JIMMA UNIVERSITY

COLLAGE OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS
MACROECONOMICS II (ECON 312)
LECTURE NOTE
By
Wondaferahu Mulugeta
1

June 2009
Jimma
Ethiopia
1
The author is lecturer of economics, collage of business and economics, department of economics,
Jimma University
CHAPTER ONE
SECTORAL DEMAND THEORIES AND FUNCTIONS
Introduction: How do households decide how much to consume today and in future?
We care about this decision because consumption is the largest component of aggregate
demand and saving is one of the determinants of growth. Thus, knowledge about how do
households arrive at this decision and what factors affect their decision making is critical.
1.1 Theories of Consumption and consumption expenditure
1.1.1 Keynesian Consumption theory: The absolute income hypothesis (AIH)
Keynes postulates three complementary propositions/assumptions:
1. Consumption will rise as disposable income rises. In other words, income is the
most important determinant of consumption. That is the higher the income of a
household the higher will be consumption.
2. The MPC is positive and less than 1. This is to mean the increase in consumption
will be smaller that the increase in disposable income. \in other words households
spend less that their total income
3. APC (
y c /
) is greater than the MPC but assumed to fall as income rises. The
implication is that on average the rich spend less of their income than (or saves
more than) the poor.
Algebraically, Keynes’s short-run consumption function is given by
y c c β + ·

---------------------------------------------------------------- (1)
Where

c
is autonomous consumption and
β
is c′ or the MPC and is greater than 1 (by
the first proposition). Graphically, the function is shown in Figure 1.1, which plots
consumption expenditure (
c
), against real income (
y
). This function indicates the
observation that as income increase people tend to spend a decreasing percentage of
income, or conversely tend to save an increasing percentage of income(by the second
proposition). The slope of the line from the origin to a point on the consumption function
gives the average propensity to consume (APC) or the
y c /
ratio at that point.
The slope of the function itself is the Marginal Propensity to Consume (MPC). From the
graph it is clear that the MPC is less that APC. If the ratio of
y c /
falls as income rises,
the ratio of increment in
c
( c ∆ ) to the increment in
y
(
y ∆
), or c′ (MPC), must be
smaller than
y c /
. Keynes saw this as the behavior of consumer expenditure in the short-
run- over the duration of a business cycle- reasoning that as income falls relative to the
recent levels, people will protect consumption standards by not cutting consumption
proportionally to the drop in income, and conversely as income rises, consumption will
not rise proportionally.
2

c
E



) ( y c

1
s B

1
c A




c


y

1
y
2
y
Figure 1.1: Keynes Consumption Function (absolute income hypothesis)
The line OE is the
0
45 line along which all income is consumed. At income level
1
y ,
consumption is given by
1
Oc , while savings are given by
1
Os and represent that amount
of income not spent. The average propensity to consume (
1 1
/ y c ) is represented by the
slope of line OA . The figure also represents APC declines as income increases. Suppose
now that income increased from
1
y to
2
y . The APC is now given by the slope of the
line OB , which is less than the slope of OA and hence APC has declined.
The acceptance of the theory that APC MPC < ; so that as income rises
y c /
falls led to
the formulation of stagflation thesis around 1940. It was observed that if consumption
follows this pattern, the ratio of consumption demand to income would decrease as
income rises. The problem for fiscal policy that the stagflation thesis poses can be seen as
follows. If
g i c y + + ·
or
y
g
y
i
y
c
+ + · 1
------------------------------------- (2)
is the condition for equilibrium growth of real output (
y
), and there is no reason to
assume that the ratio of private investment to income (
y i /
) will rise as economy grows,
then government expenditure to income (
y g /
) must rise to balance the consumer
expenditure to income (
y c /
) drops to maintain full-employment demand as
y
grows.
In 1946, Simon Kuznets published the first long-run time-series data for the USA for the
period 1869 -1929 a study on consumption and saving behavior dating back to the Civil
War (1865). Kuznets’ data pointed out two important things about consumption behavior.
First, it appeared that on average over the long-run the ratio of consumer expenditure to
income (
y c /
) or APC, showed no downward trend, so the MPC equaled the APC as
income grew along trend. This meant that along trend the
) ( y c c ·
function was a
straight line passing through the origin as shown in Figure 1.2
3

c

Long-run function: APC MPC ·

Short-run function: APC MPC <



y
Figure 1.2: Long-run and short-run consumption functions
Second, Kuznets’ study suggest that years when the
y c /
ratio was below the long-run
average occurred during boom periods, and with
y c /
ratio above the average occurred
during periods economic slump (recession). This meant that the
y c /
ratio varied
inversely with income during cyclical fluctuation, so that for the short period
corresponding to a business cycle empirical studies would show consumption as a
function of income to have a slope like that of the short-run functions of Figure 1.2 rather
than the long-run functions. Thus, by the late 1940s it was clear that there were three
observed phenomena, which the consumption function must account for
1. Cross-section budget studies show
y s /
increasing as
y
rises, so that in cross-
section of the population APC MPC <
2. Business cycle, or short-run data show that the
y c /
ratio is smaller than average
during boom periods and greater than average during slumps, and hence in the
short-run, as income fluctuates, APC MPC <
3. Long-run trend data show no tendency for the to change over the long-run, so that
as income grows along trend, APC MPC ·
In addition, the theory of consumption should be able to explain the apparent effect of
liquid assets on consumption. Therefore, the failure of Keynesian consumption function
to explain long-run behavior of consumption in cross-section studies and the effect of
liquid assets on consumption has motivated to the emergence of alternative consumption
theories in 1950s. Unlike Keynes, the theories that were developed by Fisher, Ando-
Modigliani, and Friedman have basic foundation in the microeconomics theory of
consumer intertemporal choice to explain these phenomena. In particular, Modigliani and
Friedman begin with the explicit common assumption that observed consumer behavior
is the result of an attempt by rational consumers to maximize utility by allocating a
lifetime stream of earning to an optimum lifetime pattern of consumption. Thus, we begin
the discussion of these three theories at their common points of departure in the theory of
consumer behavior and follow them individually as they diverge.
1.1.2 Irving Fisher’s model of consumption (the intertemporal choice)
4
Consumption is assumed to be the purpose of all economic activities. However, though
consumption theories before Fisher introduced some dynamics into consumption
behavior, they do not have sound micro foundation.
Fisher assumes that household’s utility depends upon its lifetime profile of consumption.
Hence, he began his explanation with a single rational consumer utility maximization
behavior as
) ,..., ,..., (
0 T t
c c c f U ·
--------------------------------------------- (1)
Where, lifetime utility U is a function of the individual’s real consumption
c
in all time
period up toT , the instance before he/she dies. The consumer will try to maximize
his/her utility, that is obtain the highest level of utility, subject to the constraint that the
present value ( PV ) of his/her total consumption cannot exceed the PV of his/her total
income in life. That is
∑ ∑
+
·
+
T T
t
t
t
t
r
c
r
y
0 0
) 1 ( ) 1 (
------------------------------------------- (2)
Where, T is the individual’s expected lifetime. The constraint says that the individual
can allocate his/her income stream to a consumption stream by borrowing or lending, but
the present value of consumption is limited by the present value of income. We thus have
an individual with an expected stream of lifetime income who will want to spread that
income over a consumption pattern in an optimum way. We might imagine that his/her
expected income stream begins and ends low, with a rise in the middle, and he wants to
smooth it out into a more even consumption pattern.
To keep the analysis as simple as possible and formulate the problem in a workable
manner he assumed that the individual lives only for two periods: today; period zero and
tomorrow; period 1 (intertemporal choice). The two-period case utility of the household
for is thus given as:
) , (
1 0
c c u U ·
------------------------------------------------ (3)
Second, the household is assumed to maximize lifetime utility subject to the borrowing-
lending constraint imposed by its real wealth, where wealth is defined as the present
value of all future income streams. In a two-period model this is simply:

·
+
+
·
·
+
1
0
1
1
0
0
) 1 ( ) 1 ( ) 1 (
t
t
t
r
y
r
y
r
y

r
y
y A
+
+ ·
1
1
0 0
-------------------------------------------- (4)
Where,
0
A
represents the household’s expected real wealth measured in terms of current
period (period 0);
0
y
is this period’s real income; and
1
y is next period income
discounted by the real rate of interest, r .
5
Third, it is also assumed that the agent knows with certainty the expected future rate of
interest and that capital market is perfectly competitive. This means that the household
can either lend or borrow money as much as it wants at the going rate of interest without
affecting the rate. Forth, transaction cost is also assumed to be zero. Since this is a two-
period model and consumption is the sole determinant of economic growth (GDP), it
follows that lifetime wealth will be the constraint of lifetime consumption. Thus at
equilibrium, equation (4) can be
r
c
c
r
y
y
+
+ ·
+
+
1 1
1
0
1
0
---------------------------------------- (5)
Figure 1.3 shows the structure of intertemporal model. The vertical axis measures income
and consumption in period 1 while the horizontal axis measures income and consumption
in the current period (or period zero).
Period 1


1 0
) 1 ( y r y + +
B





1
c
E

1
U


1
y
A 0
U


r
y
y
+
+
1
1
0


0
c

0
y
C Period 0
Figure 1.3: Two-period consumption case: utility maximization added
The budget constraint (BC) in the above graph indicates the maximum amount of lifetime
consumption. If the household is to consume its entire lifetime income stream in period
zero by borrowing against period 1, then the maximum amount that can be consumed can
be
r
y
y
+
+
1
1
0
, which is the intercept of the budget line in period zero axis, point C .
Conversely, if the household decides to consume nothing in period zero, delaying or
postponing all consumptions until period 1, then the maximum it can consume in period 1
is 1 0
) 1 ( y r y + +
, which is given by point B on period 1 axis. The slope of the budget
6
constraint (line) is given by differentiating the wealth constraint for a given level of
interest rate, which is
1 0
) 1 ( y r y + +
1 0
) 1 ( y r y · + −
) 1 (
0
1
r
y
y
+ − ·


------------------------------------------------- (6)
Point Ain figure 1.3 shows that the amount of income the household will earn in period
zero, 0
y
and the amount of income he/she will earn in period 1,
1
y
. The household has
also indifference map, representing preference for consumption in both periods and
given by lines 0
U
and
1
U
. The subscripts of U denote increasing level of utility.
The optimal consumption position for the household is thus given by indifference curve
labeled
1
U
. From point E it is clear that the household saves in period zero for 0 0
y c <
and dissaves in period 1 as
1 1
y c >
. That is the unspent income (saving) in period 0:
≡ − ·
0 0 0
c y s Money lent --------------------------------- (7)
By lending this amount, the individual will receive in period 1 an amount equal to
) 1 (
0
r s +
, so that his/her consumption in period 1 can exceed his/her income by that
amount, which is his/her period 1 dissaving,
1
s
1 1 0 1
) 1 ( c y s r s − · + − ·
------------------------------------- (8)
Since the slope of the indifference curve (IC),
1
U is equal to the slope of the budget line
at point E , the marginal utility of consumption (MUC) in period 0,
0
/ c U ∂ ∂
to that in
period, 1
1
/ c U ∂ ∂ , is exactly equal to
) 1 ( r + −
. That is the MRS between consumption
in period 0 and consumption in period 1 is
) 1 ( r + −
.
Furthermore, if the indifference curves (ICs) are homogenous of degree zero, then the
slope of all ICs are identical along the straight line passing through the origin. This
implies that the MRS of
0
c
and
1
c depends only on the ratio of
1 0
/ c c
and not on the
absolute size of
0
c
and
1
c .
This assumption has an important implication that if consumption is not an inferior good,
one with negative income/wealth effect, then whenever a consumer received an extra Birr
worth of resource he/she would allocate it between 0
c
and
1
c in exactly the same
proportion as he/she allocated his/her original resource.

1.1.3 The Ando-Modigliani approach: The Life-cycle Hypothesis of consumption
7
In order to explain the three observed consumption function relationships discussed
earlier under 1.1.1, Ando and Modigliani postulate a life-cycle hypothesis. According to
this hypothesis:
• The typical individual has different income streams in his/her
lifetime. It is relatively low at the beginning and end of his/her life, when his/her
productivity is low and high during the middle of his/her life. This “typical” income
stream is shown as the
y
curve in figure 1.5, whereT is expected lifetime
$

y
Adult


c
= Average income
Youth Old



T Time

Figure 1.4: The ‘life-cycle’ hypothesis of consumption
• On the other hand, the individuals might be expected to maintain
a more or less constant/smooth or perhaps slightly increasing level of consumption
that maximizes his/her utility, shown as the
c
line in Figure 1.4 throughout his life.
The model suggests that in the early years of a person’s life, the first shaded portion of
Figure 1.4, the individual is a net borrower. In the middle years (when adult) he/she saves
to repay debt and provide for retirement. In the late years, the second shaded portion of
Figure 1.4, the individual dissaves. This is to say that their consumption level does not
vary with their income but with
, IC
and r .
Hence if the life-cycle hypothesis is correct then the high-income groups would contain a
higher-average proportion of persons who are high-income levels because they are in the
middle years of life, and thus have a relatively low APC (
y c /
) ratio. Similarly, the
low-income groups would include relatively more persons whose incomes are low
because they are at the end of the age distribution, and thus have high APC (
y c /
).
Thus, if the life-cycle hypothesis is true, a cross section study would show APC (
y c /
)
falling as income rises, explaining the cross section studies showing . APC MPC <
Therefore, it seems reasonable to assume that in the absence of any particular reason (say
holiday, unforeseen events/contingencies like hospitalization, rise in payment bills, car
repairs, and the like) to favor consumption in any one period over any other, for
representative consumer ( i ) if
i
PV rises, all his/her consumption in period t (
i
t
c ) rises
more or less proportionally. In other words, the Ando-Modigliani life-cycle hypothesis of
consumption for the
th
i consumer can be written algebraically, as
) (
i
t
i i
t
PV k c ·
; 1 0 < < k ------------------------------------------ (1)
8
Where,
c
is consumption; i represents an individual; t is time (in year); and PV
implies present value. On the other hand, k is a constant, which is assigned overtime to
indicate that an individual will spend certain proportion of his/her PV income and asset
values on consumption of goods and services. Here
i
k , the fraction of consumer s i'
PV he/she wants to consume in period t , would depend on the shape of the
indifference curve and the interest rate.
Equation (1) says that if an increase in any income entry, present or expected, rises the
consumer’s estimate of PV , he/she will consume the fraction of the increase in the
current period.
If the population distribution by age and income are constant, and tests between the
present and future consumption (that is the average shape of indifference curves) are
stable through time, we can add up all the individual consumption functions (1) and
obtain a stable aggregate function
2
:
) (
t t
PV k c ·
--------------------------------------------------------- (2)
The next step is to develop an operational consumption function from (2) is to relate the
PV term measurable economic variables
3
. The Ando-Modigliani began to make the
PV tem operational by noting that income can be divided into income from labour (
L
y
) and income from asset or property (
P
y ). That is,
∑ ∑
+
+
+
·
T
t
P
t
T
t
L
t
r
y
r
y
PV
0 0
0
) 1 ( ) 1 (
------------------------------------- (3)
Where, time zero is the current period and t changes from zero to the remaining years of
life of life expectancy of an individual ( T ), which is highly unpredictable.
Now, if capital markets are reasonably efficient, we can assume that the PV of income
form an assets is equal to the value of the asset itself, measured at the beginning of the
current period. That is,
0
0
) 1 (
α ·
+

T
t
P
t
r
y
------------------------------------------------------ (4)
Where,
0
α
is real household net worth at the beginning of the period. Furthermore, we
can separate the known current labour income (
L
Y
0
) from the unknown (future or
(expected) labour income (
L
t
Y ). Then substituting (4) into equation (3) we get
2
Branson (1998) noted that the gradual change in age and income distribution in the U.S. since World War
II certainly meet the Ando-Modigliani assumption.
3
This is the crucial step in empirical investigation of the consumption function, as it is in almost any
empirical study in economics. The theory involves consumption as a function of expected income, which
of course cannot be measured.
9
0
1
0 0
) 1 (
α +
+
+ ·

·
T
t
t
L
t L
r
y
y PV
---------------------------------------- (5)
In equation (5), current labour income (
L
Y
0
) and the value of current wealth or assets (
0
α
) are known. But, the expected or future stream of labour income that flow overtime
during the lifetime (

·
+
T
t
t
L
t
r
y
1
) 1 (
) is unknown. The next step is this sequence is thus
determining how the expected labour income (
L
T
L
Y Y ...
1
) might be related to the current
observable variables. First, let as assume that there is an average expected labour income
in time zero,
e
y
0
such that:

+ −
·
T
t
L
t e
r
y
T
y
1
0
) 1 ( 1
1
------------------------------------------ (6)
4
Where, 1 − T is the remaining life expectancy of the population up to retirement, which
is 37 (19 to 55 years) for an Ethiopian who joins the labour force at the age of 18 and
1
1
− T
averages the present value of the future stream of labour income over 1 − T
years. Then the expected labour income term in expression 5 can be written as:

+
· −
T
t
L
t e
r
y
y T
1
0
) 1 (
) 1 (
----------------------------------------- (7)
Substituting, the term in the left hand side of equation (7) into equation (5) we get
0 0 0 0
) 1 ( α + − + ·
e L
y T y PV ------------------------------------- (8)
Equation (8) has only one remaining variable that is not measured - average expected
labour income; that is
e
y . We now need a final hypothesis linking average expected
labour income to a current variable – current labour income.
The simplest assumption Ando and Modigliani considered was that the expected average
income is just a multiple of present labour income; that is
) (
0 0
L e
y y β ·
and
0 > β
. This
assumes that if current income rises, people adjust their expectation of future incomes up
to that
e
y rises by the fraction
β
of the increase in
L
y . We might note here that this
assumption assigns great importance to movements in current income as a determinant
of current consumption. Thus, substituting
L
y
0
β for
e
y
0
in expression (8) we obtain:
0 0 0 0
) 1 ( α + − + ·
L L
y T y PV
0 0 0
)] 1 ( 1 [ α β + − + ·
L
y T PV ------------------------------------------ (9)
4
In equation (3.6), 1 indicates the first year an individual is entitled legally to be employed in formal
sectors. For instance, the constitution indicates that the minimum age for an Ethiopia to apply for a
vacancy and be employed in formal sectors is the age of 18. In Sweden an individual who has celebrated
his/her 16
th
birthday is permitted to engage in formal sector.
10
Where,
β
is a constant which represents the discount rate or by how much the future
stream of labour income will be discounted? Equation (3.9) is an operational expression
for PV in that both and can be measured statistically. Finally, substituting, equation (9)
into equation (2) for consumption we obtain a statistically measurable form of the Ando-
Modigliani lifecycle consumption function as:
0 0 0
)] 1 ( 1 [ α β k y T k c
L
+ − + ·
---------------------------------------- (10)
For instance, the coefficients of
L
y and
α
in equation (10); that is the marginal
propensity to consume out of labour income and marginal propensity to consume out of
asset, were measured by Ando and Modigliani using annual U.S. date and obtained
t
L
t t
y c α 06 . 0 72 . 0 + · ------------------------------------------------ (11)
The econometric result of Ando and Modigliani indicates that a $1 billion (or 1%)
increase in real labour income will raise real consumption by about $0.72 billion or the
marginal propensity to consume out of labour income by 72%. Similarly, the marginal
propensity to consume out of assets is 0.06 billion for an increase of households net
worth by $1 billion.
Comparing the estimates of the coefficients in (11) with the derived coefficients in (8),
we can see from the coefficient of
α
in equation 11, that is k is 0.06. This suggests,
from equation (2) that on aggregate, households consume about 6% of their net worth in a
year. Using this value for k equal to 0.06 and 45 years as a rough estimate of average
remaining lifetime ( T ), we can obtain the value of
β
(discount rate) from equation (10)
that is implicit in the estimate of the
L
y coefficient in (11):
)] 1 ( 1 [ 72 . 0 − + · T k β

)] 1 45 ( 1 [ 06 . 0 72 . 0 − + · β
] 44 ( [ 06 . 0 06 . 0 72 . 0 β + ·
)] 64 . 2 ( 06 . 0 72 . 0 β · −
)] 64 . 2 ( 66 . 0 β ·
25 . 0
64 . 2
66 . 0
· · β
This suggests that when current labour income (
L
y
0
) goes by $100, in the aggregate, the
average expected labour income (
L
t
y ) rise by $25. Put differently, when current income
doubles (increases by 100%), then the expected labour income will rise by 25%.
The Ando-Modigliani lifecycle consumption function of equation (10) is shown in Figure
1.5 below, which graphs consumption against labour income. The intercept of the
consumption-income function is set by the level of assets; that is
t
α
. The slope of the
function – the marginal propensity to consume out of labour income – is the coefficient
of
L
y in the Ando-Modigliani consumption function. In short-run, cyclical fluctuations
with assets remaining fairly constant, consumption and income will vary along a single
11
consumption-income function. Over the longer run, as saving causes assets to rise the
consumption-income function shifts up as t

increases.
X

c


72 . 0 · Slope

t


0
L
y
Figure 1.5: Estimated consumption function: Ando and Modigliani
Thus, overtime we may observe a set of points such as those along the line OX in Figure
1.5, which shows constant consumption – income ratio along trend as the economy
grows. This constancy of the
y c /
ratio can be derived from the Ando-Modigliani
consumption as follows. We can divided all the terms in equation (11) by total real
income to obtain
t
t
t
L
t
t
t
y y
y
y
c α
06 . 0 72 . 0 + ·
----------------------------------------------- (12)
If the
y c /
ratio given by this equation is constant as income grows along trend, then the
line OX , which gives the average propensity to consume
y c /
, will go through the origin
in Figure 1.5. The
y c /
will be constant if the y y
L
/ - the labour share in total income –
and
y / α
- the ratio of assets or capital to total output/income – are roughly constant as
the economy grows along the trend
5
.
Ando and Modigliani noted that the observed data for the U.S. confirm that both the
labour share of income and the ratio of assets to income terms were fairly constant
around 76% and 300% (or simply 3) respectively. Substituting, these typical values into
equation (12), for the APC or
y c /
ratio we obtain
72 . 0 18 . 0 54 . 0 ) 3 ( 06 . 0 ) 75 . 0 ( 72 . 0 · + · + ·
t
t
y
c
5
Ando-Modigliani noted that the observed data for the U.S. confirm that both these terms were fairly
constant. Overtime, the labour share of income has remained around 75 percent with a slight tendency to
drift up, and the ratio of assets to income has been roughly constant at about 3 percent with a slight
tendency to drift downward overtime.
12
Thus, the average propensity to consume out of total income (
y c /
) is constant at about
0.72, which implies that the line OX in Figure 1.5 is a straight line passing through the
origin with the slope of 0.72.
Merits of the life-cycle hypothesis
1) The Ando-Modigliani model of consumption behavior
explains all three of the observed consumption phenomena. That is
(A) It explains the APC MPC < result of cross-section budget studies by the life-
cycle hypothesis.
(B) It provides an explanation for the cyclical behavior of consumption with the
consumption-income ratio inversely related to income along a short-run
function (see Figure 1.3) and
(C) It also explains the long-run constancy of the average propensity to consume out
of total income (
y c /
ratio).
2) In addition, it explicitly includes assets as an explanatory
variable in the consumption function, a role which was observed in the post-World
War II inflation.
Limitations of the life-cycle hypothesis
1) There remains a question concerning the role of current income in explaining
current consumption whether
1.1.4 The Friedman approach: Permanent Income Hypothesis
Freidman also begins with the assumption of individual consumer utility maximization
which gives the relationship between an individual’s consumption and PV of future
streams of income. That is
) (
i i i
PV f c · --------------------------------------------------------- (1)
Where, the change in consumption with respect to or
0 > ′ f
. Friedman differs from
Ando-Modigliani beginning with his treatment of the PV . Multiplying expression (1) by
the rate of return on assets ( r ) gives us Friedman’s permanent income.
) (
i i
P
PV r y · ---------------------------------------------------------- (2)
Where,
i
P
y and r are permanent income and interest rate respectively. Equation (2) is
the permanent income from the consumer present value, which includes his/her human
capita- the PV of his/her future labour income stream, that is included in PV in equation
(2) and his/her wealth (
0
α
).
0 0
α + ·
i i
P
y y ---------------------------------------------------------- (3)
Like Ando-Modigliani, Friedman also assumes that an individual consumer wants to
smooth his/her actual income stream into a more or less flat/uniform consumption
13
pattern. This assumption gives a level of individual’s permanent consumption (
i
P
c ),
which is proportional to his/her permanent income (
i
P
y ):
) (
i
P
i i
P
y k c · ---------------------------------------------------------- (4)
The individual’s permanent consumption to permanent income ratio (
i
k ) mainly
depends on the interest rate
) (r
-the return on saving and individual tests
) (τ
shaping the
indifference curves, and the variability of expected income. That is,
P P
y r k c ) , ( τ · ------------------------------------------------------- (5)
Thus, if there is no reason to expect these factors to be associated with the level of
income, we can assume that the average
i
k for all income classes will be the same;
equal to the population average

k
. If we classify the population by income strata, we
would expect that the average permanent consumption in each income class i (using
subscripts for income class as opposed superscripts to denote individuals) would be

k

times the average permanent income.
), (
Pi
Pi y k c
− − −
·
for all income class i ------------------------------ (6)
Equation (6) states that permanent consumption of any income class (group) i , be it the
high or lower than average-income group, is a certain proportion of the group’s
permanent. According to Friedman, total income of an individual is composed of two
components: permanent income ( Pi
y
), which the individual has imputed for himself,
plus a random transitory/random income ( Ti
y
), which can be positive, negative, or zero,
and really represents income deviations from permanent income. That is, measured
income is the sum of permanent and transitory income.
Ti Pi i
y y y + ·
-------------------------------------------------------- (7)
In equation (7) the subscript T refers to “transitory” not time. Permanent income is
therefore, that part of income which the household regards as normal or expected, while
transitory income is the difference between measured and permanent income, which
arises due to unexpected or unforeseen occurrences or chances (such as a win in lottery).
Similarly, total consumption in any period is the sum of permanent consumption ( Pi
c
)
and a random transitory-consumption
6
component (
Ti
c
), which can be positive, negative,
or zero, and represents deviations from the “normal” or permanent level of consumption.
Thus, measured consumption is the sum of permanent and transitory consumption.
Ti Pi i
c c c + ·
------------------------------------------------------- (8)
6
It is important to note that, at any period, transitory consumption can also be planned in advance or
unplanned at all. Whether planned or unplanned, random expenditures will be made only for a very short
period of time. Examples include expenditure on weeding, in case of condolence, hospitalization, inviting
a friend (s), etc.

14
In order to give the model some predictable power Friedman makes three further
assumptions concerning the relationship between permanent and transitory income,
permanent and transitory consumption, and transitory income and consumption. The
assumptions concerning these relationships give the explanation in the Friedman theory
of the cross-section result that . APC MPC <
First, Friedman assumes that there is no symmetric relationship or correlation between
permanent income and transitory income; in other words,
T
y
is just a random
disturbance (fluctuation) around
P
y
. So the covariance of
P
y
and
T
y
across
individuals; i.e., the
0 ) , ( ·
Ti Pi
y y Cov
This assumption has the following implication for cross-section budget study results.
Suppose we draw a sample of families from a roughly normal income distribution and
then sort them out by income classes.
 Since
P
y
and
T
y
are not related, the income class that centers on the population
average income will have an average transitory-income component equal to zero
(i.e.,
0 ·

T
y
) and for that income class observed income will be equal to permanent
income (or
− −
·
P
y y
).
 As we go up from the average income strata, we will find for each income class,
more people in that income group because they had unusually high incomes that
year, that is
0 >
Ti
y
than people who were in that class because they had unusually
low incomes that year. This happened because in a normal distribution, for any
income class above the average, there are more people with permanent income
below that class who can come up into it because
0 >
Ti
y
in any one period than
there are people above that class who can fall down due to
0 <
Ti
y
. Thus, for
income classes above the population mean transitory income is positive (
0 >

T
y
)
and hence observed income will be greater than permanent income (
− −
>
P
y y
).
 Similarly, below the average-income level, for any income class, there are more
people who can fall into it due to having bad year so that
0 <
Ti
y
than people who
come up to it by having good year so that
0 >
Ti
y
. Thus, for the population in the
below average- income class transitory income is negative (
0 <
Ti
y
). As a result,
observed income will be less than permanent income (
− −
<
P
y y
).
This result, that when sorted by measured income, groups above the population mean
have
0 >

T
y
and groups below the population mean have
0 <

T
y
is important for
Friedman’s analysis, as we will see shortly.
15
Second, he assumes that there is no correlation or symmetric relationship between
permanent consumption and transitory consumption. In other word,
T
c
is just a random
disturbance (fluctuation) around
P
c
, which implies the
0 ) , ( ·
Ti Pi
c c Cov
.
Finally, he assumes that there is no symmetric relationship or correlation between
transitory consumption and transitory income. In other words, a sudden increase in
income due to transitory fluctuation will not contribute immediately to an individual’s
consumption. Thus, he concluded that the
0 ) , ( ·
T T
c y Cov
.
The last assumption is intuitively less obvious or is highly debatable than the previous
two, suggesting a lottery win does not increase transitory consumption. But it seems
fairly reasonable since we are dealing with consumption as opposed to consumer
expenditure. Freidman justifies this by arguing that in the face of a transitory rise in
income individuals usually stick to the consumption plan and just opt to increase their
savings. An alternative explanation is that his definition of consumption includes only the
flow of service from durable goods and not expenditure on durable goods. If transitory
income is spent on durable goods, then this can be classified as unplanned saving rather
than unplanned consumption. In this sense the assumption looks much more credible.
The last two assumptions, that transitory consumption is not correlated with either
permanent consumption or transitory income, mean that when we sample the population
and classify the sample by income levels, for each income class the transitory variation in
consumption will cancel out so that for each income class
0 ·

Ti c
and average permanent
consumption is the population average,
Pi c c
− −
·
; for all income class i .
We can now bring this series assumptions together into an explanation of the cross-
section result that APC MPC < even when the basic hypothesis of the theory is that the
ratio of permanent consumption to permanent income is a constant

k
.
1.1.4.1 Cross-section consumption function
Consider a randomly selected sample of population classified by income levels. For
simplicity, let us denote income group i above and below the population average by
different letters as the above average population income group by H and the below
average population income group by B . On the other hand, the average population
income refers to national income/output divided by total population, which is most
popularly known as the Per Capita Income (PCI). In figure 1.6 it is designated by
− −
·
P
y y
in the horizontal axis.
A group H with average observed income

H
y
above the average population income will
have a positive average transitory-income component
TH
y

. Then for this above-average
16
group, observed average income will be greater than average permanent income; that is
PH H
y y
− −
>
(see to the right of the mid point of the horizontal axis in Figure 1.6).
Observe that average consumption, both measured and permanent for group i is given
by multiplying permanent income by

k
to obtain permanent consumption along the
solid line in figure 1.7. That is, first all income groups will have average permanent
consumption equal to
Pi
y k
− −
(or
Pi
Pi y k c
− − −
·
) along the

k
line. Since transitory
consumption of income group i (
Ti c

) is not related to either to its permanent
consumption (
Pi c

) or transitory income (
Ti
y

); by assumption 1, all groups, including
the above-average income group will have zero average transitory-consumption
component. Moreover, measured average consumption of income group i (i.e.,
i c

) is
equal to its permanent consumption (
Pi c

) or
Pi i c c
− −
·
. Linking these two consumption
conditions gives us
Pi
Pi i y k c c
− − − −
· ·
----------------------------------------------------- (8)
From equation (8), we know that
Pi
Pi
Pi
i
y
c
y
c
k





· ·
. The solid line

k
represents the
relationship between permanent consumption and permanent income. The point

y
is the
population average measured income and if the sample is taken in “normal” year when
measured average income is on trend or along

k
line, then average transitory income
will be zero; so that measured average and permanent income will be equal (i.e.,
P
y y
− −
·
). On the other hand, the point
P c c
− −
·
is the population average measured consumption
and permanent consumption.
However, though the above-average income group have average measured consumption (
H c

) equal to permanent consumption (
PH c

), its average measured income (
H
y

) is
greater than permanent income (
PH
y

) as shown by point A. As a result, an above-
average income group’s measured consumption to income ratio (
H
H y c
− −
/
) will be less
than
Pi
Pi
Pi
i
y
c
y
c
k





· ·
. A similar story follows for the below-average income group ( B ).
For this group, the average observed income is below average population income as
17
shown by point B and hence measured consumption to income ratio (
B
B y c
− −
/
or
B
PB y c
− −
/
) is greater than

k
. These results are illustrated in Figure 1.6.
First, consider sample group H with average income above the population average
(i.e.,
− −
> y y
H
). This group has positive average transitory income component (
TH
y

),
which is greater than the population average permanent income (i.e.,
− −
>
P TH
y y
), as
shown in the horizontal axis of Figure 1.6. Nevertheless, neither measured consumption
nor the permanent consumption of the above average income group does not increase
proportional to the increase in transitory income; so that
PH H c c
− −
·
in the upper part of
the vertical axis. In order to locate both the measured and permanent average
consumption for group H we multiply permanent income (
PH
y

) by

k
to obtain
PH H c c
− −
·
along the

k
line. Thus, for an above-average income group ( H ) we observe

H
c
and

H
y
ate at point A, which lies below the permanent consumption line

k
.

) (

n cons c


k


PH H c c
− −
·
A


P c c
− −
·


0 >

TH
y


PB B c c
− −
·
B


0 <

TB
y

B
y


PB
y


− −
·
P
y y

PH
y


H
y


) (Income y
Figure 1.6: Friedman’s permanent income hypothesis consumption function
Next, observing lower than-average income group ( B ), we see in the horizontal axis that
the average income of the group (
B
y

) is less than the national average income (

y
) or
18
− −
< y y
B
. This is because, the average transitory income of the below-average sample
group (
TB
y

) is less than zero. Nevertheless, average observed consumption (i.e.,
B c

)
does not decrease from that of the permanent consumption of s B' income group.
Furthermore, we observe that
B c

and know that it is equal to
PB c

and
PB
y k
− −
or
PJ
PJ J y k c c
− − − −
· ·
along the

k
line. The location of
B c

and
B
y

gives us point B , lying
above the

k
line.
Therefore, connecting the points A and B, we obtain the cross-section consumption
function that connects observed average income-consumption points. Since, this function
has smaller slope than the underlying permanent function, it implies that in the cross-
section budget studies we expect to see that marginal propensity to consume (
) MPC
is
less than average propensity to consume
) ( APC
or APC MPC < if (but only if) the
Friedman permanent hypothesis is correct (holds).
1.1.4.2. Time series data
The permanent income hypothesis can also be used to explain the time series data. In
Figure 1.7, the long run permanent consumption function is again given by

k
. Overtime,
as the economy and the national average permanent income grows along trend. What we
observe in a long-run time series data are thus movements of the national average
consumption and income along the line

k
; giving a constant
y c /
ratio. As the economy
cycles along its trend growth path, the average
− −
y c/
point will move above and below
the long-run line

k
. During boom year, say period 1, when

t
y
is above the trend, the
average transitory income of the population will be positive as measured by the distance
1 1 P
y y
− −

and hence average income will be greater than permanent income (or
1 1 P
y y
− −
>
).
But average transitory consumption will be zero; implying
P
P y k c c
− − − −
· ·
. Thus, when

y
is above trend,
1
1/
− −
y c
will be less than
k y c
P
P ·
− −
1
1/
.
Similarly, in times of economic slump or when

t
y
is below the trend as in year 2,
2

y

will be negative;
2 2 P
y y
− −
<
; and the
− −
2
2 / y c
ratio will be greater than

k
. The cyclical
movement is depicted in Figure 1.7. Again joining point A and B gives the short-run
time-series consumption function, where again the short run MPC is less than the long
run MPC and APC MPC < , but in the long-run APC MPC · .
19
Note that the difference between figure 1.6 and 1.7 is that in figure 1.6 the variation in
income and consumption is in a cross-section in any one time, while in figure 1.7 the
variation is in average income and consumption over the business cycle.

c


k


1

c
A


0

c


2

c
B

2 T
y


1 T
y



2

y

2 P
y


0

y

1 P
y


1

y

y
Figure 1.7: Friedman’s consumption function: cyclical movements
2.2.3 Distinguishing features of the lifecycle and permanent income hypotheses
Similarities
I. The two models are similar in the starting point of the analysis in the
consumption-present value relationship given in equation 2.1. In other words,
both hypotheses have micro foundation. Thus, they argued that an individual have
different income stream of income in life and smooth out consumption overtime
II. Both concentrate on the structural relationship between expected lifetime income
and current consumption.
III. Both the LCH and PIH treated the wealth effect on consumption.
Differences: The two theories differ in the empirical implementation of the theory
I. The LCH model exhibit smaller MPC than PIH because the former also includes a
wealth variable whereas in the latter the wealth effect is included in permanent
income.
II. Friedman’s consumption model/function is somewhat less satisfactory than
Modigliani in that assets are only implicitly taken into account as determinants of
permanent income. In short, he did not clearly distinguishes between permanent
income ) (
P
Y and
0
α
(which is considered as a shift factor) as did by Ando-
Modigliani , and
20
SR Consumption functions
III. Friedman relies on the unobservable concepts of income (i.e., permanent income
and transitory incomes) while Ando-Modigliani relies on the observable income
(i.e., income from labour and income from assets/property or the value of assets)
Applicability of the consumption theories to LDCs
How consumption theories discussed so far are relevant to LDCs such as a typical
African economy?
1) Both the LCH and PIH emphasize on households consumption smoothing or have
uniform consumption pattern (intertemporal consumption) due to their assumption of
absence of borrowing and lending (liquidity) constraints to households. However,
these assumptions are unrealistic in explaining the actual situation of African
economies where households have excessive borrowing and lending constraints.
This is because we know that financial sectors are underdeveloped in almost all African
economies. Due to this the majority of households do not have easy access to financial
sectors. As a result, households in Africa, particularly those living in rural areas, are
forced to relay mostly on individual creditors or usurers for borrowing. Even when there
are financial intermediaries they have acute shortage of loanable fund due to high
propensity to consume /or low propensity to save/ by the population due to high
dependency ratio and in part due to commercial banks weak capacity to mobilize savings.
Moreover, protracted loan application screening and disbursement processes; high
collateral requirements of banks than most households can afford; and high lending
interest rates are also some of the major constraints. For instance lending rate of
commercial banks in Ethiopia is greater than 10% compared to only 1.5% in England.
In some cases, there are preferential treatments of financial intermediaries to public
sectors borrowing than private firms and/or individuals in LDCs. This biased policy can
be either due to political reasons; credit ceilings; or poor loan repayment enforcement
mechanism to defaulters. The later has to do mostly with the underdevelopment of legal
and judiciary system in LDCs.
2) The notion of the present value of future income streams in both the LCH and PIH
models implies that consumers or economic agents have long planning horizon.
Nevertheless, this assumption is irrelevant for a typical LDC even though there is no
borrowing and lending constraints.
The reason is that, the planning horizon in LDCs is different than developed countries
due to uncertainty in terms of what will happen next, which in turn influence peoples’
preferences for investment (which is more of short term than long term planning
horizon); perception of life, and control over assets.
3) Parallel to the second limitation of the models, the assumption of perfect capital
markets in both the LCH and PIH and hence income from assets at any time is equal
to the value of asset itself are also irrelevant to LDCs or African economies. This is
because markets in LDCs are more of imperfect and hence getting information about
the value of assets is costly.
21
4) The argument of the LCH that individuals will save when income is high during
adult for retirement does not also explain much LDC economies that have different
demographic structure compared to developed countries. This is because LDCs have
more young population, large family size, and high population growth
7
compared to
developed countries due to high birth rate.
High population growth and the type and composition of family in LDCs (extended
family compared to nuclear family in developed countries) have in turn lead to high
dependency ratio. Thus if resources are shared between workers and the dependents, the
need for hump or saving when adult for retirement as the LCH argued is not necessary.

5) Income derived from agriculture is not considered explicitly in the models.
In a typical African household economy, there is high uncertainty of income due to the
erratic behavior of agricultural output or its vulnerability to weather change and
macroeconomic instabilities such as fluctuation of price and exchange rate fueled by
internal and external shocks. Hence, the subsistence income level derived from
agriculture possesses a real threat to consumption level of households, a threat that is
likely to exert powerful influence on the way in which income is spend and saved. Thus,
in such a context the standard model in which permanent consumption is equal to
permanent income cannot be derived from the utility maximization of an individual.
In general, the implication of the above limitations of the models is that
t
L
t t
y c α + <
in
most LDCs. Therefore, the direct applicability of the models in explaining the subsistence
economy of a typical LDCs or African economies is less compared to that of developed
countries.
Exercise 1.1:
1) Distinguish between consumption of durable goods and consumer purchase of durable
goods. Why is this distinction important?
2) Use the two period intertemporal model of consumption to show the effect of the
following
(A) an decrease in income in period 1
(B) supposing an individual faces a borrowing constraint in period zero and period 1
3) In the context of the permanent income hypothesis what happen to consumption when
(A) There is charismas bonus
(B) There is temporary tax increase
(C) There is a major house repair required
4) Assume that you have established an empirical consumption function of
t t t t
y y c α 006 . 0 20 . 0 40 . 0
1
+ + ·

Where, ,
,
t t
y c
and t
α
are real consumption, real income, and real wealth. What would
you estimate to be
(A) The short-run MPC?
7
For instance the average size and population growth in Ethiopia are 6 and 2.5% respectively. With this
growth rate, the WB (2004) has forecasted that Ethiopia will be the 9
th
populated country in the world by
the year 2050.
22
(B) The long run MPC?
(C) The short run APC?
1.2 INVESTMENT DEMAND HYPOTHESES
Investment is the accumulation of physical capital by firms’ overtime. There are three
different types of real capital goods: fixed capital, items such as plant, machinery, and
building; working capital, which consists of stock of raw materials, manufactured input,
and final goods awaiting for sale; and residual investment, which include new houses for
purchase or rent. Of these components of investment, fixed capital is the most important
and is commonly referred as gross domestic capital formation.
Investment is much smaller than consumption, but it is the most volatile component of
aggregate demand. Despite its size, investment is very important for the macro economy,
since it is by investing in plant and machinery that the economy can produce goods for
consumption in the future. Thus investment is an inherently dynamic process, whereby
consumption is sacrificed today in order to enhance production and consumption in the
future. Investment is therefore an element of economic growth.
From a theoretical point of view a stationary economy one where the capital stock is
constant and the level of investment is exactly equal to the rate of depreciation of the
existing capital stock. So although existing machineries are replaced as they wear out,
there are no new additions to the capital stock, thus net investment, N
i
is zero. In this
case, total or gross investment, G
i
is exactly equal to replacement investment-
R
i
. This
can be represented by a simple identity
R N G
i i i + ·
--------------------------------------------------- (1)
In the following sections four principal alternative theories of investment will be
considered: Keynes theory of investment; the neoclassical theory of investment; the
accelerator theory; and the Tobin’s Q model of investment.
1.2.1 Keynesian Explanation of investment
There are two distinctive components in the Keynes’ theory of investment. First, he
emphasizes on the role of expectations in deriving investment demand and second, he
explicitly refers to the supply of capital goods which is related to the marginal efficiency
of capital (MEC). In modern project analysis, the two components of Keynes’ theory of
investment are called discounting measures of project worth or investment
assessment criteria
1.2.1.1 Net Present Value (NPV)
For Keynes the value of the owners unit of capital equipment was the flow of income, j
y
it would yield over its life in excess of the purchase cost. The flow can be thought as the
net present value of income (NPV) or the demand price,
D
V
, of the machine. Thus, the
discounted net lifetime income of the machine is given as:

·
+
·

,
`

.
|
+
·
+
+ +
+
+
+
+ ·
N
j
D
t
j
j t
j
j
V
r
y
r
y
r
y
r
y
y NPV
0
2
2
1
1
0
) 1 ( ) 1 (
...
) 1 ( ) 1 (
--- (2)
23
Where, r is the rate of interest and N is the life of the asset. Thus, if NPV or the
demand price is greater than zero the investment project is profitable, in that the expected
future revenue exceeds cost. As progressively more marginal projects are added the
demand price of new capital declines until NPV becomes equal to zero, after which the
additional project yields negative returns (profit).

D
V
) (r D
K

0 K
Figure 1.8: The demand price of capital
Figure 1.9 shows that the demand schedule for capital good, which rises as the demand
price falls, for a given market rate of interest and stream of expected returns.
A project’s net benefits have to be measured against the benefits that could have been
gained by investing the equivalent sum for alternative uses. This is termed as the
opportunity cost of capital achieved by using Discounted Cash Flow (DCF) measures of
project worth. In investment project analysis discounting is normally used to work out the
Present Value (PV) of a set of several Future Values (FVs). In its simplest form
equation (2) can be expressed as:

]
]
]

+
·
t
r
FV NPV
) 1 (
1
--------------------------------------------------------------- (3)
Where, r is the discounted rate expressed as a fraction or percentage and t is year. The
value in the bracket is called discounted factor (DF) for each year.
The NPV is defined as the difference between the present values of the future benefits
and costs. It is the simplest of all the four methods and is essentially a measure of the
present value of aggregate surplus generated by the project over its expected operating
life. It is calculated by subtracting the present values of costs (PVC)
8
from the present
values of benefits (PVB). This implies that NPV represents the net benefit over and
above the compensation for time and risk. This involves two steps of calculations as
expressed by the formula.

∑ ∑
· ·
− ·
N
t
N
t
PVC PVB NPV
0 0
--------------------------------------------------- (3a)
Or
∑ ∑
· ·
+

+
·
N
t
t
t
N
t
t
t
r
C
r
B
NPV
0 0
) 1 ( ) 1 (
--------------------------------------------- (3b)
Where, N is the life of a project
8
Total cost is the sum of investment costs, incremental working capital (incremental stocks plus net
incremental receivables, account receivable less account payable), and operating cost.
24
Decision Rule:
a. Accept the project if the NPV is positive, which implies that the net
benefits will be created after allowing for the required rate of return fixed principally
to cover the cost of capital in financing or opportunity cost of a sacrificed
investment.
b. If the NPV is zero, is a marginal case and hence the decision may need to be
informed by other criteria particularly for public sector projects. NPV equal to zero
means the project will return the capital utilized, but it will not generate any surplus.
c. Reject the project if the NPV is less than zero or negative because the
project will not recover its cost at the specified rate of discount.
1.2.1.2 Marginal efficiency of capital (MEC) or Internal Rate of Return (IRR)
In addition to the concept of the demand price of capital goods Keynes also introduced
the concept of the marginal efficiency of capital (MEC). The marginal efficiency of
capital is defined as the rate of discount,
m
, which would make the present value of
expected returns from the capital asset during the project life to just equal to zero or the
supply price,
S
V ; that is;
0
) 1 (
0
· ·

,
`

.
|
+

·
N
j
S
t
t
t
V
m
y
------------------------------------------------ (4)
Where,
m
is the supply price of capital asset, which would just induce a manufacturer to
produce new additional unit of such assets. That is the supply price is the replacement
cost of new machine and not the cost of the purchase of second-hand machine, which of
course does not add to the stock of capital in the economy as a whole. Thus the MEC or
m
, is drawn for a given capital stream of expected returns and the supply price of
capital. Indeed if
r m >
, new capital equipment would be profitable to acquire, since only
then will the MEC exceed the market interest rate, which denotes the return on alternative
asses. In equilibrium, Keynes argued that the MEC in general is equal to the rate of
interest; that is
r m ·
.
In sum the PV ranking depends on the market interest rate-the rate at which earning can
be reinvested-while the MEC of investment is not related to the market rate. So the PV
rankings can be different from
m
rankings. The best way to see this is to look at an
example which can be easily generalized.
Example 1: Suppose we have two investment projects, both with initial cost one million.
Both projects have zero return in period/year 1, when they are built. Project I returns 0 in
period 1, and 4 in period 2. Project II on the other hand, returns 2 million in period 1 and
1 million in period 2. The costs and returns of two projects are summarized in the table
below.
Year Project I Project II
Cost Return Cost Return
0 1 0 1 0
1 0 2
25
2 4 1
Given the information given in the table above
1) Calculate the NPV of the two projects at market interest rate equal to 5% and 10%
2) In which project should an investor invest when market interest rate are 5% and
10%? Why?
3) If financial constraint dictates the investor to invest in one of the projects which
one should be chosen at the lowest interest rate? Why?
4) Calculate the MEC (
m
) for the two projects
5) If the two projects are competing which of the two projects is better according to
the MEC criterion? Why?
6) If the projects are not competing should we select and invest in both projects
according to the MEC criterion? Why or why not?
SOLUTION:
1) The NPV of the two projects at interest rate equal to 5% and 10%. To
calculate the NPV we follow the following three steps
First: Find the net benefit of the two projects by subtracting the return of the projects
in each year. The net benefits of project I and II are shown in column 2 and 3
respectively.
Second: Find the discount factor at 5% and 10% from year zero to year two. This can
be obtained by using the formula;
,...
) 1 (
1
,
) 1 (
1
1 0
r r + ·
.It is shown in the 3
rd
and 4
th
column in the table below.
Third: Multiply the net benefit of project I and II in each year by the corresponding
discount factors to get the NPV of the projects in each year. Summing up the NPV of
the projects in each year gives the overall NPV as shown from column 6 to column 9.
Table 1.1: Net Present Value (NPV) and Marginal efficiency of capital (MEC)
Net benefit (Return – Cost) Discount Factors NPV Project I NPV Project II
1.Year 2.Project I 3.Project II 4.r=0% 5. r=1% 6.(1*3) 7.(1*4) 8.(2*3) 9.(2*4)
0 -1 -1 1 1 -1 -1 -1 -1
1 0 2 0.9524 0.9091 0 0 1.9048 1.8182
2 4 1 0.9070 0.8264 3.625 3.3056 0.9070 0.8264
SUM 0.9804 0.9612 2.6281 2.3056 1.8118 1.6446
2) Based on the overall NPV of the two projects as shown in the last row of
column 6 to column 9 an investor should invest in both projects. This is because
the overall NPV of the projects at 5% and 10% are greater than zero. However, the
NPV of both projects is higher at 5% than at 10%.
3) If an investor has financial constraint to invest in the two projects, he/she
should decide to invest in project II than in project I both at 5% and 10% market
interest rate for it yields higher NPV; that is as can be seen in the last row of table
1.1 above 2.6281 is greater than 1.8118 when the market interest rate is 5% and
2.3058 is greater than 1.6446 at 10%. However, not that if the NPV of projects
vary as the market interest rate changes the criterion does not help to make such a
26
conclusion. The reason is that if we compare two projects, the one which has
larger return in the distant future (e.g. project I in year 2) will have higher NPV at
some low interest rate than the second project that yields smaller return in future
(e.g. in year 2) and will have a higher NPV at some higher market interest rate that
pushes down the PV of the distant returns of the first project. For instance,
calculate and determine which project is better according to the NPV criterion
when market interest rate is zero and 100%.
4) The marginal efficiency of capital (MEC) or IRR using the NPV formula
but looking for the interest rate that makes the NPV equal to zero for each
projects.
MEC of Project 1:
0
) 1 (
4
) 1 (
0
) 1 (
0
1
2 1 0
1
·
+
+
+
+
+
+ − ·
m m m
MEC
2
) 1 (
4
1
m +
·
Solving this equation for
m
, we have
4 ) 1 (
2
· +m
2 4 1 · · +m
1 1 2 · − · m . This implies that the NPV of project
I will be equal to zero when the rate of discount,
m
,is 100%.
MEC of Project 2:
0
) 1 (
1
) 1 (
2
) 1 (
0
1
2 1 0
2
·
+
+
+
+
+
+ − ·
m m m
MEC
Moving 1 − to the other side of the equation and multiplying both sides by
2
) 1 ( m +
gives
2
2 1
2
) 1 (
) 1 (
1
) 1 (
2
) 1 ( m
m m
m +
]
]
]

+
+
+
· +

1 ) 1 ( 2 ) 1 (
2
+ + · + m m
1 2 2 ) 1 (
2
+ + · + m m . Factorizing the left hand side we get
1 2 2 2 1
2
+ + · + + m m m . Subtracting m 2 1+ from both sides we have
2
2
· m
414 . 1 2 · · m . This implies that the rate of discount (
m
) that
makes the NPV of the second project zero is 141.4%.
Thus, since the MEC of the two projects is greater than the market interest rate both
investment projects should be chosen. The MEC investment criterion or IRR indicates
that project II is unequivocally better than project I, because
1 2
m m >
or 1 414 . 1 > . The
implication is that project I will have higher NPV at market interest rate lower than the
equilibrium interest rate that makes the NPV of the two projects equal and the NPV of
project II will be at higher at interest rate higher than the equilibrium rate.
27
In reference to this conclusion someone may raise the following questions. What is
equilibrium interest rate that makes the NPV of the two projects equal? How can we
calculate it? How can we show it graphically? We follow the steps below to answer these
questions for projects with two years life.
First: Find the NPV of the two projects when interest rate is zero. Following the same
procedure in example 1, we will get the NPV of project I equal to 3 and that of project II
is 2 when the market interest rate is zero or there is no market interest rate to be charged
on funds obtained from borrowing.
Second: Find the equilibrium interest rate that makes the NPV of the two projects equal.
This can be determined by equating the NPV of the two projects as
2 1
NPV NPV ·
2 1 2 1
) 1 (
1
) 1 (
2
1
) 1 (
4
) 1 (
0
1
r r r r +
+
+
+ − ·
+
+
+
+ −
. Dropping 1 − from both sides
and multiplying through by
2
) 1 ( r + gives us
1 2 2 4 + + · r
5 . 0 2 / 1 · · r . This implies that the NPV of the two projects will be equal when
interest rate is 50%. In short, the equilibrium interest rate is half of the lower discount
rate; that is ) ( 2 / 1
1
m .
At 5 . 0 · r or 50% the NPV of both projects is 0.78. You can verify this using the NPV
criterion we have applied in example 1 while computing the NPV of the projects at 5%
and 10%. Therefore, if the two projects are competing the investor should choose project
I if the market interest rate is below 50% and project II if the market interest rate is above
50%.
Third: We depict the NPV of the projects in the first and second steps as well as at the
rate of discount (
m
) graphically as follows.
PV
3.0
2.0
1.0
0.78 E


0.2 0.4 0.6 0.8 1 1.4 II 2 r
I
Figure 1.9: Present value and the market interest
Decision rule for MEC:
28
• Accept the project if the MEC or IRR is greater than the market interest rate.
For competing projects choose the one with the higher IRR.
• If MEC or IRR is equal to the market interest rate, it indicates the project has
no net return but will recover the cost to be incurred. In other word the project is
marginal.
• Reject the project with MEC or IRR less than the market interest rate because it will
not recover its cost after allowing for the cost of capital.
Exercise 1.2: Given information on the costs and returns for investment project X and Y
answer the following questions.
1) Find the sum of the net benefit streams of the projects and discus the implication
2) Calculate the NPV of the two projects at the market interest rate of 5%. Which of
the two investment project is better according to the NPV criterion? Why?
3) Calculate the MEC of the projects. Which one is better according to the MEC?
Why?
4) What is the equilibrium market interest rate? What will be the NPV of the projects
at that interest rate? In witch should we invest if market interest rate is below the
equilibrium rate?
 Evaluation of NPV:
The NPV as one of the discounting criteria of measuring project worth has the following
advantages.
a. It takes into account the value of resources overtime.
b. It considers the net benefit stream in its entirety.
c. The NPV of various projects, measured as they are in
today’s Birr can be added. The additive property of NPV ensures that a poor project
(one which has a negative NPV) will not be accepted, just because it is combined
with a good project, which has positive NPV.
d. The concept is clear and the solution is always
determined.
Despite the above advantages, the NPV has its opponents towards some limitations.
a. The application and dimension of NPV, seems to be
constrained in ranking investment or projects, is influenced by the discount rate.
b. The NPV is expressed by in absolute terms rather
than relative terms and hence does not factor in the scale of investment. For
example, project A may have a NPV of 5000 while project B has a NPV of 2500, but
project A requires an investment of Birr 50,000 whereas project B may require an
investment of 10,000. Advocators of NPV argue that what matters is the surplus
value (rate of returns) irrespective of what is invested. However, opponents argue
that for the NPV is an absolute measure of value it does not show the efficiency of a
project in using capital. Out of the two projects B is efficient than A for its
investment capital generates a 25% return than as compared to 10% of A.
c. The NPV rule does not consider the life of the
project. Hence, when mutually exclusive projects are with different lives are
considered the NPV is rule is biased in favour of the longer-term projects.
29
 Evaluation of MEC or IRR:
The use of MEC or IRR as a measure of project worth has the following advantages.
a. It is more familiar concept and better understood by most
people
b. It takes into account the value of resources overtime.
c. It considers the net benefit stream in its entirety.
d. It provides a measure of efficiency of the project in using
capital.
The limitations of MEC or IRR include:
a. Table 1.1 illustrates on of the deficiency of the MEC for ranking
investment projects. That is the MEC criterion makes no reference to the market
interest rate, which measures the opportunity cost of capital.
b. It does not distinguish between large and small investment and it does
not tell anything about the timing of the net benefits of the project. Therefore, it is not
very useful for deciding between two or more mutually exclusive projects.
c. It is also possible that if the net benefit stream of a project changes or
has more than one sign, there may be more than one IRR.
Exercise 1.3:
(1) Calculate the NPV for the hypothetical X and Y projects at
10%. The cost and benefit streams are given in the table below (All figures in
million)
Year 1.Total
cost
2.Total
Revenues/Benefits
0 140 0.0
1 65 100
2 95 150
3 95 200
4 75 150
5 55 100
(2) Given the cash flow for 2 projects calculate the NPV of the
two projects at 10% interest rate
Yea
r
Project 1 Cash
flow
Project 2
Cash flow
0 (1,000,000) (1,000,000)
1 65,000 35,000
2 55,000 45,000
3 45,000 55,000
4 35,000 65,000
1.2.2 The Flexible Accelerator (inventory) model
The relationship between the growth rate of output and the level of net investment implied
in the previous section is called the accelerator principle since it suggests that an increase
in the growth rate of output or acceleration is needed to increase the level of investment.
The PV criterion suggests that this relationship between output growth and net
investment is not a fixed one. However, an increase in interest rate should reduce the
30
level of net investment associated with a given growth rate of output. This variable
relationship between the growth rate of output and the level of net investment is
frequently known as the flexible accelerator model.
Equilibrium capital stock: we begin with the general production function
) , ( K L f y ·
;
0 , >




K
y
L
y
------------------------------------------- (2.1)
Here,
y
is output pre unit of time; L is human power input per unit of time; and K is the
capital stock.-plant and equipment. Implicitly we assume here a constant rate of
utilization of capital stock so that there is a one-to-one relationship between capital stock
and machine hour input. Thus a firm will expand its plan size until the marginal product
of capita equals the real user cost of capital.
c
P
C
K
y
≡ ·


----------------------------------------------------------- (2.2)
Where,
c
is the real user cost of capital. Equation (2.2) can be seen in another way. The
increase in revenue which a competitive firm will obtain by adding another unit of capital
, given its labour input is price of output times the increment to output produced by the
increase in K .
K
y
P
K
R


·


.
The increased cost to the firm of adding another unit of capital is simply the user cost of
that unit
c
K
C
·


As long as the increase in revenue is greater than the increase in cost from another unit of
capital the competitive firm will add capital. Equilibrium will be reached when
K
C
K
R


·


and
c
K
y
P ·


.
, which is the same condition as equation
(2.2).
This marginal condition (2.2) determines the equilibrium capital stock of the firm. Let’s
take the following Cobb-Douglas production function as an example.
β β −
·
1
L aK y
This production function has the property that the exponent of the capital and labour
inputs add up to one, which gives constant return to scale. If capital and labour inputs are
doubled, output will also double. The marginal product of capital in the Cobb-Douglas
function is given by
β β
β
− −
·


1 1
L aK
K
y
--------------------------------------------------- (2.3)
This can also be written as
31

K
y
K
L aK
K
y β β
β β
· ·


− 1
, substituting
y
back into
β β − 1
L aK .
Thus with the Cobb-Douglas function, in equilibrium
P
C
K
y
K
y
· ·

∂ β
----------------------------------------------------- (2.4)
The right hand side of equation (2.4) can be solved for the equilibrium level of capital
stock in the Cobb-Douglas function
P
C
y
C
Py
K
E
β β
· ·
-------------------------------------------------- (2.5)
The equilibrium capital stock rises with an increase in
y
and falls with an increase in the
real user cost of capital. Equation (2.5) gives the expression for a particular production
function. We can generalize this by writing
E
K
as a function of
, , C y
and P .
) , , ( P C y K K
E E
· ------------------------------------------------ (2.6)
In equation (2.6), y K
E
∂ ∂ / and P K
E
∂ ∂ / are positive and C K
E
∂ ∂ / is negative. With
equation (2.6) as a general expression for the determinants of
E
K
, we can now develop
the investment demand function relating realized investment to
E
K
.
Investment demand and output growth: Total or gross investment is given as the sum
of net investment ( N
i
) and replacement investment (
R
i ).
R N G
i i i + ·
------------------------------------------------------- (2.7)
Net investment is that part of gross investment that increases the level of capital stock.
On the other hand, replacement investment is part of gross investment needed to keep the
capital stock at a constant level and is equal to economic depreciation of the stock in any
one period. Replacement investment will simply be the depreciation of the capital stock
) ( K δ
K i
R
δ · ----------------------------------------------------------- (2.8)
Where, δ is the depreciation rate; a number like one-tenth for building and one-fifth for
vehicles. Net investment in the absence of lags in the adjustment process of actual capital
stock to desired capital stock, would be
E
N
K i ∆ · --------------------------------------------------------- (2.9)
Thus we can see that net investment depends on changes in equilibrium level of capital
stock, whereas replacement investment depends on the level of capital stock.
Looking at net investment first using the Cobb-Douglas function gives

,
`

.
|
∆ · ∆ ·
C
Py
K i
E
N
β
-------------------------------------------- (2.10a)
32
If we assume that the ratio of user cost of capital to the price level, ceteris paribus,
remains fairly constant overtime, we can rewrite equation (2.10a) as
y
C
P
i
N

,
`

.
|
·
β
---------------------------------------------------- (2.10b)
This makes it clear that over the long run, with no trend in P C / , it is the growth of
output or demand that gives us the level of net investment. The relationship between the
change in output and the level of investment is the flexible accelerator model that
introduced a basic dynamic relationship into the model of the economy. Thus, if net
investment is related to
y ∆
by equation (2.10b) and net investment is also some fraction-
the net saving ratio
) (s
-of
y
; that is

sy i
N
·
Then we have the basic growth relationship
y
C
P
sy ∆
,
`

.
|
·
β
----------------------------------------------------- (2.11)
Dividing both sides of equation (2.11) by
y
and solving for the growth rate of
y
,
y
y
C
P
y
y
s

,
`

.
|
·
β
y
y
C
P
s

,
`

.
|
·
β
, dividing both sides by
P
C
β
, we have
·

y
y
Growth rate of
y
C
P
s
P
sC
β
β
· ·
----------------------------------- (2.12)
Since investment increases the supply of output by increasing the capital stock, but it is
also associated with the level of demand through the multiplier, equation (2.12) gives the
rate of growth of output that would maintain supply equal to demand.
Second let’s look at total investment using the concept of net and replacement investment
we have developed. Ignoring for a moment the lagged adjustment of actual to desired, we
have from equation (2.7), (2.8), and (2.9) that
K K i i i
E
R N G
δ + ∆ · + ·
----------------------------------------- (2.13)
In the general case, we can write the investment equation (using equation 2.6)
K P C y K i
E
G
δ + ∆ · ) , , (
----------------------------------------- (2.14)
In the Cobb-Douglas example, G
i
is given by
K
C
Py
i
G
δ
β
+
,
`

.
|
∆ ·
----------------------------------------------- (2.15)
And in the special case where the real user cost of capital,
c
is fairly constant we have
33
K y
c
i
G
δ
β
+ ∆ ·
--------------------------------------------------- (2.16)
as the accelerator relationship.
The accelerator and stabilization policy: The accelerator relationship in the gross
investment function, equation (2.14) poses an interesting difficulty in the short-run
stabilization policy. This is shown in figure 1.10. The Figure shows what happens to
investment as output rises from one stable level in two time period, 0 to
1
t and
2
t on
and a transition period of unspecified length between the two.
Real

i y k , ,

E
K


· ∆
2
1
t
t
N
i K
K

y


G
i

R
i
N
i


0
1
t

2
t
t
Figure 1.10: The “accelerator principle” on investment
In the first period there is a given level of output,
, y
which implies a given equilibrium
capital stock K .At time
1
t
, the government increases government purchases
g
to
stimulate demand and output and equilibrium capital stock move to new higher levels in
the second period, from
2
t
on. Since the capital stock is constant both before
1
t
and after
2
t
, the level of investment is zero in each period and the level of
R
i
is positive in each.
In order for the capital stock to increase to its new higher level in the second period, there
must be a positive level of net investment in the transition period. This is indicated by the
bulge in N
i
between
1
t
and
2
t
. Since G
i
is the sum of N
i
and
R
i
, this means that
during the transition period gross investment has also this bulge as shown by the dashed
line in figure 1.10. Thus, total or gross investment in each period is summarized as
follows
From 0 to
1
t
: R G
i i ·
From
1
t
to
2
t
: N R G
i i i + ·
34
From
2
t
on: R G
i i ·
1.2.3 The neoclassical model of investment
This investment theory assumes:
1. A firm is a forward looking; that is it cares about the future stream of income
not only the present
2. The firm operates under perfect competitive; that is it is a price taker
3. There is no uncertainty about profit; there is no difference between expected
and actual profit. With these assumptions
) (
) 1 (
1
0 t
I
t t t t t
t
i P L w y P
r
PV − −
+
·
∑ -------------------------------------- (3.1)
The above profit maximization is subject to two constraints: technological constraints
and capital stock. Assuming CRS, we write the first constraint as
) , (
t t t
K L y y ·
------------------------------------------------------------------- (3.2)
Where, t
L
is workers hour of input and t
K
capital stock - plants and equipments.
Besides,
; 0 > ∂ ∂ · L y MPL
and
0 > ∂ ∂ · K y MPK
The second constraint, which is capital stock, is written as
t t t t
K i K K δ − + ·
+1
------------------------------------------------------- (3.3)
Where,
1 + t
K
is capital stock in the next period. Whereas
t
K
and
t
i
refer to capital stock
available and additional investment in period t .On the other hand,
t
K δ
is the
depreciation or obsolete of capital stock in the production process. Constraint (3.2)
implies investment is a flow and capital is a stock. Thus, 1 + t
K
is determined by the
difference between t t
K i δ −
.
The profit maximization equation is thus
[ ]
∑ ∑

·
+
− − + + − −
+
·
0
1
) 1 ( ) (
) 1 (
1
t
t t t t t
I
t t t t t
t
K K i i P L w y P
r
Max δ λ 
------------ (3.4)
However, based on the first constraint we know that t t
y P
can be expressed as
) , (
t t t
K L P
. Thus, equation (3.4) can be written as
[ ]
∑ ∑

·
+
− − + + − −
+
·
0
1
) 1 ( ) ) , ( (
) 1 (
1
t
t t t t t
I
t t t t t t
t
K K i i P L w K L P
r
Max δ λ 
-------
(3.5)
The question we want to address is that what will the optimum amount of labour to hired
( t
L
); capital stock/goods to employ ( t
K
); and additional investment ( t
i
) to make in
order to maximize profit or equation (3.5). These can be achieved by the first order
derivative of equation (5) with respect to our variable of interest. That is
35
0
) 1 (
1
·
]
]
]




+
·


t
t
t
t
t
t
w
L
y
P
r L

---------------------------------------------- (3.6a)
This refers to the demand for labour. Rearranging (3.6a) gives us MPL is equal to real
wage. That is t
t
t
w
L
y
·



0 ) 1 (
) 1 (
1
1
· − − +
]
]
]



+
·


− t t
t
t
t
t
t
K
y
P
r K
λ δ λ

-------------------------------- (3.6b)
Where, 1 − t
λ
refers that whatever capital stock that will be available next period is
dependent on what some one has this year. This comes because t
K
is the end of period
capital stock for 1 − t
K
.
0
) 1 (
1
· +
+
− ·


t
I
t
t
t
P
r i
λ

--------------------------------------------------------- (3.6c)
0 ) 1 (
1
· − + − ·


+ t t t
t
K K i δ
λ

----------------------------------------------------- (3.6d)
What is the profit maximizing capital stock? Rearranging (3.6c) gives us:
I
t
t
t
P
r) 1 (
1
+
· λ
. This implies that
I
t
t
t
P
r
1
1
1
) 1 (
1



+
· λ
Substituting these two into (3.6b) for t
λ
and 1 − t
λ
we will obtain the users cost of capital.
0
) 1 (
1
) 1 (
) 1 (
1
) 1 (
1
1
1
·
+
− −
+
+
]
]
]



+
·




I
t
t
I
t
t
t
t
t
t
t
P
r
P
r K
y
P
r K
δ

--------------- (3.6c1)
Recall that, by the rule of exponent
]
]
]

+ +
·
+
− − 1 1
) 1 (
1
) 1 (
1
) 1 (
1
r r r
t t
or
) 1 (
) 1 (
1
r
r
t
+
+
.
When we substitute this in equation (6c1) gives you
0 ) 1 (
) 1 (
1
) 1 (
) 1 (
1
) 1 (
1
1
· +
+
− −
+
+
]
]
]



+
·



r P
r
P
r K
y
P
r K
I
t
t
I
t
t
t
t
t
t
t
δ


) 1 ( ) 1 (
1
r P P
K
y
P
I
t
I
t
t
t
t
+ + − − ·



δ
------------------------------------------- (3.7)
Equation (3.7) says that the value of marginal productivity of capital orVMPK is equal
to the users cost of capital.
Finally, dividing both sides of equation (3.7) by t
P
we have the expression like equation
(3.8), which shows the users cost of capital relative to the price of the product or the
marginal cost of capital is equal to the real cost of capital.
36
t
I
t
I
t
I
t
I
t
t
t
P
P P rP P
K
y ) (
1 1 − −
− − +
·

∂ δ
---------------------------------- (3.8)
Where,
·
I
t
P δ
the rate at which the investment good/capital stock depreciates at time t
·

I
t
rP
1
The interest charge for investment or holding capital valued at
I
t
P
1 −
the
beginning of period t
· −

) (
1
I
t
I
t
P P
The gain or loss (overvaluation or undervaluation) in the price of
investment good in period t
1.2.4 Tobin’s Q theory of investment
Tobin (1969) devised a way of relating investment demand to financial variables which is
more amenable to empirical treatment than other investment models, while still having a
firm theoretical basis. In fact the crucial variable, Tobin marginal Q has already been
defined under the neoclassical model above in equation (3.7), which states VMPK is
equal to the users cost of capital. That is
0 ) 1 ( ) 1 (
1
· + − − +



r P P
K
y
P
I
t
I
t
t
t
t
δ
----------------------------------------- (4.1)
Rearranging this equation gives
) 1 ( ) 1 (
1
r P P MPK P
I
t
I
t t t
+ · − +

δ
------------------------------------------- (4.2)
Dividing both sides of equation (4.2) by
) 1 ( r +
, it becomes
[ ] ) 1 (
) 1 (
1
1
δ − +
+
·

I
t t t
I
t
P MPK P
r
P
----------------------------------------- (4.3a)
Expression (4.3a) is last year supply price of capital goods. In current time this dynamic
equation becomes
[ ] ) 1 (
) 1 (
1
1 1 1
δ − +
+
·
+ + +
I
t t t t
P MPK P
r
P
------------------------------------- (4.3b)
This relationship says that the supply price of capital goods, t
P
, is the discounted future
revenue stream plus the part of capital still in use. This is therefore identical to the NPV
concept discussed earlier.
Dividing the above expression first by t
P
, the price of new capital goods, gives the
expression for Tobin’s marginal Q as
t
I
t t t
P
P MPK P r ] ) 1 ( )][ 1 /( 1 [
1
1 1 1 + + +
− + +
·
δ
-------------------------------- (4.4)
Note that the numerator has three components: the term in the first bracket is the discount
rate; inside the second bracket the first term is the additional revenue from the sale of
output and the second term is simply the increase in the value of the firm’s capital in
period
, 1 + t
that is the value of capital in next period less any depreciation. Therefore,
37
the numerator is the increment to the value of the firm from the purchase of one more
machine, discounted back to the current period. So Tobin’s marginal Q is the rate of
change in the value of the firm to the added cost of acquiring new capital. If the firm
is in equilibrium, then
1 · Q
as in (expression 4.4)
Under the constant return to scale
) (CRS
, from elementary theory of the firm, the
marginal cost is proportional to average cost and thus under the CRS marginal Q is
proportional to average Q. That is, marginal Q can be expressed as the ratio of the firm’s
total valuation, PV , to total cost of its capital, PK , which is known as average Q.
PK
PV
Q ·
----------------------------------------------------------------------- (4.5)
1.2.5 Determinants of investment in the case of Developing Countries
Applicability:
• Tobin’s suggestion is easy to measure from the stock market, but this is not applicable
in LDC’s for the financial sector is not well developed in many developing countries
• The assumption of perfect competition is not valid because markets in LDCs are more
of imperfect than perfect
• Exchange rate is more of rationed than auctioned in LDCs
• Political instability which is more common in LDCs implies uncertainty that affects
investment adversely is not mentioned
• The existence of huge public sector investment has also an impact on private
investment; depending the type of investment. It might be complementary (such as
investment on infrastructure, transportation, electricity etc) that crowed in (encourage)
private investment or supplementary that crowed out (affect adversely) to private
investment
• Transaction cost, the cost of doing business such as bureaucracy, corruption, bribe etc
are very high in Africa.
1.3 THE SUPPLY OF AND DEMAND FOR MONEY
1.3.1 Money Supply and monetary expansion
A. MONEY STOCK (SUPPLY)
Introduction: There are three measures of money stock- M
1
, M
2
, and M
3
. M
1
is the
narrowest of the fed’s money supply definition. It includes currency held by non-bank
private sector (or held outside bank for circulation including travelers checks (TC)) and
checkable or demand deposits held by non-bank private (firms and households) sector (
1 1 1
D D D
h F
· +
). M
1
is the potential base for deposit expansion and money supply
creation.
M
2
is the broadest measure of money supply than M
1
. It includes M
1
, other quasi money or
deposit (D
2
) such as time deposits (TD), saving deposits (SD), and money market mutual
funds (MMMFs) of individuals and firms (for example, dollar denominated deposits in
foreign banks and agreements in which a corporation purchases T-bills from a bank and
the bank agrees to buy them back the next day at a slightly higher price) on which limited
38
checks can be written. Funds in quasi deposit and MMMFs are typically regarded as
investment in short-term bonds. M
2
is the most widely accepted measure of money supply.
Finally, M
3
includes M
2
and other assets less liquid than M
2
such as money market mutual
funds held by institutions (MMMIs)-such as provident funds, pension contributions, and
saving and credit associations fund- and other assets (for example, gold deposits of
individuals) (OAs). Funds, which are not counted as part of M
2,
are typically invested in
long-term securities. M
3
is used less frequently as a measure of money supply than M
1
and
M
2
. In short,
M
1
= C+D
1
---------------------------------------------------------------------------------------- (1)
M
2
= M
1
+ D
2
(TD+SD +MMMFs) ------------------------------------------------------------ (2)
M
3
= M
2
+MMMIs + OAs------------------------------------------------------------------------ (3)
Monetary expansion mechanism
As we have defined it, money supply consists of currency and demand deposits which are
supplied by the commercial banks. These banks have balance sheet made up of liabilities
including demand deposits and assets reserve and loans. The Federal Reserve System
requires that commercial banks retain a certain percent of their liabilities as reserve, mainly
as deposits in the Federal Reserve Banks, in our case in the NBE. This reserve is called the
reserve requirement.
Suppose the Fed decides to expand money supply. The managers of the Fed’s open market
account buys in the bond market a certain amount of treasury bonds; say worth of Birr 100
thousand and issues a check, drawn by the Fed for Birr 100 thousand to the seller. The
seller then deposits the check in his/her checking account in Bank A, creating a Birr 100
thousand liability for the bank, the claim o the bank by the depositor and also a Birr 100
thousand in asset for the bank , the claim on the Fed. If there is a 20% reserve requirement,
bank A can loan Birr 80 thousand of its increase in assets and must retain Birr 20 thousand
as a reserve as shown in table below.
Bank A Bank B
Assets Liabilities Assets Liabilities
Br 100 Deposits 100 Br 80 Deposits 80
Reserve 20 Reserve 16
Loan 80 Loan 64


Bank C
Assets Liabilities
Br 64 Deposits 84
Reserves=12.8
39
Loan 51.2
From the balance sheet of the three banks we understand that, the increase in money
supply from the Birr 100 thousand reserve increases is given by
..., 2 . 51 64 80 100 + + + + · ∆M

Thus, in this simple example assuming
1. The banks are fully loaned up or there is no
excess reserve and
2. There is no linkage into increased public
holding of currency, the change in money supply is given by

R
r
M ∆ · ∆
1
-------------------------------------------------------- (1.3.1)
Where, R ∆ is the initial reserve increase due to OMO and r is the reserve requirement
ratio. With the above two assumptions and reserve ratio is 20%, the initial reserve increase
will increase money supply by Birr 5 thousand
5 100
20
1
· · ∆M
Consolidated money stock
Given information regarding the reserve requirement ratio as well as assets and liabilities of
both the commercial and central/national banks the consolidated money stock/supply in an
economy can be computed and posted in the balance sheet shown in table 1.1.
Table 1.1: The Banking System Consolidated Balance sheet
3.2. Money Demand: The Transaction and Portfolio theories of money demand
1) The transaction demand for money:
Baumol and Tobin noted that money is held to smooth out the difference between
frequent income receipts and continual expenditure payments. This view of transaction
National Bank
Assets
Symbol
Liabilities
Symbol
Gold & foreign exchange reserves
R
High powered money
H
Lending to the government

G
L
Commercial Banks
Assets Liabilities Symbol
Currency and deposits with the national bank
b
H
Deposits from the public
D
Lending to the personal and corporate sector

P
L
Consolidated Banking sector
Assets Symbol Liabilities Symbol
Gold & foreign exchange reserves
R Currency in circulation:
b
H H −

P
H
Domestic credit:
P G
L L + DC Deposits from the public
D
Money supply: DC R +

S
M
Money supply: D H
P
+
S
M
40
demand for money assumes that individuals hold all the proportion of their income that
they intend to spend in any on period in cash. Cash balances are, however, typically non-
interest bearing and so is costly to hold large amount of cash. Individuals therefore
generally choose to hold only the cash they need for current transactions while leaving the
rest in a bank deposit where it earns interest. This implies that, individuals and business
firms maintain certain average level of cash and deposits because they need to make day-
to-day transactions. If receipts of income and expenditure were always synchronized
perfectly with respect to time, there would be no need for such idle cash balances.
Because people are paid once a month or once a week and because they do not make all
their disbursements as exactly the time they receive their income, they must maintain
(hold) some amount of cash for the purpose of meeting their transaction needs.
In developing their model, Baumol and Tobin considered a hypothetical individual who
receives monthly nominal income Y (say Birr 2,400) at the beginning of the month and
spends it on transaction during the month (this period) at a uniform rate. If the individual
keeps certain proportion of money his/her income in cash to carryout transactions, then
his/her money balance follows the Saw-tooth pattern displayed in Figure 1.11. Time is
measured horizontally and the amount of money balance held at hand and balance in bank
account (bond holding) at the beginning of the time period is measured in the vertical axis.
In panel (a) we assume that the person received Y Birr of income (say Birr 2,400) at the
beginning of the month (time zero) and spends the entire amount on transaction that occur
at a uniform or constant rate during the course of the month. At the beginning of the
month he has Birr 2,400, and by the end of the month he/she has zero balance because
he/she has spent all. In other words, at the beginning of the month the person holds Y Birr
and at the end, no money (cash) left. Since money is spent at a uniform rate (constant
rate or stable intervals) throughout the month, his/her average holding of cash balance
over the course of the month is simply 2 / Y Birr (or Birr 1,200)-holding at the beginning
of the month, Birr 2,400 plus holding at the end of the month, Birr 0, divided by 2. It is
this average idle balance that we call the transaction demand for money. Household
average cash balance for
n
number of withdrawals over any period can be written as:

,
`

.
|
·
n
Y
M
b
2
1
--------------------------------------------------------------- (1)
Beginning bond balance is thus
b b
BC Y BB − ·
------------------------------------------------------------ (2)
Where, b
BB
and b
BC
denote beginning bond and beginning cash balance respectively.
Part of money balance ( Y ) that yields return to the bond holder is called average bond
balance, which is half of beginning bond balance. It is expressed as
2
.
b
b
BB
B AV · ------------------------------------------------------------- (3)
Assuming for a moment there is no transaction cost (this assumption will be relaxed
shortly), net interest total revenue (TR) earned by the individual or is given by
41
]
]
]

,
`

.
|
− ·
n
Y Y
r TR
2
1
2
------------------------------------------------------ (4a)
Equation (1.4a) says that net interest earned by the individual or total revenue is the rate of
interest multiplied by the unspent income in bank deposit or bond balance less the amount
withdrawn in cash in the half way point. The expression in the bracket is equal to average
bond holding. Hence, total revenue can also be written as
) . (
b
B AV r TR ·
---------------------------------------------------------- (4b)
Suppose now the household withdraws half of the money from the bank at the start of the
period and withdraws the other half at the start of the third week. When 2 · n , panel (b)
of Figure 1.11 shows that average cash balance is
600 4 / ) 2 / ( 2 / 1 · ·Y Y
. Alternatively,
panel (b) can be interpreted as the case in which the individual decides to make one bond-
cash transaction by holding half of his/her Birr 2,400 in cash and put the remaining half
into income earning bonds. In other word he/she holds Birr 1,200 in cash and uses the
other Birr 1,200 to buy a Treasury bond at the beginning of the month.
Since bonds cannot be used directly to carryout transactions, he/she must sell the bonds
and turn them into cash so that he/she can carryout his/her half month transactions. Thus,
the individual’s bond holdings drop to zero at the middle of the month, and his/her cash
balance rise up to Birr 1,200. By the end of the month all the cash is gone. When he again
receives his/her next Birr 2,400 monthly payments, he/she again divides it into Birr 1,200
cash and Birr 1,200 of bonds, and the process continues. Using equation (3), the net result
of this process is that the bond balance that yields return to the individual is
600 ) 1200 ( 2 / 1 ) ( 2 / 1 · ·
b
BB
. It is clear that using equation (4a) or (4b) net interest or
total revenue (TR) obtained from this process is 24. The value of marginal revenue (
n TR ∆ ∆ / ) is also 24.
Panel (c) shows when the household makes three times (per ten days) withdrawal or two
bond-to-cash transactions. In this case, two third of the income Y (or Birr 1,600) will be
put into bonds initially. Ten days into the month, half of the bonds [
Y ) 3 / 2 ( 2 / 1
] or third
of Y ; that is Birr 800 can be cashed. Each bond will then yield [
)] ( 9 / 1 [ ] ) 3 / 1 ( 3 / 1 [ Y r Y r ·
. Ten days latter the other half can be cashed having earned
)] ( 9 / 2 [ Y r
revenue for this third of Y . Total revenue in the three withdrawals or two
bond-to-cash transactions cases will then be
32 ) 3 / ( ) 9 / 2 ( ) 9 / ( · · + Y r Y r Y r
. You can
verify this also using equation (1.3.4a) or (1.3.4b). Marginal revenue is simply 32 less 24
or
8 ] 12 / [ )] ( 4 / 1 ) ( 3 / 1 [ · · − Y r Y Y r
This analysis entails that for withdrawals greater than one (
) 1 > n
total revenue (TR) can
also be obtained by analyzing the revenue is obtained each time when withdrawals are
made
9
or bonds are cashed using the expression below.
9
Where, n r / multiplied by n Y / ,
,..., / 2 n Y
and
N Y n / ) 1 ( −
indicate amount of money that yield interest
during the second , third,…, and last withdrawals. For instance, if 6 · n N Y n / ) 1 ( − is the amount of money
withdrawn for the 5
th
time
42
]
]
]

,
`

.
| −
+ + + + ·
n
Y n
n
Y
n
Y
n
Y
n
r TR
) 1 (
...
3 2 1

( )
]
]
]

− + + + + · Y n Y Y Y
n
r ) 1 ( ... 3 2
1
2
---------------------------------- (5a)
(a) Plan/strategy/ 1: 1 · n or no bonds-to-cash transaction
Y

2 / Y
Av. M
b
=Birr 1,200


1 2 3 4 Weeks
(b) Plan/strategy/ 1: 2 · n or one transaction
Y

Bond
Y/2=1200


M
b
=Cash Av. M
b
=Y/4=Birr 600

1 2 3 4 Weeks
(c) Plan 3: 3 · n or 2 transactions
Y

Bond


Y/3=800
M
b
=Cash Av. M
b
=Y/6=400
43

1 2 3 4 Weeks
(d) Plan 4: 4 · n or 3 transactions

Y

Bond



Av. Mb=Y/8=400
M
b
=Cash
1 2 3 4 Weeks

Fig 1.11: Individual’s transaction demand for money
For instance, for 3 · n ,
( )
]
]
]

+ · Y Y r TR 2
3
1
2

( ) 32
3
96
3
2400
04 . 0
3
3
9
1
· ·
,
`

.
|
·
,
`

.
|
·
]
]
]

·
Y
r Y r
This revenue is the sum of
) 9 / 2 ( & ) 9 / ( Y r Y r
which give net earning equal to 10.67 and
21.33 in the second and third withdrawal or first and second bond-to-cash transaction.
Finally, panel (d) depicts that if the household makes four times (weekly) cash withdrawal
or three times bond-to-cash transactions. In this case the average cash balance held is only
Birr 300 or 8 / Y , which is
] ) 4 / 1 ( 2 / 1 [ Y
.These example shows that the average cash
balance held by the individual household falls as the number of cash withdrawals
increase.
Examples above prompt the question as to what determines the number of withdrawals or
transactions (
n
) demand for money at any given period. There are two main factors.
First, since a bank deposit account offers interest on funds remaining in the account, as
interest rate rise households will economies/decrease their holding of idle/average cash
balance for transaction purpose, thereby increasing
n
. In figure 1.12 below, other things
being equal, the number of withdrawals that maximize the TR of the individual increases
from 0
n
to
1
n when the market interest rate increases from 0
r
to
1
r Therefore, the
44
transaction demand for money is sensitive and inversely related to the level of interest
rate.
Assuming the interest rate is 4% per month and no transaction cost, the expression for the
net interest or total revenue earned when the individual makes two to five times
withdrawal or one to four bonds-to-cash transactions at a constant interval using equation
(1.5) will be:
 For
2 · n
24
4
96
4 2
1
2
1
· · ·
]
]
]

,
`

.
| Y
r Y r
 For
3 · n
32
3
96
3
04 . 0
3 3
1
3
2
3
1
3
1
· · · ·
]
]
]

,
`

.
|
+
,
`

.
| Y Y
r Y Y r
 For
4 · n
36
8
288
8
3
04 . 0
16
6
4
1
4
3
4
1
4
2
4
1
4
1
· · · ·
]
]
]

,
`

.
|
+
,
`

.
|
+
,
`

.
| Y Y
r Y Y Y r
 For
5 · n

4 . 38
5
192
5
2
04 . 0
25
10
5
1
5
4
5
1
5
3
5
1
5
2
5
1
5
1
· · · ·
]
]
]

,
`

.
|
+
,
`

.
|
+
,
`

.
|
+
,
`

.
| Y Y
r Y Y Y Y r
Results discussed so far regarding the revenue side of transaction demand for money are
is illustrated in table 1.2 below given % 4 · r and no transaction cost.
Table 1.2: Marginal revenue from increasing transactions from bonds to cash
N
o
of withdrawal (
) n & duration
Initial (Beginning) Average (mid point)
Cash
balance
Bond
Balance(
b
B
)
Cash balance
) (
b
M
Bond
balance
Total
Revenue
Marginal
Revenue
Amount
withdrawn
) (
b
M Y − ) 2 / (
b
BM ) 2 / (
b
BB ) . (
b
B AV r n TR ∆ ∆ /
1(beginning of
the month)
Y=2,400 - 1,200 - - -
2 (Per 15 days) Y/2=1,200 Y/2 =1,200 ¼(Y)=600 ¼(Y)=600 24 r(Y/4)=24
3 (Per 10 days) Y/3= 800 2/3(Y) =1,600 1/6(Y)=400 1/3(Y)=800 32 r(Y/12)=8
4 (Per 7 days) Y/4= 600 ¾(Y) =1,800 1/8(Y)=300 3/8(Y)=900 36 r(Y/24)=4
5 (Per 5days) Y/5= 480 4/5(Y) =1,920 1/10(Y)=240 2/5(Y)=960 38.4 r(Y/40)=2.4
Note: TR in this table is computed on the assumption that transaction cost is zero. In this case TR and net
interest earned are equal. However, TR will be greater than net interest earned when transaction cost is
involved in making transaction.
From these strategies, it is clear that:
1) The lower the average holdings of cash balance and
the higher the bond holding the more interest the individual will earn. But increases
at a decreasing rate
2) The marginal revenue from increasing the number
of transactions is positive and decreasing as the number of transactions
n
increases.
45
3) Looking at the differences in MR column in table
1.2, we can see that as
n
increases the drop in MR decreases. This gives us
) (
0
r MR
curve in figure 1.12, which shows MR is a function of the number of
transactions
n
for given interest rate o
r

The second factor that determines the size of
n
is the transaction cost in terms say
cn
.
On the cost side, we assume that each transaction has a give cost,
c
, perhaps a brokerage
fee for the buying and selling of bonds, the implicit cost of time spent transacting
business, transportation cost, or trouble of making frequent visits to the bank in order to
affect cash withdrawals, for making more trips. Then we can add a MC schedule to the
figure 1.12. Combining with the initial
) (
0
r MR
curve gives the profit maximizing
number of transaction 0
n
, where . MC MR · similarly, the number of withdrawals will be
1
n when interest rate increases from
0
r
to
1
r

MC MR ,


1
MC

0
MC
) (
1
r MR

) (
0
r MR
0
n

2
n
1
n
n
Figure 1.12: Determination of the number of transactions
The above figure also indicates that as transaction cost per withdrawal or MC increases
from
0
MC
to
1
MC other things being equal, the number of withdrawals made by the
individual decreases from
1
n to
2
n .This also mean that average cash holding will
increase and that of bond balance or deposits will likely be decline.
When making withdrawal or converting bond-to-cash involves transaction cost the TR is
not also net interest earned on average bond holding, which is shown in column 6 of table
1.2 for the net declines by the amount of transaction cost multiplied by the number of
withdrawal. Instead, TR is considered as gross interest earning. The expression net interest
( NI ) when transaction cost is involved thus
cn B AV r NI
b
− · ) . ( ------------------------------------------------------ (5b)
For example assume that transaction cost per withdrawal is Birr 2. In this case, when an
individual makes 2 withdrawals transaction cost will be 4 2 2 · · x Cn . Thus, net interest
will be 24 minus 4, which is equal to Birr 20. Similarly, net interest ( NI ) declined by Birr
6, 8, and 10 when 3,4, and 5 withdrawals were made.
Aggregate money demand
46
To move to the aggregate money demand for each representative consumer whose money
transaction balance is given by equation (1), there is assumed to be someone on the other
side of the market. Suppose, for example that the consumer buys goods from a
representative firm and that firm periodically converts its money holding into bonds. The
firm’s pattern of bond and money would follow the same saw-tooth pattern exactly
complementary to the consumers’ pattern in Figure 1.11. The aggregate money DD in the
transaction s model is therefore, the sum of the households’ demands and that of the firms
on the other side of the market. This means that we must double, b
M
in equation (1) to
get the aggregate demand for real money balance p M
d
T
/ . Aggregate money transaction
balance or simply cash balance in nominal and real term are given by
n
Y
M M
b
d
T
· · 2
----------------------------------------------------------- (6a)
n
Y
m
P
M
b
d
T
· · 2 ----------------------------------------------------------- (6b)
Where, the subscript T indicates aggregate or total.
Exercise 1.4:
1) If interest rates on bonds go to zero, what does the Baumol-Tobin analysis suggest the
individual’s average holding of money balances should be? Explain
2) If brokerage fees or time and transportation cost go to zero, what does the Baumol-
Tobin analysis suggest regarding total revenue and net interest earning on holding of
money balances should be? Explain
3) Consider an individual who earns Birr 3600 per month, who can earn 5% interests per
month on saving deposits, faces Birr 2 transactions cost per withdrawal, and has an
initial withdrawal plan of 4. Moreover, assume that the individual’s elasticity of
withdrawal with respect to change in interest rate and transaction cost are ½ and 2
respectively. Given the above information:
(A) Compute the individual’s average monthly cash and bond
balances for the information given above and illustrate the values using the saw-
tooth pattern graph.
(B) Other things remain constant, by how much will the individual’s
number of withdrawals and hence average monthly cash and bond balances change if
the rate of interest falls to 3%?.
(C) While interest rate remains constant, what will happen to the
number of withdrawals and hence individual’s average monthly cash and bond
balances change if transaction cost declines to Birr 1? Calculate the values and show
graphically
(D) Compute the net interest earned from money kept in the bank or
holding of short term bonds in the case of (a) to (c) by rounding the values to nearest
whole number.
1.3.2. The Portfolio Approach (Reading assignment)
47
Introduction: According to Keynes, the demand for real money balance function, divided
into speculative component, inversely related to interest rate, and transaction component,
positively related to income and inversely related to interest rate, is given by
) ( ) ( ) , ( y k r l y r f m
P
M
+ ≈ · ·
------------------------------------ (1)
Where, r m ∂ ∂ / is negative and
y m ∂ ∂ /
is positive
The portfolio approach is attributed to Keynes speculative (regressive) expectations model
and described by Tobin in his article on liquidity preference. The portfolio approach says
that people hold money when they expect bond prices to fall, that is, interest rates to rise,
and thus expect that they would take a loss if they were to hold bonds. Since people’s
estimates of whether the interest rate is likely to rise or fall, and by how much, vary fairly
widely, at any given interest rate there will be someone expecting it to rise, and thus
someone holding money.
The obvious problem with the liquidity preference theory of Keynes is that it suggests
individuals should, at any given time, hold all their liquid assets either in money or in
bonds, but not some of each. This is obviously not true in reality. Tobin’s model of
liquidity preference deals with this problem by showing that since the return on bonds is
uncertain, that is, bonds are risky, then the investor worrying about both risk and return is
likely to do best by holding both bond and money-diversification of portfolio.
Tobin assumes that a bond holder has an expected return on bond from two sources, the
bond’s yield – the interest payment an individual receives – and a potential capital gain
– an increase in the price of the bond from the time he/she buys it to the time he/she sells
it. The bond’s yield Y is usually stated as a percentage of the face value of the bond. The
market rate of return on the bond r is the ratio of the yield to the price of the bond
b
P
.
For example, if a hundred-dollar bond has a yield of $5, the percentage yield is 5 percent.
If the price of the price of the bond rises to $125, the $5 yield corresponds to a market rate
r of 4 percent - $5/$125. Thus, the market rate is given
b
P
Y
r ·
--------------------------------------------------------------
- (2)
And, since the yield Y is a fixed amount stated as a percentage of the bond’s face value,
the market price of a bond is given by
r
Y
P
b
·
-------------------------------------------------------------
- (3)
The expected percentage capital gain
g
is the percentage increase in price from the
purchase price
b
P
to the expected sale price
e
b
P . This gives us an expression for the
percentage capital gain; . ) (
b b
e
b
P P P g − From equation (2) and (3), with a fixedY on the
48
bond, an expected price
e
b
P
corresponds to an expected interest rate
e
b
e
YP r ·
. Thus, in
terms of expected and current interest rates, the capital gain can be written as
r
Y
r
Y
r
Y
g
e

·
Canceling, theY terms and multiplying the numerator and denominator by r gives us
1 − ·
e
r
r
g ----------------------------------------------------------
(4)
As the expectation for the expected capital gain in terms of current and expected interest
rates. For example, if the present market interest rate is 5 percent and the purchaser of the
bond expects the rate to drop to 4 percent, his expected capital gain would be
25 . 0 1 25 . 1 1
04 . 0
05 . 0
· − · − · g
or 25%
The total rate of return on a bond -
e
for earnings – will be the sum of the market rate of
interest at the time of purchase and the capital gains term. Thus,
g r e + ·
--------------------------------------------------------- (5)
And substituting for
g
from equation (5), we have an expression for the total rate
(percentage) of return
1 − + ·
e
r
r
r e -----------------------------------------------------
(6)
James Tobin in his famous article “Liquidity Preference as Behavior towards Risk”
formulated the risk aversion theory of liquidity preference based on portfolio selection.
This theory removes the following two major defects of the Keynesian liquidity
preference theory.
1) Keynes’s liquidity preference function depends on the inelasticity of
expectations of future interest rate, and
2) Individuals hold either money or bond.
Tobin starts his portfolio selection model of liquidity preference with this presumption
that an individual asset holder has a portfolio of money and bonds, even if the return
from bonds is higher that the return from money. Money neither brings any return nor
imposes any risk on holders. But bonds yields interest and also bring income. However,
income from bonds is uncertain because it involves a risk in capital gains and losses. The
greater the investment in bonds the greater is the risk of capital loss from the bonds. An
investor can bear this risk if he/she is compensated by an adequate return from bonds.
As a result, the portfolio balance approach begins with the same expression to the total
percentage return-
e
- that we have developed in equation (5) earlier.
49
g r e + ·
We have also assumed earlier (under 4) that the percentage rate of expected capital gain
given by
1 − ·
e
r
r
g
is determined with certainty by the individual: he chooses
e
r
as a function of r and no
consideration of uncertainty or risk enters the problem. The basic contribution of the
portfolio balance approach is to enter risk contributions explicitly into the
determination of the demand for money.
If
g
is the expected capital gain or loss, it is assumed that the investor bases his/her
actions on his /her estimate of its probability distribution. It is further assumed that this
probability distribution has an expected value of zero and is independent of the level of
the current rate of interest, r , on bonds. Now in place of a return expected with
certainty,
e
, we can have an expected return,

e
, where
− −
+ · g r e
-------------------------------------------------- (7)
And

g
is the mean expected capital gain from the probability distribution.
The Individual portfolio Decision
Individual portfolio consists of a proportion M of money and B of bonds where both
M and B add up to one. They do not have any negative values. If asset holder is putting
B dollars of his/her liquid assets into bonds, his/her expected total return on a
portfolio
T R

is then
) ( .
− − −
+ · · g r B e B RT
, where 1 0 ≤ ≤ B ----------------- (8)
Similarly, if the standard deviation of the probability distribution of return/capital gains
on a bond is g
σ
, which is a natural measure of uncertainty or riskiness of bonds, a
number like 2 percent, and all bonds are alike, then the total standard deviation of bond
holding is given by
g T
Bσ σ . ·
-------------------------------------------------- (9)
Equation (11) and (12) give us the technical situation facing the asset holder – the budget
constraint along which he/she can trade increased risk
T
σ for increased expected return
T R

. They also give the investor a formula for deciding how much funds to put into
bonds to achieve a given risk-return mix along the budget line. From (9) we have
T
g g
T
B σ
σ σ
σ 1
· ·
------------------------------------------ (10)
50
With g
σ
fixed by the asset holder’s probability distribution (10) gives the total bond
holdings B needed to attain any given level of risk
T
σ
. Using this expression to replace
B in (8) gives us the budget constraint,

,
`

.
|
+
· + ·

− −
g
T
g
T
T
g r
g r R
σ
σ
σ
σ
) (
-------------------------- (11)
Here r is a known current vale, fixed, at least to the individual, by the bond market. The
investor knows

g
and g
σ
, at least implicitly, from the probability distribution
s g'
in
Figure 1.13. Thus, the expression in parenthesis (13) is a given, determined number which
gives the constant rate of trade-off between return
T R

and risk
T
σ . Differentiating (11)
we have
g T
T g r
d
R d
σ σ
− −
+
· ------------------------------------------ (12)
If r is 5%;

g
is 15% and g
σ
is 5%, then
T
T d R d σ /

is 3%. In this case, an increase of
one percentage point in the standard deviation in the total portfolio
T
σ will buy a 3%
increase in the expected total return
T R

.
Tobin describes three types of investors. The first category is of risk lovers who enjoy
putting all their wealth into bonds to maximize risk. They accept risk of loss in exchange
for the income they expect from bonds. They are like gamblers. The second category is of
plungers. They will either put all their wealth into bonds or will keep it in cash. Thus,
plungers either go all the way or not at all.
But the majority of investors belong to the third category. They are risk averse or
diversifiers. Risk averters prefer to avoid the risk of loss which is associated with holding
bonds rather than money. They are prepared to bear some additional risk only if they
expect to receive with it greater increases in returns. They will, therefore, diversify their
portfolios, and hold both bonds and money. Although, money neither brings any return
nor any risk, yet it is the most liquid form of assets which can be used for buying bond
any time.
In order to find the risk averter’s preference between risk and expected return, Tobin uses
indifference curves having positive slopes indicating that the risk averter demands more
expected return in order to take more risk.

R
σ
2
I

1
I r
T
51
O Risk (
R
σ
)
B
P E
M
W C
Fig 1.13: The “diversifier’s” portfolio selection between risk and
return
In Figure 1.13, the horizontal axis measures risk (
R
σ
) and the vertical axis the expected
return (
R R
E
µ ·
). The line Or is the budget line of the risk averter. It shows both the
risk and return on the basis of which he/she arranges his/her portfolio of wealth
consisting of money and bonds.
1
I
and
2
I
are indifference curves. An indifference curve
shows that he/she is indifferent between the pairs of expected return and risk that lie on
1
I
curve. Points on curve are preferred to those on
1
I
curve. But the risk averter will
achieve an equilibrium position between expected return and risk where his/her budget
line is tangent to the indifference curve (
1
I
), at point T .
In the lower portion of the figure the length of the vertical axis shows wealth held by the
risk averter in his/her in his portfolio consisting of money ( PW ) and bonds ( OP ). The
line OC shows risk as a proportional to the share of the total portfolio held in bonds.
Thus, point E on this line drawn as a perpendicular from the point T determines the
portfolio mix of money and bonds. It is OP of bonds and PW of money. Thus, the risk
averter diversifies his/her total wealth OW by putting partly in bonds ( OP ) and partly
keeping in cash ( PW ). That is why he/she is called a diversifier. He/she is not prepared
to accept more risk unless he/she can also expect greater expected return. However, the
risk averter possesses an intrinsic preference for liquidity which can be only offset by
higher interest rates.
The aggregate demand for money in the portfolio balance model
The higher the interest rates, the lower the demand for money and the higher the
incentive to hold more bonds. On the contrary, the lower the interest rates, the higher the
demand for money and the lower the willingness to hold more bonds. This is illustrated in
Figure 1.14 below.
3
I
3
r
Expected
2
r
Return
3
T

2
I


2
T

1
I

1
r


1
T
O
52
Risk

1
B

1
E

Wealth
2
B

2
E
3
B
3
E
W C
Fig 1.14: Aggregate Portfolio selection with rising interest rates
In Figure 1.14 the slope of the budget line increases with the increase in the interest rate.
This is shown by the budget line
1
r rotating upward to
2
r and 3
r
. Consequently, returns
increase in relation to risk with increase in interest rate and the budget line touches higher
indifference curves. In Figure 1.18, budget lines
1
r
,
2
r
,and 3
r
are tangent to
1
I
,
2
I ,and 3
I

at , ,
2 1
T T and
3
T
respectively. These points trace out the optimum portfolio curve, OPC
in the figure, which shows that as the tangency points move upward from left to right, both
the expected return and risk increase.
These tangency points also determine the portfolio selection of risk averters as shown in the
lower portion of Figure 1.15. When rate of interest is
1
r , people hold
1
OB amount of bond
and W B
1
money. As the rate of interest increases from
1
r to
2
r and 3
r
, risk averters hold
successively more bonds
2
OB and 3
OB
but reduce money to W B
2
and
W B
3 in their
portfolios.
The figure also shows that as the rate of interest increases by equal amount from
1
r to
2
r and
to
3
r
, risk averters hold bonds by decreasing increment
1 1 2 3 2
OB B B B B < <
. This also
means that the demand for money falls by smaller amounts, as the rate of interest increases.
This is because the total wealth in the portfolio consists of bonds plus money. The demand
for money can be drawn on the basis of Figure 1.14 and derived in Figure 1.15 below. The
curve shows that when the rate of interest falls from a higher level, there is a smaller increase
in the demand for money.
Interest
Rate
10
r
8
r
6
r

4
r

2
r
d
M
O A B C D Speculative DD for
money
Fig 1.15: The demand for money
53
For instance, when the rate of interest falls from 10
r
to 8
r
the demand for money increases
by AB amount, which is smaller thanOA . This is because the risk averters prefer to hold
more bonds than money. But when the rate of interest falls at a lower level from
4
r
to
2
r
the increase in the demand for money is much larger; CD in figure 1.15. This demand for
money relates to the speculative demand for money not to the aggregate demand for
money.
1.4 Labour market
1.4.1 Labour demand
(A) Individual firm labour demand
Introduction: The demand for labour is a derived DD. That is to say firms do not demand
labour for its own sake but for what it is able to produce for sale in conjunction with other
factors of production, such as capita. It follows, therefore, that firms will only demand
labour if it is profitable to do so. It will be profitable to employ more labour in the marginal
revenue earned from the sale of extra output exceeds the marginal cost of producing that
output. Hence, the demand for labour by an individual firm operating in competitive
markets is based on the notion of profit maximization. Profit maximization implies that
additional labour will be demanded until the marginal cost of labour (real wage) just equals
the marginal revenue of labour obtained from the sale of extra output produced by the
marginal worker. The marginal revenue and marginal cost of a firm is determined by the
state of technology and the nature of production function. Figure 1.16 shows the production
function, which describes real output ( Y ) is a function of labour input and the capital
stock. The capital stock is fixed at

K
, which implies that this model of labour market is
strictly a model of the short run.
Y

) , (

· K N f Y

1
N

2
N
3
N
N

MPN APN ,


·
N
AP N y /

1
N
2
N
N
MP
54
Fig 1.16: The production function
The shape of the production function,
) , (

· K N y y
, shows Y increases with labour input,
so that
0 / > ∂ ∂ N y
. Initially output increases at an increasing rate with the first additions
of labour to the capital stock, shown over the range
1
ON
in Figure 1.16. Beyond the level
of employment given by
1
N
, however, Y begins to increase at a decreasing rate,
exhibiting diminishing marginal returns as the fixed capital stock is shared among more
and more workers.
In the lower panel of Figure 1.16, the relationship between the production, average and
marginal product of labour. It can be seen that as employment increases the N
AP
first
increases up to
2
N
and then decreases beyond
2
N
.The N
MP
, which represents the
additional output produced by the last worker employed and is derived from the slope of
the production function. The slope is initially rising, peaking at
1
N
, the point of inflection
point where the production function changes from convex to concave, and then falling
beyond
1
N
; intersects the N
AP
at its maximum, and reaches zero at 3
N
, where the
production function becomes flat. Beyond
1
N
the N
MP
therefore, falls with N, that is
0 /
2 2
< ∂ ∂ N y , and the N
MP
exhibits a diminishing marginal product of labour.
With this information the firm’s labour demand decision can be examined. First, the
employment of one more worker will lead output to rise by the N
MP
. If the addition
to total output is sold in a competitive market, such that the price it sells for is the same as
that for all previous units, then marginal revenue received by the firm is the price of
output multiplied by the N
MP
;
N
MP P.

. This is called the marginal revenue product of
labour ( N N
VMP MRP ·
). Thus the profit maximization condition where by the marginal
cost of extra worker is the money wage, W, equals marginal revenue product of labour is
given as
WN K N y P − ·
− −
) , ( . π
------------------------------------------- (1)

0 ·


·
L
L
d
π
------------------------------------------------------ (2)

0 · −


· W
L
y
P

W
L
y
P MRP
N
·


· ·
--------------------------------------- (3)
This indicates that at equilibrium
N
MRP
is equal to nominal wage. Alternatively, labour
demand is also written in real term as

w
P
W
L
y
L
d
· ·


·
------------------------------------------------ (4)
The above expression entails that firms determine how much labour to hire by equating
w MC MP
L L
· ·
. The marginal cost of the firm is real wage. In Figure 1.16, the N
MP

55
falls as N increases, beyond
1
N
, the demand for labour is inversely related to real wage
rate. Since the price deflator used in the calculation of real wage rate is the price of the
firm’s output, this measure of real wage is referred as the real product wage.
(B) Aggregate labour demand
In the aggregate it is assumed that the demand for labour is the horizontal summation of
individual firm’s demand for labour, which gives the downward slopping curve as depicted
in Figure 1.17 below. The aggregate demand for labour function is therefore denoted as

) (N f
P
W
w L
d
· · ·
Or
) ( . N f P W ·
----------------------------- (5)
Where
) (N f
denotes the economy wide N
MP
schedule. Since the marginal product of
labour schedule falls as N increases
0 ) ( < N f
and the real product wage is inversely
related to the aggregate demand for labour.

P
W

P
W
0

) (N f
0
N
N

w



0
w



) ( . N f P



0
N
N
Fig 1.17: The aggregate Demand for labour

1.4.2 LABOUR SUPPLY
Introduction: The individual supplier of labour is assumed to supply labour in direct relation to
the real (consumption) wage. In developing the aggregate demand for labour, we do not make any
explicit assumption about price or wage expectation of employers on the demand side of the
labour market. This is because we assume that an employer has good information on or perhaps
control of the particular prices changed and the wage rate paid. The employer is thus in a position
56
to know the real wage at each point in rime. For the employer, this real wage (
w
) is the money
wage deflated by the particular employer’s product price ( P ).
However, a worker’s information concerning price level (and subsequently about his/her real
wage) is not adequate as that of the employer. This is because workers may not know in advance
exactly what products will they need to purchase with their money (nominal) wages and second,
even if they did, they do not know the exact prices (consumers price index) of the goods in
advance. Thus, a worker must deflate his/her nominal/known wage income (W) by a an estimated
consumers price index (CPI) or
e
P
that covers a wide range of products in order to arrive at an
estimated or expected real wage,
e
w . Therefore, an explicit assumption linking workers
estimation or expectations on price level (
e
P
) and the actual price level ( P ) is important.
Hence, it is important to note that the price deflator used by the worker when deciding the
amount of labour to supply is different from the price level used by the producer in determining
how much labour to employ. These two real wage rates are referred to as the expected wage-
e
P W / (or
e
w ) and the real producer wage- P W / (or
w
) respectively.
THE AGGREGATE LABOUR SUPPLY CURVE
This is obtained by summing all individual labour supply curves for a given expected
wage rate (
e
P
) to get the aggregate labour supply curve for the entire economy; that is

·N n
. Therefore, the aggregate supply curve of labour in expected price can be
represented mathematically as:
) (
e
w N N ·
In real value: 0 ); ( > ′ · · · g N g
P
W
w L
e
e s
----------------------------- (6a) or
In nominal value: ) ( . N g P W L
e s
· · ----------------------------------- (6b)
In equation (6a),
e
P W N g / ) ( ·

can be written in the current actual real wage (
w
) and
the level of employment, N , relationship by converting the expected real wage (
e
w ) in
to the actual real wage (
w
). By definition:
P
P
P
W
w L
e
e
S
. · · , by substituting
e
P
W
by
) (N g
from equation (6a)
P
P
N g w L
e
S
). ( · · ----------------------------------------------- (7a)
This is another version of equation (6a). However, the labour supply function in nominal
wage derived from equation (7) is similar to that of (6b). That is
) ( . N g P W L
e s
· · ---------------------------------------------- (7b)
Aggregate labour supply (
S
L
) derived in current actual real and nominal wage rather
than expected real wage (equation 7) are depicted graphically as follows,
57

w
) ( . N g
P
P
w
e
·


0
w




0
N
N

W ) ( . N g P W
e
·


0
W

0
N
N
Fig 1.18: Aggregate labour supply Curve
1.4.3. Frictionless Labour Market Equilibrium and the Aggregate Supply Curve
(A) Frictionless Labour Market Equilibrium (Classical equilibrium)
We have already derived that the aggregate demand and supply of labour equations in the
labour market, both as a function of real and nominal wage in equation (5) and (7)
respectively, as
) (N f w
P
W
L
d
· · ·
Or
) ( . N f P W ·
; equation (5)
) ( . N g
P
P
w L
e
s
· · Or ) ( . N g P W
e
· ; equation (7)
The labour market equilibrium is obtained by equating labour DD (
d
L
) to labour SS (
s
L
).That is,
• In real wage: ) ( . ) ( N g
P
P
N f
e
· ---------------------------------------- (8)
• In nominal wage:
) ( . ) ( . N g P N f P
e
·
---------------------------------- (9)
The graphic representation of labour market equilibrium is represented by the intersection
of the two curves indicated in equation (8) and (9) above. For a given value of actual price
level, 0
P
and the expected price level
e
P
equilibrium real and nominal wage are
0
w
and
e
w , respectively while equilibrium employment is
0
N
, and real income, 0
y
.
58
At point E the labour market clears. But this does not imply that there is zero
unemployment. Note that if all the workers are in employment the labour supply curve
would become vertical since no matter how high real wages were pushed up, there could
be no increase in employment because all workers are employed. In Figure 1.19 the level
of full employment is given at
F
N
. The distance between 0
N N
F

therefore denotes the
level of voluntary unemployment. The level of voluntary unemployment expressed as a
percentage of total labour force in an economy is usually referred to as the natural rate of
unemployment. The voluntary unemployment due to the labour market frictions is
frequently believed to consist of two specific kinds of unemployment, namely frictional
unemployment and structural employment.
Frictional unemployment is explained by the special characteristics that it takes time to
match workers to jobs. In reality however, workers have different preference and abilities
and jobs have different characteristics and the geographical mobility of workers is often
low. Hence, searching job takes time and effort and because different jobs require different
skills and pay different wage rates, unemployed workers may not accept the first job offer
they receive. The unemployment caused by the time it takes workers to search for a job is
called frictional unemployment.

w


) ( .
0
N g
P
P
w L
e
s
· ·



0
w
E

) (N f w L
d
· ·

0
N

F
N
N
W
) ( . N g P W L
e S
· ·



0
W
E
) ( . N f P w L
d
· ·


0
N

F
N N
Fig 1.19: Equilibrium in the labour market
As structural change occur in the economy, some industries of the country may decline and
some labour skill categories become redundant as others expand. This can lead to
structural unemployment.
59
Thus, the natural rate of unemployment or the level of employment consistent with the
labour market clearing is voluntary in the sense that the number of job vacancies is equal
to the number of workers seeking job. In other words, the natural rate of unemployment
means frictionless labour market equilibrium. It corresponds to the classical labour
market equilibrium. Because the classical assume that workers have perfect foresight of the
current and expected price levels and hence price and wage rates are flexibility conclude
that the labour market always clears both in the short and long run along the aggregate
supply (AS) curve. Thus any changes in unemployment are entirely voluntary.
(B) The Aggregate Supply (AS) Curve
Aggregate supply curve is derived from the aggregate labour market and production
function to give a direct relationship between output and price level for a given state of
technology and the work-leisure preference of workers.
The derivation of the AS curve is based on the labour market equilibrium expressed in
real and nominal wages as
s d
L L ·
. That is
(1) ) ( . ) ( N g
P
P
N f w
e
· ·
Real product wage or
L
MP = Real consumption (money) wage
(2) ) ( . ) ( . N g P N f P W
e
· ·
Actual money wage = Expected nominal wage
The degree to which the expectation of workers about
e
P
adjust to the movement of P is
given by
1 ' 0 ); ( ≤ ≤ · α α P P
e
------------------------------------------- (10)
Where, ' αis the slope of the price function (or P P
e
∂ ∂ / ) and its value lies between 0 and 1
Now let us see first what will happen to labour market equilibrium level of employment,
income, and wage (real and nominal) rates of the classical and extreme Keynesians as the
price level changes and then derive their aggregate supply (AS) curves. To do so, we
assume for simplicity the following two assumptions:
1) Initially both actual and expected prices are equal or
0 0
P P
e
· and
2) The price level rises from
0
P
to
1
P .
With these assumptions we can then derive the classical AS curve of the frictionless
(classical) and extreme Keynesians school of thoughts by examining what happens to the
equilibrium level of employment, income and wage rates for a closed economy (an
economy without international trade)as price level increases exogenously?
a) The extreme Classical case:
The basic assumption of the classical regarding the labour market is that there is complete
and correct adjustment or perfect foresight of
e
P
to P .That is
P P
e
∆ · ∆
and hence 1 · α
in equation (10) above. This assumption stems from its two core assumptions about the
aggregate economy: price and wage flexibility and economic agents are rational.
60
When
e
P
moves by the same proportion as P rises from 0
P
to
1
P or 1 · α , the ratio of
P P
e
/ remains unchanged. This is evident from Figure 1.20(a) below that when the
expected price
e
P
fully adjusts to the change in the actual price the labour market
equilibrium remains at point A leaving the initial labour market equilibrium value, 0
w
and
0
N
space undisturbed. This is known as the classical result, in which movements of the
price level do not affect equilibrium level of employment and real wage.
In the second figure, however, an equal (proportional) increase of P and
e
P
shifts the
labour demand and supply curves up by the same amount (magnitude), again leaving
0
N
undisturbed. In Figure 1.20(b), the exogenous increase in actual price from
0
P
to
1
P shifts
the labour demand up (or to the right) from the initial
) ( .
0
N f P
to ) ( .
1
N f P . This is
because, the increase in price level reduces real wage and hence encourages employers to
demand more labour and increase production. The rise in the price level can be shown by
the vertical distance AB , because the price level is combined multiplicatively with the
marginal product of labour increase.
On the supply side of labour market, the higher price level translates into a higher
consumer price index (CPI), so workers will perceive a fall in their real wages, and so
contract/reduce their labour supply to the labour market. As a result, the labour supply
curve shifts up (to the left) proportionally as far as the demand curve from ) ( .
0
N g P
e
to
) ( .
1
N g P
e
. This proportional shifts the labour demand and supply curves in turn hold
equilibrium employment at
0
N
.The implication of proportional shift of labour supply to
that of labour demand is that MC has increased by the same proportion to that of MR. With
employment fixed at
0
N
output (
0
Y
) also becomes fixed at
) , (
0 0
K N f Y ·
in figure
19c. Therefore, we can conclude that with 1 · α or perfect foresight of
e
P
to P only the
nominal wage rate ( 0
W
) rises by the same proportion to the increase in price level,
holding equilibrium real wage, employment, and income constant at 0
w
, 0
N
,and 0
Y

respectively.
The insensitivity of equilibrium level of employment ( 0
N
) and output/income ( 0
Y
)
when the price level rises from 0
P
to
1
P
due to perfect foresight ( 1 · α )of workers
about the change in price in a closed economy give us a VERTICAL AGGREGATE
SUPPLY CURVE of the classical as shown in Figure 1.20(d).

w

) ( .
0
N g
P
P
L
e
s
·

0
w
A
(a)
61
) (N f L
d
·
0
N
N
W ) ( .
1
N g P
e

) ( .
0
N g P
e



1
W
B
(b)
0
W
A

) ( .
1
N f P

) ( .
0
N f P


0
N
N
Y Y


) (N Y
(c) 0
Y

0
45
0
N
N
P ) ), ( ), ( (
*
EP N f N g Y AS Y · ·


1
P
B′
(d) 0
P
A′

0
Y
Y
Fig 1.20: The Classical Labour market equilibrium and Aggregate supply (AS) curve

b) The extreme Keynesians Case:
This is the opposite of the extreme classical case. That is, the extreme Keynesians assume
zero (no) adjustment of the expected price level (
e
P
) as the actual price level changes
from 0
P
to
1
P . Hence, when
e e
P P
1 0
· or 0 · α , implying imperfect foresight (myopia or
shortsightedness) or complete money illusion. This is because of the assumption of price
and wage rigidity and static expectation of economic agents about price level.
62
With
e
P
constant as the price level changes labour supply depends only the money
(nominal) wage rate-W . When there is no adjustment of
e
P
to P , only the demand for
labour curve shifts to the right along the unchanged labour supply curve from
) ( .
0
N f P

to the higher
) ( .
1
N f P
in figure 1.21b due to the decline in real wage. Since the increase
in the price level has shifted only the labour demand curve, but not the labour supply
curve, employment raises from 0
N
to
1
N
and the nominal wage from 0
W
to
1
W
. Hence,
unlike the classical case where the nominal wage raises proportional to the change in the
price level nominal wage in the extreme Keynesian case rises by less than the rise in the
price level for expected price (
e
P
) is fixed due to myopia.
The less than increase in nominal wage than the price level is then followed by a decrease
in real wage (see panel Figure 1.21a). In Figure 1.21a, the rise in P with unchanged
e
P
reduced the ratio of P P
e
/ from
0 0
/ P P
e
to
1 0
/ P P
e
and hence shift the labour supply curve
in the
N w,
space to the right. Thus, the rigidity of price expectations at
e
P
0
on the supply
side of the labour market permits a reduction of the real wage rate as the price level
increases, inducing an increase in equilibrium employment from 0
N
to
1
N
(see panel a
and b) and hence output/income from 0
Y
to
1
Y
(see panel c).
With
e
P
given and not responsive to changes in actual P ( 0 · α ), the above equilibrium
condition in the labour market not only gives the equilibrium employment N depending on
the price level P but also the aggregate SS curve with a positive slope. This is because as
price increases, shifting the labour DD up, the labour market equilibrium N moves up
along the given labour supply curve in the
N W,
space. Therefore, if the money illusion
assumption or 0 · α holds the labour SS curve is constant, generating an increase in
employment and output and upward sloping AS curve.
The extreme Keynesians are criticized on the ground that the assumption of 0 · α is
appropriate to examine the impact of the movements of price level on equilibrium level of
employment and output during the market period (i.e., very short period of time where
supply cannot respond to demand) when the labour force has not had time to absorb new
price information on price level and adjust
e
P
to P . This criticism gave rise to the new
(general) Keynesian theory of labour market, which postulate though the degree of
adjustment of workers expected price to actual price improves with the availability of
information in the long run, the shape of the aggregate supply curve is always upward
sloping and the equilibrium level of employment and output higher than the classical but
lower than the extreme Keynesians.

w

) ( .
0
0
0
N g
P
P
L
w
s
·

) ( .
1
0
1
N g
P
P
L
e
s
·

0
w
A (a)
63

1
w
B


) (
0
N f L
d
·
0
N

1
N
N
W
) ( .
0
N g P
e


1
W
B
(b)
0
W
A

) ( .
1
N f P

) ( .
0
N f P

0
N

1
N
N
Y Y


1
Y B
) (N Y


0
Y
A
(c)


0
45
0
N

1
N N
) (
e
P P Y AS Y − + · ·

α
P


1
P
B′
(d)
0
P
A′


0
Y

1
Y
Y
Fig 1.21: Labour market Equilibrium and AS curve for extreme Keynesian
1.4.4. The New Keynesian view of the labour market
This model is some how in between the two extreme (polar) assumptions-the extreme
classical and the extreme Keynesian. The aggregate supply curve of in the general
Keynesian model, at least in the short run, in which 1 0 < < α . That is, the model in which
expectations adjust to changes in the actual price level, but not fully. It could be labeled as
imperfect foresight model.
In Figure 1.22 below, adjustment of the labour market equilibrium to an exogenous
increase in the price level from 0
P
to
1
P
by less than the exogenous increase in P .
Figure 1.22(a) shows that the increase in P reduces the ratio of the expected to actual
price level from
0 0
/ P P
e
to
1 0
/ P P
e
since adjustment expectation is less than perfect or
64
1 < α . This shifts the labour supply curve down in the
N w,
space reducing real wage
and increasing employment from 0
N
to
1
N
. The same movement is also shown in the
N W,
space of Figure 1.22( b )where we see the increase in P shifts the demand curve
up from
) ( .
0
N f P
to
) ( .
1
N f P
while the rise in
e
P
shifts the labour supply curve up,
but only by less than the movement in the demand curve, from
) ( .
0
N f P
e
to ) ( .
1
N f P
e

and cutting the demand curve at point C in stead of at point B , since 1 < α .
Furthermore, the excess demand for labour at 0
W
pulls up the nominal wage to
1
W
, an
increase less than proportionate to the price level, since dP dP
e
< . Thus, employment rises
to
1
N . The movement in employment is translated to the change in output in Figure
1.22(c), using the production function. Finally, an upward sloping aggregate supply curve
passing through (
0 0
,Y P
) and (
1 1
,Y P ) pairs is obtained in panel d . This implies that the
less than perfect foresight assumption eliminates the verticality and flatness of aggregate
supply curve of the classical and extreme Keynesian, respectively.


) ( .
0
0
0
N g
P
P
L
w
s
·

) ( .
1
1
1
N g
P
P
L
w
s
·


0
w

1
w


) (N f
0
N
1
N N
) ( .
1
N g P
e
B ) ( .
0
N g P
e

1
W D C

0
W
) ( .
1
N f P

) ( .
0
N f P

0
N
1
N N

) (N Y

1
Y

0
Y
65
0
N
1
N
N

) (
e
P P Y AS Y − + · ·

α


1
P
0
P

0
Y

1
Y
Y
Fig 1.22: Labour market Equilibrium and AS, the New (general) Keynesian case
EXCERSISE 1.5:
(1) Suppose the production function and
labour supply are given
2
5 . 12 800 ) , ( L L K L y y − · · ; and
2
5 . 2 380 L L L
s
+ · ,
respectively. Further, assume that the price levels in period zero;
1
0
· P
and it has
doubled in period 1; that is
1
1
· P
. Given this information,
A) Calculate the equilibrium
employment ( L ), output (
y
), money (nominal) wage and real wage for the
extreme Classical, extreme Keynesian, and New Keynesian case in real and
nominal term.
B) Discuss the reasons why the
results you have obtained in question 1A above happened to be and show the
results graphically.
C) Derive the AS curve for the
three cases and show the results in 1A graphically.
(2) Using the labour market equilibrium,
equation (9) and equation (10) and assuming expectations are perfect initially and set
the price index 1 · P
A) Derive the slope of Aggregate Supply curve algebraically
B) Evaluate whether the slope of the Aggregate Supply (AS) curve of extreme
Classical, extreme Keynesian, and new Keynesian are positive, negative or
zero
C) Show also the values of dP dN / for the three cases is similar to that of
dP dy /
66
CHAPTER 2: MACROECONOMICS DYNAMICS
2.1 Economic growth and technical growth
2.1.1Economic growth:
Economic growth is an expansion of an economy’s productive potentials over a long
period of time. It is concerned with the long term sustainable trend rise in output than short
term fluctuation. In other words, the dynamic behavior of macroeconomics is concerned
with the rate of change of key economic variables overtime.
Thus, economic growth is thus expressed as the change in income or output ( Y ) level
overtime as follows:
Economic growth
Y t
Y
Y
Y 1
.


· ·

------------------------------------------- (2.1)
Where,

Y
read as Y hat is the time deviation or change in the level of output or GDP and
t is time. That is,
t Y Y ∂ ∂ ·

/
or simply 1 −
− · ∆
t t
Y Y Y
. To express growth rate in
percentage we should multiply it by 100.
For instance, according to MoFED (2006) macro data real GDP in Ethiopia in 2003 and
2004 fiscal year were Birr 16,941.5 and 18,900.9 million respectively. Thus, economic
growth in 2004 was:
% 6 . 11 100
5 . 941 , 16
4 . 1959
5 . 941 , 16
5 . 941 , 16 9 . 900 , 18 ) ( 1
.
2003
2003 2004
· ·
,
`

.
| −
·

·


·

x
Y
Y Y
Y t
Y
Y
Y
From the above example, the value of equation (2.1) is 0.115657. But when multiplied by
100 and rounded to one decimal digit it becomes 11.6%.
67
The above simple analysis raises the question what are the potential sources of economic
growth? The neo-classical growth model, developed by Solow in 1956, postulates that
growth rate is derived by the rate of growth of the labour force and technical growth.
However, the endogenous growth model, which is alternative classification of technical
progress and considers the principles of to the neo-classical growth model, suggests that
savings/investment are an important factor in determining the level of economic growth.
2.1.2 Technical progress (Total factor productivity)
The study of the potential sources of economic growth stems from the aggregate
production function which links factor inputs to output for a given level of technology.
That is
) , ( N K AF Y ·
----------------------------------------------------------- (2.2a)
To keep the analysis simple consider a Cobb-Douglas constant return-to-scale (CRS)
production function
α α −
·
1
N AK Y ----------------------------------------------------------- (2.2b)
Where, Y is the level of output; A represents the state of technology; and K and N are
capital and labour inputs. In equation (2.2b),
α
is the share of capital in output and α − 1
the share of labour input in output.
Differentiation of (2.2b) with respect time gives the rate of change of output overtime,
which can be written as
N t
N
K t
K
A t
A
Y t
Y 1
) 1 (
1 1 1


− +


+


·


α α
------------------------------------ (2.3a)
Or using the hat notation as
N
N
K
K
A
A
Y
Y
∧ ∧ ∧ ∧
− + + · ) 1 ( α α
-----------------------------------------------------
(2.3b)
Thus, the rate of growth of out put or simply economic growth is identically equal to the
rate of change of technology (technical progress

A A/
), called total factor productivity
(TFP) plus the rate of growth of each factor inputs multiplied by their respective shares in
total output (that is,
α
for capital and α − 1 for labour). Equation (2.3b) is called the
growth accounting.
Technical progress or total factor productivity is the amount by which output would
increase as a result of improvement in methods of production with all factor inputs
unchanged and is distinct from labour productivity
10
.
10
Labour productivity is the ratio of output to labour input
y N Y · /
. Labour productivity may grow because of
the improvement in capital inputs per worker, k N K · /
68
The problem with equation (2.3b) is that the growth of total factor productivity (TFP)
cannot be measured directly. Solow (1957) derived an estimate of TFP by inverting
equation (2.3b) and driving TFP as a residual as shown in equation (2.4) below. This
measure of TFP is therefore sometimes referred to as the Solow residual. Due to his
inability to describe why this TFP occurred and its growth process Solow called it simply
‘Manna from heaven’.
N
N
K
K
Y
Y
A
A
TFP
∧ ∧ ∧ ∧
− − − · · ) 1 ( α α
---------------------------------------- (2.4)

To understand the applicability of equation (2.4) let us use a simple example. Suppose
capitals share of income (
α
) is 0.3 and that of labour ( α − 1 ) 0.7. Then if the labour force
grows (or
N N/

) by 1 percent, the capital stock grows (or
K K/

) at 3 percent with the total
factor productivity of 1 percent, then the growth rate of output must be, by accounting
identity of equation (2.3) be 2.6 percent. More examples are shown in table 2.1 below.
Table 2.1: Growth accounting for selected countries
Countries Growth rate
of GDP (
Y Y/

)
Growth rate contribution of Growth rate of
Capital
) / ( K K

α
Labour
N N/ ) 1 (

−α
TFP
(
A A/

)
Capital
(
K K/

)
Labour
(
N N/

)
GDP per
worker(
N Y/

)
USA 3.1 0.9 1.2 1.1 2.7 1.8 2.2
Japan 3.73 2.28 0.67 0.78 6.84 1.005 2.725
Germany 1.8 1.28 -0.49 1.01 3.84 -0.735 2.535
Source: Summer and Heston (1991) for USA and Maddison (1991) for others, and own calculations for the last
three columns
Note: The figures in the table are for the period 1960-1990 for the USA and 1973-1987 for other countries.
: The value of 3 / 1 · α is used in the calculation
Given the value of 3 / 1 · α , how the growth rates of capital and labour and GDP per
worker, shown in the last three columns, are calculated is illustrated as follows. Example,
for USA the growth rate of:
(3) The growth rate of capital is
calculated from the growth contribution of capital = 0.9. That is
9 . 0 ) / ( ·

K K α
9 . 0 ) / ( 3 / 1 ·

K K
7 . 2 ) 3 ( 9 . 0 / · ·

K K
(4) The growth rate of labour:
2 . 1 / ) 1 ( · −

N N α
2 . 1 / ) 3 / 1 1 ( · −

N N
2 . 1 ) / ( 3 / 2 ·

N N
69
8 . 1 2 / ) 2 . 1 * 3 ( / · ·

N N
(5) The growth rate of GDP is simply the
growth rate of GDP less the growth contribution of labour. That is,
N N Y Y y / /
∧ ∧ ∧
− ·
3 . 1 8 . 1 1 . 3 · − ·

y
2.2 Stylized facts
1. There are significant variations in the per capita income across countries. For example,
Jones (2000, page 56) documented that a typical person in the United State earns the
annual income of a typical person in Ethiopia in less than ten days.
2. The rate of economic growth varies across countries. Between 1960-1990 average
growth of the USA and Tiger countries was 1.4% and 5%, respectively while some
African countries had negative economic growth.
3. Growth rate of many countries is not constant or sustainable but it fluctuates.
4. A country’s position in the world is not fixed. That is countries which were poor in the
past are now growing fast and catching rich countries. China which grows by double
digits over the past 20 years is the best example in this regards. Some contraries whose
economic growth and per capita income were relatively better than others in the 1970’s
are now growing slower and lagging behind their counter parts. For example,
Ethiopia’s economic growth and per capita income which were better than that of
South Korea in 1975 are now not only incomparable to the economic growth and per
capita income of South Korea but also is one of the least in the glob
11
.
5. Economic growth and investment in human capital or education are highly correlated
due to the later contribution in ensuring social equity and improving labour
productivity.
6. Both skilled and unskilled workers are migrating from poor countries to rich countries,
which is contradictory to what economic theory postulated regarding the flow of
resources. Economic theory postulate resources should flow from where they are
abundant to where they are scarce. Thus, though the migration of unskilled labour
from developing countries to developed countries is consistent with what economic
theory postulate the migration of skill skilled workers or brain drain of developing
countries against economic theory.
2.3 Growth models
Theories of economic growth are concerned with the rate of long run equilibrium growth that
is with the rate of growth of output that yields full employment of labour and capital. Rising
unemployment of labour would, by definition, violate the full employment assumption, and it
would probably would be accompanied by the deficient demand and falling prices. On the
other hand, under utilization of capital stock would drive profit and investment incentives
down, reducing investment and the demand for output.
2.3.1The Solow Model
The neo-classical Solow growth model is based on the following six assumptions.
11
Jones (2000), “Introduction to Economic Growth” explains this fact adequately
70
1) Because the economy is assumed to be closed and there is no public sector, in
equilibrium investment will be equal to savings. That is,
I S · ------------------------------------------------------------------------- (1)
2) Savings are assumed to be proportional to income. That is,
sY S · ----------------------------------------------------------------------- (2)
Where
s
the MPS and assumed to be 1 0 < < s
3) It is assumed that no technological progress, such that
0 ·

A
in equation (2.4)
4) The change in capital stock overtime

K
is
dt
dK
and is equal to gross investment, I
less depreciation ( d ) times capital stock ( dK ). That is,
dK I K − ·

------------------------------------------------------------------ (3)
5) The labour force, N is assumed to grow at a constant (equal to population growth),
exogenous rate of
n
. That is, the rate of growth of labour force is
n
N
N
t
N N
· ·



/
------------------------------------------------------------ (4)
12
6) The neo-classical assume a constant rate to scale (CRS) production function such that
) , ( K N F Y ·
.CRS means that multiplying all factor inputs by, z will give an increase in
output by z . Formally,
) , ( zN zK F zY ·
----------------------------------------------------------- (5)
In other word, if we double labour and capital inputs are doubled, then output will also
double. With these assumptions, the production function can be written in per capita
income form. To do this let N z / 1 · , then the production function becomes

,
`

.
|
· 1 ,
N
K
F
N
Y

) (k F y ·
------------------------------------------------------------------ (6)
In equation (6) lower-case letters denote variables measured relative to population.
Hence,
y
is output per head/worker, N Y / , and capital per head/worker is N K k / · .
Hence, the equation is per head production function, in general form, which depends only
on capital per head/worker- N K k / · . As a result increasing both K and N by the
same proportion will not change
N Y y / ·
. Thus, there is no gain in output per head from
increasing both labour and capital as long as N K / ratio,
, k
is the same because of the
assumption that the production function exhibits CRS. The per capita production function is
illustrated in Figure 2.1.

N
Y
y ·

) (k f y ·
12
If 01 . 0 · n , then the labour force and population are growing at one percent per year.
71

N
K
k ·
Fig 2.1: The per capita production function
The marginal productivity of increasing the capital-labour ratio is positive but diminishing.
That is, the first order derivative is positive or
0 ) ( > k f
k and the second order derivative is
negative or
0 ) ( < · k f
kk . If the production function is assumed to take the Cobb-Douglas
form as in equation (1), then there are CRS since the factor shares sum to unity. In per
capita term the Cobb-Douglas form is written as
α α −
·
1
L AK Y

α
α
α α α
Ak
N
AK
N
N AK
y · · ·
− 1
---------------------------------------------- (7)
This production equation is sometimes called the AK model. The marginal productivity of
k is given as
0
1
> ·


·
− α
αAk
k
y
MPk
And the second order derivative;
0 ) 1 (
2
2
2
< − ·


·


− α
α α Ak
k
y
k
MPk
Which is negative because 0 < α and hence
0 ) 1 ( < − α
. This shows that the MPk is
decreasing with additions to k ; that is the production function is concave downward as
shown in figure 2.2.
From the per capita production function, equation (6), it should be apparent that the growth
rate of GDP per capita is going to be determined by the growth rate of capital per head-
k , which is written as (using assumption 5)
N K k
N
K
k log log log − · ⇒ ·

N
N
K
K
k
k
∧ ∧ ∧
− · ⇒
--------------------------------------------------------------- (8a)
Recall also
k y k y log log α
α
⇒ ⇒ ·

k
k
y
y
∧ ∧
· ⇒ α --------------------------------------------------------- (8b)
Using the assumption that growth over time of capital stock is equal to investment less
depreciation, equation (3); that savings equal to investment, equation (1), and that savings
are directly related to income from equation (2), and substituting into equation (8a)
72
n
K
dK I
k
k


·

, equation (3) and (4) substituted into equation (8a)

) ( n d
K
sY
k
k
+ − ·

, equation (1) then equation (2) substituted. Multiplying both sides by k
gives
k d n
K
sY
k k ) ( + − ·

, we know N K k / · . Substituting this in the first tern for k we
get
k d n
K
sY
N
K
k ) ( + − ·

, this can be rearranged as
k d n
N
sY
K
K
k ) ( + − ·

, we know that K K / cancels out and finally substituting
N Y y / ·
,
k d n sy k ) ( + − ·

-------------------------------------------------------- (9)
Equation (9) is the fundamental dynamic equation for the neo-classical SOLOW
GROWTH MODEL and known as the capital accumulation equation in per worker terms.
The equation says that the change in capital per worker each period is determined by three
terms: investment per worker,
sy
increases

k
; depreciation per worker dk reduces

k
, and
change in labour force, nk which reduces capital per worker

k
.
In the steady state or equilibrium, when
0 ·

k
, equation (9) will be
k n d sy ) ( + ·
-------------------------------------------------- (10a)
Equation (10a) says that the proportion of income per head/worker that is saved must be
equal to the rate of growth of capital per head. In other words, to maintain continuous full
employment, savings per head must be sufficient to replace the worn-out machines dk
and to purchase new machinery in sufficient quantity to keep the growing of population
employed nk .
Dividing both sides of equation (10) by sk we get;
s
n
k
k f
k
y α +
· ·
) (
----------------------------------------------------- (10b)
The two rays from the origin are
k n ) ( δ +
and
s n / ) ( δ +
. The first and second rays are
shown in the last term of equation (10a) and (10b) respectively. The Solow model is
illustrated graphically as follows.
73
The flatter ray
k n ) ( δ +
represents the saving/investment requirement of the model or the
amount of new investment per person required to keep the amount of capital per worker
) (k
constant-both depreciation and the growing of workforce tend to reduce the amount
of capital per person in the economy. By coincidence the difference between the two
curves is the change in the amount of capital per person
) (

k
.In the lower panel of the
figure the dynamics of adjustment are shown such that at any level of k , other than


k
, the
model automatically converges back to


k
.

,
`

.
| +
s
n δ

y

) (k f y ·
0
y


k n ) ( δ +
Consumption

sy
E
α
sk k sf sy · · ) (
0
s
0
i

*
k


k

* *
k k


k


*
k


k

* *
k k
Fig 2.2: Solow growth model equilibrium
To consider a specific example, suppose an economy has an initial capital-labour ratio of
*
k today as shown in Figure 2.2 above. What happens overtime? At
*
k the amount of
savings/investment per worker or per head of the population,
1
s
exceeds the amount of
savings/investment required to keep capital per worker
) (k
constant; that is to replace the
worn-out machines and fully employ the workforce. Thus, capital deepening occurs or
capital-labour ratio
) (k
will increase over time. Indeed, this capital deepening will
74
continue until k reaches


k
, at which
k n sy ) ( + · δ
, so that
0 ·

k
. At this point the
amount of capital per worker remains constant, and we call such a point a steady state.
Similarly when the economy starts at an initial capital-labour ratio of
* *
k the amount of
new investment coming from saving is insufficient to keep the growing labour force fully
employed. In other words, the amount of investment per worker provided by the economy
is less than the amount needed to keep capital per worker
) (k
constant; the term
0 <

k
is
negative, capital widening is occurring. Therefore, since population growth is at a rate of
n
, the capital stock must increase be growing at the rate of
n
and hence the economy as a
whole is growing at rate
n
.
The model can now be used to understand determinants of economic growth. In this
section we will examine what happens to the per capita income in an economy that begins
in steady state but then experiences a “shock”. The two shocks we will consider are the
increase in saving rate and the increase in the rate of population growth.
Comparative statistics
1) The increase in saving rate
Consider the economy has arrived at its steady state value of output per worker. Now
suppose that consumers in an economy decide to increase the saving/investment rate
permanently from
1
s
to
2
s
. An increasing in saving rate can come from a cut in the implicit
tax rate (inflation) on saving through a change in the tests of individuals between
consumption and saving. What happen to k and
y
?
The increase in saving rate shifts the saving line upward from
y s
1
to
y s
2
in figure 2.3. At
the current value of capital stock
*
k , saving per worker now exceeds the amount of
investment required to keep the capital per worker constant, and therefore the economy
begins capital deepening again. This capital deepening continues until k n y s ) (
1
δ + · and
the capital stock per worker reaches a higher value indicated by
* *
k . From the production
function, we know that this higher level of capital per worker will be associated with higher
per capita income. That is, the level of income per head rises from 0
y
to
1
y
. The economy is
now richer than it was before.

y

1
y
) (k f y ·
0
y

k n ) ( δ +
B ) (
1 1
k f s y s ·

E
) (
0 0
k f s y s ·


75

*
k
* *
k
Fig 2.3: An increase in investment rate
2. The increase in population growth
Consider an alternative exercise. Suppose the economy has reached and its steady state, but
then due to immigration, for example, the population growth rate of the economy rises
from
n
to
1
n . Due to population growth, the
k n ) ( δ +
curve rotates up to the left to a new
k n ) (
1
δ + . At the current value of capital stock
*
k , saving per worker is now no longer
high enough to keep the capital per worker constant in the face of rising population.
Therefore, the capital per worker began to fall until the point at which
k n y s ) (
1 0
δ + ·

indicated by
* *
k . The economy has less capital per worker than it begins, and is therefore
poorer. The per capita income is ultimately lower after the increase in population growth in
this example.


y

) (k f y ·

1
y

k n ) (
1
δ +


0
y

k n ) ( δ +

E
) (
0 0
k f s y s ·
B



* *
k
*
k
Fig 2.4: An increase in the population growth rate
2.3.3. Endogenous Growth Models
The alternative model of growth process seeks to explain why the rich gets richer, that is why the
supply of capital does not flow from the rich countries to the poorer countries where the marginal
productivity of capital is higher. The reason must be that the marginal productivity of capital does
not in the rich countries despite the rising capital-labour ratio. The new growth theory, therefore,
is ultimately concerned with moving the assumption of diminishing returns to reproducible
factors of production, such as capital. This is achieved by the endogenous technical progress. In
the neo-classical model technical progress drives economic growth, although it does not offer any
explanation for technical progress. In other words,
g
, the labour-augmenting technical progress
is exogenous: in a common phrase, technology is like “manna from heaven”.
The endogenous growth theories, on the other hand, postulate that the extent of labour-
augmenting technical progress is endogenous in the model, depending on the capital-labour ratio
76
to generate sustained growth in per capita income. This is to say better technology is produced as
a by product of capital investment.
To be specific, we must follow Solow and introduce technological progress, which is labour-
augmenting or “Harrod - neutral”. As was in the case with Solow model, there are two main
elements in the Romer (1990) model of endogenous technological change: an equation describing
the production function and a set of equation describing how the inputs for production evolve
over time. The main equation is similar to the equations for Solow, with one important
difference. The aggregate production function in the Romer model describes how the capital
stock, K , and labour,
Y
L
, combine to produce output, Y using the stock of idea or human
capital, A.
α α −
·
1
) (
Y
AL K Y ----------------------------------------------------------- (1)
For a given level of technology, A, the production function in equation (1) exhibits a constant
return to scale in capital, K , and labour,
Y
L
. However, when we recognize that ideas
) ( A
are
also input into production, then there are increasing returns.
The accumulation equations for capital and labour are identical to those in Solow model. Capital
accumulates as people in the economy forgo consumption in some given rate
s
and depreciates
at the exogenous rate d .
dK Y s K
K
− ·

Labour grows exponentially at some constant and exogenous rate,
n
which is equivalent to
population growth. Using the notation, L , for labour than what we have used earlier N
n
L
L
·

In the Romer model, growth in

A
is endogenized. According to him,
) (t A
is the stock of
knowledge or number of ideas that have been invented over the course of history until time t .
Then,

A
is the number of new ideas produced at any given period of time. In short,

A
is equal
to the number of people attempting to discover new ideas,
A
L
multiplied by the rate at which
they discover new ideas

ω
. That is, the production function for new ideas can be written as
A
L A
− ∧
· ω
------------------------------------------------------------------ (2)
Labour is used either to produce new idea or produce output, so the economy faces the following
resource constraint:
A Y
L L L + ·
To proceed with the endogenous growth model, emphasizing on the economics of idea or human
capital we must make the following assumptions.
77
(1) The rate at which researchers discover new ideas (

ω
) may depend on the
stock of ideas that have already been invented.
For example, perhaps the invention of ideas in the past (that is
ω
) raises the productivity of
human capital or researchers in the present. In this case,

ω
would be an increasing function of
A. The discovery of calculus, the invention of computer and laser, and the development of
integrated circuits are examples of idea that have enhanced the productivity of the later
researchers. On the other hand, the most obvious ideas discovered first and subsequent ideas
become increasingly difficult to discover. In this case,

ω
would be a decreasing function of A.
This reasoning suggest modeling, the rate at which new ideas are produced (

ω
) as
β
ω ω A ·

---------------------------------------------------------------- (3)
Where,
ω
and
β
are constant. In equation (3), if
0 > β
it indicates that the productivity of
research increases with the stock of ideas that have already been discovered or simply a positive
knowledge spillover. This also most popularly known as the “standing on shoulders” effect
13
;
0 < β
corresponds to the difficulty of discovering subsequent ideas. Finally,
0 · β
indicates that
the tendency for the most obvious ideas to be discovered first exactly offsets the fact that the old
ideas facilitate the discovery of new ideas- i.e., the productivity of research is independent of the
stock of ideas.
(2) On the other hand, the average productivity of researchers depends on the
number of people searching for new ideas at ant point in time.
For example, perhaps duplication of efforts is more likely when there are more persons engaged
in research. One way of modeling this possibility is to suppose that it is really
λ
A
L , where λ is
some parameter between 0 and 1, rather than
A
L that enters in the production function for new
ideas. Thus, focusing on equation (2) and (3) suggests focusing on the following GENERAL
PRODUCTION FUNCTION FOR IDEA.
β λ
ω A L A
A
·

----------------------------------------------------------------- (4)
In equation (4), for example, if 1 < λ it reflects an externality associated with duplication; some of
the ideas created by an individual researcher may not be new to the economy as a whole of
“stepping the toes” effect.
Growth in the Romer model
What is thus the growth rate in the endogenous model along the balanced growth path? Provided
that a constant proportion of the population is employed producing ideas, the model follows the
neo-classical model predicting that all per capita growth is due to technological progress. Letting
lower-case letters denote per capita variables, it is easy to show that
13
In this regards, Isaac Newton who has benefited from the knowledge created by previous scientists such as
Kepler, in developing his theory of gravitational force has recognized in his famous statement, “If I look
farther than others, it is because I was standing on the shoulders of the giants”.
78
A k y
g g g · ·
That is, per capita output, the capital-labour ratio, and the stock of ideas must all grow at the same
rate along the balanced growth path. It implies that, if there is no technological progress, there is
no growth. Therefore, the important question is, “What is the rate of technological progress along
the balanced growth pats?” The answer to this equation is found by rewriting equation the
production (4). Dividing both sides of equation (4) by Ayields
. .
.
A
A
L
A
A
A
β
λ
ϖ ·

or

1 −
·
β λ
ϖ A L
A
or
.
1
.
.
β
λ
ϖ


·
A
L
A
A
A
--------------------------------------------------------------- (5)
Along a balanced growth path,
A
g
A
A


is constant. But this growth rate will be constant if and
only if the numerator and the denominator of the right hand side of equation (5) grow at the same
rate. Taking logs and derivatives of both sides of this equation
A
A
L
L
A
∧ ∧
− − · ) 1 ( 0 β λ
-------------------------------------------- (6)
Along a balanced growth path, the growth rate of the number of researchers must be equal to the
growth rate of the population – if it were higher, the number of researchers would eventually
exceed the population, which is impossible. That is,
n L L
A
A ·

/
. Substituting this into equation
(6) yields
A
g n ) 1 ( β λ − ·

) 1 ( β
λ

·
n
g
A -------------------------------------------- (7)
Thus the long run growth rate of this economy is determined by the parameters of the production
function for ideas and the rate of growth of researchers, which is ultimately given by the
population growth rate.
Comparative static: A permanent increase in the R&D share
What happens to the advanced economies of the world if the share of the population searching for
new ideas increases permanently? For example, suppose there is a government subsidy for R&D
that increases the fraction of labour force doing research.
Notice that technological progress in the model can be analyzed by itself – it does not depend on
capital or output, but only on the labour force and share of the population devoted to research.
79
Now consider what happens if the share of the population engaged in research increases
permanently. To simplify things slightly, let’s assume that 1 · λ and
0 · β
again; none of the
results are qualitatively affected by this assumption. It is helpful to write equation (5) as
. .
.
A
L s
A
A
R
ϖ ·

--------------------------------------------------------- (8)
Where,
R
s
is defined as the share of the population engaged in R&D – i.e.,
L s L
R A
·
. Figure 2.5
shows that what happens to technological progress when
R
s increases permanently to
R
s′
,
assuming the economy begins in steady state. In steady state, the economy grows along a balanced
growth path at the rate of technological progress,
A
g
, which happens to equal the rate of
population growth under our simplifying assumptions. The ratio
L L
A
/
is therefore equal to
ϖ /
A
g
. Suppose the increase in
R
s
occurs at time 0 · t with a population of 0
L
, the number of
researchers increases as
R
s
increases so that the ratio of
L L
A
/
jumps to a higher level. The
additional researchers produce an increased number of new ideas so the growth rate of technology
is also higher at this point. This situation corresponds to the point labeled “ X ” in the figure.

A A/


A L A A
A
/ / ϖ ·

X
n g
A
·
ϖ /
A
g
0 0
/ A L s
R


L L
A
/
Fig 2.5: Technological progress: An increase in the R&D share
At X , technological progress
A A/

exceeds population growth
n
so that L L
A
/ declines
overtime, as indicated by the arrows. As this ratio declines, the rate of technological change
gradually falls also, until the economy returns to the balanced growth path where
n g
A
·
.
Therefore, a permanent increase in the share of the population devoted to research raises the rate of
technological progress temporarily, but not in the long run.
80
CHAPTER 3: RECENT DEVELOPMENTS IN MACROECONOMICS
3.1 Rational Expectation (Ratex hypothesis)
Before discussing the rational expectations (Ratex hypothesis), it is essential to
understand the meaning of static and adaptive expectations used in macroeconomics and
how these expectations were formed before the Ratex hypothesis was developed.
Definition: Expectations are forecasts or predications by economic agents regarding the
uncertain economic variables which are relevant to their decisions. They are based on past
trends as well as current information and experience.
People make expectations about economic variables; say price level in three ways.
a) STATIC (NAÏVE) EXPECTATIONS:
What happened in the past or yesterday will happen today and in future. Therefore, since
inflation tomorrow will be the same as today and yesterday (that is, price level in period
P
t + 2
= P
t +1
= P
t –1
or P
t0
) there will be no change in equilibrium real wageworkers receive
(w
0
), level of employment (N
0
), and income (y
0
).
b) ADAPTIVE EXPECTATIONS HYPOTHESIS:
The pioneering work was done by Cagan
14
in 1956 and Nerlove
15
in 1957. According to
adaptive expectations hypothesis, economic agents expect the future to be essentially a
continuation of the past. They expect the future values of economic variables like prices,
incomes, wage rates, etc. to be an average of past values and to change very slowly. The
economic agents make the expected values of these variables equal to weighted average of
their present and past values. They revise their expectations in accordance with the last
forecasting error. Errors resulting from past behavior represent an important source of
information in forming future expectations. But such expectations are based on the
assumption that the economic agents expect them to change very little.
In short, adaptive expectations say what will happen tomorrow (say to price) is a function
of what has happened yesterday or in the past and some adjustments made today from the
errors of last period. For instance, peoples’ expectation made last year about this year
price level is given as,
) (
1 1 2 1 1 − − − − −
− + · ·
t t t t t t
e
t
P P P P P α
------------------------------- (3.1)
Equation (3.1) says that the expected price level (
e
t
P
) in year t ; that is current period/this
year- but expectations are made in the previous (last) year ( t t
P
1 − ) is equal to inflation or
price level in last year ( 1 − t
P
) plus adjustments made (
α
) about the previous year’s
mistake in forecasting the previous year or a year before( 1 2 − − t t
P
) and to price in that
14
Cagan, P. (1956), “The Monetary Dynamics of Hyperinflation”, in M. Friedman (ed), studies in the
Quantity theory of Money.
15
Nerlove, M. (1957), “Adaptive Expectations and Cobweb Phenomenon”, Quarterly Journal of Economics,
May
81
year ( 1 − t
P
). Then, expectations made two years before about last year expected price
level is

) (
2 2 3 2 1 2 − − − − − −
− + ·
t t t t t t
P P P P α
-------------------------------- (3.2)
Substituting equation (3.2) into (3.1) for 1 2 − − t t
P

gives
] ) ( [
1 2 2 3 2 1 1 − − − − − − −
− − + + ·
t t t t t t t t
P P P P P P α α
, rearranging this we
have

2
2
2
3
2
2 1 1 − −

+ − −
− + + − ·
t t
t
t t t
P P P P P α α α α

2
3
2
2 1
) 1 ( ) 1 (


− −
+ − + − ·
t
t
t t
P P P α α α α ----------------------- (3.3)
Equation (3.3) simply says that the expected price level depends on the past trend of price
or is the weighted average of past price levels, but the weights are ordered in such a way
that more recent prices have larger effect than more distant ones. As a result, adaptive
expectation is also sometimes called the Partial Adjustment Principle.
c) RATIONAL EXPECTATIONS HYPOTHESIS:
The idea of rational expectations was first put forth by John Muth
16
in 1961 who borrowed
the concept from engineering literature. His model dealt mainly with modeling price
movements in markets. By assuming economic agents optimize and use all information
available efficiently when forming expectations about the future, he was able to construct a
theory of expectations in which consumers’ and producers’ responses to expected price
changes depending on their responses to actual price changes. Muth pointed out that
certain expectations are rational in the sense that expectations and events differ only by
a random forecast error.
Muth’s notion of rational expectations related to micro-economics. The hypothesis did not
convince many economists and lay dormant for ten years. It was in the early 1970’s that
Robert Lucas, Thomas Sargent, and Neil Wallace applied to problems in macro-economics.
Basis properties of the rational expectations hypothesis
The Ratex hypothesis holds that economic agents form expectations of the future value of
economic variables like prices, incomes, wages, etc., by using all available and relevant
17
economic information to them in an intelligent fashion. This information includes the
relationship governing economic variables, particularly monetary and fiscal policies of the
government. That is, economic agents will incorporate all “news” as it comes in. News
would come from personal experience in buying and selling, from private contact or from
newspapers and from one’s own past prediction of errors. The last resource is especially
important for it brings the difference between the rational and adaptive expectations. Thus,
the rational expectations assume that economic agents have full and accurate information
about the future economic events.
Thus, with rational expectation the expected error is zero and the errors are not linked in
any way by a spiral correlation. This is an implication for the unbiased ness of rational
16
John F. Muth (1961), “Rational Expectations and the Theory of Price Movements”, Econometrica, July
17
It is important to recognize that this does not imply that consumers or firms have “perfect foresight” or
that their expectations are always correct.
82
expectations. That is, 1 1 1 1
) (
+ − + −
·
t t t t
P P
t – 1.
The implication is that the expectation made
in period 1 − t , of the prediction that will be made at time t about 1 + t
P
is equal to the
actual prediction at t -1 of P
t + 1
. In short, the expected forecast equals current forecast. This
is known as the law of ITERATED EXPECTATION. Rational expectation is also called
Model Consistence because it is as if everyone knows the model and uses this knowledge
fully.
The conclusion based on equation (3.3) is that, if 0 · α , then 1 1 − −
·
t t t
P P
which implies
static (naive) expectation; if 1 · α , then 2 3 1 − − −
·
t t t t
P P
, which implies adjustment are
perfect or rational.
CHAPTER 4: MACROECONOMICS THEORIES AND AFRICAN ECONOMIES
4.1 Introduction: The Classical and Structuralist School
83
Two schools of thoughts emerged to explain the applicability of the conventional
macroeconomic models in LDCs in general and in Africa in particular. These are the
orthodox approach and the structuralist view
4.1.1 The Orthodox approach (Classical and monetarists)
These schools of thoughts examine the short and long term behavior of the economy in
Africa. They argued that the problem in developing countries is caused by misallocation of
resources. This is mainly due to the huge hand of the government in the economy.
The solution to long run growth problems is getting the price right or enhancing market
mechanisms to address misallocation of resources. That is, pursuing non interventionist
domestic policies or reducing government intervention and the huge hand of the state in the
market so as to avoid market distortions and leaving the market to equilibrate demand and
supply. In other hand, following sound market economy and adhering strictly to the market
economy principles are vital for sustainable long run growth. In the short run however,
solving problems of inflation and balance of payment imbalances through tight monetary
and fiscal policies, devaluation of domestic currency to become competitive in international
trade and increase revenue export and reduce BP problem, and rise interest rate to increase
savings are the optimal solutions.
4.1.2 The structuralist view:
As the name implies structural rigidities within the domestic economy are the main factors
for low aggregate demand in LDCs. This school of thought is divided into the early and
recent.
(A) The early structuralist view:
This school of thought was dominant in 1960’s and 1970’5. Exports of developing countries
consist more of primary products. As a result the products have low income and price
elasticity of demand compared to that of manufacturing outputs of developed countries.
This in turn leads to continuous deterioration of terms of trade (TOT). That is when they
produce more, the price of their exports declined significantly.
The solution proposed by the early structuralist is moving to the production of industrial
goods under the protection of infant domestic industries to replace imported goods from
abroad in the long run. This argument is simply referred as the import substitution
argument. According to the early structural school thinkers this can be facilitated among
others through high tariff barriers on imported goods, providing subsidies of various forms,
and improving access to credit and foreign exchange.
(B) The recent structuralist view:
Taylor was the most notable and influential leader recent structuralist. The recent
structuralist focuses mainly on the short run stabilization or adjustment policies. They
questioned the validity of the orthodox policy prescriptions of tight monetary and fiscal
policies and devaluation to LDC economies and argued that monetary policy or increase in
money supply is only accommodative and not the cause of high inflation. According to
them, prices and wages are not flexible and the source of inflation in LDCs is slow
84
productivity growth in agricultural, the backbone of the majority of African countries, not
money supply.
Furthermore, they argued that the main causes of slow agricultural productivity and also
that influence monetary policy in LDCs are poor land tenure system, administrative prices,
and wage indexation. Consequently, given that working capital and imported inputs play a
significant role in terms of addressing structural rigidities and limited substitution
possibilities in production a policy package combined devaluation with tight monetary and
fiscal policies will lead to stagflation. To the recent structuralists, if prices and wages are
rigid monetary or fiscal policy becomes effective in the short-run. Hence, the solutions are
some degree of government intervention in the market is necessary to eliminate structural
problems/rigidities in production before applying the standard orthodox prescriptions. This
includes undertaking interventions related to export promotion and export diversification;
such as the provision of subsidy, tax-holiday, information, etc., to exporters
4.2 Basic Features of African Economies
The distinguishing macroeconomic features of African economy include more openness to
trade in both commercial and assets; the nature of the financial markets, different attributes
of both short and long run fluctuations; the nature of fiscal deficits; determinants of the
private sector credit behavioral function (biasness or preferential treatments of public sector
enterprises for credit); and the stabilization policy regimes.
1) Openness to trade
Relative to developed countries, African economy tend to be more open and to have little
control over the price of products they exports and import. The standard measures of degree
of openness are looking into the ratio of exports plus import to GDP and the tariff structure.
The implication of these characteristics is that:
(a) The standard open macro economy policies may not hold at all or are irrelevant
(b) Given their share in the world trade and composition of their exports they do not have
control over the prices of their exports and imports have huge policy implication. That
is, first they export primary products, which are not demand determined but supply
determined. Second, they are small relative to MDC and DC. Therefore, the standard
open economy model, which assumes endogenous TOT, has little use in explaining
their macroeconomic behavior.
2) The exchange rate regime
In contrast to MDC the vast majority of African economies have exchange rates either
fixed or pegged to a foreign country, which leads in most cases to exchange rate retention
or control. In many cases the actual exchange rate deviates from the equilibrium exchange
rate. Recently many African countries have adopted flexible exchange rate but not market
determined. That is they are administered rather than auctioned or demand and supply
determined. The Ethiopian exchange rate regime is called managed floating, which is
between the two extremes - fixed and flexible exchange rates;. Since it is only the financial
institutions who buy the foreign currency through the bi-weekly inter-banks auction
market, this indicates some degree of government influences over the exchange rate.
85
3) Capital inputs
Almost all African economies are net importers of capital (both physical and financial
capital). Therefore, dependence on foreign market is an important issue.
4) The role of the state
The state plays an important role in the production and distribution of goods and services
in LDCs. In MDCs, however, the private sector has the larger share in the economy as
compare to the public sector. The policy implications are:
(A) Imported intermediate goods play important role in the aggregate production function.
(B) An increase in cost of intermediate goods affect the exchange rate and the exchange
rate affects AS because we may import more or less unlike the MDCs where the
exchange rate does not enter into AS because their exchange rate is floating/flexible/
and do not import much intermediate goods.
5) The financial sector
The financial sector in LDCs is weak and inefficient. It is characterized by the prevalence
of rudimentary/underdeveloped financial market and financial repression. That is, the
financial sector is dominated by commercial banks with little or no secondary stock and
security markets, which implies allocation inefficiencies. The two most important
implication of underdeveloped financial sector in LDCs are financial dualism and financial
repression:
(A) Financial dualism: It is the coexistence of organized and
unorganized/traditional money markets in LDCs.
The organized money market consists of commercial banks and other financial
intermediaries, which lend short-term credit at low interest rates to the modern business
sectors consisting of big companies, large scale manufacturing enterprises, and the
government. On the other hand, the unorganized money market consisting of non-
institutional money lenders, such as village money lenders, traders, shopkeepers, or the
combination of some of them, which charge higher interest rates on loans. The main reason
is that there is real shortage of savings in the traditional sector as substantial amount of
savings is horded in gold and jewelry. As a result,
• not only a significant part of financial transaction takes place control and direct
policy reach of the central banks but also there is interest rate differential
• whatever monetary policy is to be practiced must be affected by other than open
market operation. Since the government debt with its artificially low interest rate is not sold
and bought in free market the monetary authorities/central bank cannot affect the monetary
base ( R D+ ). It is rather determined by the past and current government deficits and trade
balances.
(B) Financial repression/ compartmentalization: It is a policy of the state in terms of
financial sector where nominal interest rate ( r ) that the commercial banks pay on
their deposits and charge for their loan are kept low/hold down without taking into
account the demand and supply.
86
Credits are given to public enterprises on preference basis than on demand basis; implying
the private sector does not have adequate access to credit as the public enterprises. The
implication of financial repression is that the transmission mechanism and effectiveness of
monetary policy- that is as money supply increases interest rate declines, investment
increases, and hence output grows does no work in LDCs for interest rate is fixed.
6) Government budget
Most countries have huge budget deficits and hence the policy implication of budget
deficits has become an important issue.
7) Objectives of macroeconomic policies in LDCs
The main macroeconomics objectives of the MDC are full employment, increase output
and price and exchange rate stability. Apart from these LDCs have other issues to address
and objectives to achieve. These include among others:
(A) Exchange rate management: This is because there is an overvalued exchange rate in
most African countries
(B) Stabilization of high inflation: Achieving a targeted low level of inflation per annum
is the main objective of LDCs. Nevertheless, inflation in many African countries is
higher (for example in Zimbabwe it has now become around 2000%) than targeted due
to failure of stabilization policies to yield the desired target. Low level of investment,
slow output growth, high public expenditure and use appropriate budget deficits
financing mechanisms and in ability of managing imported inflation triggered such as
by the rise in oil prices, which rises mainly transportation cost are the main reasons for
high inflation in Africa.
(C) Debt management: Both the stock (what a country borrow) and flow (unsettled &
what are to be paid) of debt to GDP are very high in Africa. Full stock is defined if the
debt flow is greater that revenue generated from foreign trade. If they are equal it is
defined as constant stock. Even if debt is also very high in MDCs they can pay without
affecting the economy. Failure to achieve sustainable economic growth and mitigate
vulnerability to adverse natural calamities such as drought are among the major
reasons
(D) Reducing capital flight: Both the profits and assets of citizens usually transferred
abroad for security and/or other purposes

8) The characteristics of AD and AS curves in LDCs
 AGGREGATE DEMAND:
Before arriving at the AD curve in LDC, we should examine the four components;
aggregate real consumption (
c
), real disposable household income (
d
y
), real private
investment ) (
P
i , and net export ( NX ) of total DD for domestic output.
To examine the nature of AD in LDC we assume hereafter that world price
*) (P
is fixed
and the effect of a change in P on the IS curve is zero in the standard LDC model. The
AD curve is downward sloped in (
P Y,
) space like the standard MDC AD curve.
However, it is much steeper than MDC AD due to the following two reasons.
87
1) The IS curve, which shifts to the left in the standard MDC model when domestic
P level rises because of its effect on net exports, doesn’t shift in the standard LDC model
because exchange rate is fixed in LDC. In fact, the effect on NX shifts IS to the left in
MDC.
Recall that the export function is
) , ( e P x X ·
and P P e / * · . From the export function
0 / < ∂ ∂ P X . Because the increase in domestic price level (inflation) will reduce P P / *
implying the exchange rate has appreciated. This will in turn reduce the X of a country
where the price level has increased, reduce NX or CAB and thus shifts IS and AD to the
left.

2) However, the IS curve is steeper in LDC due to a high marginal propensity to import (
MPM ) and a low interest elasticity of investment DD.
P P
AD AD
Y Y
AD for Developed countries AD for LDCs
 AGGREGATE SUPPLY IN LDCs: The equation is given by
) , , , ( W e r P Y AS
S
·
Where, Price
) (P
and interest rate
) (r
are endogenous while exchange rate
) (e
and
nominal wage
) (W
are exogenous variables. Moreover,
0 / , 0 / , 0 / < ∂ ∂ < ∂ ∂ > ∂ ∂ e AS r AS P AS
, and 0 / < ∂ ∂ W AS . The main difference between
the standard LDC AS curve and that usually pictured for an MDC are the following.
1 The AS curve of LDC is flatter than MDC. The reason for this is that the MDC is
normally close to full employment with less nominal wage rigidity. In LDC however, it
is more frequently found not only unemployed labour but also an underutilized capital
stock. Thus, due to rigidity of nominal wages and excess ideal (unutilized) resources,
output can be increased without increasing employment (the supply of labour and
employment in an economy), which implies DMP
L
.
2 The second characteristic is that the increase in r affects AS of LDC through its effect
on the cost of working capital, which is scarce due to low saving in LDCs.
3 Changes in the exchange rate (
e
) shifts the AS curve in LDCs for the domestic price of
imported intermediate inputs and raw materials will be affected.
P AS P
AS

88


Y Y
AS for MDCs AS for LDCs
4.3 The Applicability of Conventional Theories to African Economies
Under this section the impact of restrictive fiscal policy and monetary policies on AD and AS
curves as well as the net effect will be covered.
4.3.1) Restrictive fiscal policy ( G ↓ ):
While restrictive monetary policy is likely to increase both unemployment and inflation in
LDCs in the short run, restrictive fiscal policy is likely to become more effective (successful)
in reducing the price level without the costs of a major recession. A decrease in G will shift
the IS curve to the left from 0
IS
to
1
IS
. This results not only in a small leftward shift of the
AD curve from
0
AD
to
1
AD but also a larger shift in AS to the right because interest rate has
fallen from 0
r
to
1
r
.
Finally, the net effect (result) is a decline in the price level
) (P
from 0
P
to
1
P
and possibly even an increase in output from 0
Y
to
1
Y
. In fact, in the standard MDC
model restrictive fiscal policy reduces both price and output. The increase in output in the case
of LDCs is that because the decline in domestic price level will reduce the cost of intermediate
inputs and raw materials (due to appreciation of domestic currency for real exchange rate or
P P / * has decreased). Graphically,
0
LM
0
r
0
E


1
r

1
E
0
IS

1
IS
89

1
Y
0
Y
0
AS

1
AS

0
P
0
E


1
P

1
E
0
AD

1
AD
0
Y

1
Y

Fig 4.1: The impact of concretionary Fiscal Policy in LDC
If the increase in output is small for the LDC, then import demand is affected very little.
This is because the reduction in G, which increases the government surplus will leave the
balance of trade surplus (or deficit) essentially unchanged. The cumulative effect is thus a
reduction in the monetary base (reserves) and as a result of which economic recession
appears (or will worsen) overtime
4.3.2) RESTRICTIVE (CONTRACTIONARY) MONETARY POLICY (↓Ms):
The standard result following of a decrease in
S
M
is to increase interest rate
) (r
, which
then reduces investment, output and P.
However, in LDCs reducing the money supply has a larger impact on LM curve (for a
given P level) because of the low interest elasticity of DD. The availability of low interest
rate on loans from commercial bank also reduces retained earnings, shifting the IS curve
down. The reason why the interest rate enters into the AS function in LDCs is that:
A) The interest rate in the formal market when auctioned is not high as in the
informal market
B) Cost of borrowing is very high for cost of collateral is very high
The impact of concretionary monetary policy is thus a relatively small horizontal shift in
the AD curve. And due to the flatness of the AS curve, any shift that does occur is
relatively ineffective in reducing the price level. In LDC, this restrictive monetary policy
also rises the AS curve to the left through the increase in the interest cost on variable
inputs.
The net impact for the MDC is that the price level falls and output declines moderately; for
LDC, output also falls, but the price level may increase. Therefore, in the short run
restrictive monetary policy has few appealing implications for the policy maker.

1
LM
90
0
LM

1
r

1
E
0
r
0
E
0
IS

1
IS
0
Y

1
Y


1
AS

0
AS

1
P

0
P
0
AD

1
AD
0
Y

1
Y

Fig 4.2: The impact of restrictive monetary policy in LDCs
REFERENCE BOOKS
1) Branson, William H. (1998), “Macroeconomics: Theory and Policy”, 2
nd
Ed.,
Universal Book Stall, 5 Ansari Road, New-Delhi-110 002 (India).
2) Dornbusch, R and Fischer, S. (1994), “Macroeconomics”, 2
nd
Ed.
3) Jones, C. (2000), “Introduction to Economic growth”, 2
nd
Ed.
4) Mankiw, G. (200), “Macroeconomics”, 3
rd
Ed.
5) Pentecost, Eric, (2000), “Macroeconomics: An open Economy Approach”, 2
nd
Ed.,
Macmillan Press LTD, London
6) Pilbeam, K. (1998), “International Finance”, 2
nd
Ed.
91
Quiz number 1:
1) Using the Cobb-Douglas production function
β β −
·
1
L aK y ,
A) drive and show that the
equilibrium capital stock rises with an increase in
y
and falls with an
increase in real user cost of capital in the flexible accelerator investment
model
B) Drive also the gross
investment assuming that the real user cost of capital remains fairly
constant overtime, ceteris paribus.
2) Assume that the valves of
, , C y
and P in an
economy are 10, 4, and 1respectivelly. Further, assume that
β
is 80% and net
saving ratio
) (s
is 40% in 2009. Further assume that the real user cost of capital
92
remains fairly constant overtime, ceteris paribus. Given these information, calculate
the value of
A) real user cost of capital
B) net investment (the change in
equilibrium capital stock) if output (
y
) increases to 12 in 2010
C) growth rate of output in the
economy in 2010 that would maintain supply equal to demand
D) output change
E) gross investment, if the
depreciation rate of capital stock in the economy (δ ) is 10% in 2010
93

CHAPTER ONE SECTORAL DEMAND THEORIES AND FUNCTIONS
Introduction: How do households decide how much to consume today and in future? We care about this decision because consumption is the largest component of aggregate demand and saving is one of the determinants of growth. Thus, knowledge about how do households arrive at this decision and what factors affect their decision making is critical. 1.1 Theories of Consumption and consumption expenditure 1.1.1 Keynesian Consumption theory: The absolute income hypothesis (AIH) Keynes postulates three complementary propositions/assumptions: 1. Consumption will rise as disposable income rises. In other words, income is the most important determinant of consumption. That is the higher the income of a household the higher will be consumption. 2. The MPC is positive and less than 1. This is to mean the increase in consumption will be smaller that the increase in disposable income. \in other words households spend less that their total income 3. APC ( c / y ) is greater than the MPC but assumed to fall as income rises. The implication is that on average the rich spend less of their income than (or saves more than) the poor. Algebraically, Keynes’s short-run consumption function is given by − c = c + βy ---------------------------------------------------------------- (1) Where c is autonomous consumption and β is c ′ or the MPC and is greater than 1 (by the first proposition). Graphically, the function is shown in Figure 1.1, which plots consumption expenditure ( c ), against real income ( y ). This function indicates the observation that as income increase people tend to spend a decreasing percentage of income, or conversely tend to save an increasing percentage of income(by the second proposition). The slope of the line from the origin to a point on the consumption function gives the average propensity to consume (APC) or the c / y ratio at that point. The slope of the function itself is the Marginal Propensity to Consume (MPC). From the graph it is clear that the MPC is less that APC. If the ratio of c / y falls as income rises, y c the ratio of increment in c ( ∆ ) to the increment in y ( ∆ ), or c ′ (MPC), must be c / y . Keynes saw this as the behavior of consumer expenditure in the shortsmaller than run- over the duration of a business cycle- reasoning that as income falls relative to the recent levels, people will protect consumption standards by not cutting consumption proportionally to the drop in income, and conversely as income rises, consumption will not rise proportionally.

2

c

E
c( y )

s1 c1

B A

c

y
y1 y2

Figure 1.1: Keynes Consumption Function (absolute income hypothesis) The line OE is the 45 0 line along which all income is consumed. At income level y1 , c s consumption is given by O 1 , while savings are given by O 1 and represent that amount of income not spent. The average propensity to consume ( c1 / y1 ) is represented by the slope of line OA . The figure also represents APC declines as income increases. Suppose now that income increased from y1 to y 2 . The APC is now given by the slope of the line OB , which is less than the slope of OA and hence APC has declined. The acceptance of the theory that MPC < APC ; so that as income rises c / y falls led to the formulation of stagflation thesis around 1940. It was observed that if consumption follows this pattern, the ratio of consumption demand to income would decrease as income rises. The problem for fiscal policy that the stagflation thesis poses can be seen as follows. If
y = c + i + g or 1 =
c i g + + ------------------------------------- (2) y y y

is the condition for equilibrium growth of real output ( y ), and there is no reason to assume that the ratio of private investment to income ( i / y ) will rise as economy grows, then government expenditure to income ( g / y ) must rise to balance the consumer expenditure to income ( c / y ) drops to maintain full-employment demand as y grows. In 1946, Simon Kuznets published the first long-run time-series data for the USA for the period 1869 -1929 a study on consumption and saving behavior dating back to the Civil War (1865). Kuznets’ data pointed out two important things about consumption behavior. First, it appeared that on average over the long-run the ratio of consumer expenditure to income ( c / y ) or APC, showed no downward trend, so the MPC equaled the APC as income grew along trend. This meant that along trend the c = c( y ) function was a straight line passing through the origin as shown in Figure 1.2

3

1.2 rather than the long-run functions. the theories that were developed by Fisher. or short-run data show that the c / y ratio is smaller than average during boom periods and greater than average during slumps. and hence in the short-run. Business cycle. In particular. so that for the short period corresponding to a business cycle empirical studies would show consumption as a function of income to have a slope like that of the short-run functions of Figure 1. so that as income grows along trend.2 Irving Fisher’s model of consumption (the intertemporal choice) 4 . MPC < APC 3. Thus. Kuznets’ study suggest that years when the c / y ratio was below the long-run average occurred during boom periods. we begin the discussion of these three theories at their common points of departure in the theory of consumer behavior and follow them individually as they diverge. the theory of consumption should be able to explain the apparent effect of liquid assets on consumption. This meant that the c / y ratio varied inversely with income during cyclical fluctuation. Long-run trend data show no tendency for the to change over the long-run.1. by the late 1940s it was clear that there were three observed phenomena. and Friedman have basic foundation in the microeconomics theory of consumer intertemporal choice to explain these phenomena. MPC = APC In addition. Modigliani and Friedman begin with the explicit common assumption that observed consumer behavior is the result of an attempt by rational consumers to maximize utility by allocating a lifetime stream of earning to an optimum lifetime pattern of consumption.c Long-run function: MPC = APC Short-run function: MPC < APC y Figure 1. which the consumption function must account for 1. as income fluctuates.2: Long-run and short-run consumption functions Second. and with c / y ratio above the average occurred during periods economic slump (recession). the failure of Keynesian consumption function to explain long-run behavior of consumption in cross-section studies and the effect of liquid assets on consumption has motivated to the emergence of alternative consumption theories in 1950s. so that in crosssection of the population MPC < APC 2. Cross-section budget studies show s / y increasing as y rises. Thus. AndoModigliani. Unlike Keynes. Therefore.

In a two-period model this is simply: ∑ (1 + r ) t =0 1 yt t = y0 y1 + 0 (1 = r ) (1 + r )1 y1 -------------------------------------------. c1 ) -----------------------------------------------. To keep the analysis as simple as possible and formulate the problem in a workable manner he assumed that the individual lives only for two periods: today. ct .(3) Second. We might imagine that his/her expected income stream begins and ends low. they do not have sound micro foundation. However.(4) 1+ r Where. r .... where wealth is defined as the present value of all future income streams.(2) 0 0 Where. lifetime utility U is a function of the individual’s real consumption c in all time period up to T . Hence. that is obtain the highest level of utility. though consumption theories before Fisher introduced some dynamics into consumption behavior.. Fisher assumes that household’s utility depends upon its lifetime profile of consumption. That is T T y c ∑ (1 + tr ) t = ∑ (1 +tr ) t ------------------------------------------. T is the individual’s expected lifetime. he began his explanation with a single rational consumer utility maximization behavior as U = f (c 0 .(1) Where. We thus have an individual with an expected stream of lifetime income who will want to spread that income over a consumption pattern in an optimum way. the instance before he/she dies. The consumer will try to maximize his/her utility. cT ) --------------------------------------------. period zero and tomorrow.Consumption is assumed to be the purpose of all economic activities.. with a rise in the middle. the household is assumed to maximize lifetime utility subject to the borrowinglending constraint imposed by its real wealth. subject to the constraint that the present value ( PV ) of his/her total consumption cannot exceed the PV of his/her total income in life. and he wants to smooth it out into a more even consumption pattern. but the present value of consumption is limited by the present value of income.. The constraint says that the individual can allocate his/her income stream to a consumption stream by borrowing or lending.. The two-period case utility of the household for is thus given as: U = u (c 0 . y 0 is this period’s real income.. A0 = y 0 + 5 . A0 represents the household’s expected real wealth measured in terms of current period (period 0). and y 1 is next period income discounted by the real rate of interest. period 1 (intertemporal choice).

which is given by point B on period 1 axis. The slope of the budget 6 . 1+ r Conversely.(5) 1+ r 1+ r Figure 1. then the maximum it can consume in period 1 is y 0 (1 + r ) + y1 . This means that the household can either lend or borrow money as much as it wants at the going rate of interest without affecting the rate. then the maximum amount that can be consumed can y be y 0 + 1 . equation (4) can be y c y 0 + 1 = c 0 + 1 ---------------------------------------. it is also assumed that the agent knows with certainty the expected future rate of interest and that capital market is perfectly competitive. Since this is a twoperiod model and consumption is the sole determinant of economic growth (GDP). If the household is to consume its entire lifetime income stream in period zero by borrowing against period 1. if the household decides to consume nothing in period zero. delaying or postponing all consumptions until period 1. transaction cost is also assumed to be zero. Forth. it follows that lifetime wealth will be the constraint of lifetime consumption. Period 1 y 0 (1 + r ) + y1 B c1 E U1 y1 A U0 y0 + c0 y0 y1 1+ r C Period 0 Figure 1. The vertical axis measures income and consumption in period 1 while the horizontal axis measures income and consumption in the current period (or period zero). Thus at equilibrium.3: Two-period consumption case: utility maximization added The budget constraint (BC) in the above graph indicates the maximum amount of lifetime consumption. which is the intercept of the budget line in period zero axis.3 shows the structure of intertemporal model.Third. point C .

3 shows that the amount of income the household will earn in period zero. From point E it is clear that the household saves in period zero for c0 < y 0 and dissaves in period 1 as c1 > y1 . which is his/her period 1 dissaving.constraint (line) is given by differentiating the wealth constraint for a given level of interest rate. The optimal consumption position for the household is thus given by indifference curve labeled U 1 . then the slope of all ICs are identical along the straight line passing through the origin. 1 ∂U / ∂c1 . The household has also indifference map. Furthermore. which is y 0 (1 + r ) + y1 − y 0 (1 + r ) = y1 ∂y1 = −(1 + r ) ------------------------------------------------. This assumption has an important implication that if consumption is not an inferior good. y 0 and the amount of income he/she will earn in period 1. y1 . so that his/her consumption in period 1 can exceed his/her income by that amount. representing preference for consumption in both periods and given by lines U 0 and U 1 . 1. if the indifference curves (ICs) are homogenous of degree zero. ∂U / ∂c 0 to that in period.(6) ∂y 0 Point A in figure 1. s1 s1 = −(1 + r ) s 0 = y1 − c1 ------------------------------------. The subscripts of U denote increasing level of utility. U 1 is equal to the slope of the budget line at point E . This implies that the MRS of c 0 and c1 depends only on the ratio of c0 / c1 and not on the absolute size of c 0 and c1 . one with negative income/wealth effect. That is the unspent income (saving) in period 0: s0 = y 0 − c0 ≡ Money lent --------------------------------.3 The Ando-Modigliani approach: The Life-cycle Hypothesis of consumption 7 .(7) By lending this amount. then whenever a consumer received an extra Birr worth of resource he/she would allocate it between c 0 and c1 in exactly the same proportion as he/she allocated his/her original resource. the individual will receive in period 1 an amount equal to s 0 (1 + r ) . That is the MRS between consumption in period 0 and consumption in period 1 is −(1 + r ) .1.(8) Since the slope of the indifference curve (IC). the marginal utility of consumption (MUC) in period 0. is exactly equal to −(1 + r ) .

In order to explain the three observed consumption function relationships discussed earlier under 1.1.1, Ando and Modigliani postulate a life-cycle hypothesis. According to this hypothesis: • The typical individual has different income streams in his/her lifetime. It is relatively low at the beginning and end of his/her life, when his/her productivity is low and high during the middle of his/her life. This “typical” income stream is shown as the y curve in figure 1.5, where T is expected lifetime $ y
Adult

c = Average income
Youth

Old

T

Time

Figure 1.4: The ‘life-cycle’ hypothesis of consumption • On the other hand, the individuals might be expected to maintain a more or less constant/smooth or perhaps slightly increasing level of consumption that maximizes his/her utility, shown as the c line in Figure 1.4 throughout his life.

The model suggests that in the early years of a person’s life, the first shaded portion of Figure 1.4, the individual is a net borrower. In the middle years (when adult) he/she saves to repay debt and provide for retirement. In the late years, the second shaded portion of Figure 1.4, the individual dissaves. This is to say that their consumption level does not vary with their income but with IC , and r . Hence if the life-cycle hypothesis is correct then the high-income groups would contain a higher-average proportion of persons who are high-income levels because they are in the middle years of life, and thus have a relatively low APC ( c / y ) ratio. Similarly, the low-income groups would include relatively more persons whose incomes are low because they are at the end of the age distribution, and thus have high APC ( c / y ). Thus, if the life-cycle hypothesis is true, a cross section study would show APC ( c / y ) falling as income rises, explaining the cross section studies showing MPC < APC . Therefore, it seems reasonable to assume that in the absence of any particular reason (say holiday, unforeseen events/contingencies like hospitalization, rise in payment bills, car repairs, and the like) to favor consumption in any one period over any other, for representative consumer ( i ) if PV i rises, all his/her consumption in period t ( cti ) rises more or less proportionally. In other words, the Ando-Modigliani life-cycle hypothesis of consumption for the i th consumer can be written algebraically, as cti = k i ( PV t i ) ; 0 < k < 1 ------------------------------------------ (1)

8

Where, c is consumption; i represents an individual; t is time (in year); and PV implies present value. On the other hand, k is a constant, which is assigned overtime to indicate that an individual will spend certain proportion of his/her PV income and asset values on consumption of goods and services. Here k i , the fraction of consumer i' s PV he/she wants to consume in period t , would depend on the shape of the indifference curve and the interest rate. Equation (1) says that if an increase in any income entry, present or expected, rises the consumer’s estimate of PV , he/she will consume the fraction of the increase in the current period. If the population distribution by age and income are constant, and tests between the present and future consumption (that is the average shape of indifference curves) are stable through time, we can add up all the individual consumption functions (1) and obtain a stable aggregate function2: c t = k ( PV t ) --------------------------------------------------------- (2) The next step is to develop an operational consumption function from (2) is to relate the PV term measurable economic variables3. The Ando-Modigliani began to make the PV tem operational by noting that income can be divided into income from labour ( y L ) and income from asset or property ( y P ). That is, T T y tL y tP PV 0 = ∑ +∑ t t ------------------------------------- (3) 0 (1 + r ) 0 (1 + r ) Where, time zero is the current period and t changes from zero to the remaining years of life of life expectancy of an individual ( T ), which is highly unpredictable. Now, if capital markets are reasonably efficient, we can assume that the PV of income form an assets is equal to the value of the asset itself, measured at the beginning of the current period. That is, T y tP ∑ (1 + r ) t = α 0 ------------------------------------------------------ (4) 0 Where, α0 is real household net worth at the beginning of the period. Furthermore, we can separate the known current labour income ( Y0L ) from the unknown (future or (expected) labour income ( Yt L ). Then substituting (4) into equation (3) we get
2

Branson (1998) noted that the gradual change in age and income distribution in the U.S. since World War II certainly meet the Ando-Modigliani assumption. 3 This is the crucial step in empirical investigation of the consumption function, as it is in almost any empirical study in economics. The theory involves consumption as a function of expected income, which of course cannot be measured.

9

ytL PV0 = y + ∑ + α 0 ---------------------------------------- (5) t t =1 (1 + r )
L 0 T

In equation (5), current labour income ( Y0 ) and the value of current wealth or assets ( α0 ) are known. But, the expected or future stream of labour income that flow overtime T y tL during the lifetime ( ∑ t ) is unknown. The next step is this sequence is thus t =1 (1 + r ) determining how the expected labour income ( Y1L ...YTL ) might be related to the current observable variables. First, let as assume that there is an average expected labour income e in time zero, y 0 such that: y tL 1 T e y0 = ------------------------------------------ (6)4 ∑ T − 1 1 (1 + r ) t Where, T −1 is the remaining life expectancy of the population up to retirement, which is 37 (19 to 55 years) for an Ethiopian who joins the labour force at the age of 18 and years. Then the expected labour income term in expression 5 can be written as: T y tL e (T − 1) y 0 = ∑ t ----------------------------------------- (7) 1 (1 + r )
1 averages the present value of the future stream of labour income over T −1 T −1

L

Substituting, the term in the left hand side of equation (7) into equation (5) we get L e PV 0 = y 0 + (T − 1) y 0 + α 0 ------------------------------------- (8) Equation (8) has only one remaining variable that is not measured - average expected labour income; that is y e . We now need a final hypothesis linking average expected labour income to a current variable – current labour income. The simplest assumption Ando and Modigliani considered was that the expected average e L income is just a multiple of present labour income; that is y 0 = β ( y 0 ) and β > 0 . This assumes that if current income rises, people adjust their expectation of future incomes up to that y e rises by the fraction β of the increase in y L . We might note here that this assumption assigns great importance to movements in current income as a determinant L e of current consumption. Thus, substituting βy 0 for y 0 in expression (8) we obtain: L L PV 0 = y 0 + (T − 1) y 0 + α 0 L PV 0 = [1 + β (T −1)] y 0 + α0 ------------------------------------------ (9)
4

In equation (3.6), 1 indicates the first year an individual is entitled legally to be employed in formal sectors. For instance, the constitution indicates that the minimum age for an Ethiopia to apply for a vacancy and be employed in formal sectors is the age of 18. In Sweden an individual who has celebrated his/her 16th birthday is permitted to engage in formal sector.

10

Using this value for k equal to 0. the marginal propensity to consume out of assets is 0.06αt -----------------------------------------------.(11) The econometric result of Ando and Modigliani indicates that a $1 billion (or 1%) increase in real labour income will raise real consumption by about $0.5 below. households consume about 6% of their net worth in a year. in the aggregate.06 + 0.72 0.9) is an operational expression for PV in that both and can be measured statistically.72 0. substituting. we can see from the coefficient of α in equation 11.06 = β( 2. from equation (2) that on aggregate. Comparing the estimates of the coefficients in (11) with the derived coefficients in (8). we can obtain the value of β (discount rate) from equation (10) that is implicit in the estimate of the y L coefficient in (11): 0. that is the marginal propensity to consume out of labour income and marginal propensity to consume out of asset. consumption and income will vary along a single 11 . were measured by Ando and Modigliani using annual U. the average expected labour income ( y tL ) rise by $25.06 [ β( 44 ] − 0.06 billion for an increase of households net worth by $1 billion. then the expected labour income will rise by 25%.64 )] β= 0.(10) For instance. β is a constant which represents the discount rate or by how much the future stream of labour income will be discounted? Equation (3. the coefficients of y L and α in equation (10). In short-run. This suggests.72 y tL + 0.S. The slope of the function – the marginal propensity to consume out of labour income – is the coefficient of y L in the Ando-Modigliani consumption function.66 = k [1 + β(T −1)] = 0. cyclical fluctuations with assets remaining fairly constant.72 billion or the marginal propensity to consume out of labour income by 72%.72 0.66 = 0. date and obtained ct = 0. that is αt . when current income doubles (increases by 100%).06. Finally. that is k is 0.64 )] = β( 2.06 [1 + β( 45 −1)] = 0.64 L This suggests that when current labour income ( y 0 ) goes by $100.25 2. Put differently.06 and 45 years as a rough estimate of average remaining lifetime ( T ). The Ando-Modigliani lifecycle consumption function of equation (10) is shown in Figure 1. The intercept of the consumption-income function is set by the level of assets. equation (9) into equation (2) for consumption we obtain a statistically measurable form of the AndoModigliani lifecycle consumption function as: L c 0 = k [1 + β (T − 1)] y 0 + kα0 ---------------------------------------. which graphs consumption against labour income.72 0. Similarly.Where.

which gives the average propensity to consume c / y .06 (3) = 0. then the line OX . Substituting. confirm that both the labour share of income and the ratio of assets to income terms were fairly constant around 76% and 300% (or simply 3) respectively.5.72 yt 5 Ando-Modigliani noted that the observed data for the U. and the ratio of assets to income has been roughly constant at about 3 percent with a slight tendency to drift downward overtime.the ratio of assets or capital to total output/income – are roughly constant as the economy grows along the trend5. Overtime. will go through the origin in Figure 1. confirm that both these terms were fairly constant. Over the longer run. We can divided all the terms in equation (11) by total real income to obtain ct yL α = 0. Ando and Modigliani noted that the observed data for the U.75 ) + 0. these typical values into equation (12). as saving causes assets to rise the consumption-income function shifts up as kαt increases. 12 .72 kαt yL 0 Figure 1.5: Estimated consumption function: Ando and Modigliani Thus.consumption-income function. for the APC or c / y ratio we obtain ct = 0.18 = 0. the labour share of income has remained around 75 percent with a slight tendency to drift up. which shows constant consumption – income ratio along trend as the economy grows.S.(12) yt yt yt If the c / y ratio given by this equation is constant as income grows along trend.72 t + 0. The c / y will be constant if the y L / y . c X Slope = 0.54 + 0.the labour share in total income – and α / y . This constancy of the c / y ratio can be derived from the Ando-Modigliani consumption as follows.72 (0.5.S. overtime we may observe a set of points such as those along the line OX in Figure 1.06 t ----------------------------------------------.

i i y P = y 0 + α 0 ---------------------------------------------------------. which includes his/her human capita. i y P = r ( PV i ) ---------------------------------------------------------.(2) i Where.72. it explicitly includes assets as an explanatory variable in the consumption function. Friedman also assumes that an individual consumer wants to smooth his/her actual income stream into a more or less flat/uniform consumption 13 . Merits of the life-cycle hypothesis 1) The Ando-Modigliani model of consumption behavior explains all three of the observed consumption phenomena. That is c i = f i ( PV i ) --------------------------------------------------------. the average propensity to consume out of total income ( c / y ) is constant at about 0.the PV of his/her future labour income stream. a role which was observed in the post-World War II inflation. Multiplying expression (1) by the rate of return on assets ( r ) gives us Friedman’s permanent income.72. the change in consumption with respect to or f ′ > 0 .1.Thus. Friedman differs from Ando-Modigliani beginning with his treatment of the PV .4 The Friedman approach: Permanent Income Hypothesis Freidman also begins with the assumption of individual consumer utility maximization which gives the relationship between an individual’s consumption and PV of future streams of income. That is (A) It explains the MPC < APC result of cross-section budget studies by the lifecycle hypothesis.5 is a straight line passing through the origin with the slope of 0. Limitations of the life-cycle hypothesis 1) There remains a question concerning the role of current income in explaining current consumption whether 1. 2) In addition.(3) Like Ando-Modigliani. that is included in PV in equation (2) and his/her wealth ( α0 ).3) and (C) It also explains the long-run constancy of the average propensity to consume out of total income ( c / y ratio).(1) Where. (B) It provides an explanation for the cyclical behavior of consumption with the consumption-income ratio inversely related to income along a short-run function (see Figure 1. which implies that the line OX in Figure 1. Equation (2) is the permanent income from the consumer present value. y P and r are permanent income and interest rate respectively.

is a certain proportion of the group’s permanent. while transitory income is the difference between measured and permanent income. Similarly. total consumption in any period is the sum of permanent consumption ( c Pi ) and a random transitory-consumption6 component ( cTi ). we can assume that the average k i for all income classes will be the same. i which is proportional to his/her permanent income ( y P ): i i c P = k i ( y P ) ---------------------------------------------------------. equal to the population average k . which can be positive.(7) In equation (7) the subscript T refers to “transitory” not time. negative. y i = y Pi + yTi -------------------------------------------------------. for all income class i -----------------------------. etc. hospitalization. 14 . Whether planned or unplanned. transitory consumption can also be planned in advance or unplanned at all. c Pi = k ( y Pi ). which the individual has imputed for himself. and represents deviations from the “normal” or permanent level of consumption. That is. Permanent income is therefore. negative. random expenditures will be made only for a very short period of time.τ ) y P ------------------------------------------------------. be it the high or lower than average-income group. we would expect that the average permanent consumption in each income class i (using − subscripts for income class as opposed superscripts to denote individuals) would be k times the average permanent income.i pattern.(6) − − − − Equation (6) states that permanent consumption of any income class (group) i . If we classify the population by income strata. measured consumption is the sum of permanent and transitory consumption. and the variability of expected income. or zero. c P = k (r . that part of income which the household regards as normal or expected.(4) The individual’s permanent consumption to permanent income ratio ( k i ) mainly depends on the interest rate (r ) -the return on saving and individual tests (τ) shaping the indifference curves. measured income is the sum of permanent and transitory income. and really represents income deviations from permanent income. if there is no reason to expect these factors to be associated with the level of income.(8) 6 It is important to note that. ci = c Pi + cTi ------------------------------------------------------. Examples include expenditure on weeding. That is. or zero. Thus. which can be positive.(5) Thus. which arises due to unexpected or unforeseen occurrences or chances (such as a win in lottery). inviting a friend (s). This assumption gives a level of individual’s permanent consumption ( c P ). at any period. total income of an individual is composed of two components: permanent income ( y Pi ). According to Friedman. plus a random transitory/random income ( yTi ). in case of condolence.

Friedman assumes that there is no symmetric relationship or correlation between permanent income and transitory income. and transitory income and consumption.. yT = 0 ) and for that income class observed income will be equal to permanent income (or y = y P ). the income class that centers on the population average income will have an average transitory-income component equal to zero (i. − − − − − − − − − − 15 . for any income class above the average. permanent and transitory consumption. Thus.  As we go up from the average income strata. that is yTi > 0 than people who were in that class because they had unusually low incomes that year. that when sorted by measured income.. The assumptions concerning these relationships give the explanation in the Friedman theory of the cross-section result that MPC < APC . yTi ) = 0 This assumption has the following implication for cross-section budget study results. for the population in the below average. yT is just a random disturbance (fluctuation) around y P . more people in that income group because they had unusually high incomes that year.  Since y P and yT are not related.In order to give the model some predictable power Friedman makes three further assumptions concerning the relationship between permanent and transitory income. This happened because in a normal distribution. there are more people who can fall into it due to having bad year so that yTi < 0 than people who come up to it by having good year so that yTi > 0 .e.income class transitory income is negative ( yTi < 0 ). we will find for each income class. Suppose we draw a sample of families from a roughly normal income distribution and then sort them out by income classes. there are more people with permanent income below that class who can come up into it because yTi > 0 in any one period than there are people above that class who can fall down due to yTi < 0 . As a result. i. the Cov ( y Pi . in other words. below the average-income level. as we will see shortly.e. groups above the population mean have yT > 0 and groups below the population mean have yT < 0 is important for Friedman’s analysis. Thus. observed income will be less than permanent income ( y < y P ). So the covariance of y P and yT across individuals. This result. First. for income classes above the population mean transitory income is positive ( yT > 0 ) and hence observed income will be greater than permanent income ( y > y P ). for any income class.  Similarly.

For simplicity. for each income class the transitory variation in consumption will cancel out so that for each income class c Ti = 0 and average permanent consumption is the population average. Thus. Finally. that transitory consumption is not correlated with either permanent consumption or transitory income.4. which implies the Cov (c Pi . for all income class i .1. cT is just a random disturbance (fluctuation) around c P . a sudden increase in income due to transitory fluctuation will not contribute immediately to an individual’s consumption. We can now bring this series assumptions together into an explanation of the crosssection result that MPC < APC even when the basic hypothesis of the theory is that the − ratio of permanent consumption to permanent income is a constant k . Freidman justifies this by arguing that in the face of a transitory rise in income individuals usually stick to the consumption plan and just opt to increase their savings. The last assumption is intuitively less obvious or is highly debatable than the previous two. But it seems fairly reasonable since we are dealing with consumption as opposed to consumer expenditure. he assumes that there is no symmetric relationship or correlation between transitory consumption and transitory income. If transitory income is spent on durable goods. The last two assumptions. On the other hand. suggesting a lottery win does not increase transitory consumption. the average population income refers to national income/output divided by total population. then this can be classified as unplanned saving rather than unplanned consumption. An alternative explanation is that his definition of consumption includes only the flow of service from durable goods and not expenditure on durable goods.6 it is designated by − − − y = y P in the horizontal axis. let us denote income group i above and below the population average by different letters as the above average population income group by H and the below average population income group by B . In other word. mean that when we sample the population and classify the sample by income levels. cTi ) = 0 . 1. he concluded that the Cov ( yT . he assumes that there is no correlation or symmetric relationship between permanent consumption and transitory consumption. A group H with average observed income y H above the average population income will have a positive average transitory-income component y TH .1 Cross-section consumption function Consider a randomly selected sample of population classified by income levels. In figure 1. In this sense the assumption looks much more credible. which is most popularly known as the Per Capita Income (PCI).Second. c = c Pi . In other words. cT ) = 0 . Then for this above-average − − − − 16 .

That is. For this group. by assumption 1. all groups. the point c = c P is the population average measured consumption and permanent consumption. c i ) is equal to its permanent consumption ( c Pi ) or c i = c Pi . The solid line k represents the − − relationship between permanent consumption and permanent income. Since transitory consumption of income group i ( c Ti ) is not related to either to its permanent consumption ( c Pi ) or transitory income ( y Ti ). then average transitory income will be zero. A similar story follows for the below-average income group ( B ).6). measured average consumption of income group i (i.e.(8) − − − − − − − − − From equation (8). However. Moreover. As a result. The point y is the population average measured income and if the sample is taken in “normal” year when − measured average income is on trend or along k line. − − Observe that average consumption. On the other hand. y = y P ).7. Linking these two consumption conditions gives us c i = c Pi = k y Pi ----------------------------------------------------. including the above-average income group will have zero average transitory-consumption component.. we know that k = ci y Pi − − = c Pi y Pi − − . its average measured income ( y H ) is greater than permanent income ( y PH ) as shown by point A . an aboveaverage income group’s measured consumption to income ratio ( c H / y H ) will be less than k = − − − − − − − ci y Pi − − = c Pi y Pi − − .group.e. so that measured average and permanent income will be equal (i. the average observed income is below average population income as 17 . though the above-average income group have average measured consumption ( − − − − c H ) equal to permanent consumption ( c PH ).. first all income groups will have average permanent consumption equal to k y Pi (or c Pi = k y Pi ) along the k − − − − − − − − − line. that is y H > y PH (see to the right of the mid point of the horizontal axis in Figure 1. both measured and permanent for group i is given − by multiplying permanent income by k to obtain permanent consumption along the solid line in figure 1. observed average income will be greater than average permanent income.

6. which lies below the permanent consumption line k . as shown in the horizontal axis of Figure 1.shown by point B and hence measured consumption to income ratio ( c B / y B or c PB / y B ) is greater than k . which is greater than the population average permanent income (i. This group has positive average transitory income component ( y TH ). Thus. so that c H = c PH in the upper part of the vertical axis. y TH > y P ). First. These results are illustrated in Figure 1. y H > y ).e.. Nevertheless. for an above-average income group ( H ) we observe c H and y H ate at point A . we see in the horizontal axis that the average income of the group ( y B ) is less than the national average income ( y ) or − − 18 .6.6: Friedman’s permanent income hypothesis consumption function Next. consider sample group H with average income above the population average (i.e.. neither measured consumption nor the permanent consumption of the above average income group does not increase proportional to the increase in transitory income. c(cons n) − − − − − − − k − − − c H = c PH c = cP − − A y TH > 0 − c B = c PB − − − − B y TB < 0 yB y PB − y = yP − − y PH − yH − y (Incom ) e Figure 1. In order to locate both the measured and permanent average consumption for group H we multiply permanent income ( y PH ) by k to obtain − − − − − − − − − − − − − − c H = c PH along the k line. observing lower than-average income group ( B ).

the average c/ y point will move above and below the long-run line k . y 2 will be negative. Overtime. Since. where again the short run MPC is less than the long run MPC and MPC < APC . c B ) does not decrease from that of the permanent consumption of B' s income group. average observed consumption (i. In − Figure 1..2. and the c 2 / y 2 ratio will be greater than k .1. it implies that in the crossPC ) is section budget studies we expect to see that marginal propensity to consume ( M (A PC ) or MPC < APC if (but only if) the less than average propensity to consume Friedman permanent hypothesis is correct (holds). this function has smaller slope than the underlying permanent function. Again joining point A and B gives the short-run time-series consumption function. The location of c B and y B gives us point B . The cyclical movement is depicted in Figure 1. c 1 / y 1 will be less than c P1 / y P1 = k .4. Thus.7. we observe that c B and know that it is equal to c PB and k y PB or c J = c PJ = k y PJ along the k line. − − − − − − Similarly. when y is above trend. giving a constant c / y ratio. connecting the points A and B. − − − − − − − − − − − − − − But average transitory consumption will be zero. when y t is above the trend.7. What we observe in a long-run time series data are thus movements of the national average − consumption and income along the line k . but in the long-run MPC = APC . This is because. the average transitory income of the population will be positive as measured by the distance y 1 − y P1 and hence average income will be greater than permanent income (or y 1 > y P1 ). we obtain the cross-section consumption function that connects observed average income-consumption points. lying − − − − − − − − − − − − − above the k line. Nevertheless.e. the average transitory income of the below-average sample − − group ( y TB ) is less than zero. implying c = c P = k y P .y B < y . − − − − − 19 . Therefore. As the economy cycles along its trend growth path. Time series data The permanent income hypothesis can also be used to explain the time series data. as the economy and the national average permanent income grows along trend. Furthermore. in times of economic slump or when y t is below the trend as in year 2. During boom year. the long run permanent consumption function is again given by k . 1. y 2 < y P 2 . say period 1.

Thus.3 Distinguishing features of the lifecycle and permanent income hypotheses Similarities I. Both concentrate on the structural relationship between expected lifetime income and current consumption. Differences: The two theories differ in the empirical implementation of the theory I. The two models are similar in the starting point of the analysis in the consumption-present value relationship given in equation 2.Note that the difference between figure 1. and 20 . he did not clearly distinguishes between permanent income (YP ) and α0 (which is considered as a shift factor) as did by AndoModigliani .7 is that in figure 1. both hypotheses have micro foundation. In other words. The LCH model exhibit smaller MPC than PIH because the former also includes a wealth variable whereas in the latter the wealth effect is included in permanent income.7: Friedman’s consumption function: cyclical movements 2. they argued that an individual have different income stream of income in life and smooth out consumption overtime II. III. In short. while in figure 1. c k − c1 c0 c2 yT 2 − − SR Consumption functions A − − B y T1 − − − − − − y y 2 y P 2 y 0 y P1 y 1 Figure 1. Friedman’s consumption model/function is somewhat less satisfactory than Modigliani in that assets are only implicitly taken into account as determinants of permanent income.6 and 1. Both the LCH and PIH treated the wealth effect on consumption. II.6 the variation in income and consumption is in a cross-section in any one time.2.7 the variation is in average income and consumption over the business cycle.1.

households in Africa. which in turn influence peoples’ preferences for investment (which is more of short term than long term planning horizon). are forced to relay mostly on individual creditors or usurers for borrowing. This is because markets in LDCs are more of imperfect and hence getting information about the value of assets is costly. high collateral requirements of banks than most households can afford.e. and high lending interest rates are also some of the major constraints. income from labour and income from assets/property or the value of assets) Applicability of the consumption theories to LDCs How consumption theories discussed so far are relevant to LDCs such as a typical African economy? 1) Both the LCH and PIH emphasize on households consumption smoothing or have uniform consumption pattern (intertemporal consumption) due to their assumption of absence of borrowing and lending (liquidity) constraints to households. The later has to do mostly with the underdevelopment of legal and judiciary system in LDCs. In some cases.5% in England. For instance lending rate of commercial banks in Ethiopia is greater than 10% compared to only 1. As a result. the planning horizon in LDCs is different than developed countries due to uncertainty in terms of what will happen next. protracted loan application screening and disbursement processes. these assumptions are unrealistic in explaining the actual situation of African economies where households have excessive borrowing and lending constraints.e. However. there are preferential treatments of financial intermediaries to public sectors borrowing than private firms and/or individuals in LDCs. permanent income and transitory incomes) while Ando-Modigliani relies on the observable income (i. This is because we know that financial sectors are underdeveloped in almost all African economies. Moreover. The reason is that. Due to this the majority of households do not have easy access to financial sectors. or poor loan repayment enforcement mechanism to defaulters. and control over assets. This biased policy can be either due to political reasons. Even when there are financial intermediaries they have acute shortage of loanable fund due to high propensity to consume /or low propensity to save/ by the population due to high dependency ratio and in part due to commercial banks weak capacity to mobilize savings. Friedman relies on the unobservable concepts of income (i. particularly those living in rural areas.. perception of life.III. 3) Parallel to the second limitation of the models. Nevertheless. credit ceilings.. the assumption of perfect capital markets in both the LCH and PIH and hence income from assets at any time is equal to the value of asset itself are also irrelevant to LDCs or African economies. 2) The notion of the present value of future income streams in both the LCH and PIH models implies that consumers or economic agents have long planning horizon. 21 . this assumption is irrelevant for a typical LDC even though there is no borrowing and lending constraints.

Hence. ct . Why is this distinction important? 2) Use the two period intertemporal model of consumption to show the effect of the following (A) an decrease in income in period 1 (B) supposing an individual faces a borrowing constraint in period zero and period 1 In the context of the permanent income hypothesis what happen to consumption when There is charismas bonus There is temporary tax increase There is a major house repair required 4) Assume that you have established an empirical consumption function of ct = 0.20 y t −1 + 0.4) The argument of the LCH that individuals will save when income is high during adult for retirement does not also explain much LDC economies that have different demographic structure compared to developed countries. the subsistence income level derived from agriculture possesses a real threat to consumption level of households. What would you estimate to be (A) The short-run MPC? 7 For instance the average size and population growth in Ethiopia are 6 and 2. Thus if resources are shared between workers and the dependents. Thus. the WB (2004) has forecasted that Ethiopia will be the 9th populated country in the world by the year 2050. In a typical African household economy. the need for hump or saving when adult for retirement as the LCH argued is not necessary.5% respectively. This is because LDCs have more young population. in such a context the standard model in which permanent consumption is equal to permanent income cannot be derived from the utility maximization of an individual. With this growth rate. a threat that is likely to exert powerful influence on the way in which income is spend and saved. real income. large family size. Therefore.006 αt Where.40 y t + 0. High population growth and the type and composition of family in LDCs (extended family compared to nuclear family in developed countries) have in turn lead to high dependency ratio. 5) Income derived from agriculture is not considered explicitly in the models. the implication of the above limitations of the models is that ct < y t + α t in most LDCs. 22 . the direct applicability of the models in explaining the subsistence economy of a typical LDCs or African economies is less compared to that of developed countries.1: 1) Distinguish between consumption of durable goods and consumer purchase of durable goods. and real wealth. and αt are real consumption. y t . there is high uncertainty of income due to the erratic behavior of agricultural output or its vulnerability to weather change and macroeconomic instabilities such as fluctuation of price and exchange rate fueled by internal and external shocks. and high population growth7 compared to developed countries due to high birth rate. L In general. 3) (A) (B) (C) Exercise 1.

whereby consumption is sacrificed today in order to enhance production and consumption in the future. and final goods awaiting for sale. total or gross investment. thus net investment.(2)  (1 + r ) (1 + r ) (1 + r ) j =0   23 . Thus investment is an inherently dynamic process. working capital. the two components of Keynes’ theory of investment are called discounting measures of project worth or investment assessment criteria 1. First. This can be represented by a simple identity iG = i N + i R --------------------------------------------------. In this case. V D . In modern project analysis. and building. and residual investment. the discounted net lifetime income of the machine is given as: N yj  yt + j  y1 y2 D NPV = y 0 + + + .2 INVESTMENT DEMAND HYPOTHESES Investment is the accumulation of physical capital by firms’ overtime. manufactured input.i R . which consists of stock of raw materials. of the machine.1 Keynesian Explanation of investment There are two distinctive components in the Keynes’ theory of investment. but it is the most volatile component of aggregate demand.2. and the Tobin’s Q model of investment. Investment is much smaller than consumption. Of these components of investment. which include new houses for purchase or rent.. he emphasizes on the role of expectations in deriving investment demand and second. he explicitly refers to the supply of capital goods which is related to the marginal efficiency of capital (MEC).(B) The long run MPC? (C) The short run APC? 1. From a theoretical point of view a stationary economy one where the capital stock is constant and the level of investment is exactly equal to the rate of depreciation of the existing capital stock. investment is very important for the macro economy. the neoclassical theory of investment. machinery. There are three different types of real capital goods: fixed capital.1 Net Present Value (NPV) For Keynes the value of the owners unit of capital equipment was the flow of income. since it is by investing in plant and machinery that the economy can produce goods for consumption in the future. y j it would yield over its life in excess of the purchase cost. Despite its size. there are no new additions to the capital stock..2.1. + = ∑ 1 2 j  (1 + r ) j  = Vt --.(1) In the following sections four principal alternative theories of investment will be considered: Keynes theory of investment. the accelerator theory. 1. fixed capital is the most important and is commonly referred as gross domestic capital formation. The flow can be thought as the net present value of income (NPV) or the demand price. Thus. iG is exactly equal to replacement investment. items such as plant. i N is zero. Investment is therefore an element of economic growth. So although existing machineries are replaced as they wear out.

N is the life of a project NPV = ∑ 8 Total cost is the sum of investment costs.(3a) t =0 N N N t =0 Or N Bt Ct −∑ t t --------------------------------------------. This is termed as the opportunity cost of capital achieved by using Discounted Cash Flow (DCF) measures of project worth. and operating cost. It is calculated by subtracting the present values of costs (PVC)8 from the present values of benefits (PVB). r is the rate of interest and N is the life of the asset. Thus. 24 . The NPV is defined as the difference between the present values of the future benefits and costs.(3b) t =0 (1 + r ) t =0 (1 + r ) Where. In investment project analysis discounting is normally used to work out the Present Value (PV) of a set of several Future Values (FVs). A project’s net benefits have to be measured against the benefits that could have been gained by investing the equivalent sum for alternative uses. incremental working capital (incremental stocks plus net incremental receivables. account receivable less account payable). NPV = ∑ PVB − ∑ PVC --------------------------------------------------.(3)  (1 + r )  Where.9 shows that the demand schedule for capital good. This involves two steps of calculations as expressed by the formula. in that the expected future revenue exceeds cost. for a given market rate of interest and stream of expected returns. after which the additional project yields negative returns (profit). It is the simplest of all the four methods and is essentially a measure of the present value of aggregate surplus generated by the project over its expected operating life. r is the discounted rate expressed as a fraction or percentage and t is year.Where. As progressively more marginal projects are added the demand price of new capital declines until NPV becomes equal to zero. In its simplest form equation (2) can be expressed as:  1  NPV = FV  t  --------------------------------------------------------------. if NPV or the demand price is greater than zero the investment project is profitable. The value in the bracket is called discounted factor (DF) for each year.8: The demand price of capital Figure 1. V D D K (r ) 0 K Figure 1. This implies that NPV represents the net benefit over and above the compensation for time and risk. which rises as the demand price falls.

The marginal efficiency of capital is defined as the rate of discount. is a marginal case and hence the decision may need to be informed by other criteria particularly for public sector projects. Both projects have zero return in period/year 1. V S . which of course does not add to the stock of capital in the economy as a whole. In sum the PV ranking depends on the market interest rate-the rate at which earning can be reinvested-while the MEC of investment is not related to the market rate. The best way to see this is to look at an example which can be easily generalized. but it will not generate any surplus. when they are built. m . m is the supply price of capital asset. Reject the project if the NPV is less than zero or negative because the project will not recover its cost at the specified rate of discount. In equilibrium. which implies that the net benefits will be created after allowing for the required rate of return fixed principally to cover the cost of capital in financing or opportunity cost of a sacrificed investment. c.(4)   j =0   Where.2 Marginal efficiency of capital (MEC) or Internal Rate of Return (IRR) In addition to the concept of the demand price of capital goods Keynes also introduced the concept of the marginal efficiency of capital (MEC). is drawn for a given capital stream of expected returns and the supply price of capital. that is m = r . So the PV rankings can be different from m rankings. Project I returns 0 in period 1. which would just induce a manufacturer to produce new additional unit of such assets. Accept the project if the NPV is positive. new capital equipment would be profitable to acquire. that is.Decision Rule: a. returns 2 million in period 1 and 1 million in period 2. Project II on the other hand. both with initial cost one million.2. Year 0 1 Project I Cost Return 1 0 0 Project II Cost Return 1 0 2 25 . NPV equal to zero means the project will return the capital utilized. Example 1: Suppose we have two investment projects. b. and 4 in period 2. which denotes the return on alternative asses. Thus the MEC or m . The costs and returns of two projects are summarized in the table below. Keynes argued that the MEC in general is equal to the rate of interest. since only then will the MEC exceed the market interest rate. That is the supply price is the replacement cost of new machine and not the cost of the purchase of second-hand machine. Indeed if m > r . N  yt  ∑  (1 + m) t  = Vt S = 0 -----------------------------------------------.1. 1. which would make the present value of expected returns from the capital asset during the project life to just equal to zero or the supply price. If the NPV is zero.

.(1*3) 7.Project I 3.1 above 2.6281 is greater than 1.3056 NPV Project II 8.(1*4) -1 -1 0 0 3.(2*4) -1 -1 1. However.8264 1.6446 2) Based on the overall NPV of the two projects as shown in the last row of column 6 to column 9 an investor should invest in both projects.8118 1. not that if the NPV of projects vary as the market interest rate changes the criterion does not help to make such a 26 . 3) If an investor has financial constraint to invest in the two projects. r=1% 1 1 0.9070 0. that is as can be seen in the last row of table 1.9091 0. 1 1 .625 3.Project II -1 -1 0 2 4 1 0.. Third: Multiply the net benefit of project I and II in each year by the corresponding discount factors to get the NPV of the projects in each year.8182 0.r=0% 5. Second: Find the discount factor at 5% and 10% from year zero to year two.9804 0. This can be obtained by using the formula.9070 0.9612 Discount Factors 4.9048 1. The net benefits of project I and II are shown in column 2 and 3 respectively. Summing up the NPV of the projects in each year gives the overall NPV as shown from column 6 to column 9..3056 2.8264 NPV Project I 6.Year 0 1 2 SUM Net benefit (Return – Cost) 2.8118 when the market interest rate is 5% and 2.(2*3) 9..6446 at 10%. the NPV of both projects is higher at 5% than at 10%. This is because the overall NPV of the projects at 5% and 10% are greater than zero.1: Net Present Value (NPV) and Marginal efficiency of capital (MEC) 1. To calculate the NPV we follow the following three steps First: Find the net benefit of the two projects by subtracting the return of the projects in each year.It is shown in the 3rd and 4th 0 (1 = r ) (1 + r )1 column in the table below. Table 1.2 4 1 Given the information given in the table above 1) Calculate the NPV of the two projects at market interest rate equal to 5% and 10% 2) In which project should an investor invest when market interest rate are 5% and 10%? Why? 3) If financial constraint dictates the investor to invest in one of the projects which one should be chosen at the lowest interest rate? Why? 4) Calculate the MEC ( m ) for the two projects 5) If the two projects are competing which of the two projects is better according to the MEC criterion? Why? 6) If the projects are not competing should we select and invest in both projects according to the MEC criterion? Why or why not? SOLUTION: 1) The NPV of the two projects at interest rate equal to 5% and 10%. he/she should decide to invest in project II than in project I both at 5% and 10% market interest rate for it yields higher NPV. However.6281 2.3058 is greater than 1.9524 0. .

414 > 1 .g. Thus.conclusion. Subtracting 1 + 2m from both sides we have m2 = 2 m= 2 = 1. 1+m = 4 = 2 MEC of Project 2: MEC 2 = −1 + 0 2 1 + + =0 (1 + m) 0 (1 + m)1 (1 + m) 2 Moving −1 to the other side of the equation and multiplying both sides by (1 + m) 2 gives   2 1 (1 + m) 2 =  + (1 + m) 2 1 2  (1 + m) (1 + m)   (1 + m) 2 = 2(1 + m) +1 (1 + m) 2 = 2 + 2m +1 . since the MEC of the two projects is greater than the market interest rate both investment projects should be chosen. The MEC investment criterion or IRR indicates that project II is unequivocally better than project I. 27 . calculate and determine which project is better according to the NPV criterion when market interest rate is zero and 100%.is 100%. This implies that the NPV of project I will be equal to zero when the rate of discount. in year 2) and will have a higher NPV at some higher market interest rate that pushes down the PV of the distant returns of the first project.4%. The implication is that project I will have higher NPV at market interest rate lower than the equilibrium interest rate that makes the NPV of the two projects equal and the NPV of project II will be at higher at interest rate higher than the equilibrium rate. The reason is that if we compare two projects. This implies that the rate of discount ( m ) that makes the NPV of the second project zero is 141. Factorizing the left hand side we get 1 + 2m + m 2 = 2 + 2m + 1 .g. m . project I in year 2) will have higher NPV at some low interest rate than the second project that yields smaller return in future (e. the one which has larger return in the distant future (e.414 . MEC of Project 1: MEC 1 = −1 + 0 0 4 + + =0 0 1 (1 + m) (1 + m) (1 + m) 2 4 1= (1 + m) 2 (1 + m) 2 = 4 Solving this equation for m . For instance. 4) The marginal efficiency of capital (MEC) or IRR using the NPV formula but looking for the interest rate that makes the NPV equal to zero for each projects. because m2 > m1 or 1. we have m = 2 − 1 = 1 .

At r = 0. the equilibrium interest rate is half of the lower discount rate.4 0. if the two projects are competing the investor should choose project I if the market interest rate is below 50% and project II if the market interest rate is above 50%. PV 3.0 0.9: Present value and the market interest Decision rule for MEC: r 28 . In short.6 0. Following the same procedure in example 1.78. Second: Find the equilibrium interest rate that makes the NPV of the two projects equal.4 II 2 I Figure 1. This can be determined by equating the NPV of the two projects as NPV 1 = NPV 2 0 4 2 1 −1 + + = −1 + + .5 or 50% the NPV of both projects is 0.5 .8 1 1.0 2. Therefore. What is equilibrium interest rate that makes the NPV of the two projects equal? How can we calculate it? How can we show it graphically? We follow the steps below to answer these questions for projects with two years life.0 1.78 E 0. we will get the NPV of project I equal to 3 and that of project II is 2 when the market interest rate is zero or there is no market interest rate to be charged on funds obtained from borrowing. This implies that the NPV of the two projects will be equal when interest rate is 50%. that is 1 / 2(m1 ) . First: Find the NPV of the two projects when interest rate is zero. Third: We depict the NPV of the projects in the first and second steps as well as at the rate of discount ( m ) graphically as follows. You can verify this using the NPV criterion we have applied in example 1 while computing the NPV of the projects at 5% and 10%. Dropping −1 from both sides 1 2 1 (1 + r ) (1 + r ) (1 + r ) (1 + r ) 2 and multiplying through by (1 + r ) 2 gives us 4 = 2r + 2 + 1 r = 1 / 2 = 0.2 0.In reference to this conclusion someone may raise the following questions.

It considers the net benefit stream in its entirety. In other word the project is marginal. a. • Reject the project with MEC or IRR less than the market interest rate because it will not recover its cost after allowing for the cost of capital. seems to be constrained in ranking investment or projects. b.000. The concept is clear and the solution is always determined. For competing projects choose the one with the higher IRR. Out of the two projects B is efficient than A for its investment capital generates a 25% return than as compared to 10% of A. the NPV has its opponents towards some limitations.2: Given information on the costs and returns for investment project X and Y answer the following questions. The additive property of NPV ensures that a poor project (one which has a negative NPV) will not be accepted. The NPV of various projects. opponents argue that for the NPV is an absolute measure of value it does not show the efficiency of a project in using capital. a. Hence. c. Advocators of NPV argue that what matters is the surplus value (rate of returns) irrespective of what is invested.• Accept the project if the MEC or IRR is greater than the market interest rate. • If MEC or IRR is equal to the market interest rate. The NPV rule does not consider the life of the project. project A may have a NPV of 5000 while project B has a NPV of 2500. The application and dimension of NPV. just because it is combined with a good project. Which of the two investment project is better according to the NPV criterion? Why? 3) Calculate the MEC of the projects. Exercise 1. which has positive NPV. it indicates the project has no net return but will recover the cost to be incurred. 29 . measured as they are in today’s Birr can be added. is influenced by the discount rate. However. It takes into account the value of resources overtime. Which one is better according to the MEC? Why? 4) What is the equilibrium market interest rate? What will be the NPV of the projects at that interest rate? In witch should we invest if market interest rate is below the equilibrium rate?  Evaluation of NPV: The NPV as one of the discounting criteria of measuring project worth has the following advantages. For example. The NPV is expressed by in absolute terms rather than relative terms and hence does not factor in the scale of investment. 1) Find the sum of the net benefit streams of the projects and discus the implication 2) Calculate the NPV of the two projects at the market interest rate of 5%. but project A requires an investment of Birr 50. when mutually exclusive projects are with different lives are considered the NPV is rule is biased in favour of the longer-term projects.000 whereas project B may require an investment of 10. b. d. c. Despite the above advantages.

It does not distinguish between large and small investment and it does not tell anything about the timing of the net benefits of the project. which measures the opportunity cost of capital. It is also possible that if the net benefit stream of a project changes or has more than one sign. b. there may be more than one IRR.Total cost 0 140 1 65 2 95 3 95 4 75 5 55 2. It is more familiar concept and better understood by most people b.000 45.000 55. it is not very useful for deciding between two or more mutually exclusive projects. c. That is the MEC criterion makes no reference to the market interest rate. Table 1.000) 35. It considers the net benefit stream in its entirety. However.0 100 150 200 150 100 (2) Given the cash flow for 2 projects calculate the NPV of the two projects at 10% interest rate Yea r 0 1 2 3 4 Project 1 Cash flow (1. d.000 45. The limitations of MEC or IRR include: a. Evaluation of MEC or IRR: The use of MEC or IRR as a measure of project worth has the following advantages.2 The Flexible Accelerator (inventory) model The relationship between the growth rate of output and the level of net investment implied in the previous section is called the accelerator principle since it suggests that an increase in the growth rate of output or acceleration is needed to increase the level of investment. c.000.000. Exercise 1.000) 65.000 1.000 55. The cost and benefit streams are given in the table below (All figures in million) Year 1. It provides a measure of efficiency of the project in using capital.2. a.3: (1) Calculate the NPV for the hypothetical X and Y projects at 10%.000 65. an increase in interest rate should reduce the 30 . Therefore.000 35.1 illustrates on of the deficiency of the MEC for ranking investment projects.000 Project 2 Cash flow (1. It takes into account the value of resources overtime. The PV criterion suggests that this relationship between output growth and net investment is not a fixed one.Total Revenues/Benefits 0.

output will also double. ∆K ∂K The increased cost to the firm of adding another unit of capital is simply the user cost of that unit As long as the increase in revenue is greater than the increase in cost from another unit of capital the competitive firm will add capital. y is output pre unit of time. and K is the capital stock.level of net investment associated with a given growth rate of output. > 0 ------------------------------------------. c is the real user cost of capital. Equation (2. ∆R ∂y = P.2) determines the equilibrium capital stock of the firm. ∂y C = ≡ c ----------------------------------------------------------. Equilibrium will be reached when (2. which is the same condition as equation and P.2) ∂K P Where. y = aK β L1−β This production function has the property that the exponent of the capital and labour inputs add up to one. Implicitly we assume here a constant rate of utilization of capital stock so that there is a one-to-one relationship between capital stock and machine hour input. Let’s take the following Cobb-Douglas production function as an example. ∆K ∆K ∂K ∆C =c ∆K This marginal condition (2. Thus a firm will expand its plan size until the marginal product of capita equals the real user cost of capital. given its labour input is price of output times the increment to output produced by the increase in K . ∆R ∆C ∂y = = c . This variable relationship between the growth rate of output and the level of net investment is frequently known as the flexible accelerator model. ∂y ∂y .1) ∂L ∂K Here.(2. L is human power input per unit of time. If capital and labour inputs are doubled. Equilibrium capital stock: we begin with the general production function y = f ( L.2).-plant and equipment. The marginal product of capital in the Cobb-Douglas function is given by ∂y = βaK ∂K β− 1 L1−β --------------------------------------------------.(2. which gives constant return to scale. K ) . The increase in revenue which a competitive firm will obtain by adding another unit of capital .2) can be seen in another way.3) This can also be written as 31 .(2.

Replacement investment will simply be the depreciation of the capital stock (δ ) K i R = δK ----------------------------------------------------------. We can generalize this by writing K E as a function of y .6) KE = K y In equation (2.6) as a general expression for the determinants of K E .10a)  C  32 .4) ∂K K P The right hand side of equation (2. Looking at net investment first using the Cobb-Douglas function gives  βPy  i N = ∆K E = ∆  -------------------------------------------.4) can be solved for the equilibrium level of capital stock in the Cobb-Douglas function βPy βy = C -------------------------------------------------. On the other hand. we can now develop the investment demand function relating realized investment to K E .7) Net investment is that part of gross investment that increases the level of capital stock. K E = K E ( y. C . a number like one-tenth for building and one-fifth for vehicles.(2. Equation (2. whereas replacement investment depends on the level of capital stock. would be i N = ∆K E --------------------------------------------------------.9) Thus we can see that net investment depends on changes in equilibrium level of capital stock.5) C P The equilibrium capital stock rises with an increase in y and falls with an increase in the real user cost of capital. Net investment in the absence of lags in the adjustment process of actual capital stock to desired capital stock. With equation (2.(2. replacement investment is part of gross investment needed to keep the capital stock at a constant level and is equal to economic depreciation of the stock in any one period. iG = i N + i R ------------------------------------------------------.(2. P ) -----------------------------------------------. δ is the depreciation rate. substituting y back into aK ∂K K K β L1−β . C .∂y βaK β L1−β βy = = . in equilibrium ∂y βy C = = ----------------------------------------------------.(2. Investment demand and output growth: Total or gross investment is given as the sum of net investment ( i N ) and replacement investment ( i R ).(2.(2.6).5) gives the expression for a particular production function. ∂ E / ∂ and ∂K E / ∂P are positive and ∂K E / ∂C is negative. and P .(2.8) Where. Thus with the Cobb-Douglas function.

remains fairly constant overtime. (2. P ) + δK ----------------------------------------. we can rewrite equation (2.(2.9) that iG = i N + i R = ∆K E + δK ----------------------------------------. ceteris paribus.10a) as  βP  iN =  ∆y ---------------------------------------------------.6) iG = ∆K E ( y . we have from equation (2. Second let’s look at total investment using the concept of net and replacement investment we have developed. with no trend in C / P .12) gives the rate of growth of output that would maintain supply equal to demand. iG is given by  βPy  iG = ∆  + δK ----------------------------------------------. dividing both sides by β . that is the net saving ratio i N = sy Then we have the basic growth relationship  βP  sy =  ∆y ----------------------------------------------------. Thus. but it is also associated with the level of demand through the multiplier. we have P  C  y sC s ∆ y = = =Growth rate of y βP βP ----------------------------------. equation (2.If we assume that the ratio of user cost of capital to the price level.10b)  C  This makes it clear that over the long run.(2.12) y C Since investment increases the supply of output by increasing the capital stock.(2.(2. C .8). The relationship between the change in output and the level of investment is the flexible accelerator model that introduced a basic dynamic relationship into the model of the economy.11)  C  Dividing both sides of equation (2.11) by y and solving for the growth rate of y . and (2.(2.10b) and net investment is also some fraction(s ) -of y . if net y investment is related to ∆ by equation (2. we can write the investment equation (using equation 2. c is fairly constant we have 33 . s y  βP  ∆y =  y  C  y C  βP  ∆y s =  .15)  C  And in the special case where the real user cost of capital.(2. Ignoring for a moment the lagged adjustment of actual to desired.14) In the Cobb-Douglas example.13) In the general case.7). it is the growth of output or demand that gives us the level of net investment.

this means that during the transition period gross investment has also this bulge as shown by the dashed line in figure 1.16) c as the accelerator relationship. 0 to t1 and t 2 on and a transition period of unspecified length between the two. Thus. total or gross investment in each period is summarized as follows From 0 to t1 : iG = i R iG = i R + i N From t1 to t 2 : 34 .10. the level of investment is zero in each period and the level of i R is positive in each. which implies a given equilibrium capital stock K . there must be a positive level of net investment in the transition period. Since the capital stock is constant both before t1 and after t 2 . The Figure shows what happens to investment as output rises from one stable level in two time period. y .(2. Since iG is the sum of i N and i R .β ∆y + δK --------------------------------------------------. i KE ∆K = ∑ i N t1 t2 K iG y iR iN 0 t1 t2 t Figure 1.14) poses an interesting difficulty in the short-run stabilization policy. y. Real k .10: The “accelerator principle” on investment In the first period there is a given level of output. In order for the capital stock to increase to its new higher level in the second period. iG = The accelerator and stabilization policy: The accelerator relationship in the gross investment function. the government increases government purchases g to stimulate demand and output and equilibrium capital stock move to new higher levels in the second period. equation (2. from t 2 on.10. This is indicated by the bulge in i N between t1 and t 2 .At time t1 . This is shown in figure 1.

that is it cares about the future stream of income not only the present 2. K t + is capital stock in the next period. A firm is a forward looking.plants and equipments. and M K = ∂y ∂ > 0 The second constraint. M L =∂ ∂ >0.3 The neoclassical model of investment This investment theory assumes: 1.2. based on the first constraint we know that Pt y t can be expressed as Pt ( Lt . These can be achieved by the first order derivative of equation (5) with respect to our variable of interest. equation (3. which is capital stock. K t + is determined by the 1 it −δK t . Thus.From t 2 on: iG = i R 1.3) Where. P y L P K Besides. K t ) . there is no difference between expected and actual profit. δ t is the depreciation or obsolete of capital stock in the production process. and additional investment ( it ) to make in order to maximize profit or equation (3. Whereas K t and it refer to capital stock 1 K available and additional investment in period t . With these assumptions PV 0 = ∑ 1 ( Pt y t − wt Lt − Pt I it ) -------------------------------------.5). difference between The profit maximization equation is thus Max  = ∑ t =0 ∞ 1 ( Pt y t − wt Lt − Pt I it ) + ∑λt [it + (1 − δ ) K t − K t +1 ] -----------.2) Where.On the other hand. capital stock/goods to employ ( K t ). that is it is a price taker 3. The firm operates under perfect competitive. K t ) ------------------------------------------------------------------. Assuming CRS. K t ) − wt Lt − Pt I it ) + ∑λt [it + (1 − δ ) K t − K t +1 ] ------t (1 + r ) (3.1) (1 + r ) t The above profit maximization is subject to two constraints: technological constraints and capital stock.(3.2) implies investment is a flow and capital is a stock.4) can be written as Max  = ∑ t =0 ∞ 1 ( Pt ( Lt .5) The question we want to address is that what will the optimum amount of labour to hired ( Lt ).(3. There is no uncertainty about profit. Constraint (3. Lt is workers hour of input and K t capital stock . That is 35 . is written as K t +1 = K t + it − δK t ------------------------------------------------------. we write the first constraint as y t = y ( Lt .4) t (1 + r ) However.(3.(3. Thus.

6c) t ∂it (1 + r ) ∂ = it − (1 + δ ) K t − K t +1 = 0 ----------------------------------------------------.(3. dividing both sides of equation (3.7) by Pt we have the expression like equation (3. 36 . This comes because K t is the end of period capital stock for K t − .6c) gives us: λt = 1 1 I Pt I .∂ 1 = ∂Lt (1 + r ) t  ∂y t  − wt  = 0 ---------------------------------------------.(3.7) ∂K t Equation (3. That is ∂Lt ∂ 1 = ∂K t (1 + r ) t  ∂y t   Pt  + λt (1 − δ ) − λt −1 = 0 -------------------------------. 1 ∂ 1 =− Pt I + λt = 0 --------------------------------------------------------. This implies that λt −1 = Pt −1 (1 + r) t (1 + r ) t −1 Substituting these two into (3. λ− refers that whatever capital stock that will be available next period is t 1 dependent on what some one has this year.6d) ∂λt What is the profit maximizing capital stock? Rearranging (3.6b) for λ and λ− we will obtain the users cost of capital.(3.7) says that the value of marginal productivity of capital or VMPK is equal to the users cost of capital.6c1) + t  t t t −1 ∂K t (1 + r )  ∂K t  (1 + r ) (1 + r ) Recall that.(3.6b)  ∂K t  Where.6a)  Pt  ∂Lt  This refers to the demand for labour. t t 1 ∂ 1  ∂y t  1 1 I = P Pt I (1 − δ ) − Pt −1 = 0 --------------. Rearranging (3.(3. = t −1 t  −1  or (1 + r )t (1 + r ) (1 + r ) (1 + r )  When we substitute this in equation (6c1) gives you ∂ 1  ∂yt  1 1 = P Pt I (1 − δ ) − Pt I 1 (1 + r ) = 0 + − t  t t ∂K t (1 + r )  ∂K t  (1 + r ) (1 + r )t ∂y t I Pt = −Pt I (1 − δ ) + Pt −1 (1 + r ) ------------------------------------------. Finally.(3. which shows the users cost of capital relative to the price of the product or the marginal cost of capital is equal to the real cost of capital.8). by the rule of exponent 1   1 1 1 (1 + r ) .6a) gives us MPL is equal to real ∂y t = wt wage.

(4.2) t t t− Dividing both sides of equation (4.(4.(4.(3. P . inside the second bracket the first term is the additional revenue from the sale of output and the second term is simply the increase in the value of the firm’s capital in period t +1.3a) is last year supply price of capital goods. 37 .1) − ∂K t Rearranging this equation gives P MPK t + P I (1 − δ ) = P I 1 (1 + r ) ------------------------------------------. is the discounted future t revenue stream plus the part of capital still in use.2. This is therefore identical to the NPV concept discussed earlier.4 Tobin’s Q theory of investment Tobin (1969) devised a way of relating investment demand to financial variables which is more amenable to empirical treatment than other investment models. In fact the crucial variable.(4. gives the t expression for Tobin’s marginal Q as [1 /(1 + r )][ P +1MPK t +1 + (1 − δ ) Pt I 1 ] t + 1= -------------------------------. which states VMPK is equal to the users cost of capital. Therefore.8) ∂K t Pt I Where.3b) t+ ] This relationship says that the supply price of capital goods. it becomes PI 1 = t− 1 PM PK t (1 + r ) [ t + P I (1 −δ) ----------------------------------------.7). In current time this dynamic equation becomes P = t 1 P 1t M K P + (1 + r ) [ t+ 1 + P I 1 (1 −δ) ------------------------------------. while still having a firm theoretical basis. That is Pt ∂yt + Pt I (1 − δ ) − Pt I 1 (1 + r ) = 0 ----------------------------------------.(4. δPt = the rate at which the investment good/capital stock depreciates at time t I I rPt −1 =The interest charge for investment or holding capital valued at P − the t 1 beginning of period t I I ( Pt − Pt −1 ) = The gain or loss (overvaluation or undervaluation) in the price of investment good in period t 1.4) P t Note that the numerator has three components: the term in the first bracket is the discount rate. Dividing the above expression first by P .3a) t ] Expression (4.I I ∂y t δPt I + rPt −1 − ( Pt I − Pt −1 ) = ---------------------------------.2) by (1 +r ) . the price of new capital goods. Tobin marginal Q has already been defined under the neoclassical model above in equation (3. that is the value of capital in next period less any depreciation.

to total cost of its capital. PK . M1 is the narrowest of the fed’s money supply definition. It includes M1. marginal Q can be expressed as the ratio of the firm’s total valuation.(4. M2. which is known as average Q. bribe etc are very high in Africa. So Tobin’s marginal Q is the rate of change in the value of the firm to the added cost of acquiring new capital. but this is not applicable in LDC’s for the financial sector is not well developed in many developing countries • The assumption of perfect competition is not valid because markets in LDCs are more of imperfect than perfect • Exchange rate is more of rationed than auctioned in LDCs • Political instability which is more common in LDCs implies uncertainty that affects investment adversely is not mentioned • The existence of huge public sector investment has also an impact on private investment. then Q =1 as in (expression 4. dollar denominated deposits in foreign banks and agreements in which a corporation purchases T-bills from a bank and the bank agrees to buy them back the next day at a slightly higher price) on which limited 38 .1 Money Supply and monetary expansion A. from elementary theory of the firm. transportation.5) PK 1. M2 is the broadest measure of money supply than M1. saving deposits (SD). M1 is the potential base for deposit expansion and money supply creation. 1.the numerator is the increment to the value of the firm from the purchase of one more machine.2. If the firm is in equilibrium. discounted back to the current period. electricity etc) that crowed in (encourage) private investment or supplementary that crowed out (affect adversely) to private investment • Transaction cost. the marginal cost is proportional to average cost and thus under the CRS marginal Q is proportional to average Q. and money market mutual funds (MMMFs) of individuals and firms (for example. PV .M1. It includes currency held by non-bank private sector (or held outside bank for circulation including travelers checks (TC)) and checkable or demand deposits held by non-bank private (firms and households) sector ( D1F + D1h = D1 ).5 Determinants of investment in the case of Developing Countries Applicability: • Tobin’s suggestion is easy to measure from the stock market. It might be complementary (such as investment on infrastructure. That is. the cost of doing business such as bureaucracy. Q= PV ----------------------------------------------------------------------. and M3. MONEY STOCK (SUPPLY) Introduction: There are three measures of money stock.3. depending the type of investment.4) Under the constant return to scale (CRS ) .3 THE SUPPLY OF AND DEMAND FOR MONEY 1. corruption. other quasi money or deposit (D2) such as time deposits (TD).

This reserve is called the reserve requirement. pension contributions. the claim o the bank by the depositor and also a Birr 100 thousand in asset for the bank . In short. These banks have balance sheet made up of liabilities including demand deposits and assets reserve and loans. say worth of Birr 100 thousand and issues a check. in our case in the NBE. gold deposits of individuals) (OAs). Finally. money supply consists of currency and demand deposits which are supplied by the commercial banks. are typically invested in long-term securities. The managers of the Fed’s open market account buys in the bond market a certain amount of treasury bonds. If there is a 20% reserve requirement. Funds. bank A can loan Birr 80 thousand of its increase in assets and must retain Birr 20 thousand as a reserve as shown in table below. M3 includes M2 and other assets less liquid than M2 such as money market mutual funds held by institutions (MMMIs)-such as provident funds. which are not counted as part of M2. M3 is used less frequently as a measure of money supply than M1 and M2. drawn by the Fed for Birr 100 thousand to the seller. creating a Birr 100 thousand liability for the bank. Bank A Assets Br 100 Reserve 20 Loan 80 Liabilities Deposits 100 Assets Br 80 Reserve 16 Loan 64 Bank B Liabilities Deposits 80 Bank C Assets Br 64 Reserves=12. and saving and credit associations fund. the claim on the Fed. The seller then deposits the check in his/her checking account in Bank A. Funds in quasi deposit and MMMFs are typically regarded as investment in short-term bonds.(1) M2 = M1+ D2 (TD+SD +MMMFs) -----------------------------------------------------------.(3) Monetary expansion mechanism As we have defined it.and other assets (for example. M2 is the most widely accepted measure of money supply.8 Liabilities Deposits 84 39 .(2) M3 = M2+MMMIs + OAs-----------------------------------------------------------------------. M1 = C+D1 ---------------------------------------------------------------------------------------. Suppose the Fed decides to expand money supply.checks can be written. mainly as deposits in the Federal Reserve Banks. The Federal Reserve System requires that commercial banks retain a certain percent of their liabilities as reserve.

With the above two assumptions and reserve ratio is 20%. the increase in money supply from the Birr 100 thousand reserve increases is given by ∆M = 100 + 80 + 64 + 51 .2 From the balance sheet of the three banks we understand that.Loan 51.3. in this simple example assuming 1. Thus.1: The Banking System Consolidated Balance sheet National Bank Symbol Assets Liabilities Gold & foreign exchange reserves High powered money R Lending to the government Assets Currency and deposits with the national bank Lending to the personal and corporate sector Assets Gold & foreign exchange reserves Domestic credit: LG + LP Money supply: R + DC Symbol H Symbol LG Commercial Banks Liabilities Deposits from the public Hb D LP Symbol Consolidated Banking sector Symbol Liabilities R Currency in circulation: H − H b Deposits from the public DC HP M S Money supply: H P + D D MS 3. The banks are fully loaned up or there is no excess reserve and 2.2 +. Money Demand: The Transaction and Portfolio theories of money demand 1) The transaction demand for money: Baumol and Tobin noted that money is held to smooth out the difference between frequent income receipts and continual expenditure payments.. the change in money supply is given by ∆M = 1 ∆R -------------------------------------------------------.2.1) r Where... the initial reserve increase will increase money supply by Birr 5 thousand ∆M = 1 100 = 5 20 Consolidated money stock Given information regarding the reserve requirement ratio as well as assets and liabilities of both the commercial and central/national banks the consolidated money stock/supply in an economy can be computed and posted in the balance sheet shown in table 1.1. Table 1. There is no linkage into increased public holding of currency. This view of transaction 40 .(1. ∆R is the initial reserve increase due to OMO and r is the reserve requirement ratio.

demand for money assumes that individuals hold all the proportion of their income that they intend to spend in any on period in cash. Cash balances are, however, typically noninterest bearing and so is costly to hold large amount of cash. Individuals therefore generally choose to hold only the cash they need for current transactions while leaving the rest in a bank deposit where it earns interest. This implies that, individuals and business firms maintain certain average level of cash and deposits because they need to make dayto-day transactions. If receipts of income and expenditure were always synchronized perfectly with respect to time, there would be no need for such idle cash balances. Because people are paid once a month or once a week and because they do not make all their disbursements as exactly the time they receive their income, they must maintain (hold) some amount of cash for the purpose of meeting their transaction needs. In developing their model, Baumol and Tobin considered a hypothetical individual who receives monthly nominal income Y (say Birr 2,400) at the beginning of the month and spends it on transaction during the month (this period) at a uniform rate. If the individual keeps certain proportion of money his/her income in cash to carryout transactions, then his/her money balance follows the Saw-tooth pattern displayed in Figure 1.11. Time is measured horizontally and the amount of money balance held at hand and balance in bank account (bond holding) at the beginning of the time period is measured in the vertical axis. In panel (a) we assume that the person received Y Birr of income (say Birr 2,400) at the beginning of the month (time zero) and spends the entire amount on transaction that occur at a uniform or constant rate during the course of the month. At the beginning of the month he has Birr 2,400, and by the end of the month he/she has zero balance because he/she has spent all. In other words, at the beginning of the month the person holds Y Birr and at the end, no money (cash) left. Since money is spent at a uniform rate (constant rate or stable intervals) throughout the month, his/her average holding of cash balance over the course of the month is simply Y / 2 Birr (or Birr 1,200)-holding at the beginning of the month, Birr 2,400 plus holding at the end of the month, Birr 0, divided by 2. It is this average idle balance that we call the transaction demand for money. Household average cash balance for n number of withdrawals over any period can be written as:
Mb = 1 Y    --------------------------------------------------------------- (1) 2 n 

Beginning bond balance is thus BB b = Y − BC b ------------------------------------------------------------ (2)
B C Where, B b and B b denote beginning bond and beginning cash balance respectively.

Part of money balance ( Y ) that yields return to the bond holder is called average bond balance, which is half of beginning bond balance. It is expressed as BBb AV .Bb = ------------------------------------------------------------- (3) 2 Assuming for a moment there is no transaction cost (this assumption will be relaxed shortly), net interest total revenue (TR) earned by the individual or is given by 41

 Y 1  Y  TR = r  −   ------------------------------------------------------ (4a)  2 2  n 

Equation (1.4a) says that net interest earned by the individual or total revenue is the rate of interest multiplied by the unspent income in bank deposit or bond balance less the amount withdrawn in cash in the half way point. The expression in the bracket is equal to average bond holding. Hence, total revenue can also be written as TR = r ( AV .Bb ) ---------------------------------------------------------- (4b) Suppose now the household withdraws half of the money from the bank at the start of the period and withdraws the other half at the start of the third week. When n = 2 , panel (b) of Figure 1.11 shows that average cash balance is 1 / 2(Y / 2) = Y / 4 = 600 . Alternatively, panel (b) can be interpreted as the case in which the individual decides to make one bondcash transaction by holding half of his/her Birr 2,400 in cash and put the remaining half into income earning bonds. In other word he/she holds Birr 1,200 in cash and uses the other Birr 1,200 to buy a Treasury bond at the beginning of the month. Since bonds cannot be used directly to carryout transactions, he/she must sell the bonds and turn them into cash so that he/she can carryout his/her half month transactions. Thus, the individual’s bond holdings drop to zero at the middle of the month, and his/her cash balance rise up to Birr 1,200. By the end of the month all the cash is gone. When he again receives his/her next Birr 2,400 monthly payments, he/she again divides it into Birr 1,200 cash and Birr 1,200 of bonds, and the process continues. Using equation (3), the net result of this process is that the bond balance that yields return to the individual is 1 / 2( BB b ) = 1 / 2(1200 ) = 600 . It is clear that using equation (4a) or (4b) net interest or total revenue (TR) obtained from this process is 24. The value of marginal revenue ( ∆TR / ∆n ) is also 24. Panel (c) shows when the household makes three times (per ten days) withdrawal or two bond-to-cash transactions. In this case, two third of the income Y (or Birr 1,600) will be put into bonds initially. Ten days into the month, half of the bonds [ 1 / 2( 2 / 3)Y ] or third of Y ; that is Birr 800 can be cashed. Each bond will then yield [ r[1 / 3(1 / 3)Y ] = r[1 / 9(Y )] . Ten days latter the other half can be cashed having earned r[ 2 / 9(Y )] revenue for this third of Y . Total revenue in the three withdrawals or two bond-to-cash transactions cases will then be r (Y / 9) + r (2Y / 9) = r (Y / 3) = 32 . You can verify this also using equation (1.3.4a) or (1.3.4b). Marginal revenue is simply 32 less 24 or r[1 / 3(Y ) −1 / 4(Y )] = r[Y / 12 ] = 8 This analysis entails that for withdrawals greater than one ( n >1) total revenue (TR) can also be obtained by analyzing the revenue is obtained each time when withdrawals are made9 or bonds are cashed using the expression below.
9

Where, r / n multiplied by Y / n , 2Y / n,..., and ( n −1)Y / N indicate amount of money that yield interest during the second , third,…, and last withdrawals. For instance, if n = 6 ( n −1)Y / N is the amount of money withdrawn for the 5th time

42

 1  Y 2Y 3Y ( n − 1)Y  TR = r   + + + ... +  n n n  n  n 1  = r  2 ( Y + 2Y + 3Y + ... + (n − 1)Y )  ---------------------------------- (5a) n 

(a) Plan/strategy/ 1: n = 1 or no bonds-to-cash transaction Y
Y /2

Av. Mb =Birr 1,200

1

2

3

4

Weeks

(b) Plan/strategy/ 1: n = 2 or one transaction Y Bond Y/2=1200 Mb=Cash 1 2 3 4 Av. Mb=Y/4=Birr 600 Weeks

(c) Plan 3: n = 3 or 2 transactions Y

Bond

Y/3=800 Mb=Cash

Av. Mb=Y/6=400

43

the 1 44 . Finally.1 2 3 4 Weeks (d) Plan 4: n = 4 or 3 transactions Y Bond Av.11: Individual’s transaction demand for money For instance.12 below. There are two main factors.04 = 32 = 9  3  3  3 This revenue is the sum of r (Y / 9) & r (2Y / 9) which give net earning equal to 10. other things being equal. First. the number of withdrawals that maximize the TR of the individual increases from n0 to n1 when the market interest rate increases from r0 to r Therefore. 1  TR = r  2 ( Y + 2Y )  3  1  Y   2400  96 = r  ( 3Y )  = r   = 0. Mb=Y/8=400 Mb=Cash 1 2 3 4 Weeks Fig 1. as interest rate rise households will economies/decrease their holding of idle/average cash balance for transaction purpose. In figure 1. for n = 3 . Examples above prompt the question as to what determines the number of withdrawals or transactions ( n ) demand for money at any given period.These example shows that the average cash balance held by the individual household falls as the number of cash withdrawals increase. which is [1 / 2(1 / 4)Y ] . In this case the average cash balance held is only Birr 300 or Y / 8 . since a bank deposit account offers interest on funds remaining in the account.67 and 21. panel (d) depicts that if the household makes four times (weekly) cash withdrawal or three times bond-to-cash transactions.33 in the second and third withdrawal or first and second bond-to-cash transaction. thereby increasing n .

04 = = 32 3 3 3  3  3  3  3   For n = 4  1  1  2  1  3  1  6Y 3Y 288 r   Y  +  Y  +  Y  = r = 0. the expression for the net interest or total revenue earned when the individual makes two to five times withdrawal or one to four bonds-to-cash transactions at a constant interval using equation (1.4 Note: TR in this table is computed on the assumption that transaction cost is zero.04 = = 38. Assuming the interest rate is 4% per month and no transaction cost.200 ¼(Y)=600 ¼(Y)=600 24 r(Y/4)=24 3 (Per 10 days) Y/3= 800 2/3(Y) =1.2 below given r = 4% and no transaction cost.200 Y/2 =1. TR will be greater than net interest earned when transaction cost is involved in making transaction.Bb ) ∆TR / ∆n V 1(beginning of 1.400 Average (mid point) Cash balance Bond balance (M b ) Total Revenue Marginal Revenue (Y − M b ) ( BM b / 2) ( BB b / 2) r ( A . 45 .920 1/10(Y)=240 2/5(Y)=960 38. However. But increases at a decreasing rate 2) The marginal revenue from increasing the number of transactions is positive and decreasing as the number of transactions n increases.4 25 5 5  5  5  5  5  5  5  5  5  Results discussed so far regarding the revenue side of transaction demand for money are is illustrated in table 1. In this case TR and net interest earned are equal.5) will be:  For n = 2  1  1  Y 96 r   Y  = r = = 24 4 4  2  2   For n = 3  1  1  2  1  Y Y 96 r   Y  +  Y  = r = 0.04 = = 36 16 8 8  4  4  4  4  4  4   For n = 5  1  1  2  1  3  1  4  1  10Y 2Y 192 r   Y  +  Y  +  Y  +  Y  = r = 0.200 the month) 2 (Per 15 days) Y/2=1. From these strategies.transaction demand for money is sensitive and inversely related to the level of interest rate.600 1/6(Y)=400 1/3(Y)=800 32 r(Y/12)=8 4 (Per 7 days) Y/4= 600 ¾(Y) =1.800 1/8(Y)=300 3/8(Y)=900 36 r(Y/24)=4 5 (Per 5days) Y/5= 480 4/5(Y) =1.4 r(Y/40)=2. it is clear that: 1) The lower the average holdings of cash balance and the higher the bond holding the more interest the individual will earn.2: Marginal revenue from increasing transactions from bonds to cash No of withdrawal ( n) & duration Initial (Beginning) Cash Bond balance Balance( Bb ) Amount withdrawn Y=2. Table 1.

for making more trips.(5b) For example assume that transaction cost per withdrawal is Birr 2.2.Bb ) − cn -----------------------------------------------------.M R C M ( r0 ) curve in figure 1. TR is considered as gross interest earning.2 for the net declines by the amount of transaction cost multiplied by the number of withdrawal. Combining with the initial M (r0 ) curve gives the profit maximizing number of transaction n0 .4. When making withdrawal or converting bond-to-cash involves transaction cost the TR is not also net interest earned on average bond holding. the number of withdrawals made by the individual decreases from n1 to n2 . Aggregate money demand 46 . Similarly.This also mean that average cash holding will increase and that of bond balance or deposits will likely be decline. which is shown in column 6 of table 1. when an individual makes 2 withdrawals transaction cost will be Cn = 2 x 2 = 4 . where MR = MC . or trouble of making frequent visits to the bank in order to affect cash withdrawals.12. similarly. On the cost side. which is equal to Birr 20. the number of withdrawals will be n1 when interest rate increases from r0 to r 1 M . Thus.3) 1. The expression net interest ( NI ) when transaction cost is involved thus NI = r ( AV . transportation cost.12: Determination of the number of transactions The above figure also indicates that as transaction cost per withdrawal or MC increases C C from M 0 to M 1 other things being equal. and 5 withdrawals were made. the implicit cost of time spent transacting business. we assume that each transaction has a give cost. Then we can add a MC schedule to the R figure 1. Instead. 8. we can see that as n increases the drop in MR decreases. perhaps a brokerage fee for the buying and selling of bonds. This gives us Looking at the differences in MR column in table The second factor that determines the size of n is the transaction cost in terms say cn . net interest will be 24 minus 4. In this case. and 10 when 3. c . net interest ( NI ) declined by Birr 6.12. which shows MR is a function of the number of R transactions n for given interest rate ro M 1 C M 0 C M (r ) R 1 M ( r0 ) R n0 n2 n1 n Figure 1.

3.(6a) n d MT Y = 2mb = ----------------------------------------------------------.4: 1) If interest rates on bonds go to zero. who can earn 5% interests per month on saving deposits. Moreover. (C) While interest rate remains constant.11. Suppose. assume that the individual’s elasticity of withdrawal with respect to change in interest rate and transaction cost are ½ and 2 respectively. Exercise 1. Aggregate money transaction balance or simply cash balance in nominal and real term are given by d M T = 2M b = Y ----------------------------------------------------------. Given the above information: (A) Compute the individual’s average monthly cash and bond balances for the information given above and illustrate the values using the sawtooth pattern graph. The firm’s pattern of bond and money would follow the same saw-tooth pattern exactly complementary to the consumers’ pattern in Figure 1. This means that we must double. what does the BaumolTobin analysis suggest regarding total revenue and net interest earning on holding of money balances should be? Explain 3) Consider an individual who earns Birr 3600 per month. there is assumed to be someone on the other side of the market. what will happen to the number of withdrawals and hence individual’s average monthly cash and bond balances change if transaction cost declines to Birr 1? Calculate the values and show graphically (D) Compute the net interest earned from money kept in the bank or holding of short term bonds in the case of (a) to (c) by rounding the values to nearest whole number. what does the Baumol-Tobin analysis suggest the individual’s average holding of money balances should be? Explain 2) If brokerage fees or time and transportation cost go to zero. and has an initial withdrawal plan of 4. the subscript T indicates aggregate or total.2.To move to the aggregate money demand for each representative consumer whose money transaction balance is given by equation (1). the sum of the households’ demands and that of the firms on the other side of the market. M b in equation (1) to d get the aggregate demand for real money balance M T / p . 1. (B) Other things remain constant. by how much will the individual’s number of withdrawals and hence average monthly cash and bond balances change if the rate of interest falls to 3%?. faces Birr 2 transactions cost per withdrawal.(6b) P n Where. for example that the consumer buys goods from a representative firm and that firm periodically converts its money holding into bonds. The aggregate money DD in the transaction s model is therefore. The Portfolio Approach (Reading assignment) 47 .

Tobin’s model of liquidity preference deals with this problem by showing that since the return on bonds is uncertain. ∂m / ∂r is negative and ∂ / ∂ is positive M = m = f ( r . b For example. the percentage yield is 5 percent. with a fixed Y on the b b b 48 . since the yield Y is a fixed amount stated as a percentage of the bond’s face value. This is obviously not true in reality. interest rates to rise. that is. Since people’s estimates of whether the interest rate is likely to rise or fall. at any given interest rate there will be someone expecting it to rise. bonds are risky.(1) P The portfolio approach is attributed to Keynes speculative (regressive) expectations model and described by Tobin in his article on liquidity preference. This gives us an expression for the b b e percentage capital gain. If the price of the price of the bond rises to $125. The obvious problem with the liquidity preference theory of Keynes is that it suggests individuals should. the market rate is given r = Y -------------------------------------------------------------P b . g ( P − P ) P .Introduction: According to Keynes. then the investor worrying about both risk and return is likely to do best by holding both bond and money-diversification of portfolio. if a hundred-dollar bond has a yield of $5.(2) And. From equation (2) and (3). Thus. y ) ≈ l (r ) + k ( y ) -----------------------------------. The market rate of return on the bond r is the ratio of the yield to the price of the bond P . inversely related to interest rate. the market price of a bond is given by Pb = Y ------------------------------------------------------------r . the bond’s yield – the interest payment an individual receives – and a potential capital gain – an increase in the price of the bond from the time he/she buys it to the time he/she sells it. the $5 yield corresponds to a market rate r of 4 percent . and thus someone holding money. hold all their liquid assets either in money or in bonds. at any given time. and thus expect that they would take a loss if they were to hold bonds. Tobin assumes that a bond holder has an expected return on bond from two sources. and transaction component.(3) The expected percentage capital gain g is the percentage increase in price from the purchase price P to the expected sale price P e . the demand for real money balance function. that is. vary fairly widely. The bond’s yield Y is usually stated as a percentage of the face value of the bond. positively related to income and inversely related to interest rate. The portfolio approach says that people hold money when they expect bond prices to fall. but not some of each.$5/$125. is given by m y Where. divided into speculative component. and by how much.

that we have developed in equation (5) earlier. an expected price P corresponds to an expected interest rate r = YPb . As a result. Thus. This theory removes the following two major defects of the Keynesian liquidity preference theory. and 2) Individuals hold either money or bond. But bonds yields interest and also bring income. the capital gain can be written as Y Y − re r g= Y r Canceling.(5) And substituting for g from equation (5). Money neither brings any return nor imposes any risk on holders. his expected capital gain would be g= 0. The greater the investment in bonds the greater is the risk of capital loss from the bonds. if the present market interest rate is 5 percent and the purchaser of the bond expects the rate to drop to 4 percent.04 The total rate of return on a bond . For example. 1) Keynes’s liquidity preference function depends on the inelasticity of expectations of future interest rate.bond.e . An investor can bear this risk if he/she is compensated by an adequate return from bonds. the Y terms and multiplying the numerator and denominator by r gives us r g = e − 1 ---------------------------------------------------------r e e e (4) As the expectation for the expected capital gain in terms of current and expected interest rates. 49 .25 or 25% 0. e = r + g --------------------------------------------------------. the portfolio balance approach begins with the same expression to the total percentage return. we have an expression for the total rate (percentage) of return r e = r + e − 1 ----------------------------------------------------r (6) James Tobin in his famous article “Liquidity Preference as Behavior towards Risk” formulated the risk aversion theory of liquidity preference based on portfolio selection.25 −1 = 0.05 −1 = 1.e for earnings – will be the sum of the market rate of interest at the time of purchase and the capital gains term. However. Thus. even if the return from bonds is higher that the return from money. income from bonds is uncertain because it involves a risk in capital gains and losses. in b terms of expected and current interest rates. Tobin starts his portfolio selection model of liquidity preference with this presumption that an individual asset holder has a portfolio of money and bonds.

and all bonds are alike. They also give the investor a formula for deciding how much funds to put into bonds to achieve a given risk-return mix along the budget line. The basic contribution of the portfolio balance approach is to enter risk contributions explicitly into the determination of the demand for money. If g is the expected capital gain or loss. e = B(r + g ) . r . Now in place of a return expected with − certainty. where e = r + g -------------------------------------------------. a number like 2 percent. then the total standard deviation of bond holding is given by σT = B. If asset holder is putting B dollars of his/her liquid assets into bonds. his/her expected total return on a portfolio RT is then − − RT = B.σg -------------------------------------------------. if the standard deviation of the probability distribution of return/capital gains on a bond is σg . e . It is further assumed that this probability distribution has an expected value of zero and is independent of the level of the current rate of interest. we can have an expected return. They do not have any negative values. e . From (9) we have B= − σT 1 = σT σ g σ g -----------------------------------------.e=r+g We have also assumed earlier (under 4) that the percentage rate of expected capital gain given by r g = e −1 r is determined with certainty by the individual: he chooses r e as a function of r and no consideration of uncertainty or risk enters the problem.(10) 50 .(8) Similarly. which is a natural measure of uncertainty or riskiness of bonds. The Individual portfolio Decision Individual portfolio consists of a proportion M of money and B of bonds where both M and B add up to one.(7) − − And g is the mean expected capital gain from the probability distribution. on bonds. it is assumed that the investor bases his/her actions on his /her estimate of its probability distribution. where 0 ≤ B ≤ 1 ----------------.(9) Equation (11) and (12) give us the technical situation facing the asset holder – the budget constraint along which he/she can trade increased risk σT for increased expected return − − − RT .

13. Tobin uses indifference curves having positive slopes indicating that the risk averter demands more expected return in order to take more risk. −   − σT r + g  RT = (r + g ) = σ T  -------------------------. diversify their portfolios. therefore. the expression in parenthesis (13) is a given. an increase of − − σR I2 I1 r T 51 .(12) = dσ T σg − − − If r is 5%. The − investor knows g and σg . by the bond market.With σg fixed by the asset holder’s probability distribution (10) gives the total bond holdings B needed to attain any given level of risk σT . fixed. Although. They are risk averse or diversifiers. But the majority of investors belong to the third category. from the probability distribution g ' s in Figure 1. They will either put all their wealth into bonds or will keep it in cash. They will.(11) σg  σg     − Here r is a known current vale. They accept risk of loss in exchange for the income they expect from bonds. Differentiating (11) we have d RT r + g -----------------------------------------. determined number which gives the constant rate of trade-off between return RT and risk σT . at least implicitly. Thus. In order to find the risk averter’s preference between risk and expected return. at least to the individual. They are prepared to bear some additional risk only if they expect to receive with it greater increases in returns. Thus. plungers either go all the way or not at all. They are like gamblers. then d RT / dσ T is 3%. The first category is of risk lovers who enjoy putting all their wealth into bonds to maximize risk. Risk averters prefer to avoid the risk of loss which is associated with holding bonds rather than money. Using this expression to replace B in (8) gives us the budget constraint. one percentage point in the standard deviation in the total portfolio σT will buy a 3% increase in the expected total return RT . Tobin describes three types of investors. − g is 15% and σg is 5%. and hold both bonds and money. yet it is the most liquid form of assets which can be used for buying bond any time. money neither brings any return nor any risk. In this case. The second category is of plungers.

14 below.O Risk ( σR ) M P W B E C Fig 1. That is why he/she is called a diversifier. The line O is the budget line of the risk averter. the risk averter possesses an intrinsic preference for liquidity which can be only offset by higher interest rates. the risk averter diversifies his/her total wealth OW by putting partly in bonds ( OP ) and partly keeping in cash ( PW ). The aggregate demand for money in the portfolio balance model The higher the interest rates. I1 and I 2 are indifference curves. Thus. Thus. point E on this line drawn as a perpendicular from the point T determines the portfolio mix of money and bonds.13. the horizontal axis measures risk ( σR ) and the vertical axis the expected r return ( RE = µR ). It is OP of bonds and PW of money. He/she is not prepared to accept more risk unless he/she can also expect greater expected return. On the contrary. It shows both the risk and return on the basis of which he/she arranges his/her portfolio of wealth consisting of money and bonds.13: The “diversifier’s” portfolio selection between risk and return In Figure 1. the lower the demand for money and the higher the incentive to hold more bonds. In the lower portion of the figure the length of the vertical axis shows wealth held by the risk averter in his/her in his portfolio consisting of money ( PW ) and bonds ( OP ). Points on curve are preferred to those on I1 curve. the higher the demand for money and the lower the willingness to hold more bonds. This is illustrated in Figure 1. at point T . But the risk averter will achieve an equilibrium position between expected return and risk where his/her budget line is tangent to the indifference curve ( I1 ). the lower the interest rates. However. An indifference curve shows that he/she is indifferent between the pairs of expected return and risk that lie on I1 curve. The line OC shows risk as a proportional to the share of the total portfolio held in bonds. I3 r3 Expected Return r2 T3 I2 I1 r 1 T2 T 1 O 52 .

Risk Wealth B1 B2 B3 E1 E2 E3 W C Fig 1. Consequently. This also means that the demand for money falls by smaller amounts. When rate of interest is r . as the rate of interest increases. This is because the total wealth in the portfolio consists of bonds plus money. These tangency points also determine the portfolio selection of risk averters as shown in the B lower portion of Figure 1. OPC at in the figure. I 2 .14: Aggregate Portfolio selection with rising interest rates In Figure 1. In Figure 1.and I 3 1 T1 . and T3 respectively.and r3 are tangent to I1 . The curve shows that when the rate of interest falls from a higher level. returns 1 increase in relation to risk with increase in interest rate and the budget line touches higher indifference curves. r2 . The figure also shows that as the rate of interest increases by equal amount from r to r2 and 1 to r3 . The demand for money can be drawn on the basis of Figure 1. Interest Rate r0 1 r 8 r6 r4 r2 Md O A B C D Speculative DD for money Fig 1. This is shown by the budget line r rotating upward to r2 and r3 .15. These points trace out the optimum portfolio curve. T2 . budget lines r .15 below. As the rate of interest increases from r to r2 and r3 . people hold O 1 amount of bond 1 and B1W money.15: The demand for money 53 .18. which shows that as the tangency points move upward from left to right. risk averters hold bonds by decreasing increment B2 B3 < B2 B1 < OB 1 .14 and derived in Figure 1. risk averters hold 1 B successively more bonds OB 2 and O 3 but reduce money to B2W and B3W in their portfolios.14 the slope of the budget line increases with the increase in the interest rate. there is a smaller increase in the demand for money. both the expected return and risk increase.

K ) − N1 N 2 APN . It follows. which implies that this model of labour market is strictly a model of the short run. This is because the risk averters prefer to hold more bonds than money. The capital stock is fixed at K .16 shows the production function.1 Labour demand (A) Individual firm labour demand Introduction: The demand for labour is a derived DD. Figure 1.For instance. CD in figure 1. Hence. which is smaller than OA . That is to say firms do not demand labour for its own sake but for what it is able to produce for sale in conjunction with other factors of production. Profit maximization implies that additional labour will be demanded until the marginal cost of labour (real wage) just equals the marginal revenue of labour obtained from the sale of extra output produced by the marginal worker. such as capita. which describes real output ( Y ) is a function of labour input and the capital − stock. The marginal revenue and marginal cost of a firm is determined by the state of technology and the nature of production function. But when the rate of interest falls at a lower level from r4 to r2 the increase in the demand for money is much larger. therefore. that firms will only demand labour if it is profitable to do so. Y Y = f (N. 1. This demand for money relates to the speculative demand for money not to the aggregate demand for money. M PN N3 N A N =y/N P N1 N2 M N P 54 .15. It will be profitable to employ more labour in the marginal revenue earned from the sale of extra output exceeds the marginal cost of producing that output.4 Labour market 1. the demand for labour by an individual firm operating in competitive markets is based on the notion of profit maximization. when the rate of interest falls from r0 to r8 the demand for money increases 1 by AB amount.4.

It can be seen that as employment increases the A N first P increases up to N 2 and then decreases beyond N 2 . and reaches zero at N 3 .16: The production function The shape of the production function. peaking at N1 .(3) ∂L N − − R This indicates that at equilibrium M P demand is also written in real term as is equal to nominal wage. the relationship between the production. If the addition to total output is sold in a competitive market. y = y ( N . First. Alternatively. y ( N . that is 2 2 P ∂ y / ∂N < 0 . however. Beyond the level of employment given by N1 . shown over the range O 1 in Figure 1.Fig 1. K ) . labour Ld = ∂y W = = w -----------------------------------------------.(4) ∂L P The above expression entails that firms determine how much labour to hire by equating P MPL = MC L = w .The M N . exhibiting diminishing marginal returns as the fixed capital stock is shared among more and more workers. shows Y increases with labour input. The marginal cost of the firm is real wage. P. Thus the profit maximization condition where by the marginal cost of extra worker is the money wage. so that ∂y / ∂N > 0 . where the P production function becomes flat. Beyond N1 the M N therefore.M N .(1) ∂π Ld = = 0 -----------------------------------------------------.16. Y begins to increase at a decreasing rate. intersects the A N at its maximum. This is called the marginal revenue product of P − − labour ( MRP N = VMP N ). which represents the additional output produced by the last worker employed and is derived from the slope of the production function. Initially output increases at an increasing rate with the first additions N of labour to the capital stock. the P employment of one more worker will lead output to rise by the M N . K ) −WN ------------------------------------------. average and P marginal product of labour. falls with N.16. and the M N exhibits a diminishing marginal product of labour. such that the price it sells for is the same as that for all previous units. In the lower panel of Figure 1. In Figure 1. W. the point of inflection point where the production function changes from convex to concave. The slope is initially rising.16. equals marginal revenue product of labour is given as π = P . With this information the firm’s labour demand decision can be examined. and then falling P beyond N1 .(2) ∂L ∂y =P −W = 0 ∂L ∂y = MRP N = P = W --------------------------------------. then marginal revenue received by the firm is the price of P output multiplied by the M N . the M N 55 .

The employer is thus in a position 56 .4.(5) P P Where f ( N ) denotes the economy wide M N schedule.17: The aggregate Demand for labour 1. Since the marginal product of labour schedule falls as N increases f ( N ) < 0 and the real product wage is inversely related to the aggregate demand for labour. W P W0 P f (N ) w N0 N w0 P. we do not make any explicit assumption about price or wage expectation of employers on the demand side of the labour market. Since the price deflator used in the calculation of real wage rate is the price of the firm’s output. the demand for labour is inversely related to real wage rate. f ( N ) ----------------------------.2 LABOUR SUPPLY Introduction: The individual supplier of labour is assumed to supply labour in direct relation to the real (consumption) wage. beyond N1 .17 below. (B) Aggregate labour demand In the aggregate it is assumed that the demand for labour is the horizontal summation of individual firm’s demand for labour. which gives the downward slopping curve as depicted in Figure 1. this measure of real wage is referred as the real product wage.falls as N increases. The aggregate demand for labour function is therefore denoted as Ld = w = W = f (N ) Or W = P. This is because we assume that an employer has good information on or perhaps control of the particular prices changed and the wage rate paid. In developing the aggregate demand for labour. f ( N ) N0 N Fig 1.

even if they did.(6b) s e In real value: L = w = In equation (6a). However.(7a) P This is another version of equation (6a). However. By definition: W W Pe LS = w = e . N . Hence.to know the real wage at each point in rime. Pe ----------------------------------------------. this real wage ( w ) is the money wage deflated by the particular employer’s product price ( P ). Therefore. Thus. g ( N ) = W / P e can be written in the current actual real wage ( w ) and the level of employment. the aggregate supply curve of labour in expected price can be represented mathematically as: N = N ( we ) W = g ( N ). That is Ls = W = P e . 57 . that is ∑n = N . by substituting e by g (N ) from equation (6a) P P P LS = w = g ( N ). This is because workers may not know in advance exactly what products will they need to purchase with their money (nominal) wages and second. Therefore. they do not know the exact prices (consumers price index) of the goods in advance. we . For the employer.g ( N ) ---------------------------------------------.g ( N ) ----------------------------------. . g ′ > 0 ----------------------------.(6a) or Pe In nominal value: Ls = W = P e . a worker’s information concerning price level (and subsequently about his/her real wage) is not adequate as that of the employer.(7b) Aggregate labour supply ( LS ) derived in current actual real and nominal wage rather than expected real wage (equation 7) are depicted graphically as follows. These two real wage rates are referred to as the expected wageW / P e (or we ) and the real producer wage. it is important to note that the price deflator used by the worker when deciding the amount of labour to supply is different from the price level used by the producer in determining how much labour to employ. relationship by converting the expected real wage ( we ) in to the actual real wage ( w ).W / P (or w ) respectively. a worker must deflate his/her nominal/known wage income (W) by a an estimated consumers price index (CPI) or P e that covers a wide range of products in order to arrive at an estimated or expected real wage. the labour supply function in nominal wage derived from equation (7) is similar to that of (6b). an explicit assumption linking workers estimation or expectations on price level ( P e ) and the actual price level ( P ) is important. THE AGGREGATE LABOUR SUPPLY CURVE This is obtained by summing all individual labour supply curves for a given expected wage rate ( P e ) to get the aggregate labour supply curve for the entire economy.

(9) In real wage: f ( N ) = The graphic representation of labour market equilibrium is represented by the intersection of the two curves indicated in equation (8) and (9) above. equation (7) P The labour market equilibrium is obtained by equating labour DD ( Ld ) to labour SS ( Ls ).(8) P e In nominal wage: P.w w= Pe . f ( N ) = P .g ( N ) W W0 N0 N Fig 1. both as a function of real and nominal wage in equation (5) and (7) respectively.g ( N ) ---------------------------------------. and real income.18: Aggregate labour supply Curve 1. P and the expected price level P e equilibrium real and nominal wage are w0 and 0 e w . respectively while equilibrium employment is N 0 .g ( N ) Or W = P e . Pe .g ( N ) P w0 N0 N W = P e . 58 . For a given value of actual price level. equation (5) P Pe Ls = w = .3.g ( N ) ---------------------------------. as Ld = W = w = f (N ) Or W = P. Frictionless Labour Market Equilibrium and the Aggregate Supply Curve (A) Frictionless Labour Market Equilibrium (Classical equilibrium) We have already derived that the aggregate demand and supply of labour equations in the labour market.g ( N ) .4.That is. y0 . f ( N ) .

In reality however. f ( N ) N0 NF N Fig 1. unemployed workers may not accept the first job offer they receive. 59 . there could be no increase in employment because all workers are employed.19 the level of full employment is given at N F . The level of voluntary unemployment expressed as a percentage of total labour force in an economy is usually referred to as the natural rate of unemployment. But this does not imply that there is zero unemployment.g ( N ) P0 w0 E Ld = w = f (N ) N0 NF N W LS = W = P e . namely frictional unemployment and structural employment. searching job takes time and effort and because different jobs require different skills and pay different wage rates. The voluntary unemployment due to the labour market frictions is frequently believed to consist of two specific kinds of unemployment.g ( N ) W0 E Ld = w = P. w Ls = w = Pe .At point E the labour market clears. This can lead to structural unemployment. Hence. The unemployment caused by the time it takes workers to search for a job is called frictional unemployment. Frictional unemployment is explained by the special characteristics that it takes time to match workers to jobs. The distance between N F − N 0 therefore denotes the level of voluntary unemployment.19: Equilibrium in the labour market As structural change occur in the economy. workers have different preference and abilities and jobs have different characteristics and the geographical mobility of workers is often low. some industries of the country may decline and some labour skill categories become redundant as others expand. Note that if all the workers are in employment the labour supply curve would become vertical since no matter how high real wages were pushed up. In Figure 1.

α' is the slope of the price function (or ∂P e / ∂P ) and its value lies between 0 and 1 Now let us see first what will happen to labour market equilibrium level of employment. the natural rate of unemployment means frictionless labour market equilibrium. 0 1 With these assumptions we can then derive the classical AS curve of the frictionless (classical) and extreme Keynesians school of thoughts by examining what happens to the equilibrium level of employment. Because the classical assume that workers have perfect foresight of the current and expected price levels and hence price and wage rates are flexibility conclude that the labour market always clears both in the short and long run along the aggregate supply (AS) curve.g ( N ) P P Real product wage or M L = Real consumption (money) wage (2) W = P. 0 ≤ α' ≤ 1 ------------------------------------------. It corresponds to the classical labour market equilibrium. Thus any changes in unemployment are entirely voluntary.Thus. (B) The Aggregate Supply (AS) Curve Aggregate supply curve is derived from the aggregate labour market and production function to give a direct relationship between output and price level for a given state of technology and the work-leisure preference of workers.(10) Where. In other words. income and wage rates for a closed economy (an economy without international trade)as price level increases exogenously? a) The extreme Classical case: The basic assumption of the classical regarding the labour market is that there is complete and correct adjustment or perfect foresight of P e to P .That is ∆P e = ∆P and hence α = 1 in equation (10) above. This assumption stems from its two core assumptions about the aggregate economy: price and wage flexibility and economic agents are rational. we assume for simplicity the following two assumptions: 1) Initially both actual and expected prices are equal or P0e = P0 and 2) The price level rises from P to P . and wage (real and nominal) rates of the classical and extreme Keynesians as the price level changes and then derive their aggregate supply (AS) curves. The derivation of the AS curve is based on the labour market equilibrium expressed in real and nominal wages as Ld = Ls . To do so. f ( N ) = P e . the natural rate of unemployment or the level of employment consistent with the labour market clearing is voluntary in the sense that the number of job vacancies is equal to the number of workers seeking job. 60 .g ( N ) (1) w = f ( N ) = Actual money wage = Expected nominal wage The degree to which the expectation of workers about P e adjust to the movement of P is given by P e = α( P ). That is Pe . income.

and so contract/reduce their labour supply to the labour market. because the price level is combined multiplicatively with the marginal product of labour increase. In the second figure. however. As a result. This is known as the classical result. again leaving N 0 undisturbed. we can conclude that with α = 1 or perfect foresight of P e to P only the nominal wage rate ( W0 ) rises by the same proportion to the increase in price level. This proportional shifts the labour demand and supply curves in turn hold 1 equilibrium employment at N 0 . an equal (proportional) increase of P and P e shifts the labour demand and supply curves up by the same amount (magnitude).The implication of proportional shift of labour supply to that of labour demand is that MC has increased by the same proportion to that of MR. the exogenous increase in actual price from P to P shifts 0 1 the labour demand up (or to the right) from the initial P . Therefore.20(b).20(a) below that when the expected price P e fully adjusts to the change in the actual price the labour market equilibrium remains at point A leaving the initial labour market equilibrium value. employment. and income constant at w0 . This is evident from Figure 1. N 0 . f ( N ) to P . The insensitivity of equilibrium level of employment ( N 0 ) and output/income ( Y0 ) when the price level rises from P to P due to perfect foresight ( α = 1 )of workers 0 1 about the change in price in a closed economy give us a VERTICAL AGGREGATE SUPPLY CURVE of the classical as shown in Figure 1. w w0 Ls = Pe .and Y0 respectively. In Figure 1.g ( N ) to P e . The rise in the price level can be shown by the vertical distance AB . so workers will perceive a fall in their real wages. w0 and N 0 space undisturbed. the labour supply curve shifts up (to the left) proportionally as far as the demand curve from P0e . in which movements of the price level do not affect equilibrium level of employment and real wage.20(d). f ( N ) . the ratio of 0 1 e P / P remains unchanged.g ( N ) .g ( N ) P0 A (a) 61 . the higher price level translates into a higher consumer price index (CPI). holding equilibrium real wage. On the supply side of labour market. This is 0 1 because. the increase in price level reduces real wage and hence encourages employers to demand more labour and increase production. K ) in figure 19c. With employment fixed at N 0 output ( Y0 ) also becomes fixed at Y0 = f ( N 0 .When P e moves by the same proportion as P rises from P to P or α = 1 .

g ( N ) e 1 P e . That is.20: The Classical Labour market equilibrium and Aggregate supply (AS) curve b) The extreme Keynesians Case: This is the opposite of the extreme classical case. f (N ) 0 N0 (b) W0 N Y (c) Y0 Y Y (N ) 45 0 N0 N P P 1 Y = AS = Y ( g ( N ). when P0e = P e or α = 0 . implying imperfect foresight (myopia or 0 1 1 shortsightedness) or complete money illusion. f ( N ). EP * ) (d) P 0 B′ A′ Y0 Y Fig 1. 62 . Hence. f (N ) 1 P .Ld = f (N ) N0 W N P .g ( N ) 0 W1 B A P. the extreme Keynesians assume zero (no) adjustment of the expected price level ( P e ) as the actual price level changes from P to P . This is because of the assumption of price and wage rigidity and static expectation of economic agents about price level.

1 With P e given and not responsive to changes in actual P ( α = 0 ).21b due to the decline in real wage.e.g ( N ) P 1 w0 A (a) 63 . shifting the labour DD up. very short period of time where supply cannot respond to demand) when the labour force has not had time to absorb new price information on price level and adjust P e to P .W . f ( N ) 0 to the higher P .21a. N space. which postulate though the degree of adjustment of workers expected price to actual price improves with the availability of information in the long run. if the money illusion assumption or α = 0 holds the labour SS curve is constant. Since the increase 1 in the price level has shifted only the labour demand curve. Ls = 0 P0w . the rise in P with unchanged P e reduced the ratio of P e / P from P0e / P0 to P0e / P and hence shift the labour supply curve 1 w. only the demand for labour curve shifts to the right along the unchanged labour supply curve from P . Hence. f ( N ) in figure 1. Thus. employment raises from N 0 to N1 and the nominal wage from W0 to W1 . This is because as price increases. N space to the right. inducing an increase in equilibrium employment from N 0 to N1 (see panel a and b) and hence output/income from Y0 to Y (see panel c). the shape of the aggregate supply curve is always upward sloping and the equilibrium level of employment and output higher than the classical but lower than the extreme Keynesians. unlike the classical case where the nominal wage raises proportional to the change in the price level nominal wage in the extreme Keynesian case rises by less than the rise in the price level for expected price ( P e ) is fixed due to myopia.With P e constant as the price level changes labour supply depends only the money (nominal) wage rate. In Figure 1. The less than increase in nominal wage than the price level is then followed by a decrease in real wage (see panel Figure 1.21a). generating an increase in employment and output and upward sloping AS curve. but not the labour supply curve. the labour market equilibrium N moves up along the given labour supply curve in the W .. When there is no adjustment of P e to P . This criticism gave rise to the new (general) Keynesian theory of labour market.g ( N ) P0 s L1 = w P0e . Therefore. the rigidity of price expectations at P e on the supply in the 0 side of the labour market permits a reduction of the real wage rate as the price level increases. the above equilibrium condition in the labour market not only gives the equilibrium employment N depending on the price level P but also the aggregate SS curve with a positive slope. The extreme Keynesians are criticized on the ground that the assumption of α = 0 is appropriate to examine the impact of the movements of price level on equilibrium level of employment and output during the market period (i.

4. That is. 0 1 Figure 1.g ( N ) e 0 W W1 W0 B (b) A P.22(a) shows that the increase in P reduces the ratio of the expected to actual e e price level from P0 / P0 to P / P since adjustment expectation is less than perfect or 0 1 64 .4. adjustment of the labour market equilibrium to an exogenous increase in the price level from P to P by less than the exogenous increase in P . but not fully.22 below. the model in which expectations adjust to changes in the actual price level.w1 B Ld = f ( N ) 0 N 0 N1 N P . f (N ) 0 N 0 N1 N Y Y 1 Y0 Y B A Y (N ) (c) 45 0 N0 N1 N Y = AS = Y + α ( P − P e ) − P P 1 (d) P 0 B′ A′ Y0 Y 1 Y Fig 1. The New Keynesian view of the labour market This model is some how in between the two extreme (polar) assumptions-the extreme classical and the extreme Keynesian.21: Labour market Equilibrium and AS curve for extreme Keynesian 1. f (N ) 1 P . In Figure 1. at least in the short run. in which 0 < α < 1 . The aggregate supply curve of in the general Keynesian model. It could be labeled as imperfect foresight model.

N space reducing real wage and increasing employment from N 0 to N1 . an upward sloping aggregate supply curve passing through ( P . using the production function. f ( N ) 1 α <1. f ( N ) while the rise in P e shifts the labour supply curve up. since dP e < dP . respectively.g ( N ) W1 W0 e 1 B D C P. The same movement is also shown in the W .g ( N ) P 1 Ls = 0 s L1 = w0 w1 f (N ) N 0 N1 N P e . f (N ) 0 N 0 N1 N Y (N ) Y1 Y0 65 . N space of Figure 1. f (N ) 1 P . f ( N ) to P e . the excess demand for labour at W0 pulls up the nominal wage to W1 .22( b )where we see the increase in P shifts the demand curve up from P . This shifts the labour supply curve down in the w.α < 1 . and cutting the demand curve at point C in stead of at point B . from P0 . P0w . The movement in employment is translated to the change in output in Figure 1. Finally.Y0 ) and ( P . f ( N ) to P . Thus.g ( N ) 0 P . This implies that the 0 1 less than perfect foresight assumption eliminates the verticality and flatness of aggregate supply curve of the classical and extreme Keynesian. employment rises to N1 . since Furthermore.g ( N ) P0 Pw 1 . 0 1 e but only by less than the movement in the demand curve.Y1 ) pairs is obtained in panel d .22(c). an increase less than proportionate to the price level.

assume that the price levels in period zero. Further. Given this information. and New Keynesian case in real and nominal term. equation (9) and equation (10) and assuming expectations are perfect initially and set the price index P = 1 A) Derive the slope of Aggregate Supply curve algebraically B) Evaluate whether the slope of the Aggregate Supply (AS) curve of extreme Classical. and new Keynesian are positive. and Ls = 380 L + 2.22: Labour market Equilibrium and AS.N 0 N1 N Y = AS = Y + α ( P − P e ) − P 1 P 0 Y0 Y 1 Y Fig 1.5L2 . 1 A) Calculate the equilibrium employment ( L ).5L2 . P0 =1 and it has doubled in period 1. B) Discuss the reasons why the results you have obtained in question 1A above happened to be and show the results graphically. extreme Keynesian. respectively. extreme Keynesian. (2) Using the labour market equilibrium. K ) = 800 L −12 . output ( y ). C) Derive the AS curve for the three cases and show the results in 1A graphically.5: (1) Suppose the production function and labour supply are given y = y ( L. the New (general) Keynesian case EXCERSISE 1. negative or zero C) Show also the values of dN / dP for the three cases is similar to that of dy / dP 66 . that is P =1 . money (nominal) wage and real wage for the extreme Classical.

5 ∧ From the above example. ∧ Y t is time.(2.1 Economic growth and technical growth 2. = = x100 = 11 .941 . But when multiplied by 100 and rounded to one decimal digit it becomes 11.6% = Y ∂t Y Y2003 16.9 − 16.5  1959 .900 . To express growth rate in ∧ ∧ For instance.1) is 0. Y read as Y hat is the time deviation or change in the level of output or GDP and percentage we should multiply it by 100. 67 .1.115657. 1 ------------------------------------------. That is. In other words. Y = ∂Y / ∂t or simply ∆ = Yt −Yt −1 .6%.941 . the dynamic behavior of macroeconomics is concerned with the rate of change of key economic variables overtime.9 million respectively.900. the value of equation (2. economic growth is thus expressed as the change in income or output ( Y ) level overtime as follows: Economic growth = Y = ∂Y .4 = . according to MoFED (2006) macro data real GDP in Ethiopia in 2003 and 2004 fiscal year were Birr 16. It is concerned with the long term sustainable trend rise in output than short term fluctuation. economic growth in 2004 was: Y ∂Y 1 (Y2004 − Y2003 )  18.1 Economic growth: Economic growth is an expansion of an economy’s productive potentials over a long period of time. Thus.CHAPTER 2: MACROECONOMICS DYNAMICS 2.5   16.5 and 18.941. Thus.941 .1) Y ∂t Y Where.

In equation (2. α is the share of capital in output and 1 −α the share of labour input in output. the endogenous growth model. which is alternative classification of technical progress and considers the principles of to the neo-classical growth model. Y is the level of output.The above simple analysis raises the question what are the potential sources of economic growth? The neo-classical growth model. developed by Solow in 1956. Equation (2. A represents the state of technology. 2. Technical progress or total factor productivity is the amount by which output would increase as a result of improvement in methods of production with all factor inputs unchanged and is distinct from labour productivity10.2b). However.(2.(2.3b) Thus. N ) ----------------------------------------------------------.1.(2.2b) with respect time gives the rate of change of output overtime. the rate of growth of out put or simply economic growth is identically equal to the ∧ rate of change of technology (technical progress A / A ). suggests that savings/investment are an important factor in determining the level of economic growth.2b) Where.2a) To keep the analysis simple consider a Cobb-Douglas constant return-to-scale (CRS) production function Y = AK α N 1−α ----------------------------------------------------------. Differentiation of (2.3a) ∂t Y ∂t A ∂t K ∂t N Or using the hat notation as Y A K N = + α + (1 − α ) ----------------------------------------------------Y A K N ∧ ∧ ∧ ∧ (2. which can be written as ∂Y 1 ∂A 1 ∂K 1 ∂N 1 = +α + (1 −α) -----------------------------------. K / N = k 68 . α for capital and 1 − α for labour). That is Y = AF ( K . postulates that growth rate is derived by the rate of growth of the labour force and technical growth. Labour productivity may grow because of the improvement in capital inputs per worker.3b) is called the growth accounting. and K and N are capital and labour inputs. 10 Labour productivity is the ratio of output to labour input Y / N = y .2 Technical progress (Total factor productivity) The study of the potential sources of economic growth stems from the aggregate production function which links factor inputs to output for a given level of technology. called total factor productivity (TFP) plus the rate of growth of each factor inputs multiplied by their respective shares in total output (that is.

3b) and driving TFP as a residual as shown in equation (2. Suppose capitals share of income ( α ) is 0.2 (1 −1 / 3) N / N = 1. That is α( K / K ) = 0. A Y K N TFP = = − α − (1 − α ) ---------------------------------------.7.(2. by accounting identity of equation (2.735 Source: Summer and Heston (1991) for USA and Maddison (1991) for others.005 Germany 1.67 0.1 2. Table 2.28 0.9 1 / 3( K / K ) = 0.7 ∧ ∧ ∧ (4) (1 − α) N / N = 1.49 1.28 -0.8 Japan 3. then the growth rate of output must be.9 K / K = 0.4) let us use a simple example.4) below. Solow (1957) derived an estimate of TFP by inverting equation (2.2 2 / 3( N / N ) = 1.01 2.9 1. More examples are shown in table 2.4) A Y K N ∧ ∧ ∧ ∧ To understand the applicability of equation (2.7 1. Example. and own calculations for the last three columns Note: The figures in the table are for the period 1960-1990 for the USA and 1973-1987 for other countries.2 ∧ ∧ ∧ The growth rate of labour: 69 .6 percent.535 3. This measure of TFP is therefore sometimes referred to as the Solow residual.3 and that of labour ( 1 − α ) 0. the capital stock grows (or K/ K ) at 3 percent with the total factor productivity of 1 percent.3b) is that the growth of total factor productivity (TFP) cannot be measured directly.84 -0.2 1. Due to his inability to describe why this TFP occurred and its growth process Solow called it simply ‘Manna from heaven’.8 1. Then if the labour force ∧ ∧ grows (or N/ N ) by 1 percent.1 0. how the growth rates of capital and labour and GDP per worker.3) be 2.725 6.The problem with equation (2.73 2.78 2. shown in the last three columns.84 1.2 2. are calculated is illustrated as follows.9(3) = 2.9.1 below. for USA the growth rate of: (3) The growth rate of capital is calculated from the growth contribution of capital = 0.1: Growth accounting for selected countries Countries Growth rate of GDP ( Growth rate contribution of Capital Labour TFP Capital Growth rate of Labour GDP per ∧ Y/Y ) α( K / K ) (1 − α) N/ N ( A/ A ) ∧ ∧ ∧ ( K/ K ) ∧ ( N/ N ) ∧ worker( Y/ N ∧ ) USA 3. : The value of α = 1 / 3 is used in the calculation Given the value of α = 1 / 3 .

3 ∧ ∧ ∧ ∧ 2.1 −1. There are significant variations in the per capita income across countries. A country’s position in the world is not fixed. The rate of economic growth varies across countries. by definition. For example. Jones (2000. Growth rate of many countries is not constant or sustainable but it fluctuates. That is countries which were poor in the past are now growing fast and catching rich countries. 2. 11 Jones (2000). Both skilled and unskilled workers are migrating from poor countries to rich countries. 2. 6. For example. respectively while some African countries had negative economic growth. That is. Economic theory postulate resources should flow from where they are abundant to where they are scarce. On the other hand.N / N = (3 * 1. though the migration of unskilled labour from developing countries to developed countries is consistent with what economic theory postulate the migration of skill skilled workers or brain drain of developing countries against economic theory.2) / 2 = 1. and it would probably would be accompanied by the deficient demand and falling prices.1 The Solow Model The neo-classical Solow growth model is based on the following six assumptions. violate the full employment assumption. 2. which is contradictory to what economic theory postulated regarding the flow of resources.8 ∧ (5) The growth rate of GDP is simply the growth rate of GDP less the growth contribution of labour.2 Stylized facts 1. Some contraries whose economic growth and per capita income were relatively better than others in the 1970’s are now growing slower and lagging behind their counter parts. Thus. 4.8 = 1.4% and 5%. China which grows by double digits over the past 20 years is the best example in this regards. “Introduction to Economic Growth” explains this fact adequately 70 .3 Growth models Theories of economic growth are concerned with the rate of long run equilibrium growth that is with the rate of growth of output that yields full employment of labour and capital.3. 5. Ethiopia’s economic growth and per capita income which were better than that of South Korea in 1975 are now not only incomparable to the economic growth and per capita income of South Korea but also is one of the least in the glob11. Between 1960-1990 average growth of the USA and Tiger countries was 1. y = Y/ Y − N/ N y = 3. under utilization of capital stock would drive profit and investment incentives down. Rising unemployment of labour would. reducing investment and the demand for output. Economic growth and investment in human capital or education are highly correlated due to the later contribution in ensuring social equity and improving labour productivity. 3. page 56) documented that a typical person in the United State earns the annual income of a typical person in Ethiopia in less than ten days.

then output will also double. there is no gain in output per head from increasing both labour and capital as long as K / N ratio. is the same because of the assumption that the production function exhibits CRS.4) 4) The change in capital stock overtime K is and is equal to gross investment.01 . As a result increasing both K and N by the same proportion will not change y = Y / N . That is.(4) ∂t N 6) The neo-classical assume a constant rate to scale (CRS) production function such that Y = F ( N . That is. To do this let z = 1 / N . the equation is per head production function.(1) 2) Savings are assumed to be proportional to income.(3) 5) The labour force. such that A = 0 in equation (2. k . Hence. K ) . That is. zY = F ( zK . then the production function becomes Y K  = F  . S = I ------------------------------------------------------------------------. in equilibrium investment will be equal to savings. Thus. zN ) ----------------------------------------------------------. Y / N . Hence. and capital per head/worker is k = K / N . 71 . the production function can be written in per capita income form. Formally. in general form. then the labour force and population are growing at one percent per year.(2) Where s the MPS and assumed to be 0 < s < 1 3) It is assumed that no technological progress. exogenous rate of n . I dt less depreciation ( d ) times capital stock ( dK ). if we double labour and capital inputs are doubled. the rate of growth of labour force is ∂N / N N 12 = = n -----------------------------------------------------------.(5) ∧ ∧ In other word. which depends only on capital per head/worker. y is output per head/worker. S = sY ----------------------------------------------------------------------.1 N N  y = F (k ) -----------------------------------------------------------------. N is assumed to grow at a constant (equal to population growth). The per capita production function is illustrated in Figure 2. ∧ ∧ dK K = I − dK -----------------------------------------------------------------.1) Because the economy is assumed to be closed and there is no public sector.(6) In equation (6) lower-case letters denote variables measured relative to population.CRS means that multiplying all factor inputs by. z will give an increase in output by z .k = K / N . With these assumptions.1. y= Y N y = f (k ) 12 If n = 0. That is.

equation (1).(8b) y k ∧ ∧ Using the assumption that growth over time of capital stock is equal to investment less depreciation. From the per capita production function. and substituting into equation (8a) 72 . then there are CRS since the factor shares sum to unity. The marginal productivity of k is given as MPk = And the second order derivative. it should be apparent that the growth rate of GDP per capita is going to be determined by the growth rate of capital per headk . equation (3).2. That is.k = K N Fig 2. If the production function is assumed to take the Cobb-Douglas form as in equation (1). and that savings are directly related to income from equation (2). This shows that the MPk is decreasing with additions to k .(8a) k K N Recall also y = k α ⇒ log y ⇒ α log k y k ⇒ = α --------------------------------------------------------. ∂MPk ∂2 y = 2 = (α − 1)αAk α −2 < 0 ∂k ∂k Which is negative because α < 0 and hence (α −1) < 0 . the first order derivative is positive or f k (k ) > 0 and the second order derivative is negative or f kk = ( k ) < 0 . In per capita term the Cobb-Douglas form is written as Y = AK α L1−α AK α N 1−α AK α y= = = Ak α ---------------------------------------------.1: The per capita production function The marginal productivity of increasing the capital-labour ratio is positive but diminishing. that is the production function is concave downward as shown in figure 2.(7) α N N This production equation is sometimes called the AK model. that savings equal to investment. which is written as (using assumption 5) k= ∧ ∧ ∂y = αAk α −1 > 0 ∂k K ⇒ log k = log K − log N N ∧ k K N ⇒ = − --------------------------------------------------------------. equation (6).

Multiplying both sides by k k K ∧ ∧ gives k =k ∧ sY − ( n + d ) k . this can be rearranged as K sY − ( n + d )k . The Solow model is illustrated graphically as follows. N k = sy − (n + d )k -------------------------------------------------------.(9) ∧ Equation (9) is the fundamental dynamic equation for the neo-classical SOLOW GROWTH MODEL and known as the capital accumulation equation in per worker terms.(10b) k k s The two rays from the origin are ( n +δ)k and (n + δ ) / s . savings per head must be sufficient to replace the worn-out machines dk and to purchase new machinery in sufficient quantity to keep the growing of population employed nk . we know that K / K cancels out and finally substituting y = Y / N .(10a) Equation (10a) says that the proportion of income per head/worker that is saved must be equal to the rate of growth of capital per head. and change in labour force. Dividing both sides of equation (10) by sk we get. we know k = K / N . ∧ ∧ In the steady state or equilibrium. to maintain continuous full employment. equation (3) and (4) substituted into equation (8a) k K k sY = − ( d + n) . Substituting this in the first tern for k we K get K N ∧ K k= K k= ∧ sY − ( n + d )k . The equation says that the change in capital per worker each period is determined by three ∧ ∧ terms: investment per worker.k I − dK = − n . equation (9) will be sy = ( d + n) k -------------------------------------------------. nk which reduces capital per worker k . y f (k ) n + α = = ----------------------------------------------------. The first and second rays are shown in the last term of equation (10a) and (10b) respectively. In other words. depreciation per worker dk reduces k . sy increases k . 73 . equation (1) then equation (2) substituted. when k = 0 .

In the lower panel of the figure the dynamics of adjustment are shown such that at any level of k . Thus. suppose an economy has an initial capital-labour ratio of k * today as shown in Figure 2. y  n +δ     s  y = f (k ) y0 ( n +δ ) k Consumption sy s0 i0 E sy = sf ( k ) = sk α k* ∧ k − ∧ k ** k k k * k − ∧ k ** k Fig 2.The flatter ray ( n +δ)k represents the saving/investment requirement of the model or the amount of new investment per person required to keep the amount of capital per worker (k ) constant-both depreciation and the growing of workforce tend to reduce the amount of capital per person in the economy. By coincidence the difference between the two curves is the change in the amount of capital per person ( k ) . that is to replace the worn-out machines and fully employ the workforce. other than model automatically converges back to ∧ k − ∧ . the k − ∧ . this capital deepening will 74 . s1 exceeds the amount of savings/investment required to keep capital per worker (k ) constant. What happens overtime? At k * the amount of savings/investment per worker or per head of the population. capital deepening occurs or capital-labour ratio (k ) will increase over time.2 above. Indeed.2: Solow growth model equilibrium To consider a specific example.

the amount of investment per worker provided by the economy ∧ is less than the amount needed to keep capital per worker (k ) constant. saving per worker now exceeds the amount of investment required to keep the capital per worker constant. That is. Therefore. continue until k reaches − ∧ The model can now be used to understand determinants of economic growth. At this point the k amount of capital per worker remains constant. and therefore the economy begins capital deepening again. at which sy = (δ + n)k . the level of income per head rises from y0 to y1 . At the current value of capital stock k * . and we call such a point a steady state. we know that this higher level of capital per worker will be associated with higher per capita income. Now suppose that consumers in an economy decide to increase the saving/investment rate permanently from s1 to s2 .∧ . The economy is now richer than it was before. capital widening is occurring. since population growth is at a rate of n .3. Comparative statistics 1) The increase in saving rate Consider the economy has arrived at its steady state value of output per worker. Similarly when the economy starts at an initial capital-labour ratio of k ** the amount of new investment coming from saving is insufficient to keep the growing labour force fully employed. y y1 y0 y = f (k ) ( n +δ ) k B E s1 y = s1 f (k ) s0 y = s0 f (k ) 75 . This capital deepening continues until s1 y = (n + δ )k and the capital stock per worker reaches a higher value indicated by k ** . What happen to k and y ? The increase in saving rate shifts the saving line upward from s1 y to s2 y in figure 2. the capital stock must increase be growing at the rate of n and hence the economy as a whole is growing at rate n . The two shocks we will consider are the increase in saving rate and the increase in the rate of population growth. In other words. From the production function. so that k = 0 . An increasing in saving rate can come from a cut in the implicit tax rate (inflation) on saving through a change in the tests of individuals between consumption and saving. the term k < 0 is negative. In this section we will examine what happens to the per capita income in an economy that begins in steady state but then experiences a “shock”.

Due to population growth.k* k ** Fig 2. g . technology is like “manna from heaven”. such as capital. is ultimately concerned with moving the assumption of diminishing returns to reproducible factors of production.4: An increase in the population growth rate 2. Suppose the economy has reached and its steady state. postulate that the extent of labouraugmenting technical progress is endogenous in the model. Endogenous Growth Models The alternative model of growth process seeks to explain why the rich gets richer. The per capita income is ultimately lower after the increase in population growth in this example. the capital per worker began to fall until the point at which s0 y = (n1 + δ )k indicated by k ** . The increase in population growth Consider an alternative exercise. depending on the capital-labour ratio 76 . that is why the supply of capital does not flow from the rich countries to the poorer countries where the marginal productivity of capital is higher. and is therefore poorer. the ( n +δ) k curve rotates up to the left to a new ( n1 + δ ) k . Therefore. although it does not offer any explanation for technical progress. The reason must be that the marginal productivity of capital does not in the rich countries despite the rising capital-labour ratio. The economy has less capital per worker than it begins. y y1 y0 y = f (k ) ( n1 + δ ) k (n +δ)k E B s0 y = s0 f (k ) k ** k* Fig 2. the labour-augmenting technical progress is exogenous: in a common phrase. for example. on the other hand. This is achieved by the endogenous technical progress. The new growth theory. but then due to immigration. At the current value of capital stock k * . the population growth rate of the economy rises from n to n1 . The endogenous growth theories. In other words.3.3: An increase in investment rate 2. saving per worker is now no longer high enough to keep the capital per worker constant in the face of rising population. In the neo-classical model technical progress drives economic growth.3. therefore.

growth in A is endogenized. K . n which is equivalent to population growth. then there are increasing returns. According to him. the production function in equation (1) exhibits a constant return to scale in capital. there are two main elements in the Romer (1990) model of endogenous technological change: an equation describing the production function and a set of equation describing how the inputs for production evolve over time. However. The aggregate production function in the Romer model describes how the capital stock.to generate sustained growth in per capita income. and labour. To be specific. the production function for new ideas can be written as ∧ ∧ A = ω LA -----------------------------------------------------------------. which is labouraugmenting or “Harrod . LY . A is equal to the number of people attempting to discover new ideas. L . A is the number of new ideas produced at any given period of time. Y using the stock of idea or human capital. emphasizing on the economics of idea or human capital we must make the following assumptions. The accumulation equations for capital and labour are identical to those in Solow model. In short. As was in the case with Solow model. we must follow Solow and introduce technological progress. A . Y = K α ( ALY )1−α ----------------------------------------------------------. This is to say better technology is produced as a by product of capital investment. with one important difference. That is.(2) Labour is used either to produce new idea or produce output. A(t ) is the stock of knowledge or number of ideas that have been invented over the course of history until time t . A . K .neutral”. ∧ ∧ Then. LA multiplied by the rate at which they discover new ideas ω . LY . and labour. when we recognize that ideas ( A) are also input into production. The main equation is similar to the equations for Solow. K = sK Y − dK Labour grows exponentially at some constant and exogenous rate. so the economy faces the following resource constraint: L = LY + LA ∧ − To proceed with the endogenous growth model.(1) For a given level of technology. Using the notation. Capital accumulates as people in the economy forgo consumption in some given rate s and depreciates at the exogenous rate d . for labour than what we have used earlier N L =n L ∧ ∧ In the Romer model. 77 . combine to produce output.

ω and βare constant. In this case. rather than LA that enters in the production function for new ideas. it is because I was standing on the shoulders of the giants”. ω would be a decreasing function of A . One way of modeling this possibility is to suppose that it is really LA . in developing his theory of gravitational force has recognized in his famous statement. if λ < 1 it reflects an externality associated with duplication. some of the ideas created by an individual researcher may not be new to the economy as a whole of “stepping the toes” effect. Thus. In equation (3). Growth in the Romer model What is thus the growth rate in the endogenous model along the balanced growth path? Provided that a constant proportion of the population is employed producing ideas. and the development of integrated circuits are examples of idea that have enhanced the productivity of the later researchers.(3) Where. the rate at which new ideas are produced ( ω) as ∧ ω = ωAβ ---------------------------------------------------------------. This reasoning suggest modeling. for example..(1) The rate at which researchers discover new ideas ( ω ) may depend on the stock of ideas that have already been invented. Finally. This also most popularly known as the “standing on shoulders” effect13. it is easy to show that 13 ∧ λ In this regards. A = ω LA Aβ ----------------------------------------------------------------. the invention of computer and laser.i. the most obvious ideas discovered first and subsequent ideas ∧ become increasingly difficult to discover. if β > 0 it indicates that the productivity of research increases with the stock of ideas that have already been discovered or simply a positive knowledge spillover. Isaac Newton who has benefited from the knowledge created by previous scientists such as Kepler. ∧ For example. where λ is some parameter between 0 and 1. 78 .(4) In equation (4). ωwould be an increasing function of A . focusing on equation (2) and (3) suggests focusing on the following GENERAL PRODUCTION FUNCTION FOR IDEA. In this case. Letting lower-case letters denote per capita variables. β < 0 corresponds to the difficulty of discovering subsequent ideas. perhaps duplication of efforts is more likely when there are more persons engaged λ in research. the model follows the neo-classical model predicting that all per capita growth is due to technological progress. On the other hand. the productivity of research is independent of the stock of ideas.e. ∧ For example. (2) On the other hand. “If I look farther than others. β = 0 indicates that the tendency for the most obvious ideas to be discovered first exactly offsets the fact that the old ideas facilitate the discovery of new ideas. perhaps the invention of ideas in the past (that is ω ) raises the productivity of ∧ human capital or researchers in the present. The discovery of calculus. the average productivity of researchers depends on the number of people searching for new ideas at ant point in time.

Comparative static: A permanent increase in the R&D share What happens to the advanced economies of the world if the share of the population searching for new ideas increases permanently? For example. the growth rate of the number of researchers must be equal to the growth rate of the population – if it were higher. ∧ = ϖLA λ Aβ or A . the capital-labour ratio.(7) (1 − β) Thus the long run growth rate of this economy is determined by the parameters of the production function for ideas and the rate of growth of researchers. ∧ . Dividing both sides of equation (4) by A yields A A . . L A / LA = n . That is.g y = gk = g A That is. . the number of researchers would eventually exceed the population.(5) A . but only on the labour force and share of the population devoted to research. Notice that technological progress in the model can be analyzed by itself – it does not depend on capital or output. Therefore. Substituting this into equation (6) yields λn = (1 − β ) g A gA = ∧ λn -------------------------------------------. there is no growth. λ = ϖLA Aβ −1 or A A =ϖ LA --------------------------------------------------------------. A ≡ g A is constant. “What is the rate of technological progress along the balanced growth pats?” The answer to this equation is found by rewriting equation the production (4). which is ultimately given by the population growth rate.(6) LA A ∧ ∧ ∧ Along a balanced growth path. which is impossible. 1− β λ Along a balanced growth path. Taking logs and derivatives of both sides of this equation L A 0=λ − (1 − β ) -------------------------------------------. per capita output. if there is no technological progress. and the stock of ideas must all grow at the same rate along the balanced growth path. suppose there is a government subsidy for R&D that increases the fraction of labour force doing research. It implies that. the important question is. 79 . But this growth rate will be constant if and A only if the numerator and the denominator of the right hand side of equation (5) grow at the same rate.

the economy grows along a balanced growth path at the rate of technological progress. let’s assume that λ = 1 and β = 0 again. This situation corresponds to the point labeled “ X ” in the figure.5: Technological progress: An increase in the R&D share At X . g A . A/ A ∧ A/ A = ϖLA / A X ∧ gA = n g A /ϖ s′ L0 / A0 R LA / L Fig 2. The additional researchers produce an increased number of new ideas so the growth rate of technology is also higher at this point. a permanent increase in the share of the population devoted to research raises the rate of technological progress temporarily. .e. Therefore. ∧ =ϖ sR L --------------------------------------------------------.5 shows that what happens to technological progress when sR increases permanently to s′ .. Figure 2. as indicated by the arrows.(8) A . R assuming the economy begins in steady state. technological progress A/ A exceeds population growth n so that LA / L declines overtime. Where. In steady state. sR is defined as the share of the population engaged in R&D – i. LA = sR L . but not in the long run. ∧ 80 . As this ratio declines. none of the results are qualitatively affected by this assumption. It is helpful to write equation (5) as A A . Suppose the increase in sR occurs at time t = 0 with a population of L0 . the rate of technological change gradually falls also. The ratio LA / L is therefore equal to g A / ϖ . which happens to equal the rate of population growth under our simplifying assumptions. To simplify things slightly. the number of researchers increases as sR increases so that the ratio of LA / L jumps to a higher level. until the economy returns to the balanced growth path where g A = n .Now consider what happens if the share of the population engaged in research increases permanently.

in M. Therefore. M. (1956).CHAPTER 3: RECENT DEVELOPMENTS IN MACROECONOMICS 3. price level in period Pt + 2 = Pt +1 = Pt –1 or Pt0) there will be no change in equilibrium real wageworkers receive (w0).1) t t t t t Equation (3. Quarterly Journal of Economics. peoples’ expectation made last year about this year price level is given as. According to adaptive expectations hypothesis. adaptive expectations say what will happen tomorrow (say to price) is a function of what has happened yesterday or in the past and some adjustments made today from the errors of last period. Nerlove. studies in the Quantity theory of Money. Friedman (ed). incomes.1) says that the expected price level ( P ) in year t . that is current period/this t year. economic agents expect the future to be essentially a continuation of the past. P e =t −1 P = P −1 +α(t −2 P −1 − P −1 ) ------------------------------. wage rates. “Adaptive Expectations and Cobweb Phenomenon”. etc.(3. it is essential to understand the meaning of static and adaptive expectations used in macroeconomics and how these expectations were formed before the Ratex hypothesis was developed. They revise their expectations in accordance with the last forecasting error. They are based on past trends as well as current information and experience. For instance. Definition: Expectations are forecasts or predications by economic agents regarding the uncertain economic variables which are relevant to their decisions.but expectations are made in the previous (last) year ( t − P ) is equal to inflation or 1 t price level in last year ( P − ) plus adjustments made ( α ) about the previous year’s t 1 mistake in forecasting the previous year or a year before( t −2 P − ) and to price in that t 1 e 14 15 Cagan. say price level in three ways. and income (y0). (1957). People make expectations about economic variables. “The Monetary Dynamics of Hyperinflation”. The economic agents make the expected values of these variables equal to weighted average of their present and past values. Errors resulting from past behavior represent an important source of information in forming future expectations. They expect the future values of economic variables like prices. level of employment (N0).1 Rational Expectation (Ratex hypothesis) Before discussing the rational expectations (Ratex hypothesis). a) STATIC (NAÏVE) EXPECTATIONS: What happened in the past or yesterday will happen today and in future. In short. P. since inflation tomorrow will be the same as today and yesterday (that is. b) ADAPTIVE EXPECTATIONS HYPOTHESIS: The pioneering work was done by Cagan14 in 1956 and Nerlove15 in 1957. But such expectations are based on the assumption that the economic agents expect them to change very little. to be an average of past values and to change very slowly. May 81 .

Basis properties of the rational expectations hypothesis The Ratex hypothesis holds that economic agents form expectations of the future value of economic variables like prices.2) into (3. By assuming economic agents optimize and use all information available efficiently when forming expectations about the future. etc.(3. the rational expectations assume that economic agents have full and accurate information about the future economic events.2) t 1 t t t Substituting equation (3. and Neil Wallace applied to problems in macro-economics.(3. It was in the early 1970’s that Robert Lucas. The hypothesis did not convince many economists and lay dormant for ten years. incomes. Thus. Econometrica. As a result. economic agents will incorporate all “news” as it comes in. adaptive expectation is also sometimes called the Partial Adjustment Principle. with rational expectation the expected error is zero and the errors are not linked in any way by a spiral correlation.3) Equation (3. expectations made two years before about last year expected price t 1 level is t −2 P − = P −2 +α( t −3 P −2 − P −2 ) -------------------------------. c) RATIONAL EXPECTATIONS HYPOTHESIS: The idea of rational expectations was first put forth by John Muth16 in 1961 who borrowed the concept from engineering literature. Thus. That is. by using all available and relevant17 economic information to them in an intelligent fashion. His model dealt mainly with modeling price movements in markets. July It is important to recognize that this does not imply that consumers or firms have “perfect foresight” or that their expectations are always correct.1) for t −2 P − gives t 1 P = P −1 +α[ P −2 +α(t −3 P −2 − P −2 ) − P −1 ] . Muth pointed out that certain expectations are rational in the sense that expectations and events differ only by a random forecast error. “Rational Expectations and the Theory of Price Movements”. 82 . Thomas Sargent. he was able to construct a theory of expectations in which consumers’ and producers’ responses to expected price changes depending on their responses to actual price changes. Muth (1961).3) simply says that the expected price level depends on the past trend of price or is the weighted average of past price levels.. The last resource is especially important for it brings the difference between the rational and adaptive expectations. particularly monetary and fiscal policies of the government. wages. This information includes the relationship governing economic variables. Then. This is an implication for the unbiased ness of rational 16 17 John F. from private contact or from newspapers and from one’s own past prediction of errors. rearranging this we t− 1 t t t t t t have = Pt −1 − αPt −1 + αPt + 2 + α 2t − 3 Pt − 2 − α 2 Pt − 2 = (1 − α ) Pt −1 + α (1 − α ) Pt − 2 + α 2t − 3 Pt − 2 ----------------------. News would come from personal experience in buying and selling. but the weights are ordered in such a way that more recent prices have larger effect than more distant ones.year ( P − ). Muth’s notion of rational expectations related to micro-economics.

In short. which implies adjustment are static (naive) expectation. then t −1 P = P −1 which implies t t P = −3 P −2 . then t −1 t t t perfect or rational. Rational expectation is also called Model Consistence because it is as if everyone knows the model and uses this knowledge fully. The implication is that the expectation made 1 t t 1 t t −1 . This is known as the law of ITERATED EXPECTATION. the expected forecast equals current forecast. t − ( P +1 ) =− P +1 t – 1. That is. The conclusion based on equation (3. 4.expectations. of the prediction that will be made at time t about P + is equal to the in period t 1 actual prediction at t -1 of Pt + 1. if α = 0 .1 CHAPTER 4: MACROECONOMICS THEORIES AND AFRICAN ECONOMIES Introduction: The Classical and Structuralist School 83 .3) is that. if α = 1 .

They questioned the validity of the orthodox policy prescriptions of tight monetary and fiscal policies and devaluation to LDC economies and argued that monetary policy or increase in money supply is only accommodative and not the cause of high inflation. prices and wages are not flexible and the source of inflation in LDCs is slow 84 . providing subsidies of various forms. devaluation of domestic currency to become competitive in international trade and increase revenue export and reduce BP problem.2 The structuralist view: As the name implies structural rigidities within the domestic economy are the main factors for low aggregate demand in LDCs. These are the orthodox approach and the structuralist view 4. That is.Two schools of thoughts emerged to explain the applicability of the conventional macroeconomic models in LDCs in general and in Africa in particular. The solution to long run growth problems is getting the price right or enhancing market mechanisms to address misallocation of resources. 4. solving problems of inflation and balance of payment imbalances through tight monetary and fiscal policies. In other hand. pursuing non interventionist domestic policies or reducing government intervention and the huge hand of the state in the market so as to avoid market distortions and leaving the market to equilibrate demand and supply. They argued that the problem in developing countries is caused by misallocation of resources. the price of their exports declined significantly. and rise interest rate to increase savings are the optimal solutions. following sound market economy and adhering strictly to the market economy principles are vital for sustainable long run growth. In the short run however. This school of thought is divided into the early and recent. This is mainly due to the huge hand of the government in the economy. As a result the products have low income and price elasticity of demand compared to that of manufacturing outputs of developed countries.1 The Orthodox approach (Classical and monetarists) These schools of thoughts examine the short and long term behavior of the economy in Africa. That is when they produce more.1. According to the early structural school thinkers this can be facilitated among others through high tariff barriers on imported goods. and improving access to credit and foreign exchange. The recent structuralist focuses mainly on the short run stabilization or adjustment policies. (B) The recent structuralist view: Taylor was the most notable and influential leader recent structuralist.1. This in turn leads to continuous deterioration of terms of trade (TOT). According to them. The solution proposed by the early structuralist is moving to the production of industrial goods under the protection of infant domestic industries to replace imported goods from abroad in the long run. This argument is simply referred as the import substitution argument. Exports of developing countries consist more of primary products. (A) The early structuralist view: This school of thought was dominant in 1960’s and 1970’5.

2) The exchange rate regime In contrast to MDC the vast majority of African economies have exchange rates either fixed or pegged to a foreign country. Recently many African countries have adopted flexible exchange rate but not market determined. the standard open economy model. etc. given that working capital and imported inputs play a significant role in terms of addressing structural rigidities and limited substitution possibilities in production a policy package combined devaluation with tight monetary and fiscal policies will lead to stagflation. Furthermore. The Ethiopian exchange rate regime is called managed floating. To the recent structuralists. the nature of fiscal deficits. the backbone of the majority of African countries.. has little use in explaining their macroeconomic behavior. which is between the two extremes . administrative prices. such as the provision of subsidy. Therefore. Second. Since it is only the financial institutions who buy the foreign currency through the bi-weekly inter-banks auction market. they argued that the main causes of slow agricultural productivity and also that influence monetary policy in LDCs are poor land tenure system. Consequently. if prices and wages are rigid monetary or fiscal policy becomes effective in the short-run. This includes undertaking interventions related to export promotion and export diversification.fixed and flexible exchange rates.. determinants of the private sector credit behavioral function (biasness or preferential treatments of public sector enterprises for credit). information. not money supply. 1) Openness to trade Relative to developed countries. tax-holiday. the solutions are some degree of government intervention in the market is necessary to eliminate structural problems/rigidities in production before applying the standard orthodox prescriptions. the nature of the financial markets. which assumes endogenous TOT. different attributes of both short and long run fluctuations. The implication of these characteristics is that: (a) The standard open macro economy policies may not hold at all or are irrelevant (b) Given their share in the world trade and composition of their exports they do not have control over the prices of their exports and imports have huge policy implication. to exporters 4. That is. they are small relative to MDC and DC. Hence. 85 .2 Basic Features of African Economies The distinguishing macroeconomic features of African economy include more openness to trade in both commercial and assets. and wage indexation. The standard measures of degree of openness are looking into the ratio of exports plus import to GDP and the tariff structure. African economy tend to be more open and to have little control over the price of products they exports and import. this indicates some degree of government influences over the exchange rate. which leads in most cases to exchange rate retention or control. In many cases the actual exchange rate deviates from the equilibrium exchange rate.productivity growth in agricultural. That is they are administered rather than auctioned or demand and supply determined. and the stabilization policy regimes. which are not demand determined but supply determined. first they export primary products.

On the other hand. Therefore. traders. such as village money lenders. It is rather determined by the past and current government deficits and trade balances. the unorganized money market consisting of noninstitutional money lenders. the financial sector is dominated by commercial banks with little or no secondary stock and security markets. which lend short-term credit at low interest rates to the modern business sectors consisting of big companies. As a result. In MDCs. which charge higher interest rates on loans. (B) An increase in cost of intermediate goods affect the exchange rate and the exchange rate affects AS because we may import more or less unlike the MDCs where the exchange rate does not enter into AS because their exchange rate is floating/flexible/ and do not import much intermediate goods.3) Capital inputs Almost all African economies are net importers of capital (both physical and financial capital). (B) Financial repression/ compartmentalization: It is a policy of the state in terms of financial sector where nominal interest rate ( r ) that the commercial banks pay on their deposits and charge for their loan are kept low/hold down without taking into account the demand and supply. however. • not only a significant part of financial transaction takes place control and direct policy reach of the central banks but also there is interest rate differential • whatever monetary policy is to be practiced must be affected by other than open market operation. large scale manufacturing enterprises. The policy implications are: (A) Imported intermediate goods play important role in the aggregate production function. The organized money market consists of commercial banks and other financial intermediaries. (A) 86 . That is. and the government. or the combination of some of them. dependence on foreign market is an important issue. The two most important implication of underdeveloped financial sector in LDCs are financial dualism and financial repression: Financial dualism: It is the coexistence of organized and unorganized/traditional money markets in LDCs. Since the government debt with its artificially low interest rate is not sold and bought in free market the monetary authorities/central bank cannot affect the monetary base ( D + R ). which implies allocation inefficiencies. The main reason is that there is real shortage of savings in the traditional sector as substantial amount of savings is horded in gold and jewelry. the private sector has the larger share in the economy as compare to the public sector. 4) The role of the state The state plays an important role in the production and distribution of goods and services in LDCs. 5) The financial sector The financial sector in LDCs is weak and inefficient. It is characterized by the prevalence of rudimentary/underdeveloped financial market and financial repression. shopkeepers.

These include among others: (A) Exchange rate management: This is because there is an overvalued exchange rate in most African countries (B) Stabilization of high inflation: Achieving a targeted low level of inflation per annum is the main objective of LDCs. P ) space like the standard MDC AD curve. However. If they are equal it is defined as constant stock. inflation in many African countries is higher (for example in Zimbabwe it has now become around 2000%) than targeted due to failure of stabilization policies to yield the desired target. (C) Debt management: Both the stock (what a country borrow) and flow (unsettled & what are to be paid) of debt to GDP are very high in Africa. we should examine the four components. 87 . implying the private sector does not have adequate access to credit as the public enterprises. real disposable household income ( yd ). slow output growth. real private investment (iP ) . investment increases. and hence output grows does no work in LDCs for interest rate is fixed.Credits are given to public enterprises on preference basis than on demand basis. The implication of financial repression is that the transmission mechanism and effectiveness of monetary policy. Apart from these LDCs have other issues to address and objectives to achieve.that is as money supply increases interest rate declines. high public expenditure and use appropriate budget deficits financing mechanisms and in ability of managing imported inflation triggered such as by the rise in oil prices. Even if debt is also very high in MDCs they can pay without affecting the economy. and net export ( NX ) of total DD for domestic output. it is much steeper than MDC AD due to the following two reasons. aggregate real consumption ( c ). Full stock is defined if the debt flow is greater that revenue generated from foreign trade. 6) Government budget Most countries have huge budget deficits and hence the policy implication of budget deficits has become an important issue. The AD curve is downward sloped in ( Y . Failure to achieve sustainable economic growth and mitigate vulnerability to adverse natural calamities such as drought are among the major reasons (D) Reducing capital flight: Both the profits and assets of citizens usually transferred abroad for security and/or other purposes 8) The characteristics of AD and AS curves in LDCs  AGGREGATE DEMAND: Before arriving at the AD curve in LDC. Low level of investment. ) To examine the nature of AD in LDC we assume hereafter that world price (P* is fixed and the effect of a change in P on the IS curve is zero in the standard LDC model. which rises mainly transportation cost are the main reasons for high inflation in Africa. 7) Objectives of macroeconomic policies in LDCs The main macroeconomics objectives of the MDC are full employment. increase output and price and exchange rate stability. Nevertheless.

Price (P ) and interest rate (r ) are endogenous while exchange rate (e) and nominal wage (W ) are exogenous variables. P AS P AS 88 . the IS curve is steeper in LDC due to a high marginal propensity to import ( MPM ) and a low interest elasticity of investment DD.1) The IS curve. Thus. e) and e = P * / P . e. From the export function ∂X / ∂P < 0 . In fact. This will in turn reduce the X of a country where the price level has increased.W ) AD AD for LDCs Y Where. Moreover. the effect on NX shifts IS to the left in MDC. output can be increased without increasing employment (the supply of labour and employment in an economy). 1 The AS curve of LDC is flatter than MDC. ∂AS / ∂e < 0 . Because the increase in domestic price level (inflation) will reduce P * / P implying the exchange rate has appreciated. due to rigidity of nominal wages and excess ideal (unutilized) resources. and ∂AS / ∂W < 0 . which is scarce due to low saving in LDCs. it is more frequently found not only unemployed labour but also an underutilized capital stock. reduce NX or CAB and thus shifts IS and AD to the left. doesn’t shift in the standard LDC model because exchange rate is fixed in LDC. which shifts to the left in the standard MDC model when domestic P level rises because of its effect on net exports. ∂AS / ∂r < 0. 2) However. r . ∂AS / ∂P > 0. The main difference between the standard LDC AS curve and that usually pictured for an MDC are the following. 2 The second characteristic is that the increase in r affects AS of LDC through its effect on the cost of working capital. 3 Changes in the exchange rate ( e ) shifts the AS curve in LDCs for the domestic price of imported intermediate inputs and raw materials will be affected. In LDC however. which implies DMPL. The reason for this is that the MDC is normally close to full employment with less nominal wage rigidity. P P AD Y AD for Developed countries  AGGREGATE SUPPLY IN LDCs: The equation is given by AS = Y S ( P. Recall that the export function is X = x( P.

In fact.1) Restrictive fiscal policy ( ↓ G ): While restrictive monetary policy is likely to increase both unemployment and inflation in LDCs in the short run. Graphically. This results not only in a small leftward shift of the AD curve from AD0 to AD 1 but also a larger shift in AS to the right because interest rate has fallen from r0 to r . the net effect (result) is a decline in the price level (P ) from P 0 1 to P and possibly even an increase in output from Y0 to Y . restrictive fiscal policy is likely to become more effective (successful) in reducing the price level without the costs of a major recession. 4. Finally.3. The increase in output in the case of LDCs is that because the decline in domestic price level will reduce the cost of intermediate inputs and raw materials (due to appreciation of domestic currency for real exchange rate or P * / P has decreased). in the standard MDC 1 1 model restrictive fiscal policy reduces both price and output. LM r0 E0 0 r 1 E1 IS 1 IS 0 89 .3 The Applicability of Conventional Theories to African Economies Under this section the impact of restrictive fiscal policy and monetary policies on AD and AS curves as well as the net effect will be covered.Y AS for MDCs Y AS for LDCs 4. A decrease in G will shift the IS curve to the left from IS 0 to IS 1 .

any shift that does occur is relatively ineffective in reducing the price level. LM 1 90 . And due to the flatness of the AS curve. In LDC. The net impact for the MDC is that the price level falls and output declines moderately.2) RESTRICTIVE (CONTRACTIONARY) MONETARY POLICY (↓Ms): The standard result following of a decrease in M S is to increase interest rate (r ) . This is because the reduction in G. which then reduces investment.1: The impact of concretionary Fiscal Policy in LDC If the increase in output is small for the LDC. then import demand is affected very little. The reason why the interest rate enters into the AS function in LDCs is that: A) The interest rate in the formal market when auctioned is not high as in the informal market B) Cost of borrowing is very high for cost of collateral is very high The impact of concretionary monetary policy is thus a relatively small horizontal shift in the AD curve. output and P. shifting the IS curve down. The cumulative effect is thus a reduction in the monetary base (reserves) and as a result of which economic recession appears (or will worsen) overtime 4. this restrictive monetary policy also rises the AS curve to the left through the increase in the interest cost on variable inputs.3. in the short run restrictive monetary policy has few appealing implications for the policy maker. for LDC. However. The availability of low interest rate on loans from commercial bank also reduces retained earnings. output also falls. which increases the government surplus will leave the balance of trade surplus (or deficit) essentially unchanged. in LDCs reducing the money supply has a larger impact on LM curve (for a given P level) because of the low interest elasticity of DD.Y 1 Y0 A 0 S A 1 S P 0 E0 P 1 E1 A 0 D A 1 D Y0 Y 1 Fig 4. but the price level may increase. Therefore.

“Macroeconomics: Theory and Policy”. William H. 2nd Ed. (1994). 2nd Ed. (2000).. Eric. 4) Mankiw. 2nd Ed. 91 . R and Fischer. G. 3rd Ed. K. New-Delhi-110 002 (India). 2nd Ed.2: The impact of restrictive monetary policy in LDCs REFERENCE BOOKS 1) Branson. “Introduction to Economic growth”. 2) Dornbusch. S. 2nd Ed. 5 Ansari Road. 5) Pentecost. “International Finance”. C. (2000). 3) Jones.LM 0 r 1 r0 E1 E0 IS 0 IS 1 Y0 Y 1 A 1 S A 0 S P 1 P 0 A 0 D A 1 D Y0 Y 1 Fig 4. (200). Macmillan Press LTD. “Macroeconomics”. “Macroeconomics: An open Economy Approach”. (1998).. (1998). Universal Book Stall. “Macroeconomics”. London 6) Pilbeam.

Further. C . Further assume that the real user cost of capital 92 .Quiz number 1: 1) Using the Cobb-Douglas production function y = aK β L1−β . and 1respectivelly. assume that β is 80% and net saving ratio (s ) is 40% in 2009. 4. and P in an economy are 10. A) drive and show that the equilibrium capital stock rises with an increase in y and falls with an increase in real user cost of capital in the flexible accelerator investment model B) Drive also the gross investment assuming that the real user cost of capital remains fairly constant overtime. ceteris paribus. 2) Assume that the valves of y .

if the depreciation rate of capital stock in the economy ( δ ) is 10% in 2010 93 . calculate the value of A) real user cost of capital B) net investment (the change in equilibrium capital stock) if output ( y ) increases to 12 in 2010 C) growth rate of output in the economy in 2010 that would maintain supply equal to demand D) output change E) gross investment. ceteris paribus.remains fairly constant overtime. Given these information.

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