government revenue, we see that in most
countries of West Africa, Indirect Taxes for a long time have been the major source of government
revenue. The reason for this is not far fetched. The heavy dependence on international trade has led to
the importance of indirect taxes as a source of revenue to the government, especially in the 1960s and
1970s. During this period, a lot of revenue came from import duties and export duties. As the economy
of this country was not very developed then, most manufactured goods were imported from abroad.
Secondly, the country depended largely on the exportation of primary products and export duties have
to be imposed on the exports of these primary products.
(ii) Direct Taxes: Direct Taxes only made much impact in the revenue of the country recently. With rapid
economic growth and development in the last two decades, many industries were established which
provided good jobs for people thereby making the number of people in wage employment to increase
significantly. Equally the number of taxable companies in the country increased tremendously as well as
mining companies. It is likely that direct taxes will continue to be a major source of revenue to the
government in many years to come. The relative importance of direct taxes as a source of revenue in
this country in future will depend on whether this country will actually embark on greater industrialisation
or not. With greater industrialisation, people’s income will increase and their tax will, as well,
increase. More companies will also spring up thereby increasing the revenue from corporate profit tax.
(iii) Borrowing as an important source of revenue to government may not be seen as an ideal source of
revenue. Much money is sometimes borrowed from other countries and world financial institutions, but
most countries try to avoid borrowing except when the conditionalities are bearable.
(iv) The importance of profit made by government corporations and commodity boards as source of revenue
depends on the recent rate of privatisation exercise in this country. If more government owned
companies are privatilised and passed over to private individuals, less will be left for the government
and much revenue will no longer be realised from such companies. Again with much attention given to
agriculture as before the era of crude oil domination, there may be hope that much revenue will accrue
to the government from that source.
(v) Other sources like grants licenses and fees are not all that important because the amount of revenue
derived from them are relatively small. No country can, therefore rely on these sources in order to
carry out any meaningful project in the economy.
Students Assessment Exercise
Q1 What do you understand Economic Development and Economic growth to mean?
Q2 Why is an understanding of the meaning of development crucial to policy formulation in third World
nation?
Do you think it is possible for a nation to agree on a rough definition of development and orient its
strategies for achieving these objectives accordingly?
What might be some of the road blocks or constraints in realising these developmental objectives?
152 Principles of Economics
Q3 What is the difference between commercialisation and privatisation.
Q4 Discuss the merits or advantages of privatisation
Q5 Explain the possible problems of privatisation in economy.
4.0 Conclusion
Every nation strives after development, it is an objective that most people take for granted while economic
progress is an essential component of development. This is because development is not purely an economic
phenomenon ultimately it must encompass more than the material and financial side of peoples lives. Economic
development should therefore be perceived as a multi-dimensional process involving the reorganisation
and reorientation of entire economic and social systems. In addition to improvements in incomes and output,
it typically involves radical changes in institutional social and administrative structures as well as in popular
attitudes and sometimes even customs and beliefs.
Economic development has redefined in terms of the reduction or elimination of poverty inequality and
unemployment within the context of a growing economy. The three core value of development are life
sustenance self-esteem and freedom representing common goals sought by all individuals and societies. They
relate to fundamental human needs which find their expression in almost all societies and cultures at all times.
The major factors in or components of economic growth in any society are:
(1) Capital accumulation including all new investments in land and human resource.
(2) Growth in population, growth in the labour force.
(3) Technological progress. Professor Simon Kuznets has defined a country economic growth as a longterm
rise in capacity to supply increasingly diverse economic goods to its population, this growing
capacity based on advancing technology and the institutional and ideological adjustments that it demands.
All three principal components of this definition are of great importance.
(a) The sustained rise in national output is a manifestation of economic growth and the ability to
provide a wide range of goods is a sign of economic maturity.
(b) Advancing technology provides the basis or pre-conditions for continuous economic growth – a
necessary but not sufficient condition, in order to realise the potential for growth inherent in new
technology however.
(c) Institutional attitudinal and ideological adjustments must be made. Technological innovation without
concomitant social innovation is like a light bulb without electricity, the potential exists but
without the complementary input nothing will happen.
In his exhaustive, analysis of modern economic growth, Professor Kuznets has isolated six characteristic
feature of the growth process of almost every contemporary developed nation. They included two aggregate
economic variables.:
(1) high rates of growth of per capital output and population.
(2) high rates of increase in total factor productivity.
- Two structural transformation variables.
(3) high rates of structural transformation of the economy.
(4) high rates of social and ideological transformation.
- Two factors affecting the international spread of growth.
(5) the propensity of economically developed countries to reach out to the rest of the world for markets and
raw materials.
(6) the limited spread of this economic growth to only a third of the world’s population.
Economic Growth and Development 153
5.0 Summary
In this unit, we have successfully attempted to identify certain common characteristics and economic features
of developing countries. These are classified as the factors that inhibit rapid economic development in
developing countries. We can classify these common characteristics into six broad categories as –
- low levels of living.
- low levels of productivity.
- high rate of population growth and dependency burdens.
High and rising levels of unemployment and under development.
- Significant dependence on agricultural production and primary product exports.
- Dominance / dependence in international relations.
- Economic and social forces both internal and external are responsible for the poverty inequality and low
productivity that characterise most developing nations. The successful pursuit of economic and social
development will, therefore, require not only the formulation of appropriate strategies within the third
world but also a modification of the present international economic by system to make it more responsive
to the needs of developing nations.
6.0 Tutor-Marked Assignment
Q Discuss fully the factors that inhibit rapid Economic Development in Developing Countries.
7.0 References / Further Reading
- Lester, et al. “Partners in Developing” Report of the commission on International Development, Praeget
paperbacks. New York: (1969) Annex I pp 231-353.
- Raffaeler, J.A. The Economic Development of Nations. New York: Random House, 1971.
- Rostow, W.W. The stages of Economic growth – A Non-Communist Manifests. London: Cambridge
University Press, 1960 pp 1-12.
- Dudley, S. “The meaning of developing”, Eleventh World Conference of the Society for International
Development New Delhi, 1969.
- Dennis, G. The Cruel choice: A New Concept in the Theory of Development. New York: Atheneum:
1971.
- Arthur L.W. Is Economic Growth Desirable in the Theory of Economic Growth? Allen and Unwin,
1963.
- Gunnar, M. The Challenge of World Poverty. New York: Pantheon, 1970.
- Cleso, F. Development and Under-Development. USA: University of Califorma Press, 1964.
- Hagen, E. The Economic Development. Mcgrawhill, 1965
- Kuzents, S. Modern Economic Growth: Rate Structure and Spread. Yale University Press, 1966.
- Arthur, L.W. Theory of Economic Growth. London: Allen and Unwin, 1955.
Unit 19: Development Planning
Contents Page
1.0 Introduction ............................................................................................................................. 155
2.0 Objectives ............................................................................................................................... 155
3.0 Meaning of Development Planning ......................................................................................... 155
3.1 Distinction between Budget and Development Plan ............................................................... 157
3.2 Objectives/Usefulness/Advantages of Development Planning ............................................... 157
3.3 Sources of Finance for Development Plans ............................................................................ 160
3.4 Limitations/Problems of Implementation of Development Plans ............................................ 161
3.5 Pre-requisites for Successful Planning in Under-developed Countries ................................... 163
4.0 Conclusion ............................................................................................................................... 164
5.0 Summary ................................................................................................................................ 165
6.0 Tutor-Marked Assignments ..................................................................................................... 165
7.0 References/Further Reading ................................................................................................... 165
154
Development Planning 155
1.0 Introduction
In the four decades since Nigerian Independence in 1960, the pursuit of economic development has been
crystallised by the almost universal acceptance of development planning as the surest and most direct route
to economic progress. Until recently only few would have questioned the advisability or desirability of
formu- lating and implementing a national development plan. Planning has become a way of life in the
government ministries of Nigeria and every five years or so the latest development plan is paraded with
the greatest of fanfare.
But why, until recently, has there been such an aura and mystique about development planning and such
universal faith in its obvious utility? Basically, because centralised national planning was widely believed to
offer the essential and perhaps the only institutional and organisational mechanism for overcoming all obstacles
to development and for ensuring a sustained high rate of economic growth. In some cases, central
economic planning even became regarded as a kind of “Open Sesame” which allows Nigerians to pass
rapidly through the barrier dividing their pitiably low standards of living from the prospect of their former
rulers. But in order to catch up, Nigerians were persuaded and became convinced that they required a
comprehensive national plan. The planning record, unforntunately has not lived up to its advance billing and
sceptism is now growing about the planning mystique.
In this unit, we shall treat the economics of planning, we are not going to deal with any specific country’s
plan as such but occasional reference will be made to the different West African countries. Having grasped
this approach and idea, the reader is placed in a position to make comments on any of the West African
Government’s Economics Plans.
2.0 Objectives
At the end of this unit, you should be able to:
(i) define and specify the meaning of development planning;
(ii) state the distinction between budget and development plan;
(iii) recall the objectives, usefulness and advantages of development plan;
(iv) recognise the sources of finance for development plans;
(v) appreciate the limitations and problems of development plans;
(vi) understand the prerequisites for successful planning in under-developed countries.
3.0 Meaning of Development Planning
Development plan can be defined as a country’s collection of strategies mapped out by the government of the
country to achieve a rapid economic growth and development. It contains broad outlines of line of action
which the government or its agents in the country will follow within the specified period of time to achieve the
goals which the country wants to achieve.
Development or Economic planning may be described as the conscious governmental effort to influence,
direct and in some cases even control changes in the principal economics variables – (Consumption, Investment,
Savings, Exports, Imports, etc.) of a certain country or region over the course of time in order to
achieve a predetermined set of objectives. The essence of economic planning is summed up in these notions
of governmental influence, direction and control.
Similarly, we can describe a development plan as a specific set of quantitative economic targets to be
reached in a given period of time.
In one of its first publications dealing with developing countries in 1951, the limited Nations department of
economic affairs distinguished four types of planning, each of which has been used in one form or another by
156 Principles of Economics
most LDCs.
- First, planning refers only to the making of a programme of public expenditure, existing over from one
to say ten years.
- Second, it refers sometimes to the setting of production targets, whether for private or for public enterprises,
in terms of the input of manpower of capital or of other scarce resources or use in terms of
output.
- Thirdly, the word may be used to describe a statement which sets targets for the economy as a whole,
purporting to allocate all scarce resources among the various branches of the economy.
- And fourthly, the word is sometimes used to describe the means which the government uses to try to
enforce upon private enterprise the target which have been previously determined.
There is no agreement among economists with regard to the meaning of the term development or economic
planning. The term has been used loosely in economic literature. It is often confused with communism,
socialism and economic development. Any type of state intervention in economic affairs has also been
treated as planning. But the state can intervene even without making any plan. What then is planning?
Planning is a technique, a means to an end being the realisation of certain predetermined and well-defined
aims and objectives laid down by a central planning authority. The end may be to achieve economics, social,
political or military objectives (L. Ribbons, 1958).
Professor Lewis (1954) has referred to six different senses in which the term planning is used in economic
literature.
- Firstly, there is an enormous literature in which it refers only to the geographical zoning of factors,
residential buildings, cinemas and the like. Sometimes, this is called town and country planning and
sometimes just planning.
- Secondly, “planning” means only deciding what money the government will spend in future, if it has
money to spend.
- Thirdly, a “planned economy” is one in which each production unit (or firm) uses only the resources of
men, materials and equipment allocated to it by quota and disposes of its product exclusively to persons
or firm indicated to it by central order”.
- Fourthly, “planning” sometimes means any setting of production targets by the government, whether for
private or public enterprise. Most governments practice this type of planning if only sporadically, and if
only for one or two industries or services to which they attach special importance.
- Fifthly, here targets are set for the economy as a whole, purporting to allocate all the country’s labour,
foreign exchange, raw materials and other resources between the various branches of the economy.
- And finally, the word “planning” is sometimes used to describe the means which the government uses
to try to enforce upon private and public enterprises the targets which have been previously determined.
But Ferdyn and Zweing maintains that “Planning” is planning of the economy not within the economy. It is
not a mere planning of towns, public works or separate section of the national economy but of the economy
as a whole. Thus planning does not mean piecemeal planning but overall planning of the economy.
According to Dr. Dalton, “Economic Planning” in the widest sense is the deliberate direction by persons in
charge of large resources of economic activity towards chosen ends.
Lewis Lordwin defined economic planning as “a scheme of economic organisation in which individual and
separate plants, enterprises, and industries are treated as co-ordinate units of one single system for the
purpose of utilising available resources to achieve the maximum satisfaction of the people’s needs within a
given time”.
In the words of Zweig, “Economic planning consists in the extension of the functions of public authorities
Development Planning 157
to organisation and utilisation of economic resources. Planning implies and leads to centralisation of the
national economy”.
One of the most popular definitions is by Dickinson who defines planning as the making of major economic
decisions what and how much is to be produced, how, and when and where it is to be produced, to whom it
is to be allocated, by the conscious decision of a determinate authority, on the basis of comprehensive survey
of the economic system as a whole.
Even though there is no unanimity of opinion on the subject, yet economic planning as understood by the
majority of economists implies deliberate control and direction of the economy by a central authority for the
purpose of achieving definite targets and objectives within a specified period of time.
Students Assessment Exercise (SAE)
(i) What is the nature and purpose of development planning?
3.1 Distinction between Budget and Development Planning
There are important differences between a budget and a development plan. A budget, as already implied in
one of the previous units, is a short-time plan depicting the way and manner government intends to
undertake the expenditure and generate the revenue for a given year.
A development plan on the other hand is a long term programme designed to achieve some permanent
structural changes in an economy. It involves a deliberate attempt by the government to speed up the process
of social and economic development.
- Firstly, while a budget is usually planned for a year, a development plan may cover a period for a year,
a development plan may cover a period ranging from two to twenty-five years.
- Secondly, difference is in terms of coverage. While a budget may not cover the whole system of the
economy and may in fact be designed to correct an inflationary situation, a perceived imbalance in
income distribution or resolve a balance of payments disequilibrium, a development plan on the other
hand covers the entire structure to the economy. It seeks to find permanent solution to the problems of
the economy like changing the structural base from agriculture to industrialisation.
- Thirdly, a budget is concerned with current problems such as debt servicing meeting of pressing social
needs like schools, road maintenance, or the financing of planned capital projects.
A development plan, however, may attempt to change the distribution system from a capitalist oriented
one to a socialist system or vice versa. It may also attempt to shift the ownership and control of the
commanding heights of the economy from foreigners to citizens.
- Finally, a budget relies heavily on internal direct and indirect taxes and the flow of revenue is relatively
more stable.
- A development plan, on the other hand, at least in the context of West African Countries, depends
heavily on foreign exchange earnings and heavy capital inflow from abroad for implementation and
achievement of growth targets.
3.2 Objectives/Usefulness/Advantages of Development Planning
Most of the development plans formulated by West African countries have tended to establish some form of
mixed economy in which the state plays a more significant role. Almost all plans are based on the recognition
that if economic development is left solely to the market forces engendered by private firms seeking profits,
an adequate measure of economic growth will not be attained from any stand point. The stated objectives of
most of the plans can be briefly summarised.
158 Principles of Economics
(i) To create conditions for self-sustained economic growth and development. However, it should be realised
that the basic objective of most plans is not merely to accelerate the rate of economic development
and the rate at which the level of living of the population can be raised. It is also to give West African
Governments and the masses an increasing measure of control over their own destiny.
The objective not only focus on the achievement of growth but also the sustenance of the growth to
ensure steady improvement in the standard of living of the people. This can only be achieved when
selfness and right thinking people are placed is authority.
(ii) To ensure a steady rate of economic growth. It is realised that much can be achieved through steady
growth as compared with intermittent development. In the absence of plans which attempt to allocate
resources in the best way possible, the countries cannot avoid unbalanced growth. There is use or
necessity for the overall balance in the economy.
(iii) To expand and improve the productive machinery of the countries in question, diversification of the
economy is necessary. It is thus realised that the level of living of the people depends very much on the
productivity of the people. It, therefore, become inevitable that a substantial amount of the West African
resources available should be used for increasing productivity rather than for immediate consumption,
measures to mobilise domestic resources both through the government and through private business
must have high priority.
It allows for diversification of economics base. A good development plan will create a proportional
sectoral development because each sector is planned to develop according to a rate that fits it into the
entire development of the economy.
Diversification may lead to the development of many industries which will help to reduce our import
bills. Diversification will not only lead to the production of many products for domestic uses and exports
but will improve the country’s foreign exchange position.
(iv) To organise a proper allocation of resources in order to achieve the objectives of the plans. It is with the
recognition of this objective that greatest emphasis has been placed upon the expansion of agriculture,
both for exports and for domestic use through crop diversification and modernisation of techniques,
emphasis is also laid on a shift of manpower from agriculture to industry, expansion of industrial establishments,
encouragement of more exports of manufactures and processed goods. If all these could be
done, it is hoped that it would lead to a loosening of trade and financial links with ex-colonial masters and
more economic co-operation among African States.
Good development plans will make it possible for resources both human and material to be fully
harnessed and utilised for economic growth and development. Here again proper allocation of scarce
resources is not only necessary for the success of the plan but also for the sustenance of the growth in
the economy.
(v) To increase employment opportunities. With proper allocation of resources to those projects and to
those sectors of the economy which promotes a high rate of growth, it is contended that more employment
opportunities would be provided for the growing population in West African countries. The successful
implementation of various objectives contained in the plan will definitely generate employment
opportunity for greater number of people.
The increase in employment opportunities will only be achieved through proper allocation of resources
to those sectors of the economy as well as projects that promise high rate of growth.
(vi) To increase the inflow of capital on terms suitable for sustained economic growth and to mobilise
domestic resources and to effectively utilise external assistance. It is realised that external capital is a
necessity in order to implement the plans.
Development planning is a tool for stimulating foreign and indigenous investment. A good development
plan by setting targets for key sectors of the economy provides opportunities for interested foreign
investors to bring in capital to invest in sector which are attractive to them. This is also true of indigDevelopment
Planning 159
enous investors.
Development plan is a base for seeking foreign loans. A realistic development plan when presented to
foreign international financial organisation, may win tier support and encourage soft loans to implement
some of the projects to be embarked upon in the plan.
(vii) To stimulate the vigorous growth of the private sector, in particular the development of manufacturing
production. Since the private sectors in many West African economics are substantial and the governments
generally recognise this, any plan that fails to co-ordinate the activities of this sector could not
easily achieve its objectives.
(viii) It is argued that development plan allow for cohesion of the various sectors and the development of
linkages for the entire economy. A project is not looked at from its viability alone as an independent
project but rather in terms of how it is dependent on other projects as well as other projects depending
on it. A textile industry can be set up upon the background of a planned cotton industry.
(ix) Development of Infrastructure: The social capital of the developing country need to be fully
developed.
The social capitals include good network or roads, railways, waterways, telecommunications, education
and hospitals to ensure good health facilities. The presence of well-developed infrastructure of the
economy will enhance productivity.
(x) To achieve even distribution of income: It has been noted that in developing countries, there is always
unequitable distribution of income. In Nigerian for example, about five per cent of the population is
owning fifty per cent of the total wealth of the country. With the implementation of the objectives of
development plan, income will be more equitably distributed.
From our foregoing discussion one can say without any fear of contradiction that the basic aim of most of the
development plans of West African governments is to give a sense of direction to the economy, a sense of
priorities and urgency and to enlist the support and co-operation of all sections of the community to work for
a better future. It is aimed to attract popular enthusiasm which is both the lubricating oil of planning and the
petrol of economic development - a dynamic force that almost makes all things possible.
The planning for development is indispensable for removing the poverty of nations. For raising national and
per capita income, for reducing, inequalities in income and wealth, for increasing employment
opportunities, for all round rapid development and for maintaining their newly won national independence,
planning is the only path open to under-developed countries. There is no greater truth than this that the idea
of planning took a practical shape in an under-developed countries of the world.
To sum up in the words of Professor Gadgil, “Planning for economic development is undertaken presumably
because the pace of direction of development taking place in the absence of external intervention is not
considered to be satisfactory and because it is further held that appropriate external intervention will result in
increasing considerably the pace of development and directing it properly. Planners seek to bring about a
nationalisation, and if possible and necessary some reduction of consumption to evolve and adopt a long-term
plan of appropriate investment of capital resources with progressively improved techniques, a programme of
training and education through which the competence of labour to make use of capital resources is increased,
and a better distribution of the national product so as to attain social security and peace. Planning, therefore,
means in a sense, no more than better organisation, consistent and far-seeing organisation and comprehensive
all-sided organisation. Direction, regulations, controls on private activity and increasing the sphere of
public activity, are all parts of organisational effort.
Students Assessment Exercise (SAE)
(i) What are usually the primary objectives of economic development plans formulated in West African
countries?
160 Principles of Economics
3.3 Sources of Finance for Development Plans
Development planning calls for a feasibility study of the plan to see that the projects envisaged are economically
viable and to make sure that the aggregate amount of resources required to carry out the plan does not
exceed the aggregate amount of resources available. This point emphasises that deficit financing and inflation
are to be avoided and this is to check at the sectoral level by making such that the projected rate of
expansion in the output of commodities by a certain critical margin. Furthermore, it is necessary to check the
consistency of the plan, to make sure that demand and supply for particular commodities and services are
equated to each other and that there is an equilibrium relationship between the different parts of the economy.
If the plan is found to be both feasible and consistent, the next stage is how to finance it.
Finance for development plans had been obtained from various sources by West African governments.
Let us look briefly at the financing methods which West African governments use in procuring necessary
funds for implementing development plans.
The key sources of finance for development plan includes both domestic and foreign sources:
(i) Domestic sources includes export proceeds and buoyant funds realised from the sale of export commodities
like cash crops, minerals, crude oil, etc. but as from 1960s there was great dependence on
external sources i.e. export earnings to finance development plans.
(ii) Other sources of domestic finance include:
(a) Fiscal Measures: The governments have introduced various fiscal measures to provide funds for
developmental purposes. They use the well-known method of budget surplus whereby there is an
excess fiscal revenue over expenditure. New tax reforms are also introduced to provide funds for
development e. g. Taxes, especially indirect taxes as tariffs. However, indirect taxes in particular
custom duties provide a lot of funds for governments. It must be realised that the decline in export
proceeds has affected receipts from export duties. In addition, the drive for substitution of imports
by local production, a common feature of all development plans of West Africa tends to reduce
the receipts from import duties.
(b) Revenues from Publicly owned Enterprises: Full cost pricing for the services of public enterprises
and utilities can add very much to the financial resources available for public investments.
This means that the people would have to pay full cost for public services and utilities such as
water, electricity, transport, etc.
In most of the development plans and especially, those of Nigeria, Ghana and Senegal there is
the provision for abolishing most subsidies to public services. This will bring about substantial
saving on government account.
In Nigeria for instance, the Statutory Corporations are expected to participate in the government
capital programme and they are expected to make profits. The business organisations also
contribute from their profits and reserves to the financing of development plans, etc., - Education
Tax Fund.
(c) Internal Borrowing: Government now device various ways to encourage savings. In their plans,
several governments envisaged to obtain substantial amounts to finance public investment by
borrowing from the private sector.
To promote and mobilise effectively personal savings for development, governments expects to
establish a variety of new financial institutions and broaden existing ones. These institutions are
expected to offer the potential investor a variety of inducements to invest his savings in the public
sector, either directly by purchasing government securities or indirectly by saving through such
government institutions such as post office savings bank, insurance companies and pension funds.
The Central Bank of each country are expected to provide investment avenue for institutional
savers – banks, business firms, insurance companies, etc.
Development Planning 161
In most of the West African countries development corporations and development are created
to supply funds to the private sectors for the development of agriculture and small-scale industries,
the development of which are envisaged in the plans.
(d) Deficit financing sometimes includes resorting to the printing of currency notes. However, deficit
financing in the accepted sense of the word can only be practised by countries that have their own
Central Bank.
(e) Domestic Resources of the Private Sector – Accumulated Savings. The domestic resources
required for financing investments in the private sector are to come mainly from private savings of
individuals and business enterprises reinvested profits and other internal and external resources of
foreign and domestic residents.
(f) Share proceeds of government owned enterprises.
Foreign Sources
Since capital formation in very low in most of West African countries, there is need for foreign savings and
foreign capital. We should realise that foreign capital cannot be avoided by developing countries willing to
industrialise even if the governments decided to build and operate all the plant and equipment themselves.
The machinery must come from abroad and even the workers who build the factories and who construct the
necessary infrastructure. Foreign exchange is needed to pay for essential imports for the investment programme,
and the demand for foreign capital rises sharply with increasing investments such as projected in
most of the development plans. West African countries rely heavily on foreign capital to finance their development
plans. Most of these foreign capital comes in different ways.
(a) External Borrowing
(i) Long-term Credits: These consist of loans and grants from developed countries for long duration.
It may be loan for ten or more years. Both the principal and the interest have to be repaid.
Countries such as USA, United Kingdom, West Germany, etc., and other International Organisations
such as the World Bank – IMF, IFC, IDA, BRD, etc., do give such long-term loans.
(ii) Short-term Credits: Most of West African countries make use of this method of financing. These
credits include contractor finance and export credits.
(b) Foreign Aid and Grants from Foreign Government and Organisation: These are in form of gifts,
technical assistance, and official donation to developing countries in order to accelerate their economic
development.
Students Assessment Exercise (SAE)
(i) Analyse critically main sources of finance for National Development plans in West Africa.
(ii) How might the differing kinds of financial institutions created affect the implementation of the Economic
development plans in Nigeria?
3.4 Limitations/Problems of Implementation of Development Plans
Most of the development plans in developing countries were not fully implemented because of some problems
facing the plans. Nigeria in particular and West Africa in general cannot be exceptions. Some of these
problems include:
162 Principles of Economics
(i) Political Instability
Most of the governments in developing countries, especially in Africa and South America are not
stable. Governments in those countries are changed just as people change their dresses. As a result of
this constant change, some of the projects in the plans are dropped and new ones chosen by the new
government. Lack of stability in the government leads to abandonment of already started projects and
picking up others and this causes a wastes of scarce resources.
(ii) Priorities are not well chosen
Some of the projects are chosen on a political grounds and not on economic grounds. As a result of this,
some projects are not profitable and money spent on them are wasted. This occurs more in countries
with heterogeneous population where condiments overrides right judgment. Tribalism is one of the
banes in this country and has just delayed development of the country.
(iii) Shortage of Highly Skilled Manpower
In most of the developing countries of the world there are not enough technicians to carry out some of
the projects drawn on the plans. However, some of the countries presently are no longer lacking technician
in any way. In the case of Nigeria, with the introduction and expansion of secondary schools and
the establishment of many institutions of higher learning, priority is given to the development of human
resources. So skilled manpower is no longer a problem in Nigeria rather the problem is now that of
unemployment.
(iv) Dependence on Foreign Capital
In most of the development plans drawn, especially in very poor countries, greater proportion of the
capital for the implementation of the development plan is expected to come from foreign countries. In
some cases, the capital may not be received and the plan becomes a great failure. Government should,
therefore, not rely completely on foreign capital as the failure to get that paralyse the project.
(v) Lack of Statistical
For a good development plan to be successfully implemented, it has to spend on accurate statistical
data. In developing countries, where development plans are usually drawn, statistical data are not
available and where they are eventually available, they may not be reliable. So it is not wrong to say that
developing countries lack reliable statistics on which plans can be based.
(vi) Lack of Provision for Effective Implementation
In most plans, there is no provision for effective implementation of some of the projects in the plan.
There is always need to include in the plan the strategies for implementation. For example, a project
may have the monitoring team and the project may be divided into stages and expected date or the
completion of each stage clearly stated. This will ensure that the work will be carried out without
unnecessary delay.
Finally, the achievement of development plan objectives requires the efforts and support of all the elements in
the economy without any exception. It is only through this way that the objectives of a development plan can
be realised.
Development Planning 163
Nigeria’s Third National Development Plan, 1975 -1980
It is necessary to discuss one of the national development plans and the one that will require our attention is
the third one. Nigeria’s third National Development plan which lasted from 1975-1980 was estimated to cost
N445 billion. The long-term objectives of this plan are not different from the previous ones. The objectives
aimed at achieving these:
(i) A united, strong and self-reliant nation
(ii) A great and dynamic economy
(iii) A just and egalitarian society
(iv) A land of bright and full opportunities for all the citizens, and
(v) A free and democratic society.
In this third development plan, the economy was divided into four (4) broad sectors.
(i) Economic sector which includes all types of agriculture, mining, manufacturing commerce, transport
and communication.
(ii) The social overhead sector which comprises development and sports.
(iii) Regional development sector which comprises town and country planning.
(iv) Administration comprising defence, general administration, manpower development and utilisation and
plan implementation and control. Of the 45 billion estimate, the private sector accounted for 10 billion
while the public sector provided the rest. It has to be noted that the third National Development plan
was a break-through to modernity. It was infact a real and historic turning point in the history of the
economy. The period also represented a glorious era in the history of Nigeria as great changes in the
economy were witnessed.
Students Assessment Exercise (SAE)
Q1 Explain the role of fiscal policy in developing country.
Q2 Discuss the role of government spending in contractionary fiscal policy.
Q3 What is public finance? How does it differ from private financing.
Q4 List and discuss the instruments of fiscal policy showing how they are applied.
Q5 Discuss the tools of monetary policy in the country.
Q6 What are the similarities and differences between fiscal policy and monetary policy?
Q7 Why is public expenditure continuously increasing in most of the developing countries?
Q8 What are the actual difference between national debt and public debt?
Q9 Discuss any of Nigeria’s National Development plan.
3.5 Pre-requisites for Successful Planning in Under-Developed Countries
There are certain conditions or pre-requisites which must be fulfilled for the successful working of a development
plan in under-developed countries. They are as follows:
(1) Planning Commission
The first pre-requisite for the success of a plan is the setting up of a planning commission.
164 Principles of Economics
(2) Statistical Data
A pre-requisite for sound planning is a thorough survey of the existing and potential resources of a
country with its deficiencies.
(3) Fixation of Targets and Priorities
The next problem is to fix targets and priorities for achieving the objectives laid down in the plan.
Targets must be bold and cover every aspects of the economy. They include quantitative production of
targets.
(4) Maintaining Proper Balance
Successful working of the plan requires the existence of proper balances in the economy to avoid lopsided
development and bottlenecks.
(5) Incorrupt and Efficient Administration
A strong, efficient and incorrupt administration is the sine que non of successful planning.
(6) Proper Development Policy
The state should lay down a proper development policy for the success of a development plan and to
avoid any pitfalls that may arise in the development process.
(7) Economy in Administration
Every effort should be made to effect economics in administration particularly in the expansion of
ministries and some departments.
(8) An Education Base
For a clean and efficient administration, a firm educational base is essential. For planning to be
success- ful, it must take care of the ethical and moral standards of the people.
(9) A Theory of Consumption
An important requirement of modern development planning is that it has a theory of consumption.
Under-developed countries should not follow the consumption pattern of the more developed countries.
(10) Public Corporation
Above all, public corporation is considered to be one of the important levers for the success of the plan
in a democratic country. Planning requires the sustained co-operation of the people.
4.0 Conclusion
Development plan usually involves both private and public sectors of the economy. Any development plan is
supposed to specify or show the investment policy of the country. This means that the volume should be made
clear.
In any development plan, efforts are usually made to specify the key sectors in the country’s economy
which need priority attention so as to make the achievement of the objectives of the plan possible. In some
Development Planning 165
countries, emphasis is laid on speedy industrilisation as a priority for rapid economic growth and
development while in others people feel that rapid economic growth and development can be achieved
through the devel- opment of agriculture. We cannot say that rapid economic growth and development can
be better achieved through industrilisation or through the development of agriculture.
5.0 Summary
In this unit, we have discovered that usually the strategies for economic growth and development are embedded
in a development plan. Therefore, in order to achieve rapid economic growth and development the
developing countries usually draw up development plans.
In this unit, we examined the goals, objectives, financing, problems and limitations of development
planning as practiced in Third World nations, both in its own right and in the broader framework of national
economic policy.
6.0 Tutor-Marked Assignments
(a) What is Development Plan?
(b) What are the objectives of Development Plans in most countries?
(c) What are the problems facing the implementation of National Development plan in most countries?
7.0 References/Further Reading
- Michael, P. Development Planning Models and Methods. Nairobi: Oxford University Press, 1971.
- United Nations Department of Economic Affairs “Measures of the Economics Development of Under
development Countries”, New York: (1951).
- Kilick, T. “The Possibilities of Development Planning, Instituate for Development Studies”, Oxford
Economic Papers, July, 1976.
- Waterston, A. Development Planning: Lessons of Experience. John Hopkins University Press,
1965.
- Derek, T. “Development Policy” New Thinking about an Interpretation, Journal of Economic Literature,
September, 1973.
- Robvins, L. Economic Policy and International Order.
- Lewis, W.A. The Principles of Economic Planning
- Zweig, F. Planning of Free Societies.
- Gadgil, D.R. Planning and Economic Policy in India.
Unit 20: Unemployment
Contents Page
1.0 Introduction ............................................................................................................................. 167
2.0 Objectives ............................................................................................................................... 167
3.0 Problems of Definitions ........................................................................................................... 167
3.1 Causes/Types of Unemployment ............................................................................................ 168
3.2 Unemployment and Inflation – Is there a trade off? ............................................................... 172
3.3 The Effects/Problems of Unemployment ................................................................................ 172
3.4 Policies to Reduce Unemployment ......................................................................................... 172
4.0 Conclusion ............................................................................................................................... 174
5.0 Summary ................................................................................................................................ 174
6.0 Tutor-Marked Assignment ...................................................................................................... 174
7.0 References/Further Reading ................................................................................................... 174
166
Unemployment 167
1.0 Introduction
As we noted in the previous units, the control of unemployment is a key target of macro-economic policy.
Indeed, following the widespread mass unemployment of the inter-war period, the control of unemployment
was at the top of the political agenda in the hey-day of most governments all over the world in the post-war
period. As this time and up until the mid-1970s, 1990s, economists and politicians spoke glibly about full
employment as an objective of macro-economic policy.
In the 1980s, worldwide unemployment rose to levels that were unprecedented since the end of the
Second World War. Not only was the overall level of unemployment wastefully large, the structure of unemployment
was highly varied. Currently, the most serious problem of localised unemployment is the very high
rates among the many unskilled residents of the decaying inner cores of large industrial cities. The effects of
high long-term unemployment are still serious. Disillusioned workers give up trying to succeed within the
system and sow the seeds of social unrest. The existence of two-worlds the affluent employed and the
unemployed - strains the social fabric, and offends many people’s sense of social justice.
Unemployment is a hazard of an industrialised economic system. Primitive communities were usually selfsufficient
and had no unemployment problems, though they had to accept a very low standard of living. The
people shared the work that had to be done, and if any time remained afterwards they enjoyed their leisure.
Industrialisation, with division of labour and specialisation brought about a higher standard of living than
communities had ever previously enjoyed, but it also brought with it the risk of unemployment. In fact, some
unemployment can be attributed directly to industrial progress. That is why, perhaps rather belatedly, it was
the leading industrial nations that were the first to introduce schemes of social security.
There are a number of different causes of unemployment. Clearly, before plans can be formulated for
maintaining full employment, it is necessary to distinguish between these different causes, for only after an
accurate diagnosis has been made can the appropriate remedy be applied.
2.0 Objectives
At the end of this unit, you should be able to:
(i) specify the meaning of unemployment.
(ii) put current levels of unemployment into an appropriate perspective;
(iii) understand that some individuals in the population choose to be economically inactive;
(iv) distinguish between various types of unemployment – Frictional, Structural, demand deficient and classical;
(v) understand the Keynessian view that unemployment results from a deficiency of demand in the economy;
(vi) appreciate the classical view that unemployment is the result of a disequilibrium in the labour market
and a failure of real wages to fall sufficiently to equate the demand for labour with the supply;
(vii) know the effects of unemployment;
(viii) define the policies that can reduce the unemployment;
(ix) established that there is a trade off between inflation and unemployment.
3.0 Problems of Definitions
The causes of these phenemena are of course, the subject of considerable disagreement among economists.
First of all, there are problems of definition which are by no means trivial.
To begin with, unemployment cannot be equated with ‘not working’ since in our society there are many
people who are not working – such as babies and young people, the elderly, house wives and so on. These
168 Principles of Economics
individuals should not be regarded as unemployed. Economists use the term economically inactive to refer to
those people who are neither in employment nor actively seeking work.
The economically inactive will comprise
- those below employment age ( babies, and school-age children);
- those above employment age (65years old for men and 60 for women);
- those who for some other reason are unfit or unable to work (e.g chronically sick and disabled people);
- those in prisons
- those in full time further education or on government training scheme;
- those who for reasons other than those above choose not to enter the labour market (e.g. the very
wealthy or mothers who stay at home to look after children).
In contrast, the economically active part of the population consists of both those who are in employment
plus those who indicate their willingness to work by registering as unemployed. The activity rate also known
as the participation rate refers to that proportion of the population of working age who are economically
active. This can be expressed as
Activity Rate = Total Employed plus registered unemployed
Total population of working age
Students Assessment Exercise
(i) What is meant by the activity rate (or participation rate)?
(ii) Are you economically active or inactive?
3.1 Causes / Types of Unemployment
In analysing the causes of trend in unemployment, it is helpful initially to distinguish different types of unemployment.
This classification of unemployment into different types is also of course, in part an explanation
of why unemployment occurs.
The unemployed can be classified in various ways: by age, sex, occupation, degree of skill and even by
ethnic groups. We may classify by location, e.g. unemployment in the South East, North West, South West,
etc. We may also classify by the duration of unemployment between, say, those who are out of jobs for long
periods of time and those who suffer relatively short-term bouts of unemployment. Finally, we may classify
the unemployment by the reasons for their unemployment.
In the present unit, we concentrate on the reasons for unemployment. Different economists find it convenient
to identify different causes, in what follows we take one common scheme for classifying unemployment
by types:
- Financial Unemployment
- Structural Unemployment
- Real wage or classical Unemployment
- Demand – deficient Unemployment
- Seasonal Unemployment
- Regional Unemployment
- Technological Unemployment
- General Unemployment
Unemployment 169
Frictional Unemployment
Overtime the pattern of consumer demand in the economy will change, both as a result of changes in
incomes and tastes and in response to a changing set of relative prices. The change in the pattern of demand
will in turn lead to a change in the amounts and the types of goods and services produced. This will then lead
to a change in the type of labour required. Moreover, technical improvements will bring about changes in the
way in which goods and services are produced, and this will alter the demand for the various types of labour.
In short, all of these changes will lead to a change in the pattern of the demand for labour.
Frictional unemployment results from this change in the pattern of demand for labour as some workers will
not find that their skills are no longer required. These workers will become unemployed for a period until they
eventually become re-employed either in a similar or in a different occupation. The use of the term “Frictional”
to describe such unemployed suggests that is results from frictions in the Labour Market. If there
were perfect information - so that workers knew that jobs were on offer and employers knew what labour
was available - and if labour were perfectly able and willing to move, there would be little or no unemployed
of this type, since the unemployed workers would be immediately redeployed in a new occupation.
Unemployment that is associated with the normal turnover of Labour is called Frictional unemployment.
People leave jobs for many reasons, and they take time to find new jobs, young persons enter the labour force
but new workers do not often fill the jobs vacated by those who leave. This movement takes time and gives
rise to a pool of persons who are “Frictionally unemployed.” They are moving between jobs. Frictional
unemployed would occur even if the occupational, industrial and regional structure of employment were
unchanging. ‘
Frictional unemployment is therefore defined as the irreducible minimum amount of unemployment caused
by the Labour turnover when new people enter the labour force and look for jobs and existing workers
change jobs.
Structural Unemployment
In contrast to frictional unemployment, which in theory at least is of short duration, structural unemployment
is of a longer-term nature. However, it too results from the dynamic nature of an economy in which the
changing pattern of consumer demand and changes in the way in which goods are produced lead to a decline
in the demand for certain types of labour. For example, in the U.K. from the 1960s onwards there was a
decline in the demand for certain types of labour. For example, in the U.K. from the 1960s onwards there
was a decline in the demand for British built ships and hence a decline in the demand for ship-builders.
Equally noticeable in the last decade has been the decline in the demand for coal miners brought about, first
by labour saving technical progress, which has enabled coal to be minded using more capital-intensive and
hence labour-saving techniques, but more importantly by the decline in the demand for U.K. produced coal,
as power stations have opted to buy cheaper imported coal or switch to gas.
By its very nature, structural unemployment tends to be concentrated in certain geographical areas. For
example, ship-building was concentrated in the north east of England, so this area was severely affected by
the decline in ship-building. This led to a further decline in the region because of regional multiplier effect.
Thus structural unemployment and regional unemployment tend to go hand in hand.
Structural changes in the economy can cause unemployment. As economic growth proceeds, the patterns
of demands and supplies change constantly. Some industries, occupations and regions suffer a decline in the
demand for what they produce while other industries, occupations and regions enjoy an increase in demand.
These changes require considerable economic readjustment. Structural unemployment occurs when the
adjustments are not fast enough. Severe pockets of unemployment then arises in areas, industries and occupations
in which the demand for labour is falling faster than its supply.
Structural unemployment is defined as the unemployment that exists because of a mismatching between
the unemployed and the available jobs in term of any relevant dimension such as regional location or required
skills.
170 Principles of Economics
Structural unemployment occurs because changes in the regional, occupational and the industrial structure
of the demand for labour do not match the changes in the structure of the supply of labour.
Structural unemployment can increase because either the pace of economic change accelerates or the
pace of adjustment to change slows down. National forces and social policies that discourage movement
among regions, industries and/or occupations can raise structural unemployment. Policies that prevent firms
from replacing laour with new machines may protect employment in the short-term. If, however, such policies
lead to the decline of an industry because it cannot compete with more innovative foreign competitors,
they can end up causing severe pockets of structural unemployment.
Demand – Deficient Unemployment
We expect the demand for labour and therefore, the level of unemployment to be correlated with the business
cycle. When the economy is in a recession, the demand for goods and services falls. Consequently, there will
also be a fall in the demand for the laobur that produces those goods and services. Hence unemployment will
rise. Because the level of such unemployment will vary with the business cycle, it is termed cyclical unemployment.
It is also sometimes referred to as demand-deficient or Keynesian unemployment.
One of Keyne’s great contributions was to argue that demand-deficient unemployment could be removed
by bringing about the increase in the level of aggregate demand. For example, the government could bring
about a budget deficit thereby injecting spending power into the economy and raising the overall level of
demand. This increase in the demand for goods and services would bring about an increase in demand for
labour and hence unemployment would fall.
The term demand-deficient unemployment or cyclical unemployment refers to unemployment that occurs
because aggregate desired expenditure is insufficient to purchase all of the output of a fully-employed labour
force. It is the main subject of the national income theory. This theory seeks to explain the unemployment that
is caused by variations in the total demand for the nation’s output.
The feature of a trade depression is a general deficiency of demand. Consumers’ wants may be as great
and extensive as ever but people do not have the means to satisfy them. The result is that nearly all industries
are affected at one and the same time - though not all to the same extent - and there is wide spread mass
unemployment. Unemployment arising from a general deficiency of demand is known as cyclical unemployment
on account of its association with the nineteenth century trade cycle.
Classical Unemployment – Real Wage Unemployment
In the previous units, we described the foreign exchange market as an example of a perfectly competitive
market. In such a market, we argued, price would be determined by relatively scarcity and the market would
be in equilibrium when demand equalled supply. Some economists believe that this same analysis can be
applied to the workings of the labour market.
This view is variously known as the classical view, the neo-classical view and (sometimes) the monetarist
view. It stands in contrast to a Keynesian analysis which suggests that, as a matter of observable fact, the
market for labour does not function in the same way as the textbook model of a perfectly competitive market.
The demand curve for labour will be downward sloping indicating that the higher the wage, the less labour
will be demanded, and the lower the wage, the more labour will be demanded. This is explained by the fact
that labour is a factor of production, which is combined with other factors of production to make goods and
services. The higher the price of labour, the more incentive to economise on its use and to substitute other
factors such as capital.
A real wage that is held above its free market level causes unemployment in that market. Setting wages
above their equilibrium levels in some markets can cause unemployment in those markets.
Unemployment 171
Seasonal Unemployment
Seasonal factors may cause unemployment in some industries. Many building workers are temporarily unemployed
in January and February when weather prevents outside working. The tourist industry employs
most of its labour during the summer holidays and, for a much shorter period, at Christmas. Much of the
labour force is not required for the rest of the year and may be regarded as seasonally unemployed.
In some occupation such as planting agriculture and building, there is a demand for labour only at certain
periods of the year. For instance, fruit gathering and building construction demand labour at certain periods of
the year. In Sweden, for instance, building constructions are usually stopped in winter, and hence some
workers become unemployed. In West Africa those who work on harvesting crops often become unemployed
after the harvesting period.
In some outdoor occupations, such as building and road making, bad weather often causes a suspension of
work, so that temporary unemployment occurs. The weather, too, may prevent a fishing fleet putting out to
sea. In some occupations, there is a demand only at certain periods of the year – hop-picking, potato-lifting,
fruit-gathering, entertaining at holiday resorts, etc.
Technological Unemployment
Whereas structural unemployment results from a change in the pattern of demand, technological unemployment
is a result of a change in the methods of production. In the dock industry, the introduction of containers
have enabled a given volume of cargo to be handled by a much smaller work force. Dockers who leave the
industry in consequence may be considered to be unemployed because of changes in Technology. One of the
dilemmas of economic efficiency, which normally involves substituting capital for labour, actually generated
technological unemployment.
The introduction of office machinery – typewriters, computers, book-keeping machines, etc., has resulted
in the employment of fewer clerks. This kind of unemployment may result from the invention of a new
machine or an innovation which may reduce the demand for labour concerned.
Residual Unemployment
This includes all those people who, on account of physical or mental disability are of so low a standard of
efficiency that few, if any, occupations are open to them. Payment of standard rates of wages, too makes it
more difficult for people so handicapped to find work.
Regional Unemployment
This type of unemployment occurs when the basic industries of an area go into decline without being replaced
by others. One way of reducing regional unemployment is to increase the geographical mobility of
labour so that the work force migrates towards areas of high economic activity, but as we have seen, the
general policy is to move industry and jobs to the regions of high unemployment.
Students Assessment Exercise
Analyse the various types of unemployment.
172 Principles of Economics
3.2 Unemployment and Inflation – Is there a Trade-off?
Newspaper editorials and public discussions about economic policy often refer to the “trade-off” between
inflation and unemployment. The idea is that to reduce inflation, the economy must tolerate high unemployment
or alternatively that to reduce unemployment, more inflation must be accepted.
Unemployment, and inflation – sometimes referred to as the “twin evils” of macro-economics are among
the most difficult and politically sensitive economic issues that policy-makers face. High rates of unemployment
and inflation generate intense public concern because their effects are direct and visible: almost everyone
is affected by rising prices.
Moreover, there is a long standing idea in macro-economics that unemployment and inflation are related.
This was discussed in detail under the concept of the Phillips curve – that there is an empirical relationship
between inflation and unemployment. The Phillips curve suggested that it was possible to reduce inflation,
but only at the cost of higher unemployment. According to the Phillips curve, inflation tends to be low
when unemployment is high and high when unemployment is low.
The origin of the idea of a trade-off between inflation and unemployment was a 1958 article by Economist
A. W. Phillips. Phillips examined 97 years of British data on unemployment and nominal wage growth data,
he found that historically, unemployment tended to be low in years when nominal wages grew rapidly and
high in years when nominal wages grew slowly. Economists who built on Phillips work shifted its focus
slightly by looking at the link between unemployment and inflation that is, the growth rate of prices – rather
than the link between unemployment and the growth rate of wages. During the late 1950’s and the 1960’s
many statistical studies examined inflation and unemployment data for numerous countries and time periods,
in many cases finding a negative relationship between the two variables. This negative empirical
relationship between unemployment and inflation is known as the Phillips curve.
In the following decades, however, this relationship between inflation and unemployment failed to hold. i.e.
the 1970s, 1980s, 1990s. During those years, unlike the 1960’s, there seemed to be no reliable relationship
between unemployment and inflation, and this applied equally to other European countries. From the perspective
of the Phillips curve the most puzzling periods were the mid-1970s and early 1980s during which many
countries experienced high inflation and high unemployment simultaneously. High unemployment together
with high inflation, is inconsistent with the Phillips curve.
3.3 The Effects/Problems of Unemployment
There are two principal costs of unemployment. The first if the loss of output that occurs because fewer
people are productively employed. This cost is borne disproportionately by unemployed workers themselves,
in terms of the income they lose because they are out of work. However, because the unemployed may stop
paying taxes and instead receive unemployment benefits or other government payments, society (in this case,
tax payers) also bear some of the output cost of unemployment.
The other substantial cost of unemployment is the personal or psychological cost faced by unemployed
workers and their families. This cost is, especially important for workers suffering long spells of unemployment
and for the chronically unemployed. Workers without steady employment for long periods lose job skills
and self-esteem and suffer from stress.
3.4 Policies to Reduce Unemployment
Many people would argue that, for both economic and social reasons, economic policies should be used to try
to lower the natural unemployment rate. Although no certain method for reducing the natural rate exists,
several strategies have been suggested
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(i) Government support for job training and worker relocation
Thus a case can be made for policy measures such as tax breaks or subsidies for training or relocating
unemployed workers. If these measures had their desired effect, the mismatch between workers and
jobs would be eliminated more quickly and natural unemployment rate would fall.
(ii) Increased Labour Market Flexibility
Currently, government regulations mandate minimum wages, working conditions, workers’ fringe
ben- efits, conditions for firing a worker, and many other terms of employment. Such regulations may
be well intentional but they also increase the cost of hiring additional workers, particularly workers with
limited skills and experience. New and existing labour market regulations should be carefully
reviewed to ensure that their benefits outweigh the costs they impose in higher unemployment.
(iii) Unemployment Insurance Reform
Although unemployment benefits provide essential support for the unemployment, they may also increase
the natural unemployment rate by increasing time that the unemployed spend looking for work
and by increasing the incentives for firms to lay-off workers during slack times. Reforms to benefit
systems that preserve the function of supporting the unemployed but reduce incentives for increased
unemployment are needed. For example, taxes on employers might be changed to force employers that
use temporary layoffs extensively to bear a greater portion of the unemployment benefits that their
workers receive.
(iv) Monetary and Fiscal Policy
These are used aggressively to keep unemployment as low as possible, the natural rate of employment
will eventually fall.
So, for example, if current employment is stimulated by monetary expansion, workers may be able to
acquire more on-the-job training which reduces mismatch and lowers the natural unemployment rate in
the long-run.
(v) Labour Turnover Causes Frictional Unemployment
In so far as frictional unemployment is caused by ignorance, increasing the knowledge of labour market
opportunities can help.
(vi) Frictional unemployment
This is inevitable part of the learning process. Policy changes that make it easier for youths to find jobs from
which they can learn and hence raise their productivity could help. Youth training, and schemes aimed at
subsidising the wage rate for young workers have also helped.
Students Assessment Exercise
(i) What is the Phillips Curve? Does the Phillips Curve relationship hold for modern data in a modern
economy?
(ii) Why is unemployment an important economic variable? What policies, if any, might be used to reduce
unemployment?
174 Principles of Economics
4.0 Conclusion
Unemployment is inability to obtain work although work is actively sought. It excludes those who are seeking
work even if they have refused work at some derisory wage. It has been an aim of governments to intervene
in the economy with fiscal and monetary policies to ensure a low level of unemployment.
Unemployment may be broken down into smaller components of which some of the most important are
Frictional unemployment, Structural unemployment, disguised unemployment, seasonal unemployment.
The costs of unemployment include output lost when fewer people are working and the personal or
psychological costs for unemployed workers and their families. Policies to reduce the unemployment rate
include government support for job training and worker relocation, policies to increase labour market flexibility
and unemployment benefit reform.
Following the famous 1958 article by A. W. Phillips, empirical studies often showed that inflation is high
when unemployment is low and low when unemployment is high. This negative empirical relationship between
inflation and unemployment is called the Phillips curve. Inflation and unemployment in European
economics conformed to the Phillips curve during the 1960s but not during the 1970s and 1980s. Economic
theory suggests that in general, the negative relationship between inflation and unemployment should not be
stable.
5.0 Summary
In this unit, we have succeeded in establishing that all people who could work choose to do so. Some such as
married women may be economically inactive in the sense that they have no paid employment.
Various explanations for the existence of unemployment can be offered. These are sometimes described
as different ‘types’ of unemployment. They consist of frictional unemployment, structural unemployment,
demand-deficient unemployment and classical unemployment, frictional and structural unemployment result
from a mismatch between the type of labour being offered and that being demanded. Demand-deficient
employment is correlated with the business cycle, rising in recessions and falling in booms. The classical
explanation for the existence of unemployment is based on an analysis which views labour as a commodity to
be brought and sold in the market. In this analysis, unemployment can only be understood as a disequilibrium
situation brought about because the price of labour (the real wage) is too high to allow the market to clear.
Finally, unemployment is the number of people who are available for work and are actively seeking work
but cannot find jobs.
6.0 Tutor-Marked Assignment
Examine the various types of unemployment and the remedies for them.
7.0 References/Further Reading
- Crowther, G. An outline of Money. Chapters 3 and 5.
- Haberler, G. Prosperity and Depression Part I. Chapter 1-3.
- Hanod, R. F. The Trade Cycle.
- Samuelson, P. A. Economics. Chapters 12 and 13.
- Keynes, T. M. General Theory of Employment, Interest and Money.
- Beveridge, W. H. Full Employment in a Free Society.
Unemployment 175
- Hanson, J. L. A Textbook of Economics. London: Mcdonald & Evans, 1968.
- Harvey, J. Intermediate Economics. London: Macmillan, 1969.
- Hacche, J. The Economics of Money and Income. London: Heinemann 1970.
- Marshal, B. V. Comprehensive Economics. Harlow: 1967.