SUPPLEMENTARY NOTES FOR MACROECONOMICS

SUPPLEMENTARY NOTES FOR MACROECONOMICS

CHAPTER 1
Learning Objectives:
At the end of this chapter, students should be able to:

i. Define economics and differentiate between microeconomics and
macroeconomics

ii. Explain and differentiate the objectives of macroeconomics in conventional and
Islamic perspectives.

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

1.1 Microeconomics versus Macroeconomics

Economics can be divided into two main branches: microeconomics and macroeconomics.
Microeconomics concentrated on the small part of the economy. It is study of how individuals
(households) and business firm make a decision for example, demand and supply of particular
goods, determination of price of specific product, number of workers employed by a single firm,
the revenue or income of a particular firm or household and the expenditure of a specific firm.

While macroeconomics view the economy activity at wide perspective. Macroeconomics
examines the factors that determine national output or national product, deals with national
income, looks at the overall price level, deals with aggregate employment and unemployment
and concentrate on aggregate demand and aggregate supply.

1.2 Macroeconomics goals.

1.2.1 Macroeconomic goals from conventional perspectives

i. Full employment

Full employment is a situation where all of factors of production available in
economic i.e. land, labour, capital and entrepreneur are fully utilized. However
we cannot achieve zero rate of unemployment because frictional
unemployment is largely unavoidable in a dynamic economy. This is because
when individuals who are looking for a new job as a result of dissatisfaction of
the current job or school-leaver and graduates are still looking for a job.
Frictional unemployment is temporary situation only and can be considered as
a normal unemployment. Thus, full employment is something less than 100%
employment of the labour force. This type of unemployment cannot be
eliminated and exist between 4-5%.

ii. Price stability

Inflation happens when there is increase in the general price level if goods and
services in the economy. Inflation is an increase in the overall average level of
prices and not an increase in the price of any specific product. Keeping the
stability of the general price level low has been a long goal of policy maker. As
high rate of inflation will reduce the value of money, purchasing power of
consumers will fall accordingly. This happens because the price of goods and
services becomes more expensive as they only can buy less quantity of goods
and services with the same amount of money.

iii. Economic growth
Economy growth is an increase in per capita real GDP over a given period of
time. The growth rate of real GDP shows how rapidly the total economy is
expanding. The standard of living depends on real GDP per capita. Positive
economy growth signalling that country’s standard of living improves.
Increasing in total output (good and services) per population will elevate
standard of living as real wages and incomes are rising.

Output Real GDP Growth rate Standard of living

iv. Equitable distribution of income

Wide income disparity was major macroeconomic problem most of the nations
want to avoid. Policymaker’s goal is trying to narrow gap between the higher

incomes with lower income group to ensure they earn equitable standard of

living. Methods to change the size distribution of income are:

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

v. i) Tax policy
The most effective is progressive taxation where higher income group
Surplus bear a higher burden of tax rate than the lower income group.
Deficit
ii) Expenditure policy
Through this policy, gap between two groups could be narrowed with
the government providing subsidies, transfer payment and educational
scheme. The benefits received tend to vary with income. Many transfer
payments benefit lower income group. Other expenditures such as
higher education tend mainly to benefit middle-income groups.

Favourable balance of payment

Balance of payment records all of economic transaction between a nation and
the rest of the world during specific period of time usually one year. Balance of
payment summarizes the information of export and import activities with other
countries, earning by domestics residents on assets locates abroad, earning
on domestics assets owned by foreign residents, and official transactions by
central banks and government.

Any transaction leads to payment to other country will be recorded as total debit
because that is outflow of money. For instance, we buy or import good and
services from other countries. Otherwise, if resident of a country export goods
and services to other countries this will leads to receipt of money. These
receipts will be recorded as total credit because that is inflow of money.
Balance of payment will be surplus when total inflow (receipts) greater than
total outflow (payment). A surplus over a few years is not good for our economy
as too much money pouring into our country it leads to inflation. Otherwise,
deficit balance of payment happens when total receipts are less than total
payment. When our balance of payment overwhelmed with deficit, the country
will experiencing with debt problem.

inflow of money greater than outflow of money inflation problem

outflow of money greater than inflow of money debt problem

1.2.2 Macroeconomic goals from Islamic perspectives.

Islam never prohibits Islamic economic agent in chasing maximum Al-Falah, as
long as they utilize all the resources devoted by Allah S.W.T. efficiently and
ensure all economics activities are not against the Shari’ah principle. Al-falah
means the success in this world as well as in the hereafter (akhirat). The
objective of Islamic economics is to get the blessing of Allah as to compare with
Conventional economics which is solely to maximize profits. According to
Islamic framework, the basic policy objectives are:

i) Social justice

Islam considers man as the best of God’s creations and exalted them
to the status of His vicegerent on the earth. In Islam, Allah is the
genuine ownership of all resources in this universe. Nevertheless, He
created everything for the use of the mankind relying on trusteeship.
Man as a trustee of His belonging carries the responsibility (amanah)
to utilize all the resources in the right way and further enrich
those resources.

Islam view all of mankind are alike regardless the status, race and skin
colour. The only creation of a man’s worth is character, ability and
service to humanity.

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In Islam, concept of equity in distribution of income and wealth does
not require everyone to be rewarded equally. This is because Islam
allowed some inequality since it promotes individual initiative and
humankind also difference in term of ability and character.

Islam insists on income-redistribution mechanism so that everyone is
guaranteed with humane and respectful standard of living. There are
three ways that is government assist in finding job for those jobless and
‘just’ remuneration for those working, emphasizing on payment of zakat
and implementation of Islamic inheritance law (faraid) on wealth of
deceased people.

ii) Universal education

In Islam, acquisition of knowledge is compulsory for every Muslim.
Muslims should be given the same chance to acquire education.
Therefore, physical investment in education is necessary to ensure all
people regardless the income level can access to the knowledge.
Thus, we can make use of the education and knowledge for the
betterment of human life. Educational effort not only to raise the
degree of literacy but to leads the Muslims to conform the teachings of
the Qur'an and Sunnah. Education must consist ever new skills,
stimulates people the incentive for research and invention of new
techniques of production and distribution in order to utilize the
resources endowed by Allah more efficiently.

iii) Optimal rate of Economic Growth

Make full use the resources efficiently are become moral obligation
since the resources are a trust from God to his trustee on the earth.
Growth in an Islamic economy is comprehensive and includes moral,
spiritual and material aspects of man's life. In terms of capital formation,
it includes human capital and material capital.

Investment is necessary for physical capital leads to the development
of an economy and this provision is more towards the social benefits.
In Islam human capital formation is also very important because man
is the centre of all economic activity. Thus, expenditure in education is
essential.

iv) Maximizing employment generation

Economic growth makes 'maximum' contribution to the creation of new
employment opportunities. The objective is however not to attain full-
employment at the cost of economic efficiency. Additional employment
in the long run must be generated in a technically efficient fashion.

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SUPPLEMENTARY NOTES FOR MACROECONOMICS
CHAPTER 2

Learning Objectives:
At the end of this chapter, students should be able to:

i. Explain the concepts and circular flow on income and expenditure in 1, 2, 3 and 4
sector economy

ii. Understand to measuring NI using three different approaches: income, expenditure
and output approach.

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

iii. Understand the concepts and measuring personal income, disposable income, and
per capita income, nominal and real income.
iv. Elaborate the uses and the problems in measuring national income.

2.1 Definition of National Income

National income can be defined as the total income received by all economic agents in the
economy based on the good and services produced in the economy, in one year after deducting
the depreciation value of the machines used in the production.

2.1.2 Concept of National Income

i) Gross Domestic Product (GDP)

Gross Domestic Product is the total market value of all final goods and services
produced within a country’s borders in a given year. GDP measures the
production of goods and services in the physical area of country, regardless by
whom the goods and services are produced either by citizen of the country or
foreigners. For example, If a Singaporean citizen lives in Malaysia and
produces cars, the total market value of these cars is counted in GDP because
the Singaporean citizen produced the cars in Malaysia.

GDP excludes non production transaction such as financial transaction and
second hand goods. Purely financial transaction includes public transfer
payment e.g. social security payment, welfare payment and pension, private
transfer payment e.g. money gifts and stock market transactions e.g. the buying
and selling of stocks since it does not include in the actual production. Second
hand sales are also excluded because it is not contributes to current
production. GDP take into consideration on final goods only which is finished
goods and services produced to end consumer. We not include intermediate
goods i.e. an input used as component of final good and services to avoid
double counting.

ii) Gross National Product (GNP)

Gross National Product is defined as total market value of final goods and
services produced by the citizen of a country in a given year. GNP measures
the production of goods and services by country’s resident, no matter where in
the world they reside. For example, Malaysian citizen lives in United States

and produce cars, the production of these cars is counted in GNP because

they were produced by Malaysian citizen.

Domestic National

GDP + (net factor income receive from abroad)

Net factor income received from abroad
factor income received abroad – factor income paid abroad

iii) Market price and factor cost

Market price refers to the current price in the market through the forces of
demand and supply. Market prices are actual price paid by customers. Factor
cost is the real price that is earned by producer or sellers. To know the actual
cost of the product, we need to adjust the market price to factor cost. The
market price will be greater than factor cost due to imposition of tax on goods

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

and services. On the other hand, subsidies could lower the market price as
compared to actual cost incurred.

market price factor cost = market price + subsidies – indirect taxes

iv) Net national product

Net national product is defined as the market value of net output of final goods
and services produced by the nation in a given year. Net national product
earned after deducted GNP with value of depreciation during the year.
Depreciation occurred when some of capital assets and machinery are likely
to go through the course of wear and tear or obsolete. This is also known as
capital consumption or disinvestment. Provision of depreciation must be
excluded to ensure net investment should be included in the National Product.

Net National Product = GNP – capital consumption/depreciation

2.1.3 Circular Flow of Income

FIGURE 2.1: CIRCULAR FLOW OF INCOME - 2 SECTOR ECONOMY
(SIMPLE)

Income received by factors

Factor of production

HOUSEHOLDS FIRMS

Good & services produced

Expenditure on goods and services

Physical flow

Monetary flow

Two major flows that occur in the economy:
1) The physical flows are:

i. From households to firm – households provide factor of production e.g.
land, labour, capital and entrepreneur to firms.

ii. From firms to households – when all factors of production are
converted into input, an output will be produced. The goods and
services will be consumed by households.

2) The monetary flows which are payment to physical flows consist of:

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i. From firms to households – as a return to the first physical flows,
households will receive payment on the factor of production that they
provided to the firms. As owners, they will receive payment in form of
profit, labour will receive wages/salaries, for those provide capital will
receive interest, while an owner of land will receive payment in form of
rent.

ii. From households to firm – because of expenditure made on goods and
services, households will pay to the firms.

FIGURE 2.2: CIRCULAR FLOW OF INCOME - 2 SECTOR ECONOMY

Income received by factors

Factor of production

HOUSEHOLDS BANKING FIRMS
Saving SECTOR Investment

Good & services produced
Expenditure on goods and services

This two-sector economy consists of households, banking sector and firms. Income
received by household will be saved in banking sector. Saving made by households
known as leakages/withdrawal because amount of income is withdrawn from the
circular flow income. A leakage means amount of income received, which is not passed
on within the circular flow and it will reduce the flow of income. Then, banking sector
will make profit by using the saving and lending it to the firms. Savings of money in the
banking sectors are the fund for investment to the firms. When firms plan to invest, the
flow of income will increase because some amount of income gets into the circular flow.
Investment is also known as injection because it raises the National Income. The
economy will thus in equilibrium.

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

FIGURE 2.3: CIRCULAR FLOW OF INCOME - 3 SECTOR ECONOMY

CONSUMPTION

HOUSEHOLDS FIRMS

INCOME

SAVING BANKING SECTOR INVESTMENT
TAXATION
GOVERNMENT GOVERNMENT
SECTOR SPENDING

A 3-sector economy consists of households, firms and government sector. The intervention by the
government will change the NI through its two activities:

i) Taxes imposed on households and firms (T)
ii) Government expenditure (G)

Government is one of the sectors that make expenditure, whether on goods or services, staffs’
remuneration, other public and development expenditure etc. Such expenditure can raise the NI and
known as injection as it makes the NI in the circular flow increases. When the government imposes the
taxation, it is not flown back into the circular flow and makes NI decreases, hence taxes known as a
leakage.

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FIGURE 2.4: CIRCULAR FLOW OF INCOME – 4 SECTOR ECONOMY

CONSUMPTION

HOUSEHOLDS FIRMS

INCOME

SAVING BANKING SECTOR INVESTMENT
TAXATION GOVERNMENT
GOVERNMENT
IMPORT SECTOR SPENDING

INTERNATIONAL EXPORT
SECTOR

A 4-sector economy is also known as an opened economy because it practices international trade
activities. It is consisting of households, firms, government sector and international trade. There are two
activities that will affect equilibrium of NI namely export and import. Export is an injection since it makes
the NI level increases. As an output is purchased by other countries, we will receive the more income
and there are some inflows of money into our country. Import indicates the expenditure that is made by
our country on foreign country’s output. Import is leakage because the money flow out of our economy
and NI will fall.

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2.2 Measuring National Income

By using three approaches eventually National Income will give the same result.

As a conclusion, we have an identity that:

National Product = National Expenditure = National Income

2.2.1 The Product Approach

There are three major economy sectors such as:
i) Primary sector; agriculture activities such as mining, quarrying, fishing, forestry, farming,

etc.
ii) Secondary sector; manufacturing, construction
iii) Tertiary sector; services activities such as telecommunication, transportation, tourism,

banking and insurance etc.

Formula:
GDPmp = 1st sector + 2nd Sector + 3rd Sector
GDPfc = GDPmp + Subsidies – Indirect tax

GNPfc = GDPfc + Net factor income received abroad
NNPfc/ NI = GNPfc – Depreciation

**Students are advised to not memorize the formula, and need to excel how to
make an adjustment
The total value of product and services will give us the ‘Gross Domestic Product at market price’.

GDPmp = Primary sector + Secondary sector + Third sector

To adjust Market price factor cost

GDPfc = GDPmp + subsidies - Indirect Tax

To adjust Domestic National

GNfc = GDPfc +Net Factor Income received abroad

To adjust Gross Net

NNPfc = GNPfc - Depreciation

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Table 2.1: NI calculation using the Product Approach RM MILLION
ITEMS 340
110
Agriculture 200
Fishing 500
Forestry 510
Manufacturing 370
Construction 40
Banking and insurance services 2070
Other services (320)
Gross Domestic Product At Market Price 450
Indirect taxes (Taxes on expenditure) 2200
Subsidies 550
Gross Domestic Product at Factor Cost (300)
Factor income from abroad 2450
Factor payment to abroad (100)
Gross National Product at Factor Cost 2350
Depreciation (Capital Consumption)
Net National Product at Factor Cost (NI)

Now student can try the following question:

Given the following data of a country, for the year ended February 2013:

ITEMS RM MILLION

Banking and Insurance services 580

Agricultural and fishing 230

Mining 310

Construction 670

Forestry 210

Manufacturing 780

Other services 400

Depreciation 230

Taxes on expenditure 320

Subsidies 450

Factor income from abroad 640

Factor payment to abroad 520

Calculate:
a) Gross Domestic Product at market price
b) Gross National Product at market price
c) Net National Product at market price
d) Net National Product at factor cost

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2.2.2 The Expenditure Approach

Based on this approach, we must add all 4 major component of Aggregate Demand
namely household, firms, government and international trade. Total expenditure made
by households is known as consumption (C), while investment made by firm is called
isnvestment or capital formation (I), expenditure made by government is called as
government expenditure (G). The value of export (X) must be included as it represents
the total expenditure made by other countries on our national product. Import (M) must
be deducted since it is also a kind of expenditure made by us but on the other countries’
national product.

Gross Domestic Expenditure = C + I + G + (X – M)

GDPmp = C + I + G + (X – M)

GDPfc = GDPmp + Subsidies – Indirect tax

GNPfc = GDPfc + Net factor income received abroad

NNPfc/ NI = GNPfc – Depreciation

***There is some adjustment need to take into account to get accurate data for the NI

To adjust Market price factor cost

GDPfc = GDPmp + subsidies - Indirect Tax

To adjust Domestic National

GNfc = GDPfc + Net Factor Income received abroad

To adjust Gross Net

NNPfc = GNPfc - Depreciation

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Table 2.2: NI calculation using the Expenditure Approach

ITEMS RM MILLION

Consumers expenditure 420

Public/Government expenditure 570

Gross Domestic Capital Formation (Gross Investment) 600

Physical increase in stock 280

Export 470

Import (270)

Gross Domestic Expenditure at market price 2070

Indirect tax (320)

Subsidies 450

Gross Domestic Expenditure at factor cost 2200

Factor income from abroad 550

Factor payment to abroad (300)

Gross National Expenditure at factor cost 2450

Depreciation (100)

Net National Expenditure at factor cost 2350

Students are required to solve the question below:

ITEMS RM MILLION
Public current expenditure 90
Household consumption 82
Gross Investment 100
Indirect taxes 50
Factor income receive from abroad 40
Factor payment to abroad 44
Depreciation 20
Subsidies 42
Import 90
Export 150

Calculate:
a) Gross Domestic Product at market price
b) Gross National Product at factor cost
c) Net National Product at factor cost

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2.2.3 The Income Approach
This approach requires us to add-up all the total income received by all economic
agents that are wages, interest, rent and profit. It is measured in terms of factor cost.

GDI = Wages + Rent + Interest + Profit Distributed profit (Dividend)

Undistributed profit (Retained earnings)
GNI = GDI + Net factor income receive abroad

NNIfc @ NI = GNI - depreciation

***remember Income approach does not start with market price so there is no adjustment from
mp to fc

Table 2.2: NI calculation using the Income Approach

ITEMS RM MILLION

Income from employment 600

Income from self employment 410

Rent and interest 400

Companies profit: Dividend 410

Retained profit 380

Gross Domestic Income at factor cost (GDI fc) 2200

Factor income from abroad 550

Factor payment to abroad (300)

Gross National Income at factor cost (GNI fc) 2450

Depreciation (100)

Net National Income at factor cost (NNI fc) 2350

Let we try an example of this approach:

ITEMS RM MILLION
Income from self employment 45,200
Income from employment 80,100
Rent and interest 45,000
Distributed profit 30,000

Undistributed profit 60,000

Other sources of income 35,000

Net property income from abroad -5,200

Depreciation 31,000

Subsidies 40,000

Calculate:
a) Gross Domestic Income
b) Gross National Income
c) National Income

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2.3 The Concepts of Personal Income (PI) Approach and Disposable Income (PDI)

Personal income represents the total income actually received by all people in the economy
whether they are economic agents or not.

National Income
Add: Transfer payment
Less: Tax on companies’ profit

Employee Provident Fund (EPF)
Social Security Contribution
(SOCSO)
Undistributed Profit

The Disposable Income is the actual amount that can be spent by individuals.

PDI = PI – Individual income tax

2.3 Uses of National Income

i. To measure the economic growth

A country experiences a satisfactory rate of economic growth if there is increase in the real
GNP over the years.

Growth rate = Real GNP1 - Real GNP10 x 100
Real GNP0

Real GNP = Price index base year x nominal GNP
Price index current year

Price index base year = 100
Nominal GNP – measured in current price

Example:

Gross National Product at current price 2010 2011
(RM Million) 360 410
Consumer Price Index
120 125

Calculate:

a) Real GNP for 2010 and 2011

RGNP 2010 = 100 x 360
120

= 299.88 (RM Million)

RGNP 2011 = 100 x 410
125

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= RM328 (RM Million)

b) The rate of economic growth from 2010 to 2011.

328 – 299.88 x 100
299.88

= 9.38%

If there is a positive economic growth, it means there is an increase in the amount of

goods and services in the country. The increasing rate of economic growth over a
period of time shows that the country’s development grows much faster.

ii. To measure standard of living

High national income indicates the country with high standard of living. Countries with high
national income namely US, UK and Canada usually said have standard of living. Countries
with lower national income such as Myanmar, Vietnam and Cambodia have lower standard of
living.

iii. To know the distribution of income in the economy

From the NI data, we will be able to see the income earned by different sector and factor of
production namely figure of rent, salary, interest and profits.

iv. Sectoral contribution

NI data in Product approach gives us picture which sector are significantly contribute to
economic growth. Major contributor to the GDP is the services sector in Malaysia. However,
before 1980s the primary sector was contributing to Malaysian economy. The trend has
changed to secondary sector in the 1980s.

v. To assist the government in the planning

Trend of national income statistic will help the government to formulate its short term and long
term planning for economic development.

vi. Comparison between countries

With National Income Per capita we can compare which country is less developed or
developed. If GNP per capita is greater than USD18,000 the country is considered as an
industrially advanced country whereas countries with GNP per capita lower than USD2,000 are
considered to be less developed.

vii. To see the government’s expenditure pattern

Figure as in expenditure approach will show the pattern of how government makes an
expenditure namely social benefits, defence, education, etc.

2.5 Problem in Measuring National Income

i. Problem of double counting
Double counting happens when intermediate goods are included in the national income. To
avoid this problem, only the value of final goods must be counted or the added value at each
stage of the production of all goods should be counted. For example, the economy produce
wheat which cost RM1.00 and firm processed it to become flour which cost RM1.80. A bakery
shop to make bread buys this flour and sell to housewife at the price of RM3.00. In order to

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calculate the NI using product approach, we have to identify value of final good only not RM5.80
(RM1 + RM1.8 + RM3.00).

ii. Problem of expertise
Lack of professional such as statistician, researchers and analyst will lead to human and
technical error.

iii. Problem of illiteracy
The producers that are illiterate and unable to keep accounts of their productive activities will
affect accuracy of information in calculating national income.

iv. Problem of non-monetized sector
There are lot of productive activities in the economy but they are not paid in term of money. For
example, system barter was implementing as an exchange for other goods and services.

v. Problems of depreciation estimation
Different method applied in estimating depreciation.

vi. Problem of less sophisticated machinery
Lack of advanced programs or some countries still use obsolete technical equipment to
calculate national income make a data are less accurate.

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CHAPTER 3

Learning Objectives:
At the end of this chapter, students should be able to:

i. Understand two approaches to determining NI Equilibrium.
ii. Explain Consumption theory and Investment theory: Conventional Autonomous

and Induced.
iii. Explain Islamic Consumption theory: Fahim Khan Islamic consumption.
iv. Understand calculation NI equilibrium in 2, 3, and 4 sector economy.
v. Understand expenditure and tax multiplier
vi. Discuss Inflationary and Deflationary Gap

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3.1 Approaches to determine national income equilibrium

There are two approaches to determine the level of equilibrium national income in economy:

i. Aggregate Demand (AD) = Aggregate Supply (AS) Approach

Component of AD = C + I + G + (X - M)
AS known as National Income (Y)

ii. Injection = Leakage Approach

Injection = I + G + X
Leakage = S + T + M

Equilibrium Condition

AS = AD Leakage = Injection

1 Sector economy (Breakeven Y=C S =0
Income
Y=C+I S=I
2-sector economy Y=C+I+G S +T = I + G
3-sector economy Y = C+ I + G + (X - M) S+T+M=I+G+X
4-sector economy

3.2 Consumption

Consumption is an expenditure made by households on goods and services which are
produced by firms. Consumer will spend partly of his income and save the rest of their income.

Income = Consumption + Saving

Y=C+S

C is function of income:

C = f(Y)

Two types of consumption:

i) Autonomous Consumption
Autonomous consumption is the amount of consumption that does not change with
income. The total income can be RM0 but the amount of consumption can never be
RM0. If we do not have an income it does not means we are not buying anything
because we still need to spend on necessities such as food, housing, and etc.

ii) Induced Consumption

Induced consumption is kind of consumption that tend to increase as income increase.

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Table 3.1: Planned Consumption by Households

Income (Y) Consumption Autonomous Induced
Consumption (a) Consumption (i)

0 40 40 0
80
100 120 40 160
240
200 200 40 320
400
300 280 40 480

400 360 40

500 440 40

600 520 40

Figure 3.1: Autonomous Consumption and Induced Consumption

C
C

a

Induced Consumption

Y

Autonomous Consumption

Average Propensity to Consume (APC)

APC measures the proportion of income that used for consumption by households, at certain
level of income.

APC = C
Y

For example: Y = RM450, C = RM290

APC = 290 = 0.64
450

This means that when the NI is RM400m, household will use 64% of the income as their
consumption.

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Marginal Propensity to Consume (MPC)

MPC measures the rate of changes in consumption when income changes.

MPC = C
Y

Example:

Y0 = RM200, C0 = RM240 320-240 = 0.8
Y1 = RM300, C1 = RM320 300-200

0.9 means that consumption will change by 90% of the changes in income.

MPC is also measuring the slope of the consumption function. C represents the vertical
distance and the Y is the horizontal distance.

From table 3.1, we can find the value of APC and MPC

Table 3.2: APC & MPC

Income (Y) Consumption APC MPC
0 -
40 -
100 0.8
200 120 1.2 0.8
300 0.8
400 200 1 0.8
500 0.8
600 280 0.93 0.8

360 0.9

440 0.88

520 0.87

Consumption Function

C = a + bYd

C = Total consumption Yd = Y - T
a = autonomous consumption T=0
b = MPC Yd = Y
Yd = Disposable income

Base on the above table, to write the consumption function as a + bYd, it should be,
C = 20 + 0.9Yd. Diagram of consumption function as below:

Figure 3.2: Consumption Function

C

C = 40 + 0.8Yd

20
Y

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Example of consumption function
C

C = f(Y)
490

380
300

0 400 Y
200

a) Identify the amount of autonomous consumption.
b) Calculate the marginal propensity to consume, MPC.
c) Write the consumption function as a + bY.
d) If the income level is RM2500, how much is the total consumption that households planned to

do?
e) At what level of income do households planned to do consumption of RM600?
f) Determine the average propensity to consume when income is RM600?

Answer:
a) 300
b) 0.55
c) 300 + 0.55Y
d) RM1,675
e) RM545.45
f) 1.05

3.3 Saving

Saving is part of income received by households that is not used for consumption.

S=Y–C because Y=C+S

Saving also function of income, so S = f(Y).

Income (Y) Consumption Saving
S=Y–C
0 40
100 120 -40
200 200 -20
300 280 0
400 360 20
500 440 40
600 520 60
80

Since the consumption does not start with RM0, saving also does not start with RM0.
Autonomous consumption as we explained earlier will be RM40 even the income is RM0. The

23

SUPPLEMENTARY NOTES FOR MACROECONOMICS

question is how the household do a spending when income is RM0? The household will took
RM40 from their saving. Thus, when income is RM0, S = -RM40 and it is known as the
autonomous saving.
Average Propensity to Save (APS)

APS measures the proportion of income that households save.

APS = S
Y

Example: Y = RM500, S = RM50, APS = 0.1

Household is planned to save 10% from the income, another 90% of the income will be
consumed.

Marginal Propensity to Save (MPS)

MPS measures the rate of changes in saving when income changes.

MPS = S
Y

Example: Y0 = 100, S0 = -10 0 - -10 = 0.1
Y1 = 200, S1 = 0 200 - 100

0.1 indicates that when income changes from RM100 to RM200, saving will change by 10% of
the changes in Y.

Table 3.2: Relationship between APC, APS, MPC & MPS

Income (Y) Consumption Saving APC APS MPC MPS
-
0 20 -40 - - -
0.2
100 110 -20 1.2 -0.2 0.8 0.2
0.2
200 200 0 1 0 0.8 0.2
0.2
300 290 20 0.93 0.07 0.8 0.2

400 380 40 0.9 0.1 0.8

500 470 60 0.88 0.12 0.8

600 560 80 0.87 0.13 0.8

Note That:

APC + APS = 1
MPC + MPC = 1

Saving Function

S = -a + (1-b)Y

S = Total Saving
-a = autonomous saving
b = MPC
thus, (1-b) = 1 - MPC = MPS

Base on the above example, the saving function can be written as S = - 40 + 0.2Y.

24

SUPPLEMENTARY NOTES FOR MACROECONOMICS
Figure 3.3: Saving Function

S

S = -40 + 0.2Y

-40 Y
S = f(Y)
Example of Saving Function
S

0 4000 Y
-500

a) How much is autonomous saving?
b) Determine the MPS.
c) Write the saving function as S = -a+1-bY
d) How much is saving when the level of income is RM4500?
e) Calculate the APS at income level of RM3500.
f) At what income level do households planned to save RM600?

Answer

a) –a = -500
b) 0.125
c) S= -300 + 0.125Y
d) RM262.5
e) 0.039
f) RM7200

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

Determinant of consumption and saving

a) The level of disposable income

There is positive relationship between disposable income with consumption and saving.
If there is increase in disposable income, people will consume more goods and services
and also will save more.

b) Distribution of wealth

Real assets and financial assets are the form of wealth the household own. People that
more wealthy will consume more goods and services as compared to less wealthy
people. Wealthy people will save more than individuals who are less wealthy.

c) Expectation

Expectation of future price and availability of goods and services will affect the current
spending and saving. People will spend more now if they expect the goods and services
in the future will increase.

d) Level of taxation

The higher the level of taxes, the less disposable income left to spend on goods and
services and saving.

e) Rate of interest

The households will save more if there is increase in interest rate and reducing their
consumption on goods and services.

Consumption from Islamic perspectives

According to Fahim Khan, the word spending has two kinds:

i) To fulfil material needs for oneself and his family
ii) To fulfil the others’ needs (to acquire Allas’s blessing)

Investment theory

There are two major types of investment:

i) Induced investment

The kind of investment that depending on level of income. It has positive relationship with
national income. When national income increases, induced investment will increases since
higher national income will attracts more investors to invest.

Investment

Induced Investment

National Income (Y)

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

ii) Autonomous investment
The kind of investment that does not depends on level of income but other factor. The
other factor such as interest rates, level o of technology, there is no relationship between
national income and autonomous investment. Whether income increase or reduce, the
investment will remain constant.

Investment

Autonomous Investment

National Income (Y)

Factors that will influence Investment
i) Rate of return

Investment regarded as not profitable as rate of return is lower than cost investment such
as cost of machinery. The more profitable the expected return, the greater will the
investment be.
ii) Rate of interest
It is a financial cost that firm has to finance in order to purchase the real assets. The higher
the interest rate, the cost of borrowing will be more expensive and the investment
considered less profitable.
iii) Government policies
Government provides a lot of facilities such as good infrastructure system, tax incentives
and grants to attract more investor from domestic and foreign.
iv) Level of technology
The advancement of technology will reduce the cost of production and improve the quality
of product and this will increase the investment.
v) Expectation of the future
Investment will made base on Business forecast and future economic condition. The firm
will be more interested to invest if they positive and confident about future profitability.
vi) Business taxes
The investment will reduce if government increase the business taxes for example
increase in corporate tax will lower the profitability of investment.

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SUPPLEMENTARY NOTES FOR MACROECONOMICS
Investment theory from an Islamic Perspective
All the resources that is gifted by Allah S.W.T must be managed and utilized for the benefit of
mankind according to Syariah. human kind has to utilize mental and physical ability to enrich
themselves and society as well as develop the word.
There are limitations of investment in Islam:
i) Halal and Haram
Islam has forbidden any investment that is against Syariah or the islamic law. Any goods
that are forbidden or haram cannot be traded such as liquor, blood, swine and any
transactions that is not certain such as gharar, gambling and etc.
ii) Investment priorities
Investment should be based on priorities and according to the needs and wants by the
society namely Dharuriyat, Hajiyat and Kamaliat.
iii) The prohibition of interest
Interest or riba prohibited in Islam. Riba technically refers to the premium that must be
paid by the borrower to the lender along with the principal amount as a condition for the
loan of for an extension in its maturity. As the alternatives, the Muslim investors can
borrow the loan by using Islamic banking that is interest-free for example by using Al-
Mudharabah or Al-Musyarakah (will be discusses on chapter 5).

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

3.4 Determination of Equilibrium NI
3.4.1 Determination of Equilibrium in 1 sector/breakeven income
Breakeven income is when the household spend all of his income and they do not do
any saving. It also called as one-sector economy where only have component of
consumption there is no saving made by household.

i) AD – AS Approach

Given, C = 20 + 0.9Y
Breakeven income Y = C
Y = 20 + 0.9Y
Y – 0.9Y = 20
Y = 20/0.1
Y = 200

Figure 3.4: AD – AS Approach

C

Break-even AS
point C = 20 + 0.9Y

20 Break-even Income
450
200 Y

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SUPPLEMENTARY NOTES FOR MACROECONOMICS
ii) Injection – Leakage Approach
Given, S = -20 + 0.1Y
Breakeven Income, S = 0
-20 + 0.1Y = 0
-20 = 0.1Y
Y = 200
Figure 3.5: Injection – Leakage Approach

S

S = -20 + 0.1Y

0 Y
200

-20

3.4.2 Determination of Equilibrium in 2 Sector Economy

Table 3.3: Aggregate Demand in 2 Sector Economy

Income Consumption Saving Investment AD = C + I
(Y @ AS)
20 -20 10 30
0 110 -10 10 120
100 200 0 10 210
200 290 10 10 300
300 380 20 10 390
400 470 30 10 480
500 560 40 10 570
600

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

i) AD – AS Approach
Component of AD in 2 sector economy is C and I
Y=C+I
Given, C = 20 + 0.9Y
I = 10
Y = 20 + 10 + 0.9Y
Y = 30 + 0.9Y
0.1Y = 30
Y = 300
Figure 3.6: AD – AS Approach

C

AS
C + I = 30 + 0.9Y
C = 20 + 0.9Y

30 Y

20 300
450
200

ii) Injection – Leakage Approach

Given, S = -20 + 0.9Y, I = 10
S=I
-20 + 0.9Y = 10
Y = 300

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SUPPLEMENTARY NOTES FOR MACROECONOMICS
Figure 3.7: Injection – Leakage Approach

S

0 S = -20 + 0.1Y
200
I = 10
-20 Y

300

3.4.3 Determination of Equilibrium in 3 Sector Economy

i) AD – AS Approach

Component of AD in 3 sector economy is C, I and G

Y=C+I+G

Given, C = 20 + 0.9Y
I = 10
G = 10
T=0

Y = 20 + 10 + 10 + 0.9Y

Y = 40 + 0.9Y

0.1Y = 40

Y = 400

ii) Injection – Leakage Approach

Given, S = -20 + 0.9Y
I = 10
T=0
G = 10

S+T=I+G

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

-20 + 0.9Y + 0 = 10 + 10
Y = 400

The effect of Tax on NI

Imposition of tax will change consumption and saving function. There are 2 types of
tax:

i) Autonomous tax

The amount of tax does not depend on the NI. For example T = RM10

Since Yd = Y – T Yd = Y – 10

The consumption function after tax will be:

C = 120 + 0.8Yd
C = 120 + 0.8(Y – 10)
C = 120 + 0.8Y – 8

C = 112 + 0.8Y

Effect of taxation on NI

C = 120 + 0.8Yd
I = 35
G = 20
T = 10

Y = 120 + 35 + 20 + 0.8 (Y – 10)
Y = 175 – 8 + 0.8Y
Y – 0.8Y = 167
Y = 167 / 0.2
Y = 835

ii) Induced tax

The amount of tax depends on the level of income. For example:

T = 0.1Y

The consumption function after tax will be:

C = 120 + 0.8Yd
C = 120 + 0.8(Y – 0.1Y)

C = 120 + 0.8 (0.9Y)

C = 120 + 0.72Y

Effect of taxation on NI

C = 120 + 0.8Yd
I = 35
G = 20
T = 0.1Y

Y = 120 + 35 + 20 + 0.72Y

Y = 175 + 0.72Y
Y – 0.72Y = 175
Y = 175 / 0.28

Y = 625

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

3.4.4 Determination of Equilibrium in 4 Sector Economy (Open Economy)

i) AD – AS Approach

Component of AD in 3 sector economy is C, I, G, X-M

Y = C + I + G+ (X – M)

Given, C = 20 + 0.9Y
I = 10
G = 10
T=0
X = 30
M = 20

Y = 20 + 10 + 10 + (30 – 20) + 0.9Y

Y = 40 + 10 + 0.9Y

0.1Y = 50

Y = 500

ii) Injection – Leakage Approach

Given, S = -20 + 0.9Y
I = 10
T=0
G = 10
X = 30
M = 20

S+T=I+G

-20 + 0.9Y + 0 + 20 = 10 + 10 + 30

Y = 500

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

3.5 Multiplier

This explains when there is a change in the component of AD, it will make the NI change.

Government Multiplier

The size of multiplier depends on the MPC and MPS

1 @1

1 – MPC MPS

1 4 - Sector Economy
1 – b + bt + m
3 - Sector Economy
1
1 – b + bt 2 - Sector Economy
T=0
1
1–b therefore t = 0

To determine new equilibrium by using multiplier approach;

Y= k
G

Example

C = 250 + 0.8Yd
I = 20
G = 120

a) Calculate the level of equilibrium NI in this economy.
b) Now government imposed tax, T = 10 + 0.1Y, calculate the new equilibrium income.
c) Based on (c), determine new equilibrium income by using multiplier approach if

government expenditure changes by RM30.

Answers:

a) Y = 250 + 0.8 Y + 20 + 120
0.2Y = 390
Y = RM1950

b) C = 250 + 0.8(Y – (10+0.1Y) + 20 + 120
= 390 + 0.8(Y – 10 – 0.1Y)
0.28Y = 390 + 0.8(0.9Y – 10)
Y = 390 + 0.72Y – 8
Y
= 382 + 0.72Y

= 382

= 382/0.28

= 1364.29

c) Y0 = 1364.29
Y1 = ?

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

T = 10 + 0.1Y, t = 0.1

Y1 – 1364.29 =1
30 1 – 0.8 + 0.8(0.1)

Y1 – 1364.29 = 3.57(30)

Y1 = 1364.29 + 107.1
Y1 = 1471.39

Investment Multiplier

The size of multiplier depends on the MPC and MPS

1 @1

1 – MPC MPS

1 4 - Sector Economy
1 – b + bt + m
3 - Sector Economy
1
1 – b + bt 2 - Sector Economy
T = 0, t = 0
1
1–b

To determine new equilibrium by using multiplier approach;

Y= k
I

Example

C = 250 + 0.8Yd
I = 20
G = 120

a) Calculate the level of equilibrium NI in this economy.
b) Determine new equilibrium income by using multiplier approach if Investment

expenditure changes by RM30.

`Answers:

Y = 250 + 0.8 Y + 20 + 120
0.2Y = 390
Y = RM1950

Y0 = RM1950
Y1 = ?
T = 0, t = 0

Y1 – 1950 =1
30 1 – 0.8

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

Y1 = 150 + 1950 Y1= RM2100
Tax Multiplier

-b 4 - Sector Economy
1-b + bt + m
3 - Sector Economy
-b M = 0, m = 0
1-b + bt
2 - Sector Economy
-b T = 0, t = 0
1-b

3.6 Inflationary Gap and Deflationary Gap

3.6.1 Inflationary Gap

Inflation is a situation where the general price level in the economy increases.
The inflationary gap will occur when the aggregate demand exceeds the
aggregate supply at the full employment level (Ye> Yf). Therefore, we cannot
simply raise the aggregate supply to fulfil the excess since economy had nearly
reached full employment level. Government can implement contractionary
fiscal policy by reducing the government expenditure and increase the taxation.

Figure 3.8: AD – AS Approach

C

AS
ADe
ADf

IG

450 Y
Yf
Ye

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SUPPLEMENTARY NOTES FOR MACROECONOMICS
Figure 3.9: Injection – Leakage Approach

S

S
I+G+X

IG
I + G + X’

0Y
Yf Ye

3.6.2 Deflationary Gap

It happens because the resources are not fully utilized and indicates the level
of national income equilibrium below the full employment level. Deflationary
gap occurs when Ye < Yf (AD < AS). The problem associated with this situation
is unemployment problem. Government can implement expansionary fiscal
policy by reducing the taxation and increase the government expenditure.

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SUPPLEMENTARY NOTES FOR MACROECONOMICS
Figure 3.10: AD – AS Approach

C

AS
ADf

DG ADe

450 Y
Ye
Yf

Figure 3.11: Injection – Leakage Approach

S

S
I + G + X’

DG
I+G+X

0Y
Ye Yf

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

CHAPTER 4
Learning Objectives:
At the end of this chapter, students should be able to:

i. Define what is money and function of money.
ii. Explain characteristics of money and types of money.
iii. Understand the central bank/commercial bank and its function.
iv. Understand the credit creation process and money supply.
v. Discuss three motive for holding money and equilibrium in the money market
vi. Discuss Monetary Policy

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

4.1 Definition of money
Long time ago, the people was implementing the barter system where the goods and services
were exchanged with other goods and services. Because of the weakneses of the barter system
that requires ‘double coincidence of wants’ and many other problems, monetary system was
took place. The evolution of money has been start, many things such as bones, fur, stones,
gems, silver, copper, and gold had been use as money. Therefore, money can be defined as
anything that is generally acceptable as a medium of exchange. Nowadays, coins and notes
used as money.

4.1.1 Characteristics of Money

4.1.2 i. Acceptable
Must be generally accepted as a means of exchange for the goods and services.

ii. Scarcity
It must be scarce and limited in supply. Just imagine if stone used as a payment
of goods and services. it is easy to get anywhere and there is no value on that
stone and could not be used as a medium of exchange.

iii. Portable
It should be easy to carry and too heavy like gold.

iv. Durability
Must last long and does not deteriorate easily

v. Divisibility
It should be able to be divided into smaller units and must be uniform and
accountable.

vi. Completely liquid
It can be easily exchange for good and services without any additional expenses.
-

Function of Money

i.A medium of exchange
Money is used as a means of exchange for goods and services as people can
accept it as a payment.

ii.A store of value
Money can be keep for future use such as buying or selling goods and services.
the value of money can be retain over time if we keep money for the future use
as long as the value of money does not fall as affected by inflation problem.

iii.A unit of account
Money serves as a measurement of value for the goods and services. Value of
goods and services was stated in term of monetary units and enable people to
make a comparison of relative value for the goods and services.

iv.A standard of deferred payment
Money can be used for payment at later date and ease us to make an agreement
to purchase goods and services and to be paid in the future.

4.1.3 Types of money

i. Commodity money
An item that have intrinsic value such as gold, silver and copper.

ii. Fiat money
Money that has no intrinsic value for example coins and notes.

iii. Current deposits
Also known as demand deposit, cheque deposit or bank deposit. They are
transferable from person to person through the use of cheque

4.2 Supply of Money

Money Supply M1

Consist of most liquid assets such as fiat money and demand deposit at commercial bank.

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

M1 = Fiat money + demand deposit
Money Supply M2

It comprises of M1 and saving, fixed account, repurchase agreement, net negotiable agreement
and foreign currency deposits at commercial bank, and Bank Negara Certificates.

M2 = M1 + saving account + fixed account + repurchase agreement, net negotiable instrument
+ Bank Negara Certificates (placed at commercial bank)

Money Supply M3

It include all the M2 plus saving, fixed deposit repurchase agreement, foreign currency deposits
and net negotiable instrument at other financial institutions, merchant bank and discount
houses.

M3 = M2 + saving account + fixed account + repurchase agreement, net negotiable instrument
+ Bank Negara Certificates (placed at other financial institutions, merchant bank and discount
houses)

Narrow Quasi Money = M2 – M1

Near Money = M3 – M1

Assets that are easily converted into cash at low cost and little risk of loss, such as money
market discount and bank deposits
4.3 The function of Central Bank and Commercial Bank

Central bank in Malaysia known as Bank Negara Malaysia and was established on 26 January
1959. It was controlled and owned by Government.

Function of Central Bank:

i. Issue currency and hold reserves in safeguarding the value of the currency

Only central bank is allowed to print the paper money and coins. The central bank also
responsible to safeguard the value of currency issued.

ii. Act as a banker and financial advisor to the government

BNM administered account government account, receive taxes, manage the
government’s debt and make a payment on behalf of the government.

iii. Act as a banker to other banks

Central bank keeps and safeguards the cash reserve of commercial bank. They also
act as a lender of last resort to commercial bank in order to avoid any panic banking
among society.

iv. Promote monetary stability and financial structure

Responsibility of central bank is to maintain the price stability and high level of
employment. Government through Bank Negara Malaysia will tighten or loosen its
monetary policy to promote monetary stability.

v. To influence the credit situation

Credit situation can be influenced when central bank fixed the reserve requirement in
order to control the loan that can be made by commercial bank.

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

Function of commercial bank:

i. Accepting deposit – receives a deposit made by customers in the form of demand
deposit, saving deposit and fixed deposit.

ii. Providing loans – give a loan such as housing loan, car loan, education loan, personal
loan etc

iii. Providing other facilities and banking services – facilitates foreign exchange,
issuing draft, provides ATM etc.

4.4 The Credit creation process

Credit creation is the process by which when the small deposit will lead the money supply of a
country is increased.
There are few assumptions for credit creation:

i. The cash ratio is determined by the central bank and the value is fixed.
ii. No leakage/withdrawals in banking system.
iii. The public will keep their money in the bank.
iv. Banks must give loans and do not keep excess reserves.
v. Transaction will use cheques.
vi. Bank assets in the form of loan and cash.

Formula:

Cash Ratio Cash x 100
Liquidity Ratio Initial Deposits

∑ liquidity asset x 100
Initial Deposits

Money Multiplier 1
Cash Ratio

Money Supply Initial deposit x money multiplier

Total Reserves Initial reserves x money multiplier

Total Required Reserves Initial required reserves x money multiplier
(cash reserve) Initial excess reserves x money multiplier

Total Excess Reserves (loan)

Total Reserves Required Reserves + Excess Reserves

Credit Creation Money supply - Initial deposit

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

Process of Credit Creation

Assume Mr. Kumar deposits RM1, 000 in Bank 123. The balance sheet of the Bank 123 as follow:

Asset Liability

Cash RM1, 000 Deposits RM1, 000

The Bank 123 must keep a cash ratio of 20% as required by BNM and lend out the balance of 80%.
Then the balance sheet of Bank 123 show:

Asset Liability

Cash ` RM 200 Deposits RM1, 000
Loans RM 800 RM1, 000
RM1, 000

Bank 123 gives loans RM800 to Mr Raju. Mr Raju make an investment and making profit then deposits
the same amount RM800 in the same bank (no leakage in banking system).

Assets Liability

Cash RM160 Deposits RM800
Loans RM640 RM800
RM800

This process will continue until the total deposits in the country reach RM5, 000.

The process to achieve RM5000 can use the formula, Initial Deposit x money multiplier (RM1000 x
1/20% = RM5000).

To find total Loan = Initial loan x money multiplier (RM800 x 5 = RM4000)

LimiTtaotifoinndstototaCl rreeqduitirCedreraetsieornv:e/cash = initial cash x money multiplier (RM200 x 5 = RM1000)

1. Cash ratio

The increase in the cash ratio, the less credit can be created.

2. Rules and Regulations are imposed by the BNM.

This will affect the amount of loans that will limit the credit creation.

3. Relax assumptions:

i. Not all members of the public will keep money in the bank.
ii. Some of the banks would keep excess reserves.
iii. In reality, there are leakages in the banking system.
iv. Public also use cash, besides cheques.

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SUPPLEMENTARY NOTES FOR MACROECONOMICS
4. Collateral security.

It is in the form of mortgages, land title, and insurance can reduce the creation because loans
are not sanctioned if people not provide the securities.
4.5 Motives of holding money
Keynes state people want to hold money for 3 purposes:

i.Transaction purpose
People hold money for the purpose of buying goods and services. The transaction
purpose is depending on level of income. There is positive relationship between income
level and amount of money that people want to hold for this purpose. As income rises,
demand of money for transaction purpose also will increase.
Figure 4.1: Transaction purpose

Income level

Demand for money

ii.Precautionary purpose
Money is demanded for the emergency or unforeseen circumstances such as accident,
illness, and others. The total amount of money for this purpose influenced by level of
income and there is also positive relationship between this purpose and income level.
Figure 4.2: Precautionary purpose

Quantity of money
Income level

Demand for money

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

iii.Speculative purpose
According to Keynes, people also hold the money to speculate on securities (bond and
shares). The quantity of money no longer depends on income level but on interest rate.
The amount of money is held for the purpose of getting profit from speculation activities.
Generally, speculators will buy more securities when the prices are low and sell it when
the prices are expensive. The share and bond’s prices are negatively related with the
interest rate. As the prices of securities fall, the interest rate will increase since the yield
of maturity of the securities is high when the securities prices are low.
Figure 4.3: Speculative purpose

Interest

Liquidity Trap
r1

r0

When the speculators feel that interest rate is at lower rate (r0), this indicates that the
prices of securities is at higher level. The speculator will expect in the future the rate of
interest will increase and price of securities are expected to fall. What speculator do is,
they will sell the securities now before the fall in the prices will really happen and convert
them into cash. That is why quantity of money is high. When speculators feel the
interest rate is high (r1), the price of securities is low. The speculator will expect the rate

of interesrt*will goes down in the future and the price will increase. They will buy more

securities now and quantity of money will decrease (Q1).
Liquidity trap is situation when the economy is stagnant and the interest rate is too low
in the market. The rate of interest is at the lowest level in the market (r*) and thus the
price of securities now is considered to be at the peak level. Speculator will speculate
the interest rate will increase at the highest level in the future and the prices of the

securities will plunge.QT1heQsp0 eculators therefore selQl a*ll the secQuruitiaenstihtyeldo,f imn oorndeeyr to

avoid any losses that may arise from crash down. This make quantity of money will
become infinity.
4.6 Islamic view regarding speculation
Speculation is a phenomenon of buying something cheap at one time and selling it at another
time, which is when future price is expected to be higher than the present.

46

SUPPLEMENTARY NOTES FOR MACROECONOMICS
Any transaction in business according to Islamic principle, it must be free be from uncertainty,
riba, manipulation, and must be based on trust and cooperation as well. Speculation is
forbidden according to Islamic framework because it involves uncertainty (gharar) and the profit
earned is considered as riba. Transaction according to Islamic framework must be hand to hand
transaction and it is dealt in the same meeting.
There is different between Investment and speculation where the investment is based on
knowledge and investors use their knowledge to calculate the probability of future return. The
decision is based on the known facts with the expectation of some positive returns. While
speculation solely based on hope and wild rumours and the accuracy is questionable.

47

SUPPLEMENTARY NOTES FOR MACROECONOMICS

CHAPTER 5
Learning Objectives:
At the end of this chapter, students should be able to:

i. Discuss Types of Budget.
ii. Explain sources of Government Revenue.
iii. Understand the government Expenditure.
iv. Understand Public Finance in Islam

48