7.2.b. Analytical method
The analytical method is a generic process combining the power of
the Scientific Method with the use of
formal process to solve any type of problem. It has these nine
steps:
+ Identify the problem to solve.
+ Choose an appropriate process.
+ Use the process to hypothesize analysis or solution
elements.
+ Design an experiment(s) to test the hypothesis.
+ Perform the experiment(s).
+ Accept, reject, or modify the hypothesis.
+ Repeat steps 3, 4, 5, and 6 until the hypothesis is
accepted.
+ Implement the solution.
+ Continuously improve the process as opportunities arise.
8
This method have been used to analyze the data collected,
other information applied to the research and to understanding theoretical
relationship between consumption, income, interest rate, inflation rate and
exchange rate.
7.2.c Historical method
We have used data from recent years and have been able to
interpret them based on historical evidences. Without history and research
materials in the past, this work would not have been able to succeed.
7.2.d Comparative method
In this research, different ways already available to help in
comparing data have been very helpful in analyzing the data in the period under
study.
7.2.e. Econometric method
Econometrics method is the application of mathematics,
statistics and computer science to economic data and is described as the branch
of economic that aims to give empirical content to economic relations.
This method has been used to compute some parameters with E-views
software and have been used in testing the hypotheses in order to determine the
level of significance. Econometrics is the application of mathematical and
statistical methods to economic data and is described as the branch of
economics that aims to give empirical content to economic relations.
8. Organization of the study
This study is composed of the introduction, three chapters and
conclusion. General introduction includes a brief detail of the above mentioned
point from the back ground to the selected methods to be used:
? The first chapter is the literature review
of the key concept, this means all theories related to the topic of
economics.
? The second chapter presents the analysis of
evolution of trends of consumption, income, interest rate, inflation rate and
the exchange rate.
? The third chapter focuses on the
econometric analysis of the impact of income, interest rate, inflation rate and
exchange rate on aggregate consumption expenditure in Rwanda. Finally, there is
conclusion of the work and suggestions to policymakers.
9
CHAP I: REVIEW OF LITERATURE INTRODUCTION
The theoretical framework of this chapter is the theoretical
literatures which explain in deep the different variables of the used model.
The presentation of different researches which was conducted using the same
variables showing the empirical evidences therefore the researcher focused on
the summary of the gaps to fill in the study.
Definition of the key concepts
1.1 Welfare: In this research, a discussion
on welfare occurred to know whether any allocation of resources is efficient or
not. By efficiency in economics a researcher mean whether any state or
situation regarding resource allocation maximizes social welfare. In welfare
economics attempt is made to establish criteria or norms with which to judge or
evaluate alternative economic states and policies from the viewpoint of
efficiency or social welfare. These criteria or norms serve as a basis for
recommending economic policies which will increase social welfare. Thus the
norms established by welfare economics are supposed to guarantee the optimal
allocation of economic resources of the society. Welfare in economics is
defined as a branch of economics that studies how the distribution of income,
resources and goods affects the economic well-being of the community. An
example of welfare economics is the study of how certain health services help
bridge the barrier between different classes of people.
1.1.a. The Genesis of Welfare State
According to Barr 2004, the Welfare State «defies precise
definition». The main reasons are that welfare derives from other sources
besides state activity and there are various modes of delivery of the services
made available to citizens. Some are funded but not produced by the State, some
publicly produced and delivered free of charge, some bought by the private
sector, and some acquired by individuals with the money handed on to them by
the State. Although its boundaries are not well defined, the Welfare State is
used as «shorthand for the state's activities in four broad areas: cash
benefits; health care; education and food, housing, and other welfare
services» (Barr 2004:21). The objectives of the Welfare in economics can
be grouped under four general headings. It should support living standards and
reduce inequality, and in so doing it should avoid costs explosion and deter
behavior conducive to moral hazard and adverse selection. All these objectives
should be achieved minimizing administrative costs and the abuse of power by
those in charge of running it.
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1.2 Consumption
Consumption is defined as the use of goods and services by
consumer purchasing or in the production of goods. Personal consumption
expenditures (PCE) are measures of price changes in consumer
goods and services. Consumption refers to the expenditures of goods and
services that give satisfaction in the present time. It is the use of resources
to satisfy human needs. Gross consumption expenditure is the use of resources
used to satisfy human needs at current price. Goods that human always use to
satisfy their needs are therefore divided into subcategories.
Durable goods: These are products that are
not quickly consumed and can be conserved along time. These are tangible goods
that tend to last for more than a year. Common examples are cars, furniture,
and appliances. Durable goods constitute about 10-15 percent of consumption
expenditures.
Non-durable goods: These are products that
are consumed immediately which mean they have a short lifespan. These are
tangible goods that tend to last for less than a year. Common examples are
clothing, food, and gasoline. Non-durable goods constitute about 25-30 percent
of consumption expenditures. Services: A type of economic
activity that is intangible not stored and does not result in ownership. A
service is consumed at the point of sale. Services are one of the two key
components of economics, the other being goods. These are intangible activities
that provide direct satisfaction to consumers at the time of purchase. Common
examples include health care, entertainment, and education. Services constitute
about 55-60 percent of consumption expenditures.
This function is used to calculate the amount of total
consumption in the economy. It is made up by autonomous that is not influenced
by current income and induced consumption that is influenced by economy's level
of income. In its most general form, the household's lifetime value function
can be: consumption in `youth' while the second
argument represents consumption in `old age'. Simply,
this function can be written in variety of ways for example, it can be
expressed as C=a+b(Y-T). Again, it can be expressed as C=C0+C1Yd
Where:
C: total consumption
C0: Autonomous consumption
C1: Marginal propensity to consume
Yd: Disposable income (This is the income after
Government taxes and transfer payment)
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1.2. a. Autonomous consumption
Autonomous consumption also known as exogenous consumption is
defined as expenditures taking place when disposable income levels are at zero.
This consumption is typically used to fund consumer necessities, but causes
consumers to borrow money or withdraw from savings accounts. It is the
consumption expenditure that occurs when income levels are zero. Such
consumption is considered autonomous of income only when expenditure on these
consumables does not vary with changes in income; generally, it may be required
to fund necessities and debt obligations. In the above mentioned function, the
autonomous consumption is shown by C0.
1.2. b. Marginal propensity to consume
In economics, the marginal propensity to consume (MPC) is a
metric that quantifies induced consumption, the concept that the increase in
personal consumer spending (consumption) occurs with an increase in disposable
income (income after taxes and transfers); therefore it is the slope of
consumption function. Because this metric is assumed to be positive, thus a
positive relationship between consumption and income occurs and if income
increases, the level of consumption increases too. However, Keynes mentioned
that the increase of income and consumption is not equal. The Keynesian
consumption function is also known as the absolute income hypothesis as it is
only based on current income and ignores potential future income.
Criticisms of this consumption led to the development of
Milton Friedman's permanent income hypothesis ad Franco Modigliani' lifecycle
hypothesis. The marginal propensity to consume (MPC) cannot be calculated
without disposable income. In the classic Keynesian framework, disposable
income is the income left over after taxes and is divided between consumption
and investment. Suppose that an individual receives an extra 2000 0 Frw and
spends 18000Frw, saving the remaining 2000 Frw. His MPC is 0.9, or
18000/20000.
The effect is said to be marginal because it assumes new
income being introduced to a previously static state. The marginal propensity
to consume was presented in John Maynard Keynes' work "The General Theory of
Employment, Interest, and Money." Keynes titled this work to evoke comparisons
between his general theory of economics and Albert Einstein's theory of general
relativity. Keynes believed his work was as seminal to mathematical economics
as Einstein's was to mathematical physics. MPC was the starting point to
Keynes' central mathematical arguments. Keynes noted that individual
consumption is divided between consumption and investment. He expressed this
argument as Y = C + I. He further
12
stipulated that any marginal increase in income would be
divided between consumption and investment, or OY = OC + OI. Keynes then
extrapolated from this that communities would have a general tendency to spend
a fraction of its new income. He shows this with OC/OY, or marginal consumption
divided by marginal income. The only thing left over from his formula,
investment, would receive the rest. Later on in "The General Theory of
Employment, Interest, and Money," Keynes manipulated the relationship between
income, consumption and investment to justify his multiplier. Later Keynesians
have argued that this multiplier effect is greater for poorer communities,
since they have many goods and services to buy; their marginal propensity to
consume is larger.
1.2. c Disposable income
People can either spend or save their disposable income. When
people are very poor, they cannot afford to save. All of their disposable
income will be spent on buying basic necessities to survive. In fact, some may
have to spend more of their income in order to be able to buy enough food and
clothing and pay for housing.
When people spend more than their income, they are said to be
dissaving. This is because they are either drawing on their past saving or more
likely, borrowing other people's savings. As income rises people are able, to
both spend and save more. As people become richer they buy more and better
quality products. It is interesting to note, however, that whilst the total
amount spent rises with income, the proportion spent tends to fall. For
example: A top class footballer in Rwanda may earn a disposable income of
150,000 Frw a month whilst an unemployed person in Rwanda may live on benefits
of 15,000 Frw a month.
The unemployed person may spend all of the 15000 Frw. The
footballer can clearly afford to spend more and is likely to do so. However,
even if he has a very luxurious lifestyle, it is unlikely that he will spend
all of the 150,000 Frw. If he spends 100,000Frw (a huge amount) he will only be
spending 80% of his disposable income, whilst the unemployed person is spending
100% of his income.
The proportion of income which people spend is sometimes
referred to as the average propensity to consume (APC). It is calculated by
dividing consumption by disposable income. As income rises, expenditure
increases but the APC falls.
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1.3 National income
National income is an uncertain term which is used
interchangeably with national dividend, national output and national
expenditure. On this basis, national income has been defined in a number of
ways. Commonly, national income means the total value of goods and services
produced annually in a country. In other words, the total amount of income
accruing to a country from economic activities in a year's time is known as
national income.
It includes payments made to all resources in the form of
wages, interest, rent and profits. In this variable, we shall be giving the
detail containing, definitions of national income, concepts of national income,
methods of measuring, national income, difficulties or limitations in measuring
national income, importance of, national income analysis as well as the
inter-relationship among different concept of national Income.
1.3.a. Definitions of National Income:
The definitions of national income can be grouped into two
classes: One, the traditional definitions advanced by Marshall, Pigou and
Fisher; and two, modern definitions. According to Marshall «The agents of
production: Land, labor and capital and organization a country acting on its
natural resources produce annually a certain net aggregate of commodities,
material and immaterial including services of all kinds. This is the true net
annual income or revenue of the country or national dividend.» In this
definition, the word `net' refers to deductions from the gross national income
in respect of depreciation and wearing out of machines. And to this, must be
added income from abroad.
Though the definition advanced by Marshall is simple and
comprehensive, yet it suffers from a number of limitations. First, in the
present day world, so varied and numerous are the goods and services produced
that it is very difficult to have a correct estimation of them. Consequently,
the national income cannot be calculated correctly. Second, there always exists
the fear of the mistake of double counting, and hence the national income
cannot be correctly estimated. Double counting means that a particular
commodity or service like raw material or labor, etc. might get included in the
national income twice or more than twice.
For example, a peasant sells wheat worth .200,000 frw to a
flour mill which sells wheat flour to the wholesaler and the wholesaler sells
it to the retailer who, in turn, sells it to the customers. If each time, this
wheat or its flour is taken into consideration, it will work out to Rs.800, 000
Frw, whereas, in actuality, there is only an increase of .200, 000 Frw in the
national income. Third, it is again not possible
14
to have a correct estimation of national income because many
of the commodities produced are not marketed and the producer either keeps the
production for self-consumption or exchanges it for other commodities.
The Pigouvian Definition:
Arthur Cecil Pigou in the field of Welfare economics
has, in his definition of national income, included that income which
can be measured in terms of money. In the words of Pigou, «National income
is that part of objective income of the community, including of course income
derived from abroad which can be measured in money. This definition is better
than the Marshallian definition. It has proved to be more practical also. While
calculating the national income nowadays, estimates are prepared in accordance
with the two criteria laid down in this definition. First, avoiding double
counting, the goods and services which can be measured in money are included in
national income. Second, income received on account of investment in foreign
countries is included in national income. The Pigouvian definition is precise,
simple and practical but it is not free from criticism. First, in the light of
the definition put forth by Pigou, we have to unnecessarily differentiate
between commodities which can and which cannot be exchanged for money.
Nevertheless, actually there is no difference in the
fundamental forms of such commodities; no matter they can be exchanged for
money. Second, according to this definition when only such commodities as can
be exchanged for money are included in estimation of national income, the
national income cannot be correctly measured. According to Pigou, a woman's
services as a nurse would be included in national income but excluded when she
worked in the home to look after her children because she did not receive any
salary for it. Similarly, Pigou is of the view that if a man marries his lady
secretary, the national income diminishes as he has no longer to pay for her
services.
Thus the Pigovian definition gives rise to a number of
paradoxes. Third, the definition is applicable only to the developed countries
where goods and services are exchanged for money in the market. According to
this definition, in the backward and underdeveloped countries of the world,
where a major portion of the produce is simply bartered, correct estimate of
national income will not be possible, because it will always work out less than
the real level of income. Thus the definition advanced by Pigou has a limited
scope.
15
Fisher's Definition:
Irving Fisher adopted `consumption' as the
criterion of national income whereas Marshall and Pigou regarded it to be
production. According to Fisher, «The National dividend or income consists
solely of services as received by ultimate consumers, whether from their
material or from the human environments. Thus, a piano, or an overcoat made for
me this year is not a part of this year's income, but an addition to the
capital. Only the services rendered to me during this year by these things are
income. Fisher's definition is considered to be better than that of Marshall or
Pigou, because Fisher's definition provides an adequate concept of economic
welfare which is dependent on consumption and consumption represents our
standard of living. But from the practical point of view, this definition is
less useful, because there are certain difficulties in measuring the goods and
services in terms of money. First, it is more difficult to estimate the money
value of net consumption than that of net production. In one country there are
several individuals who consume a particular good and that too at different
places and, therefore, it is very difficult to estimate their total consumption
in terms of money. Second, certain consumption goods are durable and last for
many years.
If we consider the example of piano or overcoat, as given by
Fisher, only the services rendered for use during one year by them will be
included in income. If an overcoat costs 20,000frw and lasts for ten years,
Fisher will take into account only 20,000 frw as national income during one
year, whereas Marshall and Pigou will include 20,000 frw in the national income
for the year, when it is made. Besides, it cannot be said with certainty that
the overcoat will last only for ten years. It may last longer or for a shorter
period. Third, the durable goods generally keep changing hands leading to a
change in their ownership and value too. It, therefore, becomes difficult to
measure in money the service-value of these goods from the point of view of
consumption.
Modern Definitions:
From the modern point of view, Simon Kuznets
has defined national income as «the net output of commodities and services
flowing during the year from the country's productive system in the hands of
the ultimate consumers. On the other hand, in one of the reports of United
Nations, national income has been defined on the basis of the systems of
estimating national income, as net national product, as addition to the shares
of different factors, and as net national expenditure in a country in a year's
time. In practice, while estimating national income, any of these three
definitions may be adopted.
16
1.3.b Concepts of National Income:
There are a number of concepts pertaining to national income
and methods of measurement relating to them. Gross Domestic Product
(GDP): J.M Keynes Defines GDP as the total value of goods and services
produced within the country during a year. This is calculated at market prices
and is known as GDP at market prices. The Governments always plans to spend
during fiscal year therefore, a reduction in planned expenditure decreases the
level of income (GDP). GDP at market price is «the market value of the
output of final goods and services produced in the domestic territory of a
country during an accounting year.» There are three different ways to
measure GDP: Product method, Income method and Expenditure
method, these three methods of calculating GDP yield the same result
because:
National Product = National Income = National
Expenditure.
Product Method: In this method, the value of
all goods and services produced in different industries during the year is
added up. This is also known as the value added method to GDP or GDP at factor
cost by industry of origin.
The Income Method: The people of a country
who produce GDP during a year receive incomes from their work. Thus GDP by
income method is the sum of all factor incomes: Wages and Salaries
(compensation of employees) + Rent + Interest + Profit.
Expenditure Method: This method focuses on
goods and services produced within the country during one year. GDP by
expenditure method includes:
(i) Consumer expenditure on services, durable and non-durable
goods (C)
(ii) Investment in fixed capital such as residential and
non-residential building, machinery, and inventories (I),
(iii) Government expenditure on final goods and services
(G),
(iv) Export of goods and services produced by the people of
country (X),
(v) Less imports (M). That part of consumption, investment
and government expenditure which is spent on imports is subtracted from GDP.
Similarly, any imported component, such as raw materials, which is used in the
manufacture of export goods, is also excluded.
Thus GDP by expenditure method at market prices = C+ I + G + (X -
M), where (X-M) is net export which can be positive or negative.
GDP at Factor Cost: It is the sum of net value added by all producers
within the country. Since the net value added gets distributed as income to the
owners of factors of production, GDP is the sum of domestic factor incomes and
fixed capital consumption (or depreciation). Thus GDP at Factor Cost =
Net value added + Depreciation.
17
GDP at factor cost includes:
(i) Compensation of employees i.e., wages, salaries, etc.
(ii) Operating surplus which is the business profit of both
incorporated and unincorporated firms. [Operating Surplus = Gross Value Added
at Factor Cost--Compensation of Employees--Depreciation]
(iii) Mixed Income of Self- employed. Conceptually, GDP at
factor cost and GDP at market price must be identical. This is because the
factor cost (payments to factors) of producing goods must equal the final value
of goods and services at market prices. However, the market value of goods and
services is different from the earnings of the factors of production. In GDP at
market price are included indirect taxes and are excluded subsidies by the
government. Therefore, in order to arrive at GDP at factor cost, indirect taxes
are subtracted and subsidies are added to GDP at market price. Thus, GDP at
Factor Cost = GDP at Market Price - Indirect Taxes + Subsidies.
Net Domestic Product (NDP):
NDP is the value of net output of the economy during the year.
Some of the country's capital equipment wears out or becomes obsolete each year
during the production process. The value of this capital consumption is some
percentage of gross investment which is deducted from GDP. Thus Net Domestic
Product = GDP at Factor Cost-Depreciation.
Nominal and Real GDP:
When GDP is measured on the basis of current price, it is
called GDP at current prices or nominal GDP. On the other hand, when GDP is
calculated on the basis of fixed prices in some year, it is called GDP at
constant prices or real GDP. Nominal GDP is the value of goods and services
produced in a year and measured in terms of money at current (market) prices.
In comparing one year with another, we are faced with the problem that is not a
stable measure of purchasing power. GDP may rise a great deal in a year, not
because the economy has been growing rapidly but because of rise in prices (or
inflation). On the contrary, GDP may increase as a result of fall in prices in
a year but actually it may be less as compared to the last year. In both 5
cases, GDP does not show the real state of the economy. To rectify the
underestimation and overestimation of GDP, we need a measure that adjusts for
rising and falling prices. This can be done by measuring GDP at constant prices
which is called real GDP. To find out the real GDP, a base year is chosen when
the general price level is normal, i.e., it is neither too high nor too low.
The prices are set to 100 (or 1) in the base year.
Now the general price level of the year for which real GDP is
to be calculated is related to the base year on the basis of the following
formula which is called the deflator index.
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GDP Deflator:
GDP deflator is an index of price changes of goods and
services included in GDP. It is a price index which is calculated by dividing
the nominal GDP in a given year by the real GDP for the same year and
multiplying it by 100. Gross National Product (GNP): GNP is the total measure
of the flow of goods and services at market value resulting from current
production during a year in a country, including net income from abroad. GNP
includes four types of final goods and services:
(i) Consumers' goods and services to satisfy the immediate wants
of the people;
(ii) Gross private domestic investment in capital goods
consisting of fixed capital formation, residential construction and inventories
of finished and unfinished goods;
(iii) Goods and services produced by the government; and
(iv) Net export of goods and services, i.e., the difference
between value of exports and imports of goods and services, known as net income
from abroad. In this concept of GNP, there are certain factors that have to be
taken into consideration: First, GNP is the measure of money, in which all
kinds of goods and services produced in a country during one year are measured
in terms of money at current prices and then added together. But in this
manner, due to an increase or decrease in the prices, the GNP shows a rise or
decline, which may not be real. The net National Product All this process is
termed depreciation or capital consumption allowance. In order to arrive at
NNP, we deduct depreciation from GNP. The word `net' refers to the exclusion of
that part of total output which represents depreciation. So NNP =
GNP-Depreciation.
NNP at Market Prices:
Net National Product at market prices is the net value of
final goods and services evaluated at market prices in the course of one year
in a country. If we deduct depreciation from GNP at market prices, we get NNP
at market prices. So NNP at Market Prices = GNP at Market
Prices-Depreciation.
NNP at Factor Cost:
Net National Product at factor cost is the net output
evaluated at factor prices. It includes income earned by factors of production
through participation in the production process such as wages and salaries,
rents, profits, etc. It is also called National Income. This measure differs
from NNP at market prices in that indirect taxes are deducted and subsidies are
added to NNP at market prices in order to arrive at NNP at factor cost. Thus
NNP at Factor Cost = NNP at Market Prices-Indirect taxes+ Subsidies
= GNP at Market Prices - Depreciation-Indirect taxes +
Subsidies.= National Income.
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Normally, NNP at market prices is higher than NNP at factor
cost because indirect taxes exceed government subsidies. However, NNP at market
prices can be less than NNP at factor cost when government subsidies exceed
indirect taxes. Normally, there are a wide number of theories of National
Income and many economists are interested in discussing about such variable.
This study combines of number of theories and these will help the researcher to
maximize analysis on National income n Rwanda.
1.4 Interest rate
Interest rate is the amount charged, expressed as a percentage
of principal, by a lender to a borrower for the use of assets. Interest rates
are typically noted on an annual basis, known as the annual percentage rate
(APR). It was found the lending interest rate is determined by the funding
cost, the loan size, and the efficiency level of microfinances.
Lending rate is the bank rate that usually meets the short- and
medium-term financing needs of the private sector. This rate is normally
differentiated according to creditworthiness of borrowers and objectives of
financing. Interest is money paid by a borrower to a lender for a credit or a
similar liability. It is the charge for the privilege of borrowing money.
Important examples are bond yields, interest paid for bank loans, and returns
on savings. A modern economy is intrinsically linked to interest rates, thus
their importance on the financial markets. Interest rates affect consumer
spending. The higher the rate, the higher their loans will cost them, and the
less they will be able to buy on credit. Interest rates are classified many we
can state: Nominal interest rate, real interest rate, effective interest rate,
and so on.
1.4. a. Nominal Interest Rate
The nominal interest rate is conceptually the simplest type of
interest rate. It is quite simply the stated interest rate of a given bond or
loan. This type of interest rate is referred to as the coupon rate for fixed
income investments, as it is the interest rate guaranteed by the issuer that
was traditionally stamped on the coupons that were redeemed by the
bondholders.
The nominal interest rate is in essence the actual monetary
price that borrowers pay to lenders to use their money. If the nominal rate on
a loan is 5%, then borrowers can expect to pay 5000 frw of interest for every
100,000 frw loaned to them.
20
1.4.b Real Interest Rate
The real interest rate is slightly more complex than the
nominal rate but still fairly simple. The nominal interest rate doesn't tell
the whole story because inflation reduces the lender's or investor's purchasing
power so that they cannot buy the same amount of goods or services at payoff or
maturity with a given amount of money as they can now.
The real interest rate is so named because it states the
«real» rate that the lender or investor receives after inflation is
factored in; that is, the interest rate that exceeds the inflation rate. If a
bond that compounds annually has a 6% nominal yield and the inflation rate is
4%, then the real rate of interest is only 2%. So Nominal interest
rate - Inflation = Real interest rate.
1.4. c Effective interest rate
One other type of interest rate that investors and borrowers
should know is called the effective rate, which takes the power of compounding
into account.
1.5. Inflation rate
Inflation is the rate at which the general level of prices for
goods and services is rising, and, subsequently, purchasing power is falling.
Central banks attempt to stop severe inflation, along with severe deflation, in
an attempt to keep the excessive growth of prices to a minimum. Inflation is a
state of economy in which the general prices of commodities and services become
high. Another way we can say that «too much money chasing too few
goods». The so called consumer price indices are prominently used to
calculate inflation. An increase in the money supply may be called monetary
inflation, to distinguish it from rising prices, which may also for clarity be
called "price inflation". Economists generally agree that in the long run,
inflation is caused by increases in the money supply. Inflationary problems
arise when we experience unexpected inflation which is not adequately matched
by a rise in people's incomes. If incomes do not increase along with the prices
of goods, everyone's purchasing power has been effectively reduced, which can
in turn lead to a slowing or stagnant economy. So someone can ask himself what
exactly causes inflation in an economy. There is not a single, agreed-upon
answer, but there are a variety of theories, all of which play some role in
inflation:
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