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CHAPTER 2
Who and what make up an economy?
An ecomony consists of:

Real sector Monetary sector

Objects such as goods, Subjects such as Objects such as money,

services, assets and households, firms, bonds, shares and other
production factors government, financial financial instruments
intermediaries and the
foreign sector

They all interact on markets such

as the product, factor, financial and
foreign exchange markets

1. INTRODUCTION
In the next chapter, we are going to build a complete model of how an economy works. Before
we can build such a model, we need to look inside the economy to see what it consists of. In this
chapter we look at the basic economic objects and subjects in the economy.

Economic objects are the non-living elements in an economy and they include goods, services,
assets and money. Economic subjects are the individuals and groups in the economy, i.e. those
who are able to make choices and who use economic objects to help them solve their scarcity
problem. The main subjects we shall study in this chapter are households, firms, government
and the foreign sector. Everything that happens in an economy is driven by human subjects and
therefore the discipline of economics boils down to a study of humans and their interactions.
Economics is therefore often called a social science.

Economic subjects and objects and their interactions create this thing we call an economy. After
completing this chapter, you should have a good understanding of the elements of the modern
economy, especially the role that the government plays in the workings of the modern economy.

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2. OBJECTS IN THE ECONOMY

Before we look at the human subjects in an economy, let's first see what the basic non-living
objects are. The basic objects are goods and services, assets and financial instruments.

Goods are physical items that can be bought and sold, for example chairs or chocolates. Services
are also bought and sold, but unlike goods, services do not have a physical existence. Services
can be defined as help provided by someone, for example legal services or education. In this
textbook the word 'product' includes both goods and services.

Most goods and services are produced in order to be consumed, but not all products are consumed
immediately. Some products are kept to create greater benefits for their owners in the future –
these products are called assets. For example, a bread-baking machine is an asset, because the
baker will use it to bake more bread in the future. The baker will sell the bread and so create
benefits (in the form of bread that can be sold) for himself in the future. Assets are also called
capital goods.

Assets can be divided further into real assets and financial assets. Real assets are usually physical
assets that can be used to produce more goods and services in the future. The bread-baking
machine is an example of a real asset, but real assets could also include things like computers
or trucks. Financial assets are money or assets that can easily be converted into money. Financial
assets are used to generate more money (not more production) in the future. For example, a
savings account with a bank is a financial asset. You don't use the savings account to produce
more goods and services. The bank pays you interest on the money in your savings account, so
the savings account generates more money for you in the future. A savings account can also
easily be turned into cash. Other kinds of financial assets are unit trusts, endowment policies or
government bonds (more about this later). Financial assets are also called financial instruments.

Based on the economic objects, we can split the economy into two parts – a real sector and a
monetary sector. The real sector of the economy contains goods and services and real assets, while
the monetary sector contains money and financial instruments.

From the first chapter you will recall that products are bought and sold on markets. The activity
of buying and selling is often called trading. Markets exist in both the real sector and the monetary
sector. We distinguish between the following markets:

• Product market, where buyers and sellers of goods and services meet, for example in a
supermarket or a spaza shop.

• Factor market, where buyers and sellers of production factors meet. One such a market is
the labour market which could be a website where those looking for jobs (supply of labour)
post their CVs so that potential employers (demand for labour) can look at them.

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• Financial market, where buyers and sellers of financial instruments meet, for example in
banks. If a firm needs money to buy machines, that firm demands money. Firms with extra
money could supply that money to those who need it. These firms are brought together by
a financial intermediary like a bank, therefore a bank could be a financial market.

• Foreign exchange market, where buyers and sellers of the currencies of other countries meet.
People need foreign currency to buy imports or to invest in foreign countries.

Product and factor markets form part of the real sector, while financial and foreign exchange
markets form part of the monetary sector.

Considering only the product market for now, every time a product is traded, the seller gives the
product to the buyer, and the buyer gives money to the seller (see figure 2.1). For example, the
buyer gets bread and gives the bakery R4 in return. Whenever such an exchange takes place, we
refer to it as a transaction.
Bread Bread
Buyer of Goods Seller of
bread market bread
Money Money

Figure 2.1: An exchange on the goods market

The goods market in the case of figure 2.1 would be the bakery shop, because that is where the
buyer and seller would meet. The transaction takes place on the market, and it has two sides – a
real flow and a monetary flow. The real flow (solid lines) is the flow of products, while the monetary
flow (broken lines) is the flow of money.

Now that we have covered the basic economic objects, we can turn to a discussion of economic
subjects. We shall return to a more detailed discussion of economic objects in the monetary
sector later in this chapter.

3. HOUSEHOLDS
One or more people living together in a house, flat or a shack is seen as one economic unit – the
household. Households consist of individuals. These individuals are mainly the consumers and
workers in an economy.

Households own many of a country's production factors. Many individuals in households can
work in jobs, so they own the production factor called labour. Most households also own land and
other natural resources. Some own real capital (real assets), like computers and equipment, and
others own some financial capital (financial assets), like money in a savings account or shares
in a company. A few individuals start their own businesses and therefore own the production
factor called entrepreneurship.

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When households sell their production factors, they earn an income. Workers sell their labour
to employers and earn wages, those who rent their land and property on it earn rent, those who
lend their capital to others earn interest, and the entrepreneurs earn profit.

Once households earn income from selling their production factors, they will spend it. They will
spend their income on consumer goods. They can spend it either on non-durable consumer
goods (goods that they will consume in less than 1 year, e.g. bread, petrol, etc.) and durable
consumer goods (like furniture and cars, which will last for many years). As consumers spend
more, they buy more products, and as a result they satisfy more of their needs and come closer
to solving their scarcity problem.

Households spend their income in order to satisfy their needs. When a consumer gets satisfaction
from consuming a product, we say that the consumer experiences utility from the consumption
of that product. If we could measure utility, we would find that utility declines as you consume
more of the same product. For example, when you are hungry, you get a lot of satisfaction (utility)
from the first hamburger you eat. If you eat a second hamburger, you may still experience utility,
but if you are no longer hungry, you will get less satisfaction. If you try to eat a third hamburger,
you will get even less satisfaction from it. We call this the law of diminishing marginal utility -
the extra (or marginal) utility you get from consuming one more of the same product falls (or
diminishes) as you consume more.

4. FIRMS
Firms (also known as businesses or companies) are responsible for the production that takes
place in an economy. A firm is started by an entrepreneur. Entrepreneurs organise and employ
other production factors to help them. For example, an entrepreneur starting a bakery will need
to employ labour (shop assistants) to help in the shop, rent a property for the shop and borrow
money from a bank to buy the equipment. The firm is the employer of production factors, and
will pay these production factors wages, rent and interest.

The firm will sell what it produces and earn revenue. Total revenue (TR) is simply the quantity
(Q) of products that the firm sells multiplied by the price (P) of those products. For example, if
the firm sells 1 000 loaves of bread per month for R4 each, the total revenue of the firm will be
R4 000 (TR = PxQ = 4x1 000) per month. The money that the firm pays to production factors is
a cost to the firm. If the firm pays wages of R1 100, interest of R600 and rent of R2 000 per month,
its total cost (TC) will be R3 700. Costs have to be paid from the revenue that the firm earns. If
there is any money left after all costs have been paid, the firm makes a profit. In this case the
profit is R300 (Profit = TR-TC = 4 000-3 700). The profit is paid to the entrepreneur and other
owners of the firm. One would expect most firms to try to maximise their profit.

As firms produce more, more products will be available for households to consume, and so we
come closer to solving the scarcity problem. But not all products reach households. Final products
are products consumed by households – products like bread, clothes or furniture. Some products

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are consumed by other firms to help them in their production, and these products we call
intermediate products. For example, a steel factory will produce a sheet of steel and sell it to a
car manufacturer. The car manufacturer will use that piece of steel to make the body of a car
and then sell that car to a household. The car is consumed by the household and is a final product.
The sheet of steel is used by the car manufacturer to produce something else, so the sheet of steel
is an intermediate product.

If all other production factors stay the same, a firm will at first produce more as it employs more
labour. But as it employs ever more workers, production will eventually start to fall. For example,
suppose you have a small patch of land on which you grow carrots. If you employ one person to
help you cultivate the land, you will initially be able to produce more carrots. If you employ
another worker, you will be able to produce even more. But there comes a time when production
will fall. Imagine what would happen if you employed 100 workers on a small patch of land. These
workers will get in each others' way and trample all over the plants. Your costs will go up and
you will produce fewer carrots. So, as you employ more workers, the extra (or marginal) production
will initially increase, but eventually it will fall. This is known as the law of diminishing marginal
returns or the law of increasing cost. You may recall that in Chapter 1 we illustrated this law by
means of the PPC, but the next table shows it numerically.

Table 2.1: Diminishing marginal returns and increasing cost

Number of workers Production Marginal (or extra) Total wages paid
production (R600 per worker)
0 0
(100-0)
1 100 100 = /(1-0) 600 (=600x1)
(250-100)
2 250 150 = /(2-1) 1200 (=600x2)
3 550 300 1800
4 600 50 2400
5 580 -20 3000

Except for labour, suppose that all other production factors (like the piece of land you use) stay
the same, and assume that you pay a wage of R600 per worker. From the table you see that the
marginal production (or return) eventually declines as you employ more labour. If the firm
employs 3 workers and then employs another one, its production will increase from 550 to 600
carrots. The extra worker therefore only helped to produce an extra 50 carrots. To be precise,
the formula for marginal production is:

MP = Change in production
Change in inputs

The law of diminishing marginal returns means that we can never produce enough products to
satisfy all needs. This happens because as firms employ more production factors, their production
will eventually fall. If production didn't fall, you would be able to produce all the vegetables the
world needs on your small patch of land simply by employing more workers – which is impossible.
You need more land to produce more, and if the amount of land is scarce, eventually production
has to fall as you employ more labour. The law of diminishing marginal returns shows that there
are limits to all economic activity.

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When it comes to firms, we find scarcity everywhere, and this scarcity leads to power struggles
and competition. There is a limit to how many products all households can consume. People
can only eat so many carrots or bread before they are full or tired of carrots and bread (recall the
law of diminishing marginal utility). Another reason why households can only buy a limited
amount of products is that their income is limited. So if there is only a limited amount of products
that consumers can or want to buy, firms have to compete for consumers' spending. Competition
between firms is good for consumers, because it motivates firms to offer more choices, better
quality and lower prices in order to make their products appear more attractive to consumers.

If consumers buy a limited amount of products, firms' revenue will also be limited. This limited
income will be spread between the different production factors in the firm, and each production
factor will want as much as possible. Workers will want the highest possible wages and entrepreneurs
will want the highest possible profit. The higher the wages go, the less money is left for profit.
The result is that there will also be conflict and power struggles between the different production
factors. Production factors may then organise interest groups to fight for a larger share of the
revenue. For example, workers form labour unions that bargain with employers for higher wages
and then threaten to go on strike (stop work) if their demands are not met.

5. GOVERNMENT
Not all products needed to solve the scarcity problem will be produced by firms. In such cases,
the economy needs a government to provide the remaining products.

What is a government?
A country's government is the group of organisations that administer a country. Government
really consists of many entities:

• National government: This is the main government to which all other forms of government
report. It includes organisations such as national government departments (for example the
Department of Trade and Industry), the country's cabinet and its ministers, as well as the
country's parliament.

• Provincial/regional government: This is the government that oversees the affairs of specific
regions or provinces (for example the Gauteng Provincial Government) and it is subject to
the authority of the national government.

• Local government: This kind of government oversees the affairs of a particular town, city or
group of towns and cities. In South Africa examples would be the Tshwane Metropolitan
Council or the Municipality of Kuruman.

• Public enterprises: These include businesses that are controlled or owned by the government.
Examples in South Africa are Eskom and Transnet.

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The national, regional and local government together make up the general government. The
public sector is the general government together with public enterprises. The public sector is
made up of those organisations controlled by the government, whereas the private sector are all
organisations controlled by private individuals and firms.

Why do we need a government?

Whenever firms don't produce the necessary products or harm the economy, we say that the
market fails. Whenever there is market failure, the government needs to intervene. Examples of
market failure include:

• Public goods: Public goods can be supplied to everyone, but the supply of such goods does
not fall even if more of them are consumed. Furthermore, public goods are normally non-
excludable, which means that one cannot prevent anyone from consuming them. If public
goods are available to everyone and nobody can be prevented from consuming them, it will
be difficult to get people to pay for such public goods (this is known as the free rider problem).
Examples of public goods include police services, motor highways or street lamps. In the case
of a street lamp, everyone benefits from the light, nobody can be prevented from seeing the
light, and the amount of light does not diminish as more people use it. If it costs money to
erect a street lamp in front of your home and the whole neigbourhood will benefit, how are
you going to get them to pay for it? They won’t pay, because you cannot prevent them from
also enjoying the light once the street lamp is working. If you cannot get people to share the
cost with you, you probably would not pay to erect a street lamp in front of your home. We
will therefore find that the market will not provide sufficient public goods, however important
such goods may be to society. Further examples of public goods are national defence, a healthy
or clean environment, foreign relations and a justice system. If the market will not provide
public goods, the government must provide these goods.

• Imperfect competition: In the absence of some government control, firms may organise
themselves in such a way to reduce competition between them. If there is less competition,
consumers have fewer choices, and this allows firms to increase prices. The extreme case is
that of a monopoly – where there is only one firm that provides the products to satisfy a
particular need. Such a firm will be able to charge consumers much higher prices compared
to a market where there is a lot of competition between many firms. Firms may also form
cartels, where a group of firms agree to reduce the supply of a product and so force up the
price of product. In such cases the government needs to intervene by imposing fines on such
firms, breaking them up into smaller parts, taking ownership of such firms or declaring their
actions illegal (as with cartels).

• Externalities: Externalities occur when firms or individuals create costs or benefits for others
through market transactions, without compensating others for the costs they create or
receiving payment for the benefits they create. For example, a factory that pollutes the air
creates costs for others by reducing the quality of the air. The wastes that the factory pumps

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into the air may cause smog and asthma, but there is no way the market can force the factory
to pay for the costs (or negative externalities) they create for others. If firms can cause negative
externalities without being forced to pay for the harm they create, one will find that firms will
create even more negative externalities. The government would then have to intervene by
putting limits on the amount of negative externalities firms are allowed to create, or by
imposing fines on firms that create these externalities. Another example is when a firm provides
scholarships to students. Other firms will get the benefit from these scholarships because
there will be a greater number of educated workers to employ. Those who benefit cannot be
forced to compensate the firm providing the scholarships and creating benefits (or positive
externalities) for others. If firms are not rewarded for creating positive externalities, one is
likely to find too few positive externalities. The government would then have to intervene by
either producing the positive externalities themselves, or rewarding others for doing so.

• Economic instability: The economy tends to go through good times (economic booms) and
bad times (recessions and depressions). Sometimes recessions can become so severe that they
create great suffering (such as large-scale unemployment and poverty) or booms can lead to
inflation getting out of control. Governments may then be called upon to use expansionary
or restrictive economic policy to stabilise the economy, and prevent unemployment or inflation
from rising out of control or from becoming too volatile.

• Inequity: The market provides goods and services only to those who pay for it – how much
people need these goods and services make no difference. Firms will provide food to fat rich
people even though they already eat too much, but will provide very little to poor people who
are dying of hunger. The market has no social conscience, and if it worked freely it would
create an unequal distribution of income that might not be acceptable to society. So the
government needs to intervene by providing poor people with free basic services (for example
primary healthcare, housing or education), lower-priced foodstuffs or some kind of social
safety net (like unemployment benefits or basic income grants).

Government spending

To provide public goods, enforce rules to control competition, influence externalities, alleviate
inequality and stabilise the economy, the government will need to spend huge amounts of money.
Government spending can be divided into the following parts:

• Exhaustive government expenditure: With exhaustive expenditure the government gets

something in return for the money that it spends. One part of exhaustive spending is
consumption expenditure by the government, which is spending on objects classified as
expenses, for example stationery, petrol, electricity, wages, etc. The other part of exhaustive
spending is capital expenditure by the government, which is spending on real assets, for
example motor vehicles, schools, hospitals, roads, bridges, etc. Consumption expenditure
made up 58% of total government expenditure in South Africa in 2002/3, while capital
expenditure made up 10%.

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• Transfers: Expenditure for which the government gets nothing in return is called transfers.
For example, when the government pays a pension to a retired government employee, it no
longer gets anything in return from that person, therefore state pensions are transfers. More
examples are child grants, unemployment benefits, subsidies or interest on government debt.
A subsidy is a money payment by the government to firms, either to encourage them to behave
in a certain way or to support unprofitable firms. Spending on transfers made up 32% of total
government expenditure in South Africa in 2002/3.

Government expenditure can also be broken down by function. The functional allocation of
government spending in South Africa appears to be appropriate to a small developing country,
with most spending on social services. Table 2.2 shows how government allocated its spending
by function in the 2002/3 tax year.

Table 2.2: Functional expenditure by the South African government (2002/03)

Functions R billion %
Education 62.8 20.2
Health 34.9 11.3
Welfare and social security 42.0 13.5
Housing and other social services 13.7 4.4
Police, prisons and courts 32.6 10.5
Defence and intelligence 20.8 6.7
Economic services 36.2 11.7
General administration 20.1 6.5
Interest on debt 47.3 15.2
Total government expenditure 310.2 100
Source: 2003 Budget Review

Taxation

In order to spend money, the government needs to get the money from somehere. This money
will come mostly from taxation.

In South Africa in 2002/3, more than 98% of the government's total revenue came from taxation.
Taxation involves the government taking a part of the income of individuals and firms in order
to pay for services it renders. A tax can be levied either directly on legal persons in such a way
that they cannot pass the tax burden on to someone else (direct taxation), or it can be levied on
activities (indirect taxation). Direct taxation includes personal income tax, company income tax,
unemployment insurance or property tax. Indirect taxation includes VAT (taxing the activity of
buying), customs duty (taxing the activity of importing) or excise duty (taxing the activity of
consuming particular products). In 2002/3 the South African government got most of its tax
revenue from personal income tax (33% of total tax revenue), VAT (25%) and company tax (22%).
More than 60% of tax revenue in South Africa comes from direct taxation.

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Taxation can be progressive, regressive or proportional. Progressive taxation occurs when the
tax rate (the percentage of income going to tax) increases as a person's income increases. The
best example of progressive taxation is personal income tax – in South Africa in 2004 people with
an income of less than R30 000 per year pay no income tax, those with an income of R100 000
pay 30% of their income in tax, while people with an income of more than R260 000 per year
have to pay 40% of their income in tax. Progressive taxation may help to distribute income more
equally – with the government taking more from the rich in order to pay for the provision of
more services to the poor. Regressive taxation occurs when the percentage of income going to
tax increases as a person's income declines. Value added tax (VAT) is an example of regressive tax.
When buying a R100 000 car, you will pay 14% (or R14 000) VAT. For people earning R20 000 per
year, this tax amount is equal to 70% of their income (14 000/20 000), but for people earning R500 000
per year, this is less than 3% of their income. Regressive taxation is seen as unfair, since it tends
to create a more unequal distribution of income. Proportional taxation occurs when the proportion
of income paid as tax remains constant regardless of a person's income.

There are so many choices when it comes to taxation that the government needs some guidance
to help it design a good tax system. The two principles that should guide the government are
equity and efficiency.

The principle of tax efficiency states that a tax should not cause people to make different choices
than they would have made if there were no tax. For example, if the government states that from
now on you have to pay a tax of R1 000 for every window in your house, you will see people
building houses with fewer windows (this actually happened in the Netherlands long ago). But
if there is no tax on windows, people will build houses with many windows. So a tax on windows
would not be efficient, because it will distort the choices people make. Or, if the income tax rate
on high income earners were 95%, you will find that people will either work a lot less than normal,
or spend a lot of energy on trying to avoid paying tax. Without the tax people would work harder
and spend more of their time working. An excessively high tax rate harms the economy and is
clearly inefficient.

The principle of tax equity states that a tax should be fair. A tax is fair if people pay more tax only
if they can afford to pay more tax (we call this the principle of ability to pay). A progressive income
tax is equitable according to this principle, because it taxes people who earn a higher income at
a higher tax rate. A tax is also fair if people pay more tax if they receive more benefits from the
government (we call this the principle of benefit received). A fuel levy is equitable according to
this principle, because it taxes only those people who benefit from using the roads the government
has built.

Tax efficiency and tax equity can sometimes be in conflict. For example, if the income tax rate
was 95% on high income earners, it would be inefficient as we said earlier. On the other hand,
such a tax would be fair according to the principle of ability to pay. Faced with such a conflict,
the government needs to find a balance. In South Africa the income tax system has struck such
a balance. High income earners pay 40% of their income in tax, and this tax rate is not so high
that it changes the choices people make when deciding how much to work (so it is fairly efficient).

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High income earners are subject to a higher tax rate than low income earners (so it is equitable
according to the ability to pay principle). However, many of the high income earners argue that
they don't get as many benefits from the government as low income earners in return for their
higher tax payments (so income tax may be inequitable according to benefit received).

Besides tax, the government can also obtain money by selling some of its services to the private
sector at a fee, receiving grants and selling its assets. When a government sells public enterprises
to the private sector, it is known as privatisation. Many economists believe that privatisation
makes the economy more efficient, while also creating additional revenue for the government.
If the government does not get enough money from taxes, fees, grants and asset sales, then it
needs to borrow money.

The National Budget and fiscal policy

Every year the government announces how it plans to spend its money and where it intends to
get the money from. We refer to this plan as the National Budget, and it is the main tool of fiscal
policy. A government that spends wisely (for example on areas such as education or infrastructure)
can help to solve the scarcity problem in a country. A government that imposes inefficient and
inequitable taxes, however, can make the scarcity problem in a country worse than before.

If the government receives more money in tax revenue (and other sources) than it spends, the
government is said to have a budget surplus. If the government spends more money than it
receives in tax revenue, the government is said to have a budget deficit. Most governments in the
world experience budget deficits, and South Africa is no exception, as you can see from table 2.3.

Table 2.3: Overview of the national budget in South Africa (2002/03)

R billion
Government revenue 275.7
Government expenditure 291.8
Main budget deficit 16.1
Deficit as % of GDP 1.4%
Source: 2003 Budget Review

The budget deficit of R16,1 billion is calculated as government expenditure minus government
revenue. The size of the deficit is normally judged in comparison with the country's GDP. In
South Africa the budget deficit went as high as 10.2% of GDP in 1993/94, and the 2002/03 budget
deficit is the lowest budget deficit in many years. A budget deficit means that the government
either spends too much or earns insufficient revenue, and therefore it needs to borrow money.

Government debt (government borrowings) increases every time the government experiences a
budget deficit. A budget deficit means the government needs more money than it receives from
taxes in order to pay for its spending. Debt is the major source of money for a government with
a budget deficit. It can borrow locally or overseas, usually by issuing government bonds (more
on this in the next section).

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A budget deficit and the resulting government debt is not necessarily a bad thing. If the budget
goes into a deficit because most government spending goes to capital expenditure, it will benefit
a country. Spending on capital goods is like an investment in the country, and will generate
greater benefits in the future. A budget deficit is less desirable if most government spending is
on consumption expenditure.

If budget deficits are not controlled, government debt may eventually rise so high that the
government falls into a debt trap. A debt trap occurs when your debt is so large that you cannot
even afford to pay the interest on your loans. A government in a debt trap will never be able to
pay off its loans, and its debt will just keep on increasing. This is what has happened in many
African countries, and explains why so many of them are asking their international creditors for
debt relief (reduction of debt) or even debt forgiveness (writing off all their debt). Many economists
believe that the South African government came close to falling into a debt trap in the 1990s
when government debt was equal to almost 50% of our GDP. Since then the government has
brought the budget deficit under control, and government debt in 2002/03 was 38.5% of GDP.

6. FINANCIAL INTERMEDIARIES
When there is money in an economy, some people will always have too much money (surplus
funds) and others will be in need of more money than they have. It is the job of financial
intermediaries to channel money from those who have surplus funds to those who need more
money. Examples of such intermediaries are banks, insurance companies, unit trust management
companies, asset managers and pension fund management firms.

Those who have surplus funds will save their money, maybe by depositing the money in a savings
account at a bank. Those who need more money than they have avalaible, will borrow money
from a financial intermediary such as a bank. It is often firms that need additional money for
buying equipment, vehicles or building a new office or factory. When firms buy such real capital
goods, we say that real investment (or capital formation) takes place. Financial intermediaries
will accept savings from many different households and firms, and will pay them interest on their
savings. The financial intermediary will then pool all this money and lend it out to firms who
need more money to invest. The firms that borrow the money will pay the financial intermediary
interest on the money that they borrow.

Financial intermediaries don't just offer savings accounts. Insurance companies offer investment
policies, banks offer negotiable certificates of deposit, unit trust companies offer unit trusts,
companies (through their representatives) offer shares, the government (through its representatives)
offer government bonds, to name a few. All of these are called financial instruments. The buying
and selling of financial instruments take place on the financial markets. For example, company
shares are bought and sold on the stock market (called the JSE Securities Exchange in South
Africa) or government bonds are bought and sold on the bond market (called the Bond Exchange
of South Africa).

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When people put their money in any financial instrument, they are not buying any real capital,
they are buying financial capital. When people buy financial instruments, we say that financial
investment takes place. People invest their money in financial instruments because they want
to obtain financial gain. For example, people put their money in savings accounts or bonds,
because they want to earn interest income. Other people buy company shares because they hope
that the shares’ price will go up, and then they can sell them for a profit. With financial investment
there is no intention to use the money to produce goods and services – financial investors are
only interested in financial gain.

If financial investment adds nothing to the real sector of the economy, how does it help to solve
the scarcity problem? Due to the possibility of earning interest or making a financial profit, people
are willing to put their surplus funds into financial instruments (such as shares, savings accounts,
pension funds, etc). The financial intermediary who sells the financial instrument to them, then
takes the money they receive and lend it to other firms. Many of these firms will use the money
they borrowed to pay for real investment (e.g. building a new factory). Real investment allows
firms to produce more and in that way solve the scarcity problem. So, financial investment is
useful because it channels money to real investment through financial intermediaries (see figure
2.2).

Savings/
financial Real
investments Loan investment
Households Financial Firms
(surplus) intermediaries (deficit)
Regular Regular
interest interest
income payments
Figure 2.2: Investment and financial intermediaries

Chapter 14 will deal with the role of money and financial markets in an economy in more detail.

7. OBJECTS IN THE MONETARY SECTOR OF THE ECONOMY

Before we turn to the last role player, we are going to stop and take a closer look at a set of
economic objects that are becoming increasingly important in the modern economy – namely
financial instruments. The two that are particularly important are shares and bonds.

When a firm wants to raise funds, it can sell parts of the firm to investors. The firm does so by
dividing its equity into equal parts, which we call shares. For example, if a firm’s total equity is
R20 000, it could perhaps divide that equity into 5 000 equal parts (shares). Every share will be
worth R4, so that 5 000 x R4 gives you the total equity of R20 000. Investors will buy one or more
shares in the firm. If you own a share in a firm, you own part of the firm. Ownership of shares
entitles you to part of the firm's profit and also allows you to vote about important decisions in

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the firm. If you own 50% or more of the shares in a firm, you become the controlling shareholder,
and you would be able to control the major decisions in the firm. A person who owns 2 500 or
more shares (50% of 5 000) in this example, will have more than 50% of the votes in the firm
and will be the controlling shareholder.

When a firm makes a profit, it will pay part of that profit to its shareholders in the form of
dividends. If the firm's profit is R4 000 and you own 20% of the shares in the firm, you are entitled
to R800 (20% of R4 000). Investors may also wish to trade in shares. In our example the price
of a share in the firm is R4. If investors are allowed to buy and sell shares, the share price will
change. For example, suppose the firm invents a cure to cancer, this firm may make big profits
in the future. Many people will want to get a share in such a firm. Shares in the firm will become
more valuable and shareholders may then only be willing to sell their shares at a much higher
price. If a shareholder sells his shares for R11 each, he will make profit of R7 per share (R11 minus
the original price of R4). When a person sells an asset (such as shares) for a higher price than
he bought it, that person makes a capital gain.

Shares are therefore financial instruments. People hold shares for financial benefit. They hope
to make more money in the future by receiving regular dividends and making a capital gain when
they sell their shares.

Similar to firms, governments also need money sometimes. To raise money, governments sell
government bonds. For example, if a government needed R30 million, it could sell 30 government
bonds at a price of R1 million each. A government bond is a promise by the government of a
country to repay the money it borrowed (from the owner of a government bond), and to make
regular fixed interest payments to the owner of a bond in the meantime. Why would people buy
government bonds? Firstly, the government promises to repay the money given to them; and
secondly, it pays interest on the money. Figure 2.3 shows a very simple representation of a
government bond.

REPUBLIC OF POLYNESIA
Government bond issued on
1 January 2005

Principal: R1 million
Coupon rate: 6.00%
Maturity date: 31 December 2014

Figure 2.3: Stylised representation of a government bond

Using the example from figure 2.3, we have a government bond that is initially sold at a price of
R1 million. The initial price of the bond is its principal. The investor pays the principal to the
government on the day the bond is issued and the government pays back the R1 million-principal
on 31 December 2014. The date on which the government repays the principal is the maturity
date. The time remaining before the principal is repaid is called the maturity of a financial

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instrument. The maturity of this bond when it is first issued on 1 January 2005 is therefore 10
years. The government will pay interest on the R1 million for the next 10 years at an interest rate
(or coupon rate) of 6%. The investor will therefore receive R60 000 (6%xR1 million) every year
for 10 years. This interest payment of R60 000 is also known as a coupon payment. The coupon
payment cannot change, it stays fixed for the whole 10 years. The coupon payment is one reason
for owning a bond – you are certain of receiving a fixed amount of money over a specific period.

People also hold government bonds to make a capital gain. Bonds are traded on the financial
market and the prices of bonds may rise and fall. From our previous example – an investor may
decide to sell a bond before its maturity date, say for R1,2 million. In this case, the investor makes
a capital gain of R200 000. But it doesn't matter how many times this bond is bought and sold,
the coupon payments to the owner will remain fixed at R60 000, and whoever owns the bond on
the maturity date will receive a fixed payment of R1 million.

The crucial difference between a share and other financial instruments is that most financial
instruments have a limited maturity, while a share never needs to be paid back. Since a share
never needs to be paid back, it has an infinite maturity. A 20-year government bond will be paid
back in 20 years' time, so its maturity is 20 years. If you deposit money in a six-month fixed
deposit with a bank, the bank has to pay your money back in 6 months, so the maturity is 6
months.

8. FOREIGN SECTOR
The foreign sector consists of all households, firms, financial intermediaries and governments
that operate outside the borders of a country. We interact with the foreign sector mainly through
exports, imports, investment and aid.

When local firms produce products and sell them to foreigners, we export to foreign countries.
Imports take place when local consumers and firms buy products from foreigners. All exports and
imports together make up a country's foreign trade. South Africa's total exports were about
R315 billion in 2002. Most of our exports are of precious stones, metals and minerals. In 2002,
South Africa's total imports were about R275 billion. Most of our imports are of capital goods (for
example vehicles, machinery and appliances).

Every country in the world has its own currency or money unit. We refer to foreign countries'
currencies as foreign exchange. For South Africans, US dollars, Japanese yen, Botswana's pula
or euros would all count as foreign currency. Currencies can be exchanged for each other at the
exchange rate. For example, we would exchange rands for dollars at the R/$ exchange rate. If the
exchange rate is $1 = R7, it means that we have to give R7 in order to buy $1. All imports and
exports require the use of foreign currency. For example, if $1 = R7, and I want to buy a book of
$100 from a bookshop in the USA, I would need to buy dollars. I will need R700 to buy $100 at
the bank, which I will then use to pay the bookshop in the USA.

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Many people think that exports are good and imports are bad. This is not correct. It is impossible
for a country to produce everything. Through imports South African firms obtain the equipment
and technology they need for production. Without these capital goods there would be a lot less
production and we would not be solving the scarcity problem. Imports and exports are both
needed. We need to export so that we can earn foreign exchange, which we can then use to buy
the required imports.

The countries that we import from and export to are called our trading partners. At the moment
South Africa’s main trading partners are the United Kingdom, United States of America, Germany
and Japan. Countries normally restrict imports (using tariffs and quotas) because cheap imports
can harm certain groups in a country (more about this in chapter 15). Sometimes countries group
themselves into trade blocs where they allow free trade amongst themselves. With free trade we
mean that such countries do not put restrictions on each others' imports and exports. The two
major trade blocs are the European Union (EU), and the North American Free Trade Area (NAFTA),
which comprises the USA, Canada and Mexico. South Africa is also part of a trade bloc called the
Southern African Customs Union (SACU), which comprises South Africa, Namibia, Botswana,
Lesotho and Swaziland. In addition, we are also part of the Southern African Development
Community (SADC), which encourages trade and cooperation between Southern African countries.

Foreigners can invest in South Africa and South Africans can invest in foreign countries – together
this is called foreign investment. When foreigners buy assets in South Africa, we say that there
is an inflow of foreign investment to South Africa. There is an inflow, because foreigners are
bringing foreign exchange into the country in order to buy those assets. When foreigners sell
their South African assets and take the money out of the country, there is an outflow of foreign
investment.

If a foreigner buys or sells real capital in another country, it is called foreign direct investment
(FDI). For example, if a foreign firm builds a new factory in South Africa, we experience an inflow
of foreign direct investment. If a foreigner buys or sells financial instruments in another country,
it is called foreign portfolio investment. For example, when a foreigner buys shares on the JSE,
we experience an inflow of foreign portfolio investment into South Africa. When the foreigner
sells those shares again and takes his money back to his home country, there is an outflow of
foreign portfolio investment.

Many African countries do not earn enough foreign exchange through exports and inflows of
foreign investment. These countries have little choice but to rely on foreign aid. Foreign aid is
help given to a poorer country by a richer country. For example, when Mozambique experienced
floods that destroyed many parts of that country, it relied on foreign aid from South Africa. South
Africa offered not only money, but also transport equipment and human expertise.

As explained in Chapter 1, a country’s transactions with the rest of the world is recorded in the
balance of payments accounts. The balance of payments can further be divided into a current
account and a financial account. A country’s foreign trade in goods and services (imports and

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exports) are recorded is the current account, while foreign investment flows and foreign aid are
recorded in the financial account.

9. CONCLUSION
In this chapter we mainly looked at the elements of the economy separately. But in the economy
all of these elements affect each other and interact in complex ways. To truly understand the
economy we must know how they all work together. The best way to do this is by building a model
of the economy that includes all of these elements and their interactions. We shall do this in the
next chapter, with the circular flow model of the economy.

10. SUMMARY

• An economy consist of a real sector and a monetary sector

• Both sectors consist of economic subjects such as households, firms, government, financial
intermediaries and the foreign sector
• The economic objects in the real sector are goods, services, production factors and assets.
The economic objects in the monetary sector are money, bonds, shares and other financial
instruments
• All these economic subjects and objects interact on markets such as the product, factor,
financial and foreign exchange markets

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