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SUPPLEMENTARY NOTES FOR MACROECONOMICS

5.1 Types of Budget

i) Deficit Budget

It happens when government’s receipts less than government spending (T < G).
Government raises their spending and reduce their taxation when our economy
experiences the problem of deflation. It is an expansionary fiscal policy to enhance
our economic activity.
ii) Surplus Budget

In time of inflation problem, Government will implement the surplus budget or also known
as contractionary fiscal policy. To implement this kind of policy, government will increase
their receipts and reduce their spending (T > G). As discussed on chapter 3, G is
component of AD, less government spending means less in AD, economic activity then
will slow down. Increase in taxation also will reduce the purchasing power of household
and also influence the component of C in AD which is AD will fall. The main purpose of
this policy is to control the spending made in the economy and reduce the pressure on
the general price level.
iii) Balanced Budget

Government adopts this kind of budget when economy is at full employment level. This
can be done by imposing the same amount of tax and spending (T = G).
5.2 Sources of government revenue

There are two major sources of government revenue:

i) Taxes – include direct tax and indirect tax

ii) Non taxes revenue – selling of goods and services, grant from other countries, fine and
forfeitures, petroleum royalty. Licenses and permits, investment incomes, receipts from
federal territories.

i) Taxes

Taxation is main revenue for our country. It is compulsory levied to individual and
organization to finance government spending on public goods and services.
There are two types of taxes:
a) Direct taxes

The burden of taxes cannot be transferred to other individual’s shoulder. The
example is personal income tax, corporate tax, petroleum revenue (levied on all
petroleum company operates in Malaysia), capital gains tax (increase in value of
capital assets between the time of purchase and the time of sales), stamp duties,
motor vehicle duties etc.
b) Indirect taxes

The kind of tax where the burden of taxes can be passed to other people. The
example is sales and services taxes, import duties, custom duties etc.

5.2.1 Structure of taxes

a. Progressive tax

The tax rate will increase as income increases. The most effective way to redistribute
incomes between population since imposition of taxes greater on higher income group
than lower income.

b. Proportional tax

The rate of tax does not change as income changes.

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c. Regressive tax
The tax rate will fall as income rises.

Tax rate Tax rate Tax rate

Formula of tax structure Income level Income level

Taxes Paid x 100
Taxable Income

Income level

Formula of tax structure

Value of taxes paid x 100
Taxable income

Progressive tax Regressive tax Proportional tax

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Table 5.1: Federal Government Revenue, 2010 – 2013 (RM Millions)

UPDATED AS AT MAC 2014 2010 2011 2012 2013 1

CUKAI LANGSUNG/DIRECT TAXES 79,009 102,242 116,939 120,523

Cukai Pendapatan/Income Taxes 74,451 96,732 110,662 113,300
Syarikat-syarikat/Companies 36,266 46,888 22,977 23,055
Perseorangan/Individuals 17,805 20,203 51,288 58,175
Petroleum/Petroleum 18,713 27,748 33,934 29,753
Koperasi dan lain-lain/Cooperatives and others
Lain-lain/Others 378 357 345 286
1,289 1,537 2,118 2,031
Lain-lain/Others 4,558 5,509 6,276 7,223
Duti Harta Pusaka/Estate Duty
Duti Setem/Stamp Duty 1 1 2 1
RPGT/Real Property Gain Tax 4,192 4,929 5,595 6,364
Lain-lain/Others 303 509 608 785

CUKAI TAK LANGSUNG/INDIRECT TAXES 62 70 71 73

Duti Eksport/Export Duties 30,507 32,643 34,706 35,429
Getah/Rubber
Petroleum/Petroleum 1,810 2,081 1,968 1,930
Timah/Tin - - - -
Minyak Sawit/Palm Oil
Lain-lain/Others 1,745 1,997 1,928 1,632
- 0 0
Duti Import dan Cukai Tokok 52 73 0 0
Import Duties and Surtax 13 11 41 298
Cukai Eksais/Excise Duties 2,524
Cukai Jualan/Sales Tax 1,966 2,026 2,282
Cukai Perkhidmatan/Service Tax 12,193
Lain-lain/Others 11,770 11,517 12,187 10,068
8,171 8,577 9,496 5,944
Jumlah Hasil Cukai/Total Tax Revenue 3,926 4,982 5,583 2,770
2,863 3,460 3,190
Hasil Bukan Cukai/Non Tax Revenue 155,952
109,515 134,885 151,643
Dividen PETRONAS/PETRONAS Dividen 54,450
Royalti Petroleum & Gas/Petroleum Royalty & Gas 48,867 49,423 54,909
Cukai Jalan/Roadtax 27,000
Dividen Bank Negara/Bank Negara Dividen 30,000 30,000 26,260 6,186
Lain-lain/Others 4,855 5,148 6,423 2,991
2,550 2,755 2,893 1,500
Penerimaan Bukan Hasil/Non-Revenue 2,000 2,000 2,000 16,774
9,462 9,521 17,332
Penerimaan Bukan Hasil/Non-Revenue 2,968
Hasil Wilayah Persekutuan 1,270 1,111 1,360
Revenue from Federal Territories 1,590
793 544 877 1,378
JUMLAH HASIL/TOTAL REVENUE 477 567 483
Sources: Economic Report, Ministry of Finance Malaysia 213,370
159,653 185,419 207,913

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5.3 Government expenditure
Two major categories of expenditure:
i) Operating expenditure – payment of emoluments, pensions, any debt services
charges, and other maintenance expenditure.

ii) Development expenditure – defence and internal security, social responsibility includes
educational projects, construction of low cost houses, health sector development,
economic services includes transportation and infrastructure such as construction of
Penang bridge, upgrading highway and roads, rural development such as drainage and
irrigation.

Table 5.2: Federal Government Operating Expenditure, 2010 – 2013 (RM Millions)

UPDATED AS AT MAC 2014 2010 2011 2012 2013 3

KESELAMATAN/ SECURITY 18,683 20,940 22,680 24,021

Pertahanan/Defence 9,749 11,079 11,156 12,209
Keselamatan dalam negeri/Internal security 8,934 9,862 11,524 11,812

PERKHIDMATAN SOSIAL/SOCIAL SERVICES 57,765 64,718 72,406 74,490

Pendidikan dan latihan/Education and training 37,821 41,741 47,040 47,973
Kesihatan/Health 12,719 14,929 16,808 17,682
Perumahan/Housing 1,115 1,626 1,658 2,006
Lain-lain/Others 6,110 6,422 6,901 6,830

PERKHIDMATAN EKONOMI/ECONOMIC SERVICES 14,527 19,555 16,450 18,848

Pertanian dan pembangunan luar bandar 3,470 4,791 4,392 4,925
Agriculture and rural development 126 125 130 135
Kemudahan awam/Public utilities
Perdagangan dan perindustrian/Trade and 6,525 7,866 7,486 8,621
industry 4,296 6,582 4,303 5,020
Pengangkutan/Transport 133
Perhubungan/Communications 58 81 85
Lain-lain/Others 53 58 59 63

PENTADBIRAN AM1/GENERAL ADMINISTRATION 1 15,342 16,480 19,092 17,846

LAIN-LAIN PERBELANJAAN2/OTHER EXPENDITURES 2 45,316 60,900 74,909 76,065
182,594 205,537 211,270
JUMLAH/TOTAL 151,633

Sources: Economic Report, Ministry of Finance Malaysia

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Table 5.3: Federal Government Development Expenditure, 2010 – 2013 (RM Millions)

UPDATED AS AT MAC 2014 2010 2011 2012 20134

KESELAMATAN/SECURITY 3,970 4,569 4,409 4,649

Pertahanan/Defence 2,666 3,711 3,590 4,038
Keselamatan dalam negeri 1/Internal Security 1 1,304 857 820 611

PERKHIDMATAN SOSIAL/SOCIAL SERVICES 20,784 12,607 12,399 10,884

Pendidikan dan latihan/Education and training 12,046 7,735 7,550 6,438
Kesihatan/Health 3,780 2,207 1,864 1,738
Perumahan/Housing 1,333 762 524 852
Lain-lain/Others 3,625 1,903 2,462 1,856

PERKHIDMATAN EKONOMI/ECONOMIC SERVICES 26,121 28,156 28,936 24,646

Pertanian dan pembangunan luar bandar 2,920 1,128 1,906 2,692
Agriculture and rural development
Kemudahan awam2/Public utilities2 5,286 6,013 5,519 3,332
Perdagangan dan perindustrian/Trade and industry 6,987 8,364 5,043 6,244
Pengangkutan/Transport 8,665 10,140 10,065 8,152
Perhubungan/Communications 688 848 455 187
Lain-lain/Others 1,574 1,663 5,948 4,038

PENTADBIRAN AWAM3/GENERAL ADMINISTRATION 3 1,917 1,085 1,187 2,032

JUMLAH/TOTAL 52,792 46,416 46,932 42,210
Sources: Economic Report, Ministry of Finance Malaysia

5.4 Public Finance in Islam

5.4.1 Sources of government revenue in Islamic Economics

a) Zakat

Zakat is compulsory for every Muslim and one of the five pillars of Islam. Every adult
who has enjoyed for one complete year of full ownership on his estates are
obligatorily to pay zakat. Zakat is also imposed on gold, silver, merchandise, certain
livestock, mines, and crops. Groups that qualified to receives zakat are the poor and
needy person, collector of zakat (amil), those who the heart are to be reconciled
(muallaf), the debtors, slaves, fisabillah, the wayfarer (Ibn Sabil)

b) Kharaj

The tax was imposed on the non muslim landowners. The rate will depend on the
quality of the land such as the level of fertility.

c) Jizyah

It is the poll tax which is imposed on the non Muslim in lieu of the guarantee to them
by an Islamic state for the protection of their lives, properties and religious rites. It
depends on the size of the share of national income enjoyed by the non-Muslims.

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d) Ushr

The kind of tax imposed on the agriclutrue output of Muslims. The rate depends on
the irrigation of the land. The rate one – tenth for non irrigated and one –twentieth
for irrigated land.
e) Ghanimah

The wealth seized during the wars, one – fifth of the spoils should be keeping for
the benefit of the community.

f) Taxation

Imposition of tax is allowed in Islam as long as the tax burden will not kill the
taxpayer’s incentive to work and minimize the burden of tax fall on the poor. The
collection of tax permissible in Islam, as the collection of above source is inadequate
to fulfil the basic human needs.

5.4.2 Types of expenditure

There are three types of expenditure of Islamic states

i) Permanent head expenditure – basic need fulfilment, da’wah activities, defence,
law and order and public administration.

ii) Essential expenditure – protection of environment from pollution, economic
development, and scientific research.

iii) Expenditure for the interest of public – improving the drainage system,
upgrading highway, etc.

5.4.3 Types of Islamic Banking Products.

Islamic banking refers to a system of banking that design to be compatible with Islamic
law also known as Shariah law. Legally to be part of Malaysian enforceable law, the
Islamic banking was governed under Islamic Banking Act (IBA) (1983). IBS 1983 was
the first regulatory act that required the licensing and regulation of full-fledged Islamic
banks in Malaysia to undertake Sharīʿah-compliant business and establish a Sharīʿah
advisory board to advise on the banks’ operations. After three decades, Malaysia
attempted to further strengthen the Sharīʿah governance and Sharīʿah compliance
commitment of the Islamic financial services industry by legislating the Islamic Financial
Services Act (IFSA) 2013.

The Islamic banking governed by Sharia law prohibited any operations that involved
these three activities:

1. Free from riba’. Riba’ is usury or interest rate charged on the financing amount.

2. Free from gharar. Gharar means ambiguity. For example, selling and buying
something that not under possession such as flying bird is considered gharar. Another
example is short selling which refers to sell stock or other securities or commodities
which one does not own at the time, in the hope of buying at a lower price before the
delivery time. It is considered illegal in some countries and prohibited under Sharia Law.

3. Free from maisir. Maisir refers to gambling. Maisir is prohibited in Islamic finance
because it creates wealth from chance instead of productive activity.

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So, the core values that govern Islamic banking are mutual risk and profit sharing
between parties and the assurance of fairness for all transactions. There are many
types of concepts applied under the modus operation of Islamic banking product.
Among the concept are:
1. Al-Wadiah (Safe custody)
2. Al-Mudharabah
3. Al-Bai Bithaman Ajil (deferred payment sale)
4. Al-Musyarakah (partnership arrangement of profit and loss sharing)
5. Al-Ijarah (lease or rental)

Discussion on each concept.

1. Al-Wadi`ah (Safe custody)

The core business of banking operation is to keep money of its stakeholder safely.
Hence, this concept is applied in the savings product of bank’s operation. Al-Wadi`ah
refers to a contract where an asset is placed with another party for safekeeping or as
custody only. The fundamental of Al-Wadi`ah is to keep the asset safe but not as
guarantor or the custodian has authority to use the asset as investment. In the concept
of Wadi`ah Yad Dhamanah, the depositor grants the bank to utilise the money and
guarantees the principles amount in any case subject to damaged, destroyed or stolen.

2. Al-Mudharabah

Another popular concept used under savings account is Al-Mudharabah. Al-Mudarabah
is a contract based on a fiduciary relationship between a capital provider (rabbul mal)
and an entrepreneur (mudarib). Under a mudarabah, any profit generated from the
capital is shared while financial losses are borne by the rabbul mal. The profit generated
from the capital is shared between the rabbul mal and the mudarib according to a
mutually agreed profit sharing ratio (PSR) whilst financial losses are borne by the rabbul
mal provided that such losses are not due to the mudarib’s misconduct (ta`addi),
negligence (taqsir) or breach of specified terms (mukhalafah al-shurut).

3. Al-Bai Bithaman Ajil (BBA, deferred payment sale)

Al-Bai Bithaman Ajil is a contract of sale and purchase for the asset on a deffered and
an instalment basis with a pre-agreed payment period. BBA is used for purchasing of
properties (Home financing or Commercial properties financing), or sometimes for trade
financing products. This usage is now done under the Tawarruq arrangement (using
Commodity Murabahah) where the proceeds from the sale of Commodities is used to
settle the purchases of houses or commercial properties. So now, BBA has been
replaced with Islamic arrangements of Tawarruq or Musyarakah Mutanaqisah. Other
Islamic contracts has also been known to support some elements of BBA, such as
Istisna’a (property construction), Murabahah (good sale at profit) or Ijarah / ijarah
mawsufah fi zimmah (forward lease).

4. Al-Musyarakah (partnership arrangement of profit and loss sharing)

Musyarakah is a partnership between two or more parties, whereby all contracting
parties contribute capital to the musyarakah venture and share the profit and loss from
the partnership.

Generally, there are two types of musyarakah (shirkah), namely:

i. Shirkah al-Milk (Partnership in joint ownership) refers to possession of an
asset by two or more persons with or without prior arrangement to enter into a sharing
in joint ownership. Under shirkah al-milk, each partner’s ownership is mutually

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exclusive. In this regard, one partner cannot deal with the other partner’s asset without
the latter’s consent.

ii. Shirkah al-`Aqd (Contractual Partnership) refers to a contract executed
between two or more partners to venture into business activities to generate profit.
Under shirkah al-`aqd, a partner is an agent for the other partners. In this regard, the
conduct of one partner in the ordinary course of business represents the partnership.

Islamic bank suggest Musyarakah Mutanaqisah arrangement (Diminishing Partnership)
as underlying concept for financing the houses or properties. The properties are
purchased by the Bank and leased out to the customer, who then pays rental and
gradually purchases the shares of the house and properties over time. The pays rental
is the repayment amount and gradually reduced term as mutanaqisah.

5. Al-Ijarah (lease or rental)

An ijarah refers a lease contract that transfers the ownership of a usufruct of an asset
to another person for a specified period in exchange for a specified consideration. For
instance, lease a contract to transfer usufruct of a particular asset to another person in
exchange for a rental. Al-Ijarah also refer to a contract for hiring of services of a person
for a specified period in exchange for a specified consideration. Such as hire a person
with wages paid to him as a consideration for his services. Islamic banking products
use concept Al-Ijarah for hire-purchase financing. There are three types of Al-Ijarah
suitable for Islamic banking product:

i. The ijarah muntahiyah bi tamlik is an ijarah contract which ends with the
lessee owning the leased asset and shall contain a mechanism for the transfer of
ownership of the leased asset from the lessor to the lessee during or at the end of the
lease period. It usually for financing the machines and vehicles.

ii. ijarah mawsufah fi zimmah is the contracting parties under an ijarah mawsufah
fi zimmah contract may enter into an istisna` contract where the lessor may request the
lessee to construct an asset that will be leased out in the future. It usually for financing
construction project.

a) TAKAFUL (ISLAMIC INSURANCE)
is an alternative form of cover that a Muslim can avail himself against the risk of loss
due to misfortunes. Takaful is based on the idea that what is uncertain with respect to
an individual may cease to be uncertain with respect to a very large number of similar
individuals. Insurance by combining the risks of many people enables each individual
to enjoy the advantage provided by the law of large numbers.

b) WADIAH (SAFEKEEPING)
a bank is deemed as a keeper and trustee of funds. A person deposits funds in the
bank and the bank guarantees refund of the entire amount of the deposit, or any part
of the outstanding amount, when the depositor demands it. The depositor, at the bank's
discretion, may be rewarded with Hibah (see above) as a form of appreciation for the
use of funds by the bank.

c) WAKALAH (POWER OF ATTORNEY)
occurs when a person appoints a representative to undertake transactions on his/her
behalf, similar to a power of attorney.

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CHAPTER 6

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

i. Understand definition of Inflation and Explain types of inflation.
ii. Understand the measurement of inflation.
iii. Discuss The Effects of inflation for groups will Gain and Lose during inflation
iv. Discuss the policies to control inflation in Monetary Policy, Fiscal policy and Direct control.
v. Explain the definition of unemployment and types of unemployment.
vi. Understand the measurement of unemployment.
vii. Discuss the policies to control unemployment in Monetary Policy, Fiscal policy and Direct

control.

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6.1 Inflation

6.1.1 Definition

Inflation is the sustained increase in the general price level. Inflation will decrease the
value of money as purchasing power of buyers reduces and makes it more expensive
to buy goods and services. Inflation is an ongoing process of rising price level.

We cannot classify the economy experience an inflation when there is increase in price
on the one single product only. For example, price of onion increases from RM3.50/kg
to RM7.50kg.

6.1.2 Measurement of Inflation

Inflation Rate CPI in current year – CPI in base year x 100
CPI in base year
Change in the value of
money CPI in base year x 100 - 100
CPI current year

Example:

Consumer price Index (CPI) 2010 = 134.2
Consumer price Index (CPI) 2008 = 100

Inflation Rate = CPI in current year – CPI in base year X 100
CPI in base year

= 134.2 – 100 X 100
100

= 34.2 %

6.1.3 Types of Inflation

i) Demand Pull Inflation

The main cause of this inflation is an excessive growth in spending. Excessive
in demand than output will put pressure on price level. When economy reached
the full employment level of income, an increase in Aggregate Demand will only
cause increase in price level. The excessive spending because too much
money supplied in the economy according to implementation of the
expansionary monetary policy and deficit budget policy.
From figure 6.1, initial the aggregate demand curve is AD0, the aggregate
supply curve is AS0. Increase in aggregate demand, shifts the aggregate
demand curve rightward to AD1.The price level will increase from P0 to P1. As
the increase in aggregate demand is continuous, aggregate demand curve
increase up to AD2. At this level, price jumps to P2. As price goes up output will
also increase as business finds it profitable to expand it production to meet the
increase in demand.

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However, when the economy at full employment (or full capacity), labor and
raw material shortages mean that it becomes more difficult for firms to expand
production to meet rising in demand. As a result, the AS becomes more
inelastic while AD curve remain increases.
Therefore, at full employment, any increment in AD such as AD2 to AD3 will
only leads to increase in price level from P2 to P3 while output remained at same
level; Q2=Q3 as that is the highest level of output economy can produce. Thus,
the price will go up more and lead to the inflation.

Figure 6.1: Demand Pull Inflation

Price (RM) AS0

P3 AD3
P2 AD2

P1 AD1 Quantity (units)
P0 AD0
Q0 Q1 Q2=Q3
0

ii) Cost Push Inflation

It is caused by an increase in the cost of production. For example, increase in
cost of labor, raw material, construction, equipment, borrowing and as well as
taxes on business and profit. Increase in the cost of production, decrease the
ability of producer to produce more product, thus decreasing in aggregate
supply and the aggregate supply curve will shifts leftward.

Base on the figure 6.2. initially, the aggregate demand curve is AD0, the
aggregate supply curve is AS0. Decreases in aggregate supply (resulting from
increases in cost of production) shifts the aggregate supply curve leftward to
AS1. The equilibrium moves to point E1 from E0 where the aggregate supply
AS1 intersects the aggregate demand curve AD0. The price level will increase
from P0 to P1 thus it will cause inflation.

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Figure 6.2: Cost Push Inflation

Price (RM) AS1
AS0

E1
P1
P0 E0

AD0

0 Q0 Q1 Quantity (units)

6.1.4 Effects of Inflation

i. Decrease Gross Domestic Product

Rea income of household will decrease as it purchasing power will reduce
according to high inflation rate. The economy growth will slow down as
Aggregate Demand is decreasing.

ii. Reduce savings

Amount of saving reduced as purchasing power of buyer decrease. Buyers
prefer the cash rather than saving because they need more money to do
spending. People will choose other forms of assets instead of saving such as
fixed assets because the price of houses and real estate increase during an
inflation time.

iii. Unequal distribution of income

The fixed wage earner will lose during inflation because increasing in general
price level will not increase their salaries. In addition to that, the value of their
income is reducing as their purchasing power has fallen. They need more
money to buy goods and services than before. Instead, an entrepreneur will
gain during inflation time, as they more profitable with higher price of goods
and services.

iv. An increase in investment and production

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The business will earn higher income during inflation because they can
reinvest their undistributed profit for larger production goods and services. The
producer will increase their production and investment and this will create more
job opportunity.

6.1.5 Measures to Control Inflation

i. Monetary Policy
a. Open Market Operation (O.M.O)
During inflation, government will reduce the money supply in economy
by selling the securities in the open market, including to banks. When
the commercial bank purchases the government securities, their
reserve will fall. A decrease in the money supply will limits the ability of
commercial bank to gives a loan to the public and this will reduce the
money supply in the economy

Money supply BNM sells securities Banks’ reserve credit

b. Reserve Requirements
During inflation, central bank will control the cash and liquidity of
commercial bank by increasing the rate of reserve requirements. By
increasing the reserve ratio, credit creation will be reduced. By
increasing the ratio, central bank will restrict the lending ability of the
commercial banks. This action will decrease the money supply and
inflation.

Money supply ratio reserve ability to give credit

c. Interest Rate and Bank Rate
The rate was charged y the Central Bank on bank’s and discount
houses’ loan. The bank rate will influence the interest rate charged by

the banks on the loans made to public. To reduce the money supply,

the discount rate should be increased so that the cost of borrowing will

be higher too. This will discourage the loan made by the banks, and

also amount of reserve available. When the interest rate increase,

ability to give loan to the public also controlled.

Money supply bank rate interest rate reserves credit

ii. Fiscal Policy
Fiscal policy refers to uses of government taxes and expenditure to be suit
with economic conditions. Since inflation is caused by excessive spending so
to the solution is to reduce the expenditure made by government.
Government will increase the taxes and reduce the spending simultaneously.
If government increase the tax, money available should be less to consume
the good and services.

iii.Direct Control

Direct control or physical control refers to the direct government intervention
in the price mechanism of the country.

a) Pricing policy

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Government will impose price ceiling and price floor on consumer
goods. Thus, the price will not increase rapidly and, therefore can
reduce the inflation.

b) Encourage saving
Consumers are encouraged to save more their money and decrease
the spending in order to reduce the pressure on price. This can be done
through imposition of higher contribution of Employees Provident Fund
(EPF)

c) Anti – hoarding Campaign
Hoarding will create the artificial shortage and will push the price up.

6.2 Unemployment

6.2.1 Definition

Unemployment is defined as people in the labor force (LF) who are currently not
working but actively looking for a job.

6.2.2 Term relates to unemployment

Terms Explanation
Discourage workers
A worker who leaves the labor force after unsuccessfully searching
Labor Force for a job for a certain period of time.
Employed The sum of people employed and the unemployed
Unemployed
People who are working (age of 16 – 60).
Employed rate People who are not working but actively seeking for the job.

Unemployment Rate The number of people employed expressed as a percentage of
labor force.
Labor Force Participation The number of people unemployed expressed as a percentage of
Rate labor force.
Formula: The ratio of the labor force to the total population

Labor Force Total No. of People Employed + Total No. of People Unemployed

Unemployment Rate Total No. of People Unemployed x 100
Total Labor Force

Employed Rate Total No. of People Employed x 100
Total Labor Force

Labor Force Participation Total No. Labor Force x 100
Rate Total Population

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6.2.3 Types of Unemployment

i. Frictional Unemployment

This kind unemployment only happened temporarily. It happens when people
just leaving a school or study and in searching for a job or people who are
leave their job in order to find the better.

ii. Structural Unemployment

Changes in the structure of an economy will cause the worker with particular
skill are no longer suitable with the jobs available. The mismatch of skills
available and skills required for the job caused the structural unemployment.

iii. Cyclical Unemployment

Decreases in the aggregate demand due to change in the business cycle
caused this kind of unemployment. When economy is under recession, the
demand for the products decreases and the demand for the worker also
decrease.

iv. Disguised Unemployment

Disguised unemployment happens in an overstaffed industry, which means
productivity, is constant even though there are many workers. Example, four
people are working for the job of two people.

v. Technological Unemployment

It is happen because the demand of labor decreased due to the improvement
of technology. People are retrenched because of new technology. Example,
using computerization and robotic in automobile industries can reduce the
demand for labor in those industries.

vi. Seasonal Unemployment

Seasonal unemployment occurs when the demand for labor is only during
certain period of the year. This means that the labor cannot be utilized fully
the whole year round. For example, during holiday season the demand for
worker increases at holiday resort while during the rainy season fishermen will
be unemployed.

6.2.4 Effect of Unemployment

a) Loss of job skills

When the lack of application eventually the job skill will loss.

b) Loss sources of income

Unemployment will face the financial problem their self-respect will lose and
this will lead them to involve into social problem.

c) Economy cannot reach the optimum level
Since there is underutilization of the resources, output produced cannot reach
its maximum level and standard of living may decrease.

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Table 6.2: Principal statistics of the labour force, Malaysia, 2000 - 2012

Year Labour Employed Unemployed Outside Labour force Unemployment
force
labour force participation rate (%)

rate

2000 9,556.1 9,269.2 286.9 5,065.1 65.4 3.0

2001 9,699.4 9,357.0 342.4 5,239.9 64.9 3.5

2002 9,886.2 9,542.6 343.5 5,473.8 64.4 3.5

2003 10,239.6 9,869.7 369.8 5,458.6 65.2 3.6

2004 10,346.2 9,979.5 366.6 5,730.5 64.4 3.5

2005 10,413.4 10,045.4 368.1 6,048.2 63.3 3.5

2006 10,628.9 10,275.4 353.6 6,205.1 63.1 3.3

2007 10,889.5 10,538.1 351.4 6,330.1 63.2 3.2

2008 11,028.1 10,659.6 368.5 6,575.7 62.6 3.3

2009 11,315.3 10,897.3 418.0 6,665.7 62.9 3.7

2010 12,303.9 11,899.5 404.4 7,023.0 63.7 3.3

2011 12,675.8 12,284.4 391.4 7,008.8 64.4 3.1

2012 13,119.6 12,723.2 396.3 6,897.4 65.5 3.0

Sources: Department of Statistics Malaysia

6.2.5 Measures to Control Unemployment

i. Monetary Policy

iv. Monetary Policy
a. Open Market Operation (O.M.O)
During inflation, government will increase the money supply in
economy by purchasing the securities in the open market, including to
banks. When the commercial bank sell the government securities, their
reserve will increase. An increase in the money supply will increase the
ability of commercial bank to gives a loan to the public and this will
increase the money supply in the economy

Money supply BNM buy securities Banks’ reserve credit

b. Reserve Requirements
During unemployment, central bank will increase the cash and liquidity
of commercial bank by lowering the rate of reserve requirements. By
decreasing the reserve ratio, credit creation will be increased. By
decreasing the ratio, central bank will expand the lending ability of the
commercial banks. This action will increase the money supply and
solve the problem of unemployment.

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Money supply ratio reserve ability to give credit

c. Interest Rate and Bank Rate
The rate was charged by the Central Bank on bank’s and discount
houses’ loan. The bank rate will influence the interest rate charged by

the banks on the loans made to public. To increase the money supply,

the discount rate should be decreased so that the cost of borrowing will

lower too. This will encourage the loan made by the banks, and also

amount of reserve available. When the interest rate decrease, ability to

give loan to the public also increase.

Money supply bank rate interest rate reserves credit

ii. Fiscal Policy

Fiscal policy is an instrument used by government through government expenditure
and government revenue (tax). Government will implement expansionary fiscal policy
where government expenditure will exceed government revenue. Expansionary fiscal
policy is also known as budget deficit. Government will spend more and reduces tax,
as a result increase income for household may lead to increase in aggregate demand.
GDP will increase and its can prevent the unemployment rate in the country.

iii. Direct Control

- Revise education system so that people gain knowledge that compatible
requirement need in the job market.

- Providing training and technical education
More training should be provided to people that have difficulties in searching the
job. Provide them with new skills that required in the job market.

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CHAPTER 7
Learning Objectives:
At the end of this chapter, students should be able to:

i. Understand definition of international Economics.
ii. Understand the advantages of International Trade
iii. Discuss The Theory of Absolute Advantage and Theory of Comparative advantage
iv. Discuss the definition and instruments of Protectionist Policy.
v. Explain the reasons of protection.
vi. Understand the Balance of Payment
vii. Discuss the policies to control unemployment in Monetary Policy, Fiscal policy and

Direct control.

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7.1 Introduction

International trade arises when one country cannot produce the entire item needed by the
population of the country. International trade allows to exchange goods and services with others
country.

7.2 Advantages of International Trade

.
i. Varieties of goods and services

International trade allows us to consume goods which cannot produce locally due to a
lack of knowledge or technology or unsuitable climate and also higher cost. There are
varieties of goods and services available for consumption by consumers from other
counties. For example, Malaysia cannot produce apples and grapes. By international
trade, consumers can dream for such fruits.

ii. Increase world output

International trade enables nations to obtain benefits from specialization on producing
products. Specialization will increases world output and improves the standard of living.
For example, if Malaysia is said to have a comparative advantage in producing of palm
oil compared to other countries like Kenya and Ghana. Therefore, Malaysia will
specialize in producing palm oil by using all the resources exits and produce nearly half
of the world’s supply. Thus, it will increase in world output.

iii. Increase competition and product quality

International trade will increase the competition among the local goods and imported
goods. This competition will bring increase in research and development and more
rapid adoption of new technology. Thus, will supposedly increase the quality and lower
the price of products. Example is our national car, already improved from time to time
in order to compete with imported car.

iv. Sharing of knowledge and technology

Through international trade, there will be also a transfer and sharing of knowledge,
information and technology between the countries. For example, Malaysia imports new
technology-based machinery from Japan, then both country can share the technology.
Thus, Malaysia can produce their local car by sharing technology with Japan.

v. Higher income and economic growth

International trade helps generate more employment through the establishment of
newer industries to cater the demands from various countries. This will help country
bring down its unemployment rates and also increase the income of the employees
and will contribute to the economic growth of the country.

vi. Non-economic advantages

Relationship between trading partners can be improved in terms of political, science
and cultural advantages and also economic co-operations (ASEAN, AFTA) and etc.

7.3 Theory of Absolute Advantage

A country is said to have an absolute advantage in the production of a good when it can produce
more of that good than another country, using the same amount of resources.

Assumption underlying the absolute advantage theory:

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1. Only two countries in the world
2. There are two products only are produced.
3. No transportation cost
4. No trading barrier exists between two countries.
5. Law of diminishing marginal return does not exist.
6. Perfect mobility of factor of production
7. Factor of productions are fully utilized.

Table 7.1: Absolute Advantage using the same amount of the resources

Country Rice Computer

Thailand 25 8

Malaysia 10 10

In the line of production of rice, we can say that Thailand enjoyed the absolute advantage since
they can produce more of the rice 25 units as compared to 10 units only by Malaysia. In the line
of production of computer, country Malaysia enjoyed the absolute advantage which is Malaysia
produce more computer 10 units, and Thailand 8 units of computer.

Each country will specialize in the line of production where they have the absolute advantage
in. Specialization means that the country will utilize of all its resources to produce the particular
product and will not producer the other product at all. Malaysia will utilize its resources to
produce car, and so do Thailand will make full use of their resources to produce rice. They will
exchange the goods where Malaysia will import rice from Thailand, and Thailand will import car
from Malaysia.

Table 7.2: After specialization

Country Rice Computer
Thailand
Malaysia 25 x 2 = 50 -

Total Output - 10 x 2 = 20

50 20

7.4 Theory of Comparative Advantage

If both countries enjoyed absolute advantage in both productions, international trade still can
be practised by using comparative advantage by comparing the lowest opportunity cost.

Table 7.3: Comparative Advantage – before specialization

Country Rice Computer

Thailand 82

Malaysia 75

Table 7.4: Opportunity cost for both country

Country Rice Computer
Thailand
Malaysia 2/8 = 0.25 computer 8/2 = 4 rice

5/7 = 0.71 computer 7/5 = 1.4 rice

In the line of production of Rice, country Thailand has comparative advantage because the
lowest opportunity cost 0.25. For production of Computer, country Malaysia has comparative
advantage with the lowest opportunity cost, 1.4. A lower opportunity cost shows a greater
efficiency in producing a good.

Country Table 7.5: After Specialization Computer
Thailand Rice -
Malaysia
Total 8 x 2 = 16 5 x 2 = 10
- 10
16

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Thailand will export the rice to Malaysia and as an exchange, Malaysia will export computer to
Thailand.

7.4.1 Term of Trade
Term of trade is the rate at which one country’s output is exchanged against another country’s
output.

Both countries will gain from the international trade practiced if the term of trade lays between
the countries’ respective domestic opportunity cost ratio. Base on table 7.4, the opportunity
cost for both countries:

Thailand: 1 rice: 0.25 computers
Malaysia: 1 rice: 0.71 computers

Suggested Term of Trade: 0.25 + 0.71
2

: 0.48

7.5 Protectionism

Protectionism is the trade barriers that imposed on trading activities in order to protect
domestic’s interest.

7.5.1 Tools of Protectionism

i. Tariff

Tax imposed on imported goods. Tariff will discourage import as price of imported
products will become more expensive. Tariff is also called custom duties. Tariff also
one of major sources to government revenue.

ii. Quota

It is a limitation on the amount of product can be imported to our country. For example,
Malaysia imposed a quota on the import of batik from Indonesia to protect local batik
industries.

iii. Embargo

Directly control or ban certain item that would harm our countries in term of economic,
social and political. For example, drugs, pornography item and etc.

iv. Subsidies on Export

When government provides subsidies on exported good, this will reduce the cost of
production. This will make the export more competitive because their prices will be
lower.

v. Exchange Controls

This is the measure where the government will restrict the supply of foreign currencies
in the country. Government regulations on the exchange rate will control the purchase
and sale of foreign currencies. For example, if Malaysia proposes to decrease imports
from US, the government should restrict the purchase of the US Dollar by Malaysian.

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7.6 Reasons for Protectionism
i. Protect infant and local industries.
Protectionism policies are very important to protect infant and local industries. These
young industries have to compete with established industries from other countries.
Government should impose quota or tariff to protect these infant and local industries. For
example, to protect local car industry, government imposing a high tax on imported cars
that will bring higher price of imported cars compared to local cars.

ii. Increase domestic income and employment
International trade opens up all the economic activities to other countries. Without trade
restrictions, demand for local product will decrease. By imposing such restrictions likes
tariff and quota, it will increase spending on local products. Increase demand for local
products will create jobs in the local market and thus increase the income and employment
in the country.

iii. Prevent dumping
Dumping refers to the export of goods at a lower price in the foreign market compared to
the price in the local market. To prevent dumping and competition with these products,
government will charge high price for these imported goods by imposing high tariff.

iv. Reduce the deficit in the balance of payment.
Deficit in balance of payments occurs when import for the country exceeds export of that
country. Tariff will reduce imports as the price of imported goods increases. This can help
increase of government revenue and reduce the deficit in the balance of payments.

v. Diversify the economy.
Diversification of products and services in economy is important to our country. By diversify
our economics so that our country does not depend too much on the trading partners from
other countries. Political stability, war and cyclical fluctuation on the trading partner
countries will give effect to the importing countries. For example, lately one of the states in
Malaysia, which is Perlis already plant their own grapes. Maybe, 20 years from now, we
can produce our own grapes for the local market. Thus, we do not have to import from
other countries like California. Malaysia now is the third largest importer for Californian
grapes. By producing our own product for local market it will reduce cost of the country.

7.7 Balance of Payment

Balance of Payments is a record of annual transactions between one country and other
countries in carrying out the international trade activities.

It is record the debit (total payment) and credit (total receipts). The inflow of money will make
the reserve of countries will increase and outflow of money such as import will makes the
reserve decrease.

7.7.1 Structure of Balance of Payment

A) Current Account: B) Capital Account: C) Official Reserve Account
i) Balance of
Trade i) Direct Investment
ii) Service ii) Portfolio
Balance
iii) Income Investment
Account iii) Other Investment

iv) Net Transfer

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

A) Current Account

i) Balance of trade/visible trade

Refer to export and import of goods. It consisted to trading the tangible item only. For
example, export of car and import the electrical appliance.
Balance of Trade: Export – Import

ii) Service balance/invisible trade

This account records the import and export services only or intangible item such as
transportation, shipping, banking and insurance etc.
Balance of services: Export of services – import of services

iii) Income account

- Compensation to employees: retrenchment benefit, SOCSO, etc.
- Investment income: money inflow from Malaysian investment abroad and money

outflow to foreign country such as profit, interest payment on loan, dividend from
plants, real assets and securities.

iv) Net transfer

Gift made by our government or private parties to other government or countries. For
example: remittance made by immigrant to their relatives and financial aid to Tsunami
victim in Aceh. Outflow of money or if we assist the foreign country by giving financial
aid to particular country will record debit and inflow of money or we receive the financial
aid from other countries will records credit.

B) Capital Account

i) Direct Investment

Also known as corporate investment or physical invest such as foreign direct
investment that Malaysia receives from foreign conglomerate. That is inflow of capital
for example manufacturing sectors in electronics in Malaysia. The outflow of capital
when Malaysian private company invested in foreign country.

ii) Portfolio Investment

The buying or selling of stock, bond and government securities.

iii) Other Investment
Repayment of loan (external borrowing) by the government and the Non-financial
Public Enterprises.

A + B + error and omission = Overall Balance

Error and Omission is adjustment, correction or omitted in which the credit and debits must be
equal.

C) Official Reserve Account

A government possesses official reserve balance in the form of foreign currencies and gold. It
reserve with the International Monetary Fund (IMF) and the Special Drawing rights (SDR).

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A surplus in the balance of payment account shows the total receipt exceeds the total of all
payment made. So, the excess will be used to buy the gold and foreign currencies. The net
change in BNM reserves in IMF will be negative (-ve) and this is added to the reserves.

While, a deficit in the balance of payment account shows the total payment made exceeds the
total of all receipts. So, a deficit will reduce the gold and foreign currencies. The country has
to make payment more than the money that it reserves. The net change in Central Bank
International reserve (BNM reserves in IMF) will be positive (+ve) and this is reduction in
reserves or outflow of foreign currencies.

Table 7.1: Balance of Payments, 2000 – 2013 (RM Millions)

Balance on goods and services 2009 2010 2011 2012 2013
144,528 135,307 145,293 108,980 91,537

Goods 140,355 136,751 151,565 125,190 108,230

Services 4,173 -1,444 -6,272 -16,210 -16,693
Transport -15,818 -22,391 -25,064 -27,994 -30,280
Travel 32,168 31,617 28,959 24,821 29,424
Other services -12,177 -10,670 -10,167 -13,037 -15,837

Primary income -14,215 -26,333 -21,806 -36,050 -34,126

Compensation of employees -1,463 -2,082 -2,331 -3,082 -3,824
Investment income -12,751 -24,251 -19,475 -32,969 -30,302
Secondary income -19,587 -21,790 -21,061 -18,469 -17,504
Balance on Current Account 110,727 87,183 102,426 54,460 39,907

Capital Account -51 -111 -133 241 -21
23,265 -23,014 -15,807
Financial account -80,173 -19,945 -9,337 -24,415 -5,450
-55,324 -51,957 -41,159
Direct investment -22,315 -13,976 45,987 27,542 35,708
26,139 63,859 -3,041
Assets -22,928 -49,163
-76 972 -253
Liabiliti/Liabilities 613 35,187 6,539 -63,431 -7,062

Portfolio investment -1,781 48,467 23,132 -22,773 -15,828

Financial Derivatives 2,369 -698 -30,876 -27,814 -9,431
94,682 3,873 14,649
Other investment -58,447 -53,738

Balance on capital and financial -80,224 -20,056
accounts

Net errors and omissions -16,671 -69,754

Overall balance 13,831 -2,628

Source: Department of Statistics, Malaysia; Central Bank of Malaysia

7.8 Measures to Correct Balance of Payment Deficit

i) Discourage import

Imposition of tariff on the imported goods will make the price of imported goods
getting more expensive. The purchasing power of buying on imported goods
will reduce, and this will reduce the import from foreign countries.

ii) Devaluation

An action by government to lower the value of local currency make the
household or firm need more local currency to get the product. Indirectly, this

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make the price of imported goods are more expensive and lead to reduction in
import. For example:

Before devaluation USD 1 = RM3.10
After Devaluation USD1 = RM4.00

Then if Malaysian want to import the computer from the U.S at the price of
US$RM200

Before Devaluation USD200 = RM620
After Devaluation USD200 = RM 800

iii) Encourage export

Subsidies given to producers will hep them to reduce the cost of production
and enable them to increase the total export.

iv) Imposed contractionary fiscal policy

Imposition of tax will make the purchasing power of buyer decrease and the
demand on imported good will reduce.

v) Practices contractionary monetary policy

When money supply decrease, the aggregate demand on imported good also
will decrease as government through Bank Negara Malaysia increase the
interest rate, increase the cash reserve and sell the government securities in
open market operation.

7.9 Exchange Rate System

Exchange rate is the price of one currency in terms of another currency. Exchange rate ease

two or more different countries to do trading activities because every country have their own
currencies. We need to know the value of our country in term of other countries’ currencies value.

There are 3 systems:

1. Gold standard system

Most industrial countries use the gold standars system between the 1870s until the 1930s. In

this system, the currencies were defined in terms of gold. The supply of money will closely
related with supply of gold. Under this system, a country’s balance of payment will influence the

supply of gold available in their country.

For example: 1 oz = $20
1 oz = £4

Exchange rate between two currencies will be $5 = £1

When the BOP deficit, the country must finance the deficit by sending the gold to other
countries. This will result the supply of money is decreases and will decreases the aggregate
demand for goods and services.

2. Bretton Woods Agreement (managed fixed system)
After the Great Depression and the World War II in 1944, the new monetary system introduced
to replace the gold standard. Under this system, country has to peg their currency to the U.S
Dollar instead to the gold. For example:

US$ 1.00 = 0.0286 oz
US$ 1.00 = RM3.8

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SUPPLEMENTARY NOTES FOR MACROECONOMICS

US$ 1.00 = ¥50
To import the car worth 500 million yen from Japan, the payment should be:

¥500 milion = US$ 10 million = RM38 million

3. Floating exchange rate (flexible exchange rate)

Under this system the currencies are determined by market forces and there is no intervention
from the government. The supply and demand will determine the exchange rate. If the demand
greater than supply, the price of the currency will appreciate. Otherwise, when the demand
less than supply, then the price of currency will depreciate. Disadvantages of this system as
follow:

i. Instability of the exchange rate will affect the stability of the economics.
ii. Will affect the flow of import and export, depreciation of Malaysian currencies will

increase the price of imported goods. The business who imported their raw material
from foreign countries will face loss because the cost of production increases.
iii. Discourage long term investment when exchange rate keep fluctuates.

7.9.1 Exchange Rate in Islam
Islam permits trade of different currencies to facilitate the trading activities. Exchange of money
can follow as follow:

- Exchange between currencies e.g.: RM with US$
- Exchange metal with metal e.g.: gold with gold
- Exchange with different metal e.g.: gold with silver
- Exchange metal with non metal e.g.: gold with money
-
According to As - Shafie, only metal such as gold and silver considered as ribawi and non metal
such as money are not considering as ribawi. Transaction of local currency must be equal value
such as Rm1 with RM1. The exchange of foreign currencies can be similar value (need not to
be exact) are permitted.

There are four types of foreign exchange market in Islamic economics:

i. Spot market

The Islamic law on currency exchange provides for simultaneous transfer of two
currencies at the prevailing rates. It does not allow any time lag in the exchange of
currencies. The prophet SAW and his companion insisted on simultaneous exchanges
when trading currencies due to the nature of money itself. Charge against time for the
delay of payment is considered as a riba.

ii. Swap market

It occurs when dealers conclude two kinds of contract, one spot and the other forward.
The price is differed due to the time involved in the transactions. Money is considered
as a commodity and just like other commodity it must be sold to earn profit. In Islam
this kind of transaction is haram because it earns the interest. Money considered as a
medium of exchange not a commodity to be transacted.

iii. Forward market

It means the party agreed to sell a currency against another at an agreed price but the
delivery of both currencies is made in the future. The price will be determined with
reference to the prevailing interest rates. From the Islamic point of view, forward
contracts in foreign exchange are no legally enforceable until the date of maturity, since
currencies are yet to be exchanged

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iv. Future market
In the future market, the dealers deal in future trades. The dealer only settles the
difference price without actually taking the delivery of any particular currency. The
speculators make money by the price differences over the different maturity periods,
as future market does not involve simultaneous and actual delivery of two currencies
and Islam does not allow it.

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