Money and banking
13.0 Introduction
“Money bewitches people. They fret for it, and sweat for it. They devise most ingenious ways to get it. Money is the only commodity that is good for nothing but be gotten rid of. It will not feed you, clothe you, shelter you or amuse you unless you spend it or invest it. It imparts value only in parting. People will do almost anything for money and money will do almost anything for people. Money is a captivating, circulating, masquerading puzzle” Federal Reserve Bank of Philadelphia, ‘Creeping Inflation’; Business Review, August 1957 p3. In this chapter among other issues, we are going to define money and discuss its functions. In additionmarket equilibrium interest rates will be determined where money supply equals the demand for money.
13.1 Functions of money
Good money is characterised by stability, scarcity, portability, divisibility, uniformity, acceptability, and durability. Money can be identified as anything that is generally acceptable in the settlement of debts. It can be described by what is does, that is, money can best be described by its functions. Money plays the following important roles in the economy
13.1.1 Medium of exchange
Money as a medium of exchange allows consumers to exchange their preferences. That is people exchange their goods and services for money rather than for other goods and services like what used to happen in barter trade. Thus money is usable in buying goods and services.
13.1.2 Measure of value
Money as a measure of value becomes a common denominator upon which relative exchange values can be established. The value of one product can be expressed in monetary terms (price). For example the value of a vehicle can be expressed as $200m and not 20 herds of cattle.
13.1.3 Store of wealth
Money presents a convenient form in which to store wealth especially because of its liquidity, that is, money can easily be used to pay for transactions. People can prefer to keep their wealth in the form of money which is liquid rather than illiquid assets such as bonds. One other reason for this preference is because money is not perishable as compared to some other assets such as cattle.
13.1.4 Standard of deferred payments
Deferred payments are future payments obligations. Money as a standard of deferred payments allows credit transaction to be undertaken. For example people can buy on hire purchase and sign a contract to repay in monthly instalments.
NB* Money should maintain a constant purchasing power over a long period if it were to perform these functions properly. The purchasing power of money is what a given currency can buy in the domestic economy. The purchasing power or value money is reduced by inflation. For example, if our Z$ loses its purchasing power, people would quote their prices in other currencies such as the US$ and they would prefer to accumulate assets that appreciate in value such as houses rather than storing their wealth in the form of money.
13.2 Money Supply
The different functions of money give rise to different definitions of money supply in the economy. The official definition of money supply in Zimbabwe is M3 which is derived as follows:
13.2.1 Money as medium of exchange (M1)
M1 defines transaction money, that is, money used to pay for day to day transactions and it is given by;
M1 = Notes and coins in circulation + Demand deposits with financial institutions.
Demand deposits refer to deposits that can be withdrawn without giving notice of withdrawal to the bank, for example current account deposits which can be withdrawn by writing a cheque.
13.2.2 Money as a spending potential of the economy (M2)
This definition identifies all deposits that are easily convertible into cash. These deposits are made up of notes and coins in circulation, demand deposits with financial institutions, savings deposits and fixed time deposits that mature within 30 days.
Thus M2 is given by;
M2 = M1 + Savings deposits + Fixed time deposits that mature within 30 days.
13.2.3 Money as store of wealth (M3)
This definition includes quasi or near money, that is, assets that are not easily convertible into cash. This is the official definition of money supply in Zimbabwe and it is given by;
M3 = M2 + Fixed time deposits that mature after 30 days.
Thus M3 has five items, namely notes and coins in circulation, demand deposits with financial institutions, savings deposits, fixed time deposits that mature within 30 days and fixed time deposits that mature after 30 days.
NB* The supply of money at any given time is a measurable aggregate. It is determined by the Reserve Bank and thus can be taken as fixed in the short-term. The supply of money curve is vertical showing that money supply is independent interest rates.
13.3 Money Demand
Keynes described the demand for money as “demand for money to hold.” This is the amount of cash balances people wishes to hold rather than illiquid assets that yield income such as bonds or government securities. The demand for money is called liquidity preference. Keynes identified three motives for holding money:
13.3.1 Transactions motive
People hold money to use to buy goods and services, that is, they need money to pay for day-to-day transactions such as bus fare.
13.3.2 Precautionary motive
In addition to the amount of money they hold to pay for day-to-day transactions, additional cash is held for precautionary purposes, that is, to make it available in case of need, not only for the emergency situation such as illness but even to buy a bargain if it should be available.
NB* The amount of money held as transactions and precautionary balances are referred to as active balances. The amount held as active balances depend upon the level of prices, the level of income, the frequency at which income payments are made and the financial development of the economy.
13.3.3 Speculative motive
People also hold cash balances in order to take advantage of improving interest rates and prices of financial assets. People holding money for speculative purposes must be convinced that for the time being, it is more rewarding to hold money than real income earning assets. People will prefer to hold cash balances than bonds when the yield on bonds (interest rates) is low. At lower interest rates, less will be lost by not investing it, whereas the reverse is true for higher interest rates. The demand for money is positively related to income and negatively related to the rate of interest. Thus the liquidity preference curve (demand for money curve) is downward sloping.
13.4 Determination of market interest rates
The intersection of the demand for money curve and the supply of money curve determine the market equilibrium rate of interest.
Fig 13.1 The market equilibrium rate of interest
O M0 Money Balances
Any changes in the level of income and prices will shift the money demand curve while money supply changes will shift the money supply curve. The equilibrium interest rate will change in the process.
13.5 Credit creation by commercial banks
In their duty of lending commercial banks create bank deposits that are directly related to money supply. To determine the extent to which commercial banks create credit, we use the credit multiplier.
13.5.1 Simplifying assumptions
i. Assume a multiple banking system that is, assume that there are numerous banks in theeconomy..
ii. Assume a 20% cash reserve ratio, that is, 20% of total deposits need not be advanced as loans but set aside as cash reserve requirement. This amount is set aside fro client withdrawal and will not be advanced as an overdraft.
iii. Bank transactions are only loans and payments are made and paid by way of cheques.
iv. There are no cash leakages and banks keep no excess reserves.
13.5.2 Illustration of the credit creation process
Based upon the above assumptions, an initial $100m deposit into CBZ will increase CBZ’s deposits by $100m. CBZ will have $100m at its disposable and can give out an 80% overdraft of $80m to Ben by writing a cheque in his favour. Ben will deposit the cheque into his FBC account where upon FBC’s deposits will increase by $80m. FBC will give an overdraft of $64m to Chen while reserving $16m for client withdrawal. Chen will deposit the cheque into his Stanbic account. The process will continue until further deposits approach zero. The total deposits or credit generated can be summarised by the following table.
Table 13.1 The credit creation process
Stage
|
Bank
|
Deposit
|
Cash Reserves
|
Overdraft
|
1
|
CBZ
|
100
|
20
|
80
|
2
|
FBC
|
80
|
16
|
64
|
3
|
Stanbic
|
64
|
-
|
-
|
-
|
-
|
-
|
-
|
-
|
-
|
-
|
-
|
-
| |
Total
|
5000
|
1000
|
4000
|
The total amount of bank deposits created can be calculated using the credit multiplier:
Credit multiplier = 1
Cash ratio
Thus, total deposit created = Initial deposit
Cash Ratio
= $100m
0.2
= $100m x 5
= $5 000m
NB* It should be understood that the money supply in this case is not only notes and coins alone but the ‘invisible money’ called credit. Banks can not create notes and coins but they can as illustrated, create credit by giving out loans or overdrafts. The amount of cash money in the system remains the same. The system works because of a fundamental assumption that the depositor, who is the bank’s creditor, comes back to withdraw only a little which is catered by 20% cash ratio, in this case. A bank could collapse if all depositors claimed their money back all at one time because the bank would not have enough liquidity to pay cash (bank run). However this seldom happens.
13.5.3 Limitations to the credit creation process
There are four limitations to the ability of commercial banks to increase money through credit creation. a.No increase in deposits.
b. Lack of willingness to borrow on the part of the public.
c. Lack of willingness to lend on the part of commercial banks.
d. The cash ratio, the smaller the cash ratio the greater the amount of credit created and the larger the cash ratio, the smaller the amount of credit created. This can best be illustrated if you answer the following example.
Example
Given an initial deposit of $200b into the banking system, how much credit or bank deposits will be created if the cash reserve ratio is 10% and 50%?
13.6 Monetary policy
Monetary policy refers to deliberate attempts to manipulate the rate of interest and money supply in order to bring about desired changes in the economy.
13.6.1 Aims of the monetary policy
In general terms monetary policy is used to regulate credit conditions and the supply of money in order to fulfil macroeconomic objectives. The overall objective is to improve the standards of living within the economy. Alternative objectives can be listed as follows: -
a. To maintain stable prices, that is, control inflation or deflation.
b. To attain a rising level of employment.
c. To achieve real economic growth which is prerequisite to improvement in the standards of living. d. To secure a healthy BOP position.
13.6.2 Targets of monetary policy
To achieve the above objectives of economic policy, the authorities through monetary policy will seek to manipulate: a. Interest rates.
b. Growth in money supply.
c. Exchange rate and,
d. Growth in the volume of credit.
13.6.3 Instruments of monetary policy
There are two main categories of monetary policy instruments. On the one hand there are those instruments of policy that are designed to have a general effect on the financial sector and through that sector, on the whole economy. On the other hand there are instruments of control that are specific in their effects on particular financial organisations.
a. Instruments for general control
General control instruments affect certain key interest rates or the authorities may directly engage in transactions in key financial markets in order to affect credit throughout the economy.
i. Open Market Operations
‘Open market operations’ refers to the buying or selling of government securities (bonds or treasury bills) by the central bank to the public. The principle is to exchange ‘paper assets’ for ‘cash.’ For example, if there is excess liquidity in the market the central bank will enter the market selling government securities. People will exchange their cash for the securities and hence the excess liquidity is mopped up. Conversely if there is a shortage, the central bank will enter the market buying the securities from the public thereby injecting liquidity into the market.
ii. Discount policy or accommodation window
The discount policy refers to variations in the rates at which the central bank discounts first class bills and other terms at which the central bank, as a lender of last resort, advances funds to certain domestic parties in the money market, usually to enable those parties to make good a reserve asset deficiency. Holders of first class bills such as treasury bills can apply to the central bank for the maturity dates of their bills to be brought forward. This is granted on condition that the holder will receive an amount less than what they were going to receive upon maturity of the bill. Thus the central bank will ‘discount’ the bill. For example if an investor holds a $100m bill that will mature in the next three months, the investor can apply to liquidate the bill today but instead of receiving $100m the central bank will pay an amount less than $100m e.g. $80m. The bill would have been discounted by 20% which is the $20m. Discounting increases the liquidity situation in the market. Thus if the central bank is pursuing a tight monetary policy it will increase the rediscount rate or the central bank can close the accommodation window facility.
iii. Non-marketable government debt
The government can seek to borrow direct from the central bank for some general or specific purpose. In such cases, the terms of the loan are negotiated beforehand and those negotiating on behalf of government will be anxious to ensure that the agreed interest rate does not have an adverse influence on the absolute level of interest rates, in nominal terms.
iv. Public debt management
The Reserve Bank operates a government account through which borrowing and interest payments pass. Government borrowing or specifically the PSBR directly fuels credit creation by commercial banks if the government borrows from the banking sector.
b. Instruments of specific control
Specific instruments of control have their impact on specific financial institutions and that impact is in the short-term restricted to those specific institutions.
i. Moral suasion
Moral suasion or moral persuasion consists of central bank requests or admonitions to banking institutions to act or not to act in certain ways and it may cover any of the bank’s activities e.g. lending policy. Moral suasion in not compulsory and hence banks may not agree to change. However because of the nature of the relationship between the central bank and these banks moral suasion has been successfully implemented in Zimbabwe.
ii. Calling for special deposits with the Reserve Bank
The central bank can wish to make credit tighter and call specifically for a special deposit from commercial banks. This dampens optimism and so curtails business spending.
iii. Ceilings and directional controls
This refers to lending ceilings and selective credit controls. It involves the authorities imposing formal or informal maximum or minimum levels of amounts banks can lend to certain specific borrowers or categories of borrowers or for certain specific purposes.
iv. Variable reserve ratio
This refers to attempts to control credit creation by commercial banks by manipulating the cash ratio. From the illustration on the credit creation process we concluded that the smaller the cash ratio, the greater the banks’ ability to increase money supply and vice versa. For example the central bank can increase the cash ratio if it wants to reduce the level of money supply growth from the creation of credit.
v. Statutory Reserve Requirement
Banks are required to maintain reserve cash balances with the Reserve Bank for management purposes. These reserves can be varied depending on the monetary policy. For example with a tight monetary policy the reserves can be increased so as to reduce excess cash in the market.
vi. Directives
The central bank can issue directives such as demanding pension funds to hold a portion of their earnings in prescribed government paper.
13.6.4 Limitations of monetary policy in Zimbabwe
The advantage of monetary policy is that it is flexible and can be applied fairly quickly unlike fiscal policy that needs to have both cabinet and parliamentary approval before it can be applied.However the effectiveness of monetary policy in Zimbabwe is affected by;
a. Financial dualism that is the existence of a monetised and non-monetised sectors in the economy. The monetised sector uses money fro its transactions while the non-monetised sectors engage in barter trade. There is a largenonmonetized sector which is little affected by monetary policy.
b. There is a narrow size and inactive money and capital market.
c. There is a limited array of financial stocks and assets.
d. The notes constitute a major proportion of total money supply, which implies the relative insignificance of bank money in the aggregate supply of money.
e. Foreign owned commercial banks in Zimbabwe can easily neutralise the restrictive effects of a strict monetary policy as they can replenish their reserves by selling foreign assets and can draw on the international market.
13.7 Zimbabwe’s financial system
It has been argued that the Zimbabwean financial system is one of the well developed, mature, diversified and geographically spread financial system. The financial system may promote or hinder the process of economic development depending on its nature. If the financial system is well developed, it may provide economic development, that is, financial development lead to economic development. Howeverthe financial system in Zimbabwe recently has been involved in non-core activities such as buying the whole year’s production of bricks and other speculative activities. This has led to placement of more than five financial institutions including commercial banks under curatorship and some were subsequently liquidated. The historic case of ENG and Trust Bank will come to mind.
13.7.1 The Reserve Bank of Zimbabwe (RBZ)
The RBZ or the central bank is at the apex of the financial institutions. It plays a supervisory and regulatory role in the financial sector. The RBZ plays important internal and external roles.
a. Internal functions of the RBZ
The internal functions of the RBZ can be grouped into three classes
i. Banking functions
Banker to the government – the RBZ operate a government account through which government revenue, expenditure and borrowing is processed.
Banker to other banks - banks are required by statute to maintain reserve requirement accounts with the central bank for administrative purposes. In addition the RBZ operates a cheque clearing house through which cheques from various commercial banks are settled.
Lender of last resort - the central bank acts a lender of last instance.
Banker to the nation – Firstly, the RBZ is responsible for the printing and replacement of notes (money). Secondly, the central bank maintains the country’s gold and foreign currency reserves.
ii. Regulatory institutions
The RBZ is a licensing authority, that is, it licenses all financial institutions for example it issues commercial banks with banking licenses. The central bank is there to supervise the activities of other financial institutions. It ensures that codes and practices that the government lays down are conformed to by the financial sector.
iii. Monetary policy function
The central bank formulates monetary policy; supervise the implementation of the monetary policy and makes periodic evaluations of the monetary policy (for example quarterly reviews) on behalf of the government.
b. External functions of the RBZ
i. Stabilisation of the exchange rate function
This is done in conjunction with government policy. The central bank can devalue or revalue the dollar depending on the state of the economy. The RBZ administers the foreign currency movements.
ii. Interactive function
The central bank is the one that interacts with external financial institutions. The RBZ represents the government in the international money markets for example repayment of the government debt to the IMF.
13.7.2 Commercial banks
Commercial banks accept deposits from the public and pay the depositors interest rates which are the interest earnings of the deposits. They also offer overdrafts and charge lending rates and these are the cost of borrowing. Commercial banks offer a variety of services that include, current accounts, ATMs, safe custody of valuables such as jewellery, financial advice and savings deposits.
13.7.3 Building societies
These basically provide finance for home ownership (mortgage lending) and act as a medium for small savings through various types of accounts which offer different rates of interest. However it is now difficult to draw a line between a building society and a commercial bank because they have the same legal requirements and building societies can also offer the serves that commercial banks offer.
13.7.4 Merchant banks
Merchant banks offer trade finance and give advice to those companies dealing with international finance. In addition merchant banks advice companies on mergers and acquisition. They also underwrite the issue of new shares (Initial Public Offer). That is, merchant banks guarantee the issue of shares not bought by the general public in order for the issuing company to raise the required funds.
13.7.5 Discount houses
Discount houses act as intermediaries between other financial institutions and the central bank. They specialise in the sale and purchase of securities with different maturities and dates. They operate ‘call accounts’ which form part of the liquid assets held by banks and other institutions.
13.8 Money and capital markets
Financial markets are the means by which savings are channelled back into the economy as loanable funds. The process is known as financial intermediation. Financial intermediation arises because lenders and borrowers have different requirements in terms of risk and time. One of the more important distinctions within the financial markets is that between money and capital markets.
13.8.1 Money market
Money market is a submarket of the finance market and specialises in short term lending or borrowing. That is the money market contracts are up to one year. Institutions in the money market include commercial banks, savings clubs, micro finance corporations and individuals. The instruments through which people can borrow in the money market include treasury bills, trade bills, call loan and negotiable certificates of deposits. Interest rates in the money market apply to periods of usually up to twelve months. The interest rate is dependent on the bank rate, that is, the rate at which the central bank advances loans to financial institutions as a lender of last resort. Thus interest rates in the money market are influenced by the central bank (commercial bank lending rate equals bank rate plus mark-up).
13.8.2 Capital market
The capital market constitute of institutions such as the stock exchange market, mortgage market, new issues of shares market and the corporate market (bonds issued by the government).The capital market, unlike the money market, specialises in longterm lending. Amounts involved are generally bigger and are supposed to be repaid in more than one year. The capital market deals with long-term private and government securities and funds. It’s a market for long-term borrowing and lending using instruments such as bonds, equity shares, debentures and preference shares. The central bank does not influence interest rates in the capital market. The market is a free market where the rate of interest is determined by the forces of demand and supply of securities. As a result, interest rates in the capital market are one of the best indicators of the market’s current expectations about future interest rates.
13.8.3 The role of money and capital markets
The money and capital markets are of great importance in Zimbabwe because
a. They promote savings and investment
b. They represent a counter for borrowings (deficit units) hence are a major source of funding. c. They offer financial advice
d. They offer banking and financial services to the community
e. Money and capital markets
f. Standards of living are improved through transactions in the money and capital market
13.9 The quantity theory of money
In the Quantity Theory of Money, Milton Friedman improved Irvin Fisher’s equation of exchange to illustrate the role of money in the economy.
13.9.1 The Classical Quantity Theory
Fisher thought that money was used only as a medium of exchange. Its sole function was to act as a means of payment in transactions for goods and services. According to Fisher, if the number of transactions is independent of the amount of money, then the total money value of transactions will be given by:
P, the price level of goods and services bought and sold, multiplied by,
T, the number of transactions, to equal PT (P x T = PT)
The amount of money required to pay for these activities is given by:
M, the money supply, multiplied by
V, the velocity of circulation, to give MV (M x V = MV).
The velocity of circulation (V) measures the speed at which money changes hands in the economy. MV must always equal PT because they are simply two different ways of measuring the same transactions. MV looks at society as consumers while PT looks at society as producers.
13.9.2 The new quantity theory
Friedman improved the classical quantity theory of money to
MV = PQ where,
M = Money supply
V = Velocity of circulation
P = General level of prices
Q = National income or real output.
The velocity of circulation (V) is assumed to be fairly constant. The economy is assumed to be at or near full employment such that it is not possible to increase output. Thus Q is constant. Given that V and Q are constants, a change in M will directly affect P. for example, if M doubles, Q must also double for the equation to remain holding. Thus an increase in money supply will directly result in an increase in the level of prices (inflation).
13.9.3 Criticism of the quantity theory
a. The assumption full employment of resources is unrealistic. It is true that at full employment any increase in the money supply can only result in a higher price level since output cannot expand. With unemployed resources available, a rise in the amount of money is likely to result in changes in production as well as prices.
Velocity of circulation is unlikely to remain constant. An increase in the money supply will probably cause an increase in velocity when people expect a sharp rise in inflation. They will try to spend before prices rise. In every depressed economy, an increase in the money supply may cause a compensating fall in velocity as people cut back spending. This leaves the price level and the number of transactions unaltered.
Theory of national income distribution
14.0 Introduction
The assumption is that all factor income generated through economic activity will be distributed among the factors of production used to produce the output. Land will earn rent, capital earns interest, labour earns wages and salaries and the entrepreneur will earn profit. The question remaining is how to determine how much each of the factors of production will receive (pricing of factors of production). In this chapter we are going to illustrate in theory how wages and salaries, rentals, interest payments and profits are determined. However, it may be important to note that in reality these theories are not religiously applied in determination of the factor earnings.
14.1 The marginal revenue productivity theory of wages
The marginal revenue productivity theory is based on the fact that labour is wanted not for its own sake but for the sake of the product it can produce. As a result the payments for labour (wages) are derived from the return from the sale of the product of labour hence if labour productivity increase, labour tend to enjoy increased remuneration.
14.1.1 Assumptions
a. Assume a perfectly competitive labour market; for example, assume that there are very large numbers of employers and workers, that labour is homogenous and so on.
b. Assume that labour is the only variable factor of production to be applied to other fixed factors.
c. Assume that the marginal physical product of labour can be measured; that is, each additional workers contribution total product can be measured.
Given the above conditions, a profit maximising firm will employ additional units of labour up to the point where MRP = MC.
14.1.2 The marginal revenue productivity (MRP)
Marginal Revenue Product (MRP) of labour is the addition to the firm’s total revenue that comes as a result of employing one more unit of labour. It is given by,
Marginal Revenue Product = Marginal Physical Product x Price of the Product
The marginal physical product (MPP) of labour is the addition to total product that comes as a result of the employment of an additional unit of labour. Due to the law of diminishing returns which maintains that as you add more and more units of a variable factor, with all other factors held constant, the addition to output (MPP) becomes smaller and smaller. Thus the MRP curve initially rises, reaches a maximum and then falls due to the influence of diminishing marginal returns.
Marginal Cost (MC) of labour is the amount that each additional unit of labour adds to the firm’s total costs. Since we assume conditions of perfect competition, this is the wage rate and is constant because workers take the wage as given. Under conditions of perfect competition the price of the product does not change as the firm changes its output.
A profit maximising firm operating under conditions of perfect competition where it cannot influence the price of labour will employ additional units of labour up to the point where the MRP = MC. Infact the MRP curve is the firm’s demand curve for labour because it indicates to the firm what the additional unit of labour is worth in terms of revenue.
14.1.3 Demand for labour
The demand for labour is derived demand rather than direct. It is derived from the demand for the product of labour, that is, the demand for labour just like the demand for any other factor of production depends on its productivity and on the price at which the product which is produced is sold. This is because labour does not directly satisfy consumer need but do so indirectly by producing goods and services. Demand for labour is downward sloping due to the influence of diminishing marginal returns and equal to that part of the MRP curve that lies below the ARP curve.
The demand for labour depends on:
a. The demand for the product of labour and therefore the prices of the product of labour. b. The productivity of labour (MRP).
c. The importance of labour costs in total costs of production.
d. The possibilities of substituting labour with other factors as wages rise.
Any changes in these factors will shift the demand for labour curve either to the right or to the left.
14.1.4 The supply of labour
The supply of labour curve is upward sloping. Justification for the upward sloping supply curve can be found in the need to pay workers higher wages to induce them to work longer hours (as illustrated by higher rates on overtime work) and by the need to pay higher wages to attract new workers into the industry.
The supply of labour to a particular industry depends on:
a. The standard of living and the extent to which workers value leisure relative to income.
b. The prevailing social attitudes towards the nature of work.
c. The mobility of labour, that is, the extent to which restrictions on entry such as education, training and skills requirement is applicable.
d. The extent to which trade unions and professional associations are able to control recruitment.
14.1.5 The equilibrium wage and level of employment
The intersection of the demand for and supply of labour will determine the market wage rate and the level of employment. Fig 14.1 Market equilibrium wage rate and level of employment
Any changes in the factors that affect demand for and supply of labour will change the equilibrium position. In which case, the curves will shift either to the right or to the left.
14.1.6 Criticism of the marginal revenue product theory
The theory is based on several assumptions, some of which are not realistic, for example labour can never be homogeneous and it is difficult to measure the productivity of each individual labour. In reality the productivity of labour depends on the productivity of other factors of production such as capital. In addition, the theory ignores the importance of trade unions and government policy which often set wages.
14.2 Imperfectly competitive labour markets
The supply of labour is not at all competitive in the labour market. Instead, it is controlled by a labour monopoly know as a trade union. A trade union is a group of workers who band together to pursue certain common aims, especially the achievement of wage increases for their members and the lobbying of government to pass legislation in favour of workers.
14.2.1 Effects of trade union on wages and the level of employment - restriction of supply
Workers with specific skills such as doctors and accountants can form acraft union that can restrict supply by controlling the length of apprenticeship programmes and restricting membership for example by imposing licensing and other entry requirements.
Fig 14.2 The effect of restricting labour on wages and the level of employment
W1
If supply is restricted, the supply curve will shift from S0 to S1thereby increasing the wage rate from W0 to W1. However, at the higher wage rate (W1), it becomes expensive for firms to hire labour hence the level of employment decreases from L0 to L1.
14.2.2 Effects of trade union on wages and the level of employment - wage setting –
Workers in a single industry may be represented by an industrial union or workers union. Such unions derive their strength from numbers of their membership and hence can force firms in the industry to bargain exclusively with the union over wages and other conditions of employment. Thus bargaining power enables the union to obtain wages for its members above the level that would pertain in a perfectly competitive market.
Fig 14.3 The effect of a minimum wage on wages and the level of employment
Wage Rate
W1
W0 Wage floor
O L1 L0 Ls No of workers
The perfectly competitive wage rate is W0. If the union gains control of the supply of labour, it can fix the wage rate at W1.
Given a downward sloping demand curve, the level of employment will decrease to L1. Thus involuntary unemployed labour is Ls –
L1.
14.2.3 Effects of trade union on wages and the level of employment - increasing labour demand
Trade unions may support, or even conduct training courses to increase productivity and therefore the demand for labour. Unions also have an interest in supporting employers in lobbying for tariff legislation that protects their industry from import competition. Tariffs raise the price of imports. This will tend to increase the demand for domestically produced goods which are substituted for the more expensive imported goods. Thus the demand for labour used to produce the domestic goods will increase (the demand curve will shift outwards) as shown on the following diagram.
Fig 14.4 The effect of increasing labour demand on wages and level of employment
O L0 L1 No. of workers
An outward shift of the demand curve for labour from D0 to D1 will raise wages from W0 to W1 and employment rises from L0 to
L1.
14.2.4 Monopsony
A monopsony is a market where one buyer purchases a product or factor of production from many sellers. It is, in a sense, the opposite of monopoly. A labour market where one employer confronts a non-unionised group of workers competing for jobs is a monopsony. To attract additional workers, the monopsonistic firm must raise wages, that is, it faces an upward sloping supply of labour curve. If we assume that labour is the only factor of production, the supply curve will be equal to the AC curve (S=AC).
If AC is rising the MC will be rising even faster.
According to the marginal productivity theory, a profit maximising firm will hire labour by equating MC to MRP. The same will apply for a monopsonist who will hire L0 units of labour at a wage rate W0 as illustrated in the following diagram
Fig 14.5 Monopsony level of wages and employment
The monopsonistic firm will equate MC to MRP to employ L0 number of workers. The wage is determined from the supply curve, since a point on the supply curve indicates the wage for which workers are willing to supply their labour services. Hence, the wage will be W0 per worker. Not only is employment depressed by monopsony but also the wage rate paid (W0) is lower than would have resulted under competitive conditions in the labour market (W1).
14.3 Wage differentials in the labour market
Why do workers in the same industry or in the same occupation earn different wages? Wage differentials can be explained by differences in labour productivity, that is, highly productive labour will be in great demand and hence will be paid higher wages.
However, other reasons can be cited.
a. Labour markets can be segmented into distinct segments and it is extremely difficult and costly for an individual to move from one segment to another.
b. Differences in labour market structures - wages in perfectly competitive labour markets differ markedly form those in monopsony.
c. Institutions in the labour market – trade unions could through a number of activities ranging from bargaining to a restriction of supply, also alter the wage rate from that which would hold in a perfectly competitive market.
d. Human capital – education and training impart skills but requires effort, time and resources. Thus higher wages should be paid for qualified labour.
e. Opportunity cost – acquiring human capital involves foregoing income. As a result, individuals expect to recover this opportunity cost through higher incomes on completion of studies.
f. Experience and on the job training – there is a positive relationship between the individual’s wage and the length of time spent at a specific company.
g. None monetary rewards – such as esteem and social status given to doctors or the country’s president who happen to earn a salary far less than what most managing directors in industry get..
h. Discrimination – racial, tribal and gender discrimination.
14.4 The loanable fund theory of interest
The term capital is used either to describe capital goods or to describe financial resources. Capital is formed by forgoing current consumption and diverting these resources to the production of future wealth. In other words capital accumulates by doing without now and using the resources so freed to create more wealth in the future. Interest is the reward for parting with liquidity for a specified period. According to the loanable fund theory or classical theory of interest, the interaction of the savings (supply of loanable funds) and borrowings (demand for loanable funds) determine the rate of interest. The theory is an alternative to the Keynesian’s liquidity preference theory looked at in chapter 13.
14.4.1 The supply of loanable funds (savings)
The supply of loanable funds refers to the willingness and ability of households or firms with excess funds (savings) to make them available to borrowers at a certain rate of interest. People save from their current incomes and the level of savings will depend on:
a. The social framework of the society – if the society encourages savings and there are saving intermediaries such as savings clubs, people will save.
b. The size of the income of an individual – the higher the income the more likely will the present wants be fully satisfied with some funds being left over as savings.
c. The preference of individuals for present over future consumption – if people are impatient to spend their incomes in the present, that is, if they have a greater preference for present over future enjoyment of goods, then the higher have to be the rate of interest to induce them to save and lend their money.
d. The degree of uncertainty regarding enjoyment in the future – the more certain an individual is of the ability to enjoy his income in the future, ceteris paribus, the less impatient he will be to spent money in the present.
The supply of loanable funds curve is upward sloping showing that higher interest rates encourage individuals to consume less now and save more.
14.4.2 The demand for loanable funds (borrowings)
The demand for capital refers to the willingness and ability of households, firms and the government to borrow funds to finance their various consumer needs and investment projects. Capital is demanded because it makes it possible a much future output. Firms borrow with the aim that these productive investments will yield a rate of return that exceeds the cost of borrowing thereby reaping profits for the firm. Just like the demand for labour, the demand for capital is derived demand and it depends on the marginal revenue product of capital (the marginal efficiency of capital).
14.4.3 The market interest rate
The interaction of the supply and demand for loanable funds curves determines the market interest rate.
Fig 14.6 Determination of the market equilibrium interest rate
O Le Loanable funds The market interest rate i0 is determined at the intersection of the savings and borrowings curves. Any changes in the factors that determine the supply and demand for loanable funds will change the market equilibrium interest rate.
14.4.4 Why interest is paid
a. Lenders want to be compensated for the sacrifice that they make when parting with liquidity. This sacrifice comes in the form of forgoing present consumption for that of the future. Utility derived from present consumption is greater than that of the future.
b. A dollar advanced today as a loan will be worth less than a dollar by the same time next year due to inflation. To cushion against this, interest rate greater than the inflation rate must be charged on loans.
c. Lenders should also be paid interest because the loans made to borrowers carry risk even if the loans are fully secured by collaterals. The interest rate must vary according to the degree of risk involved.
d. When loans are issued out, administrative costs such as the cost of the loan application form are incurred. These costs are incorporated in the interest charge to the borrowers.
14.5 Profit
Profit is defined as the reward for risk-taking or the reward for uncertainty bearing. There are insurable and non-insurable risks in business. Insurable risks include fire, theft and accident. Since this risk can be insured against, they are not rewarded by profit. Profits therefore are rewards for non-insurable risks such as changes in demand for the product or cost conditions for the product.
14.5.1 The role of profit
a. Profits are the reward to the entrepreneur hence they act as an incentive.
b. Profits influence the level of resource utilisation and the allocation of resources among alternative uses.
c. It is the profit or the expectation of profit that induces firms to innovate. Innovation stimulates investment, total output and employment. That is, it is the pursuit of profit that underlies most innovation.
d. The occurrence of economic profit is a signal that society wants that particular industry to expand.
e. Profits are the financial means by which firms can add to their productive capacities, that is, ploughed back profit inject working capital.
14.5.2Why profits vary from firm to firm in the same industryFirms in the same industry may earn different profits because
a. One firm may be enjoying economies of scale while the other is not, that is, cost differences.
b. One firm may have built a reputation by excellent service in the past and hence the firm may derive advantages from an outstanding goodwill.
c. The nature of the returns in production; firms that are operating under conditions of increasing returns to scale tend to make greater profits than those in which diminishing returns are threatening, if not actually operative.
14.5.3 Why profits vary from firm to firm in different industries
a. Differences in degrees of risks for example new industries have high degree of risk and high profit levels.
b. Market structure for example one firm may be operating in a monopolistic industry and making great profits than the other firm that may be operating under a perfectly competitive industry.
c. Differences in the degree of elasticity of demand for the commodity or service.
14.6 Rent
The meaning of the word ‘rent’, in its everyday usage, is the payment made for the use of property, usually in the form of land or buildings. The same word is often used as a synonym for ‘hire’. The rent that is paid in this case is commercial rent. Any payment made to any factor, therefore, simply for the purpose of retaining, as it were, possession of it should be regarded as rent; where the supply of the factor is fixed, and it is specific in its use, so it cannot be used for anything else, any surplus or extra money paid to it is economic rent. The earnings of most factors of production consist of economic rent and transfer earnings. Transfer earnings are defined as the minimum amount that must be earned to prevent a factor of production from transferring to another use. Economic rent is said to be earned whenever a factor of production receives a reward that exceeds its transfer earnings.
14.6.1 Determination of rent
The total quantity of land is fixed in supply. Unlike the other factors of production such as capital and labour, the available supply of land cannot be increased by human efforts. Thus, the total quantity of land supplied is the same at every price. That is, the supply of land is represented by a vertical or perfectly inelastic supply curve. On the other hand demand for land just like demand for any other factor of production is derived from demand for its product. It will depend on the quality or the productivity of the piece of land (fertile versus barren), its location (rural land versus urban land) and the number of uses for that piece of land. Given these conditions, the free market rent will be determined by the intersection of the demand and supply of land curves.
Fig 14.7 Determination of rent
O Q0 Quantity of land
From the diagram, the total supply of land is to a large extent fixed. Increased demand does not bring increased supply but it increases the rent earnings of those who are fortunate enough to own land. For example if demand for housing increase in Harare due to Operation Murambatsvina which destroyed illegal structures, the demand curve will shift fromD1 to D2 and rentals will increase to R2 .
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