1.1. Introduction To Macroeconomics: Chapter One

COMBINED MACROECONOMICS FOR AcFN STUDENTS
CHAPTER ONE
1. Introduction
1.1. Introduction to Macroeconomics
1.1.1. Discussion of Basic Concepts
Economics is the study of economies and the behaviour of economic agents in them. The
subject matter of economics is conventionally divided into two branches known as
microeconomics and macroeconomics. This distinction is important because, though they are
related, the problems considered in the two branches are different. Their methods of analysis
are also different.
Microeconomics deals with ‘parts’ of the economy; it takes sectoral view rather than a
general view of economic activities. In microeconomics we are largely concerned with
individual markets and the individual economic agents in these markets such as consumers
and firms. Analysis in this branch of economics deals with such matters as:
 The determination of the prices of particular commodities.
 The output, wage and employment level of individual firms and industries.
 The income of individuals, etc.
Macroeconomics, on the other hand, deals with an economy in its totality. In this branch of
economics we study the behaviour of aggregates rather than the parts of the economy; it goes
beyond the determination of prices in particular markets and deals with the market for goods
as a whole, treating all markets as a single market. Similarly, it deals with the labour market
as a whole, abstracting from the differences between the markets for, say, unskilled daily
labour and engineers. Generally, macroeconomics concerns itself with:
 The level and rate of growth of national level of output.
 The general price level and fluctuations in price levels (inflation and deflation).
 The level of national un/employment, investment, wage and economic growth.
It is important to note, however, that microeconomics and macroeconomics are related in that
it is necessary to understand the parts, if one is to understand the whole.
1
1.1.2. Definition and Scope of Macroeconomics
Macroeconomics is broadly defined as ‘a branch of economics that deals not with individual
quantities as such, but with aggregates of the quantities; not with individual incomes but with
national income; not with individual prices, but with price level; not with individual outputs
but with national output’ by Boulding.
The broad problems which form the scope of Macroeconomics are related to:
 Fluctuations in the level of employment of labour and general level of money wage.
 Fluctuations in average prices.
 Allocation of resources between consumer and capital goods and their productivity.
 The relation between international trade and the level of employment, prices and
growth of the domestic economy.
1.1.3. Tools of Analysis for the difference between Microeconomics and
Macroeconomics
‘Micro’ means small, hence microeconomics means ‘the economy in small’ which deals with
single economic units. On the other hand, ‘Macro’ means very large, hence macroeconomics
means ‘the economy in large’ which deals with the economy as a whole and focuses on the
utilization of resources, particularly level of employment and general level of prices. In
general, microeconomics and macroeconomics can be easily distinguished on the basis of
their approach, method of analysis and degree of aggregation.
 Approach: microeconomics studies the problems of each of the constituents of circular

flow of income like households, firms and markets while macroeconomics studies the
overall behaviour of the circular flow.
 Method of Analysis: in microeconomics the analysis conceives equilibrium between
demand and supply in a single commodity market while in macroeconomics the analysis
conceives equilibrium between demand and supply in the economy as a whole. Here,
since using physical quantities is impossible money value of commodities is taken. Both
make extensive use of demand and supply analysis. But they have differences on how
markets work. Microeconomics assumes that imbalances between demand and supply
are resolved by changes in price. Rises in price bring forth additional supply, and falls in
prices bring forth additional demand, until supply and demand are once again in balance.
Macroeconomics considers the possibility that imbalances between supply and demand
can be resolved by changes in quantities rather than in prices. That is, businesses may be
2
slow to change the prices they charge, preferring instead to expand or contract
production until supply balances demand.
 Degree of aggregation: both microeconomics and macroeconomics deal with demand
and supply. The only difference being the degree. The degree of aggregation is higher in
macroeconomics. In addition, microeconomics is the application of partial equilibrium
analysis while macroeconomics employs the quasi-general equilibrium analysis.
1.2. Evolution and Developments in

Macroeconomics
Macroeconomic thinking is believed to be originated from four main sources in the early
periods. These are:
 The concept of circular flow of payments: it refers to the flow of real and financial
resources in the economy.
 The concept of national income: it refers to the value of total output the country
produces within its territory each year.
 The concept of Value of money: it refers to the measurement of the value of goods and
services in common standards.
 The concept of trade cycle: it refers to the path through which the economy makes its
movement over time.
Once originated from these ideas, macroeconomics had passed through different stages of
development- known as schools of economic thoughts. They mainly differ on the basis of
whether government intervention is required for the better functioning of the economy or not.
Up to the end of the 19th century it was generally assumed that government intervention in the
working of the economic system should be kept to the minimum. Any official intervention
with the free play of market forces would only be harmful to economic development. This
view stems from Britain’s success in developing the world’s greatest industrial power on the
basis of private enterprise. Accordingly, the government’s role was limited to maintaining
peace and security and creating a framework of rules and regulations which would assist the
operation of free markets.
During the 20th century there has been a remarkable change of public opinion. The successful
control of national resources by states and the heavy and chronic unemployment during
World Wars I and II led to the rejection of the ideas that market forces should be left
unhindered and that governments should not play an active role in determining the course of
3
economic development. During the inter-war period governments were compelled to take
some positive actions to deal with unemployment. Domestic industries were protected, some
industries were given assistance etc. These efforts resulted in significant drop in
unemployment in the late 1930s.
In relation to the role of the government in the economy, the different schools of thought are:
 Classical school (1776-1870): In this period, the distinction between microeconomics

and macroeconomics was not clear. The ruling principle was the ‘invisible hand’ coined
by Adam Smith. This period was characterized by absence of government intervention in
the operation of markets, which was a result of the general conception of the time that
markets operate best when left by themselves. There was a period that immediately
follows the classical period known as -Neo classical school (1870-1936). There is no
basic difference between classical school and neoclassical school. The main difference
lies in the tool of analysis they make use of. Neo classical school introduced the concept
of marginal analysis and the mathematics with which to execute it, while the classical
school depended mainly on demand and supply analysis.
The new classical macroeconomics remained influential in the 1980s. It sees the world as one
in which individuals act rationally in their self interest in markets that adjust rapidly to
changing conditions. The government, it is claimed, is likely only to make things worse by
intervening.
The central working assumptions of the new classical school are three:
 Economic agents maximize: Households and firms make optimal decisions given all
available information in reaching decisions and that those decisions are the best possible
in the circumstances in which they find themselves.
 Expectations are rational: which means they are statistically the best predictions of
the future that can be made using the available information. Rational expectations imply
that people will eventually come to understand whatever government policy used, and
thus that it is not possible to fool most of the people all the time or even most of the time.
 Markets clear: there is no reason why firms or workers would not adjust wages or
prices if that would make them better off. Accordingly, prices and wages adjust in order
to equate supply and demand; in other words markets clear. For instance, any
unemployed person who really wants a job will offer to cut his wages until the wage is
4
low enough to attract an offer from some employer. Similarly, anyone with an excess
supply of goods will cut prices so as to sell. The essence of the new classical school is the
assumption that markets are continuously in equilibrium.
 Keynesian school (1936-1970): The great depression of the 1930s compelled

economists to recommend government intervention to improve the economic condition.
This was a radical shift of attitude compared to the general thought of the time. The
economist who first proposed government intervention was John Maynard Keynes, and
accordingly this view is regarded as Keynesian view. The main thesis of Keynes’s model
is that because of failure of the system, as is the case in the 1930s, the economy may not
achieve full employment level, this makes government intervention inevitable.
In a very simplified form we can present Keynes’s theory of recessions. Imagine an economy
that is operating at full employment level of resources. Alongside the smoothly functioning
‘real’ economy, there will be a smooth financial flows as firms earn money from their sales,
pay out their earnings in wages and dividends, and households spend these receipts on new
purchases from the firms.
But now suppose that for some reason each household and firm in this economy decides that
it would like to hold a little more cash. Keynes argued, in particular, this happens when
businessmen lose confidence and start to think of potential investments as risky leading them
to hesitate and accumulate cash instead; today we might add the problem of nervous
households who worry about their jobs and cut back on purchases of big-ticket consumer
items. Either way, each individual firm or household tries to increase its holdings of cash by
cutting its spending so that its receipts exceed its outlays.
As Keynes pointed out, what works for an individual does not work for the economy as a
whole, because the amount of cash in the economy is fixed. An individual can increase his
cash holding by spending less, but s/he does so only by taking away cash that other people
had been holding. Obviously, not everybody can do this at the same time. So what happens
when everyone tries to accumulate cash simultaneously?
The answer is that income falls along with spending. One try to accumulate cash by reducing
his/her purchases from others, and others try to accumulate cash by reducing their purchases
from him/her; the result is that both incomes fall along with their spending and neither of
them succeeds in increasing their cash holdings.
If they remain determined to hold more cash, they will react to this disappointment by cutting
5
their spending still further, with the same disappointing result; and so on and so on. Looking
at the economy as a whole, you will see factories closing, workers laid off, stores empty, as
firms and households throughout the economy cut back on spending in a collectively vain
effort to accumulate more cash, the process only reaches a limit when incomes are so
shrunken that the demand for cash falls to equal the available supply.
For Keynes to do about recessions, the first and most obvious thing to do is to make it
possible for people to satisfy their demand for more cash without cutting their spending,
preventing the downward spiral of shrinking spending and shrinking income. The way to do
this is simple, to print more money and somehow get it into circulation.
So the usual and basic Keynesian answer to recessions is a monetary expansion. But Keynes
worried that even this might sometimes not be enough, particularly if a recession had been
allowed to get out of hand and become a true depression. Once the economy is deeply
depressed, households and especially firms may be unwilling to increase spending no matter
how much cash they have; they may simply add any monetary expansion to their hoarding.
Such a situation, in which monetary policy has become ineffective, has come to be known as
a “liquidity trap”. In such a case, the government has to do what the private sector will not:
spend. When monetary expansion is ineffective, fiscal expansion must take its place. Such a
fiscal expansion can break the vicious circle of low spending and low incomes and getting the
economy moving again.
The new classical group remains highly influential in today’s macroeconomics. But a new
generation of scholars, the new Keynesians, mostly trained in the Keynesian tradition but
moving beyond it, emerged in the 1980s. They do not believe that markets clear all the time;
but seek to understand and explain exactly why markets fail.
The new Keynesians argue that markets sometimes do not clear even when individuals are
looking out for their own interests. Both information problems and costs of changing prices
lead to some price rigidities, which help cause macroeconomic fluctuations in output and
employment. For example, in the labour market, firms that cut wages not only reduce the cost
of labour but are likely to wind up with a poorer quality labour. Thus, they will be reluctant to
cut wages.
 Period of Quantitative Analysis (1970s-present): During this period there has been
no dominant school of thought in macroeconomics. However, the period is characterized
by the huge application of statistical and mathematical methods for rather than logical
6
reasoning economic analysis. Different economic views have been used in different
economies under different circumstances.
Monetarism, as advocates of free market, started challenging Keynes’s theory in the 1970s.
Milton Friedman, the founder of monetarism attacked Keynes’s idea of smoothing business
cycle on the ground that such active policy is not only unnecessary but actually harmful,
worsening the very economic instability that it is supposed to correct and should be replaced
by simple, mechanical monetary rules. This is the doctrine that came to be known as
“monetarism”.
Friedman began with a factual claim: most recessions including the huge slump that initiated
the Great Depression, did not follow Keynes’s script. That is, they did not arise because the
private sector was trying to increase its holdings of a fixed amount of money. Rather, they
occurred because of a fall in the quantity of money in circulation.
If economic slumps begin when people spontaneously decide to increase their money
holdings, then the monetary authority must monitor the economy and pump money in when it
finds a slump is imminent. If such slumps are always created by a fall in the quantity of
money, then the monetary authority need not monitor the economy; it needs only make sure
that the quantity of money doesn’t slump. In other words, a straight forward rule– “keep the
money supply steady” is good enough, so that there is no needs for a “discretionary” policy
of the form “pump money in when your economic advisers think a recession is imminent”.
All schools of macroeconomics agree on the purpose of macro policy but they disagree on
how to achieve the macro objectives of higher output, lower level of unemployment and
inflation.
The Aims of Government Policy

A government’s economic policy objectives can be classified under five headings.
Internal Balance: it refers to full employment and stable price. It is generally held that the
main objective of government economic policy is maintaining the demand for labour at a
high level so that there is full employment of the labour force. This does not mean that
everyone willing to work will always be in employment. There are serious imperfections in
the labour market. Owing to the immobility of labour, it is possible for large numbers of
people to be out of work even when there are many vacancies. Fluctuations in the general
level of prices, on the other hand, can cause harmful distortions in debtor-creditor
relationships, the balance of payments situation, and the level of production and the
7
distribution of real income. For example, a rapid increase in prices will reduce the purchasing
power of savings; it will reduce the real burdens of debts so that debtors repay less in real
terms than they borrowed; it will increase the prices of exports and make them less attractive
to foreigners, and it will reduce the real income of those on fixed money incomes, relative to
those whose incomes are rapidly adjusted to the changing price level. Governments will be
concerned to eliminate or reduce such harmful developments.
External Balance: what is a satisfactory balance of payments depends on the situation a

country finds itself. If the government has adequate foreign currency reserves and can borrow
from other countries it may allow a series of deficits to develop while imports are rising faster
than exports, as a necessary part of a policy to stimulate economic growth. In the longer run,
however, a country’s exports earning must balance its payments to other countries.
Acceptable rate of economic growth: in all developed and developing countries there is
always a desire for a better living condition. Such insistent demands for higher standard of
living have forced governments to give a high priority to policies which will bring about a
steady increase in output per head.
Redistribution of income and wealth: general dissatisfaction with the extremely unequal
distribution of income and wealth brought about by the uncontrolled operation of market
forces has obliged governments to adopt policies designed to reduce these inequalities. A
system of taxation which bears more heavily on those with higher incomes and more wealth
together with government spending on a wide range of social services which provide
important supplements to the real incomes of the poor members of society are major features
of economic policy.
The Instruments of Government Economic Policy

In order to carry out economic policies states may intervene in the operation of the economy
in three main ways.
Fiscal policy: this is a deliberate manipulation of government income and expenditure with a
view to influencing income, output, employment and prices. The state is by far the biggest
business in most developed economies and variation in its spending will have an important
influence on total demand. Similarly, changes in taxation will affect both the total of private
expenditure and its distribution on various goods and services. In an inflationary situation, for
example, where total demand exceeds total supply at current prices, the government may
reduce its own spending and increase the rates of taxation on income and expenditure.
8
Monetary policy: the government is able to control the total money supply through central
banks, National Bank of Ethiopia in our case. Total expenditure on goods and services may
be increased or decreased by variations in the supply of money and in terms of which it may
be borrowed (i.e. the rate of interest). The greater part of the money supply consists of bank
credit (i.e. bank deposits), and monetary policy aims to vary both the quantity and the price of
such credit.
Direct controls: the state has the powers, if it wishes to use them, to institute a vast range of
physical controls on the economic system. It has the political power to bring the means of
production (land and capital) into public ownership and to decide the volume and pattern of
production independently of market forces. This would call for detailed central planning so
that the planned outputs of the different sectors of the economy could be dovetailed together.
The Incompatibility of Objectives

The conduct of economic policy is a most difficult task because, so often, the principal
objectives of that policy are mutually incompatible. If governments had to pursue only one of
the aims above without having to worry about the other targets, there would be relatively few
problems of economic policy. Unfortunately, this is not the case. An attempt to achieve a
faster rate of economic growth, for example, might lead to a large increase in the imports of
basic materials, fuel and machinery, which might well put the balance of payments account
into deficit. When there are inflationary tendencies, the pursuit of price stability might require
the use of measures to reduce total demand. But these same measures could well result in a
reduction of output rather than prices, so that unemployment increases. The government will
find itself having to compromise – to balance one objective against another. Economic policy
will have to be cast in terms of priorities, which themselves will change over time. Some
degree of inflation might be the price which has to be paid for maintaining a high level of
employment; some curb may have to be placed on the planned rate of economic growth in
order to achieve acceptable balance of payments equilibrium and so on.
-------------//--------------
CHAPTER TWO
9
2. National Income Accounting
2.1. Measurements National Income Accounting
National Income is defined differently by different economist. In connection let us see
different views adopted by different economists to define national income. These are:
 The Traditional view

 The Keynesian view
 The Modern view
In the traditional view, national income is defined as follows:
''The national income or dividend consists solely of services as received by ultimate

consumers, whether from their material or from their human environment '' Fisher I. From
this definition, the economist adopts consumption as the basis of national income. But it is
not an easy task to measure net consumption and the value of services rendered by consumer
durables year after year.
''The labour and capital of country acting on its natural resources produce annually a certain
net aggregate of commodities, material and immaterial, including services of all kind. This is
the true net national income or revenue of the country or national dividend'' Marshal A.
According to him, it means that all types of goods and services which are produced, whether
they are brought to the market or not, are included in the national income. He added that the
cost of wear and tear of the machinery should be deducted from the total value of these goods
and services. He also took in account income from abroad while calculating the national
income.
''National income is that part of the objective income of the commodity, including of course,
income derived from abroad which can be measured in money'' Pigou. It means that only
goods and services exchanged for money are included in the national income.
In the Keynesian view, national income is defined with respect to three approaches:
10
 The Expenditure Approach: here, national income is equal to total consumption
expenditure and total investment expenditure systematically i.e. Y=C+I where Y is
national income, C is consumption expenditure and I is total investment expenditure
 The Income Approach: here national includes the total income of all factors of
production i.e. Y=F+EP where Y refers to national income, F is the payments
received by owners of factors of production and EP is entrepreneurial profits.
 Sale minus Cost Approach: in this approach national income(Y) is equal to total sales
of proceeds (A) less user cost (U) i.e. Y=A-U
In the modern view any of the following three approaches may be used to determine national
income of a country namely; product approach, income approach or expenditure approach.
In this course, the modern approaches are discussed in detail with the help of numerical
examples in the next section. In all cases, however, two measurements of national income are
discussed. These are gross domestic product and gross national product.
Gross domestic product [GDP] is often considered the best measure of how well the
economy is performing. The goal of GDP is to summarize in a single number the monetary
value of economic activities in a given period of time.
Definition: Gross Domestic Product (GDP) is the market value of all final goods and services
produced within an economy in a given period of time.
There are two ways to view this statistic. One way to view GDP is as the total income of
everyone in the economy. Another way to view GDP is as the total expenditure on the
economy’s output of goods and services. From either viewpoint, it is clear why GDP is a
measure of economic performance. GDP measures something people care about – their
incomes. Similarly, an economy with a large output of goods and services can better satisfy
the demands of households, firms, and the government.
How can GDP measure both the economy’s income and the expenditure on its output? The
reason is that these two quantities are really the same: for the economy as a whole, income
must equal expenditure. That fact, in turn, follows from an even more fundamental one:
because every transaction has both a buyer and a seller, every Birr of expenditure by a buyer
must become a Birr of income to a seller. When Abebe paints Kebede’s house for Birr 1,000,
that Birr 1,000 is income to Abebe and expenditure by Kebede. The transaction contributes
Birr 1,000 to GDP, regardless of whether we are adding up all income or adding up all
11
expenditure.
Imagine an economy that produces single good, bread, from a single input, labour. The
Figure below illustrates all the economic transactions that occur between households and
firms in this economy.
The inner circle in the Figure represents the flows of bread and labour. The households sell
their labour to the firms. The firms use the labour of their workers to produce bread, which
the firms in turn sell to the households. Hence, labour flows from households to firms, and
bread flows from firms to households. The outer circle represents the corresponding flow of
money. The households buy bread from the firms. The firms use some of the revenue from
these sales to pay the wages of their workers, and the remainder is the profit belonging to the
owners of the firms (who themselves are part of the household sector). Hence, expenditure on
bread flows from households to firms, and income in the form of wages and profit flows from
firms to households.
GDP measures the flow of money in this economy. To compute GDP, we can look at either
the flow of money from firms to households or the flow of money from households to firms.
Every transaction that affects expenditure must affect income, and every transaction that
affects income must affect expenditure.
For example, suppose that a firm produces and sells one more loaf of bread to a household.
Clearly this transaction raises total expenditure on bread, but it also has an equal effect on
total income. If the firm produces the extra loaf without hiring any more labour (such as by
making the production process more efficient), then profit increases. If the firm produces the
extra loaf by hiring more labour, then wages increase. In both cases, expenditure and income
increase equally.
Gross National Product [GNP] is, on the other hand, defined as the value of goods and
services produced by nationals (citizens) of a country.
12
To obtain gross national product (GNP), we add receipts of factor income (wages, profit, and
rent) from the rest of the world and subtract payments of factor income to the rest of the
world:
GNP = GDP + Factor Receipts From Abroad - Factor Payments to Abroad.
GNP = GDP + Net Factor Income.
GNP measures the total income earned by nationals (residents of a nation), while GDP
measures the total income produced domestically. For instance, if an Indian resident owns an
apartment building in Addis Ababa, the rental income he earns is part of Ethiopian GDP
because it is earned in the Ethiopia. But because this rental income is a factor payment to
abroad, it is not part of Ethiopian GNP. In Ethiopia, factor receipts from abroad are less than
factor payments to abroad; this leaves the net factor payments negative. As a result of this,
GDP is higher than GNP.
2.1. Approaches to National Income Accounting Process

Rules for Computing GDP
1. Used Goods
GDP measures the value of currently produced goods and services. The sale of used goods
reflects the transfer of an asset, not an addition to the economy’s income. Thus, the sale of
used goods is not included as part of GDP. For example, if Rahel sells her domestically
produced old TV set to her fried Liya; such transactions represent the transfer of this asset
from Rahel to Liya and transfer of money from Liya to Rahel. The value of the old TV set
represents value produced in the past. It is, therefore, omitted in measuring GDP.
2. The Treatment of Inventories
The goods and services produced in an economy may not be sold in the year they are
produced. Instead, they are put into inventory to be sold later. In this case, the owners of the
firm are assumed to have “purchased’’ the goods for the firm’s inventory, and the firm’s
profit is not reduced by the additional wages it has paid to produce the goods. Because the
higher wages raise total income, and greater spending on inventory raises total expenditure,
the economy’s GDP rises.
What happens later when the firm sells the goods out of inventory? This case is much like the
13
sale of a used good. There is spending by consumers, but there is inventory disinvestment by
the firm. This negative spending by the firm offsets the positive spending by consumers, so
the sale out of inventory does not affect GDP. The general rule is that when a firm increases
its inventory of goods, this investment in inventory is counted as expenditure by the firm
owners. Thus, production for inventory increases GDP just as much as production for final
sale. A sale out of inventory, however, is a combination of positive spending (the purchase)
and negative spending (inventory disinvestment), so it does not influence GDP. This
treatment of inventories ensures that GDP reflects the economy’s current production of goods
and services.
3. Intermediate Goods and Value Added
Many goods are produced in stages: raw materials are processed into intermediate goods by
one firm and then sold to another firm for final processing. How should we treat such
products when computing GDP? For example, a flour mill sells flour for Birr 350 to a baker
who produces 1000 loafs of bread and sells each loaf of bread for Birr 0.50. Should GDP
include the value of flour and bread or only the value of bread?
The answer is that GDP includes only the value of final goods. Thus, the bread is included in
GDP but the flour is not: GDP increases by Birr 500 (Birr 0.50×1000), not by Birr 850. The
reason is that the value of intermediate goods is already included as part of the market price
of the final goods in which they are used. To add the intermediate goods to the final goods
would be double counting – that is, the flour would be counted twice. Hence, GDP is the total
value of final goods and services produced.
One way to compute the value of all final goods and services is to sum the value added at
each stage of production. The value added of a firm equals the value of the firm’s output less
the value of the intermediate goods that the firm purchases. In the case of the bread, the value
added of the flour mill is Birr 350 and the value added of the baker is Birr 150 (Birr 500 –
Birr 350). Total value added is Birr 350 + Birr 150, which equals Birr 500. For the economy
as a whole, the sum of all values added must equal the value of all final goods and services.
Hence, GDP is also the total value added of all firms in the economy.
14
4. Housing Services and Other Imputations
Although most goods and services are valued at their market prices when computing GDP,
some are not sold in the marketplace and therefore do not have market prices. If GDP is to
include the value of these goods and services, we must use an estimate of their value. Such an
estimate is called an imputed value.
Imputations are especially important for determining the value of housing. A person who
rents a house is buying housing services and providing income for the landlord; the rent is
part of GDP, both as expenditure by the renter and as income for the landlord. Many people,
however, live in their own homes. Although they do not pay rent to a landlord, they are
enjoying housing services similar to those that renters purchase. To take account of the
housing services enjoyed by homeowners, GDP includes the “rent’’ that these homeowners
“pay’’ to themselves. Of course, homeowners do not in fact pay themselves this rent. The
relevant government agencies estimate what the market rent for a house would be if it were
rented and includes that imputed rent as part of GDP. This imputed rent is included both in
the homeowner’s expenditure and in the homeowner’s income.
Imputations also arise in valuing government services. For example, police officers and fire-
fighters provide services to the public. Giving a value to these services is difficult because
they are not sold in a marketplace and therefore do not have a market price. The national
income accounts include these services in GDP by valuing them at their cost. That is, the
wages of these public servants are used as a measure of the value of their output. In addition,
some of the output of the economy is produced and consumed at home and never enters the
marketplace. For example, meals cooked at home are similar to meals cooked at a restaurant,
yet the value added in meals at home is left out of GDP.
2.2.1. The Output Approach

This is a method of measuring gross national product by adding up the market value of output
of all firms in the country. In this method of measuring gross national product, it is important
include only final goods and services in order to avoid double counting. Double counting
arises when the output of some firms are used as the inputs of other firms. There are two
ways of avoiding this problem. These are; taking only the value of final goods and services or
taking the sum of the added value of firms at different stages of production. The following
table shows how the total output of the economy is determined for Ethiopia.
15
Sectors Value of Output (in million Birr)
1) Primary Sector
a) Agriculture 33559.92
b) Forestry 2664.03
c) Fishing 1146.73
Subtotal 37365.68
2) Secondary Sector
a) LMS Industries 5743.24
b) Construction 4566.92
c) Electricity and Water 456.69
d) Mining 304.46
Subtotal 11071.31
3) Territory Sector
a) Banking and Insurance 16399.38
b) Education 2283.46
c) Health 1037.94
d) Defence 415.17
e) Other Service 622.76
Subtotal 20758.71
Gross Domestic Product 69195.70
4) Net Income from Abroad (9195.70)
Gross National Income 60000.00
2.2.2. The Expenditure Approach

Economists and policymakers care not only about the economy’s total output of goods and
services but also about the allocation of this output among alternative uses. The national
income accounts divide GDP into four broad categories of spending:
 Consumption (C)
 Investment (I )
 Government purchases (G)
 Net exports (NX).
Thus, letting Y stand for GDP,
Y = C + I + G + NX.
GDP is the sum of consumption, investment, government purchases, and net exports. Each
dollar of GDP falls into one of these categories. This equation is an identity – an equation that
must hold because of the way the variables are defined. It is called the national income
accounts identity.
Consumption consists of the goods and services bought by households. It is divided into
three subcategories: nondurable goods, durable goods, and services.
16
Investment consists of goods bought for future use. Investment is also divided into three
subcategories: business fixed investment, residential fixed investment, and inventory
investment. Business fixed investment is the purchase of new plant and equipment by firms.
Residential investment is the purchase of new housing by households and landlords.
Inventory investment is the increase in firms’ inventories of goods (if inventories are falling,
inventory investment is negative).
Government purchases are the goods and services bought by federal, state, and local
governments. This category includes such items as military equipment, highways, and the
services that government workers provide. It does not include transfer payments to
individuals, such as Social Security and welfare. Because transfer payments reallocate
existing income and are not made in exchange for goods and services, they are not part of
GDP.
The last category, net exports, takes into account trade with other countries. Net exports are
the value of goods and services exported to other countries minus the value of goods and
services that foreigners provide us. Net exports represent the net expenditure from abroad on
our goods and services, which provides income for domestic producers. The following
example helps you know how to calculate GDP/GNP using the expenditure approach.
Expenditure Components Value (in million Birr)

1) Consumption Expenditure 52192.9
2) Gross Investment Expenditure 21548.7
Less Depreciation 5904.4
15644.3
3) Government Purchases 15052.5
4) Exports 5232.6
5) Imports 18926.6
13694.0
6) Income to Foreigners 14769.5

7) Income to Nationals 5573.8
(9195.7)

Source: MoFED.
17
2.2.3. The Income Approach
National income measures how much everyone in the economy has earned. The national
income accounts divide national income into five components, depending on the way the
income is earned. The five categories, and the percentage of national income paid in each
category, are
 Compensation of employees: The wages and fringe benefits earned by workers.

 Proprietors’ income: The income of non-corporate businesses, such as small farms,
and law partnerships.
 Rental income: The income that landlords receive, including the imputed rent that
homeowners “pay’’ to themselves, less expenses, such as depreciation.
 Corporate profits: The income of corporations after payments to their workers and
creditors.
 Net interest: The interest domestic businesses pay minus the interest they receive, plus
interest earned from foreigners.
 Depreciation (Capital Consumption Allowance) (D): the annual payment, which
estimates the amount of capital equipment used up in each year's production, is called
depreciation. It represents a portion of GNP that must be used to replace the machinery
and equipment used up in the production process.
 Indirect Business Tax (IBT): the government imposes indirect taxes on business firms.
These taxes are treated as cost of production. Therefore, business firms add these taxes
to the prices of the products they sell. Indirect business tax includes sales taxes, excise
taxes and custom duties. The following example helps you know how to calculate
GDP/GNP using the income approach.
Types of Income Value (in million Birr)
1) Compensation of Employees 45623.71
2) Rental Income 1249.32
3) Proprietor’s Income 10561.21
4) Corporate Profits 16960.33
Subtotal 27521.54
5) Net interest 5189.73
6) Depreciation 521.84
7) Indirect Business Taxes 476.51
8) Subsidy 11368.95
9) Income from abroad 2036.20
10)Payments to abroad 11231.90
(9195.70)
18
Other Measures of Income
Other measures of national income include Net National Product (NNP), National Income
(NI), Personal Income (PI) and Personal Disposable Income (PDI).
1. To obtain net national product (NNP), we subtract the depreciation of capital – the amount
of the economy’s stock of plants, equipment, and residential structures that wears out
during the year:
NNP = GNP - Depreciation.
In the national income accounts, depreciation is called the consumption of fixed capital.
Because the depreciation of capital is a cost of producing the output of the economy,
subtracting depreciation shows the net result of economic activity.
2. National Income (NI): the next adjustment in the national income accounts is for indirect
business taxes, such as sales taxes. These taxes, place a wedge between the price that
consumers pay for a good and the price that firms receive. Because firms never receive
this tax wedge, it is not part of their income. Once we subtract indirect business taxes from
NNP, we obtain national income.
National Income = NNP - Indirect Business Taxes + Subsidy
3. Personal Income: national income, however, is not that income households and non-
corporate businesses receive. The amount of income received by households and non-
corporate businesses is called personal income. In order to find personal income, first, we
reduce national income by the amount that corporations earn but do not pay out (retained
earnings and corporate taxes). This adjustment is made by subtracting corporate taxes and
retained earnings. Second, we increase national income by the net amount the government
pays out in transfer payments. This adjustment equals government’s transfers to
individuals minus social insurance contributions paid to the government. Third, we adjust
national income to include the interest that households earn rather than the interest that
businesses pay. This is because; part of the interest that businesses pay goes as interest on
government debts. Thus, personal income is
19
Personal Income = National Income - Corporate Profits
- Social Insurance Contributions
- Net Interest
+ Dividends
+ Government Transfers to Individuals
+ Personal Interest Income
4. Personal Disposable Income (PDI): is the amount of income households use for either
direct consumption or saving. It is calculated as the difference between Personal
Income and Personal Income taxes such as income taxes, property taxes and
inheritance taxes.
Personal Disposable Income (PDI) = Personal Income (PI) + Personal Taxes (PT)
Real GDP versus Nominal GDP

Economists use the rules just described to compute GDP, which values the economy’s total
output of goods and services. But is nominal GDP a good measure of economic well-being?
Consider an economy that produces only apples and oranges. In this economy GDP is the
sum of the value of all the apples produced and the value of all the oranges produced. That is,
GDP = (Price of Apples × Quantity of Apples) + (Price of Oranges × Quantity of Oranges).
Notice that nominal GDP can increase either because prices rise or because quantities rise.
It is easy to see that GDP computed this way is not a good measure of economic well-being.
That is, this measure does not accurately reflect how well the economy satisfies the demands
of households, firms, and the government. If all prices doubled without any change in
quantities, GDP would double. Yet it would be misleading to say that the economy’s ability
to satisfy demands has doubled, because the quantity of every good produced remains the
same. The value of goods and services measured at current prices is called nominal GDP.
A better measure of economic well-being would tally the economy’s output of goods and
services and would not be influenced by changes in prices. For this purpose, economists use
real GDP, which is the value of goods and services measured using a constant set of prices.
20
That is, real GDP shows what would have happened to expenditure on output if quantities
had changed but prices had not. The nominal GDP can be converted to real GDP by using
GDP deflator. It is a type price index that deflates nominal GDP to its real value.
The GDP deflator may be defined as the ratio of nominal GDP (GDP measured in current
prices) and real GDP (GDP measured in base year prices). Since the GDP deflator is based
on all goods and services produced of the economy, it is a widely used price index. It
measures the change in price that has occurred between the current year and the base year.
To compute today’s real GDP; today’s output [nominal GDP] is multiplied by the ratio of
prices of that year and in the base year. Suppose we use the price level in 2002 as the base
year price to measure real GDP in 2003 and 2004.
Real GDP for 2002 would be
Real GDP = (2002 Price of Apples/ 2002 Price of Apples × 2002 Quantity of Apples)
+ (2002 Price of Oranges/ 2002 Price of Oranges× 2002 Quantity of Oranges)
Similarly, real GDP in 2003 would be
Real GDP = (2003 Price of Apples/2002 Price of Apples × 2003 Quantity of Apples)
+ (2003 Price of Oranges/2002 Price of Oranges × 2003 Quantity of Oranges)
And real GDP in 2004 would be
Real GDP = (2004 Price of Apples/2002 Price of Apples × 2004 Quantity of Apples)
+ (2004 Price of Oranges/2002 Price of Oranges × 2004 Quantity of Oranges).
Notice that 2002 prices are used to compute real GDP for all three years. Because the prices
are held constant, real GDP varies from year to year only if the quantities produced vary.
Because a society’s ability to provide economic satisfaction for its members ultimately
depends on the quantities of goods and services produced, real GDP provides a better
measure of economic well-being than nominal GDP.
Nominal GDP
GDP deflator= .100
Real GDP
21
2.3. Difficulties in Measuring National Income
The calculation of national income is not an easy task. The difficulties faced are as follows.
1. Definition of a nation: while calculating national income, nation does not mean only the
political or geographical boundaries of a country for calculating the value of final goods
and services produced in the country. It includes income earned by the nationals abroad.
2. Stages of economic activities: it is also difficult to determine the stages of economic
activity at which the national income is determined i.e. whether the income should be
calculated at the stage of production or distribution or consumption. It has, therefore, been
agreed that the stage of economic activity may be decided by the objective for which the
national income is being calculated. If the objective is to measure economic progress, then
the production stage can be considered. To measure the welfare of the people, then the
consumption stage should be taken into consideration.
3. Transfer payments: this also poses a great difficulty in the way of calculating the national
income. It has generally been agreed that the best way is to consider only the disposal
income of the individuals of groups.
4. Underground economy: no imputation is made for the value of goods and services sold in
the illegal market. The underground economy is the part of the economy that people hide
from the government either because they wish to evade taxation or because the activity is
illegal. The parallel exchange rate market is one example.
5. Inadequate data: in all most all the countries, difficulty has been faced in the calculation
of national income because of the non-availability of adequate data. Sometimes, the data
are not reliable. This is a general difficulty and may not be solved.
6. Non-monetized sector: this difficulty is special to developing countries where a substantial
portion of the total produce is not brought to the market for sale. It is either retained for
self-consumption or exchanged for other goods and services.
7. Valuation of depreciation: the value of depreciation is deducted from the gross national
product to get net national product. But the valuation of such depreciation is full of
difficulties. For example, changes in the price of capital goods from year to year, the age
composition of capital stock, depreciation in cost due to the use of the capital stock, etc.
8. Price level changes: since the national income is in terms of money whose value itself
keeps on changing, it is difficult to make a stable calculation which is assessed in terms of
22
prices of the base year. But then, the problems of constructing price index numbers will
arise.
Importance of National Income Statistics

National income statistics are of great importance. With the help of these statistics one may
know the state of the economy’s performance. Some of the importances of national income
statistics are given below.
1. Indices of national welfare: national income statistics are useful indices of the economic
welfare of the people. With their help one can very easily draw a comparison between the
economic conditions of the people living in different countries and of those living within
the country at different periods of time. These statistics are very useful for knowing the
changes in the standard of living of the people all over the world.
2. Aid to economic policy and planning: national income statistics are pointers to the changes
in the economic activities taking place in the economy under the impact of various policies
of the government. Whether a particular policy has yielded the desired results or not may
be known by the national income statistics. And on the basis of the studies and researches
conducted with the help of these statistics, the policy makers may bring about suitable
changes in their policies. They also provide important tools for economic planning.
3. Index of economic structure: national income statistics are very useful indices of the
economic structure of a country. They provide useful knowledge about the performance of
various sectors of the economy. Thus, one can have a clear idea of the sectors which are
lagging behind in economic development and the sectors which are advancing in
economic growth.
4. Useful pace for the formulation of budgetary policies: national income statistics provide a
very useful and important base for the formulation of government budgets. It is on the
basis of these figures that the finance minister is able to have a comparative idea of the
importance of different taxation measures, public borrowing or deficit financing and other
fiscal measures. They also help the finance minister in preparing the budget, particularly in
formulating the proposal for a federal government. They are useful guides for determining
the amount of granting, aid and subsidies to be provided to various units.
5. Significance for defence and development: national income statistics enable the
government to make proper allocation of the national product between defence [non-
productive activity] and development programs [productive activities] of the economy.
23
-------------//--------------
CHAPTER THREE
3. Macroeconomics in Closed
Economies
3.1. Consumption and Investment
Spending
a) Consumption
In Chapter 2, it has been discussed that there are three major approaches to measure GDP.
Income approach which aggregates the income generated in different sectors (wage income,
rental income, interest income etc.); expenditure approach which sums expenditure of
different sectors and output approach which accounts for contributions of output by each
sector of production. In this section we focus on how aggregate national income is spent in
different sectors (expenditure of national income in different sectors).
Consumption constitutes significant share (part) of GDP in most economies. It is important to

study, therefore, the factors that determine or influence consumption. Several economists
tried to explain it in different alternative ways.
Keynes builds his theory of consumption based on his causal observation of the consumption
decision of households. He makes three important conjectures:
First, Keynes conjectured that average propensity to consume (APC) – the ratio of
consumption to total income – falls as income of households rises. He holds that as income
increases the fraction saved out of it rises. This is so because he considers saving as a luxury,
resulting in the rich saving higher proportion of their income than the poor.
C
APC =
Y
Part of the income that goes to the saving schedule is called average propensity to save and it
is given by:
S
APC =
Y
24
Second, he holds that marginal propensity to consume (MPC) – the additional spending on
consumption for a rise in income by one Birr – is between 0 and 1. That is, when an
individual earns additional income of 1 Birr, s/he will spend some of it and saves some of it.
dC
MPC=
dY =ΔC/ΔY, where C is consumption and Y is income
The change in the saving schedule as a result of change in income is called marginal
propensity to save and it is given by:
dS
MPS=
dY =ΔS/ΔY, where S is saving and Y is income
In all cases, the sums of average or marginal propensity to save and to consume are equal to
Unity i.e.
APC+APS=1 and MPC+MPS=1
Third, Keynes conjectured that consumption was a function of income. This view was in a
stark contrast to classical thought that held consumption was a function of interest rate, and
therefore they are inversely related.
On the basis of the three conjectures, Keynes’s consumption function could be defined as:
C=C+cY , C>0, 0<c <1 ,
Similarly, the saving function would be:
S=S+sY , 0<s<1 ,
Where C is a constant [autonomous consumption], c is the marginal propensity to consume,

S a constant [autonomous saving], s is the marginal propensity to save and Y is disposable
income.
Example:
Income Consumption Savin APC APS MP MPS
g C
0 20 -20 - - - -
40 50 -10 1.25 -0.25 0.75 0.25
80 80 0 1 0 0.75 0.25
120 110 10 0.92 0.08 0.75 0.25
25
160 140 20 0.875 0.125 0.75 0.25
200 170 30 0.85 0.15 0.75 0.25
240 200 40 0.83 0.17 0.75 0.25
280 230 50 0.82 0.18 0.75 0.25
C=20+0.75Y
S=-20+0.25Y
Consumption,
Saving C=20+0.75Y
S=-20+0.25Y
20
-20 Income
b) Investment
Investment is considered to be an important part of national income accounts. Investment
includes spending on new plant and equipment, net inventory investment and new residential
construction. Investment can be viewed as either gross investment or net investment. Gross
investment includes the items mentioned above. If we deduct an allowance for the amount of
the existing total of structures and producers durable equipment used in producing the output
we get net investment.
The concept of Multiplier

Multiplier refers to the ratio that expresses the relationship between increase in national
output/income/employment and investment. It refers to the rate by which investment
reproduces/multiplies output/income/employment. Let K represents the multiplier and it is
defined as:
K=ΔY/ΔI since Y= C+I
26
ΔY=ΔC+ΔI
ΔI=ΔY-ΔC
K= ΔY/(ΔY-ΔC)
K= ΔY/(ΔY-ΔC)
Dividing both the numerator and the denumerator by ΔY yields:
K= 1/(1-ΔC/ΔY) since ΔC/ΔY=MPC
K=1/(1-MPC)=1/MPS
Example: If an economy with marginal propensity to consume of 0.8 gets additional
investment of 7 million birr, then by how much does output/income increase? Determine the
magnitude of the multiplier.
K=1/(1-MPC)=1/(1-0.8)=5
K=ΔY/ΔI
ΔY =K.ΔI=5x7=35 mill. Birr
3.2. Introducing Government Expenditure to the basic
model
In section 3.1, the basic macroeconomic model was implicitly defined as a function of
consumption and saving. However, as it has been shown in chapter model the identity
includes other variables like government expenditure and net exports. In this chapter, only
government expenditure is introduced to the model as the assumption is that the economy is
closed economy and in chapter 5 net exports will be brought in to the model.
The identity function would be Y=C+I if it is assumed that there is no government spending.
The equilibrium output would be as follows in this case.
Consumption is defined as C=Ca+cYd where Yd=disposable income given by =Y-T
C=Ca+c(Y-T)
Therefore,
Y=C+I
Y= Ca+c(Y-T)+I
If T=0 (no taxation), then Y= Ca+cY+I and the equilibrium output will be:
Y-cY = Ca+ I
1
Y= [ Ca+ I ] … … … … … … … … … … … … … … … … … … … … … … … … … … … …(1)
1−c
If T≠0 (there is taxation), then Y= Ca+cY-cT+I and the equilibrium output will be:
27
Y-cY = Ca-cT+ I
1
Y= [ Ca−cT + I ] … … … … … … … … … … … … … … … … … … … … … … … … … … … …(2)
1−c
If government expenditure is introduced to the model Y=C+I will be converted to:
Y=C+I+G
Y= Ca+c(Y-T)+I+G
Y= Ca+cY-cT+I+G and the equilibrium output will be:
Y-cY = Ca-cT+ I+G
1
Y= [ Ca−cT + I +G ] … … … … … … … … … … … … … … … … … … … … … … … … … …(3)
1−c
In all the above cases, when autonomous consumption, investment and government
expenditure changes by one unit, national income change by 1/(1-c) i.e. the amount of
multiplier in the same direction while change in taxation derives the national income by
–c/(1-c) in opposite direction. Notice that,
.............................................................. This is called balanced

budget theorem.
If the government makes transfer payments out of its receipts (tax revenue) [i.e. T=T g-TR],
the identity will be change into the following form.
Y= Ca+c(Y-T)+I+G
Where T=Tg-TR
Y= Ca+c(Y-(Tg-TR)) +I+G
Y= Ca+c(Y-Tg+TR)) +I+G
Y= Ca+cY-cTg+cTR+I+G
The equilibrium output will be as follows in this case.
1
Y= [ Ca−cTg+ cTR+ I +G ] … … … … … … … … … … … … … … … … … … … … … …(4 )
1−c
If gross tax is imposed according to or on the basis of the size of income, then T G=Ta+tY. In
this case, the identity will change be into the following form.
Y= Ca+c(Y-T) +I+G
Where T=Tg-TR and TG=Ta+tY i.e. T=Ta+tY-TR
Y= Ca+c(Y-( Ta+tY-TR)) +I+G
Y= Ca+c(Y-Ta-tY+TR)) +I+G
28
Y= Ca+cY-cTa-ctY+cTR+I+G
The equilibrium output will be as follows in this case.
1
Y= [ Ca−cTa+ cTR+ I +G ] … … … … … … … … … … … … … … … … … …(5)
1−c+ ct
3.3. Money, Interest rate and Income

Supply of real money balances: Money supply refers to the quantity of money stock
circulating in the economy within a given period of time, usually a year. There are definitions
for the supply of money depending on the elements/constituents of money supply.
 The Classical and Neoclassical Economists define money supply as the total amount
of money in the hands of the public [C] and demand deposits in the banks [DD].
M1=C+DD
 In the Monetarist approach money supply includes time deposits [TD] as well.
M2=C+DD+TD
 In the Gurley and Shaw approach money supply includes nonbank intermediaries
[NBI] such as bonds and shares in addition to the above elements.
M3=C+D+TD+NBI
 The Radcliffe Committee includes near money assets [NMA] such as gold in the
definition for the supply of money.
M4=C+D+TD+NBI+NMA
If M stands for the supply of money and P stands for the price level, the M/P is the supply of
real money balances. The theory of liquidity preference assumes that there is a fixed supply
of real balance. That is,
( M /P )s =M / p .
The money supply M is an exogenous policy variable chosen by the central bank. The price
level P is also exogenous variable in this model. (We take the price level as given because the
IS-LM model considers the short run when the price level is fixed). These assumptions imply
that the supply of real balances is fixed and, in particular, does not depend on the interest rate
shown in the figure below.
29
r Money Supply
M/P M/P
Demand for real money balances: refers to the amount of money people require for different
purposes in the economy such as the transaction motive [for day to day transaction],
precautionary motive [as a contingency insurance] and speculative motive [to derive interest
income] as stated by Keynes. People hold money because it is a “liquid” asset- that is,
because it is easily used to make transaction. The theory of liquidity preference postulates
that quantity of real balances demanded depends on interest rate as well as income. The
interest rate is the opportunity cost of holding money. When the interest rate rises, people
want to hold less of their wealth in the form of money. We write the demand for real money
balances as
(Md) = L(y, r)
This equation states that the quantity of real balances demanded is a function of the interest
rate and income. There is inverse relationship between money demand and interest rate. This
is shown by a downward sloping demand curve. As interest rate increases liquidity preference
(the desire to hold money) decreases.
L(r)
Md
According to the theory of liquidity preference, the interest rate adjusts to equilibrate the
30
money market. At the equilibrium interest rate, the quantity of real balances demanded equals
the quantity supplied. The equilibrium condition is shown in the figure below.
Money supply
Demand for money

r*
Md
M/P
M/P
The adjustment of the interest rate to this equilibrium of money supply and money demand
occurs because people try to adjust their portfolios of assets if the interest rate is not at the
equilibrium level. If the interest rate is too high, the quantity of real balances supplied
exceeds the quantity demanded. Banks and other financial institutes respond to this excess
supply of money by lowering the interest rates they offer (If interest rate is greater than r *,
there will be excess money supply which pushes the interest rate down). Conversely, if the
interest rate is too low, so that the quantity of money demanded exceeds the quantity
supplied. This excess demand for money pushes the interest rate up towards r*. Individuals
try to obtain money by making banks withdrawals, which derives the interest rate up. At the
equilibrium interest rate people are content with their portfolios of monetary and non
monetary assets.
General equilibrium in the Economy
A general equilibrium in the economy refers to the equilibrium level of interest rate (price)
and national income that balance the demand for all goods and services to their supply in the
goods market and the demand for and the supply of money in the money market. The
simultaneous equilibrium in these markets is presented by the model known as IS-LM model.
The IS-LM model was developed by Hicks in 1946 aiming at presenting an interpretation to
Keynes’s General Theory. The model shows the determinants of national income during a
period in which prices are sticky.
31
The components of the IS–LM model are, the IS curve and the LM curve. The IS curve
summarizes what is going on in the market for goods and services. IS stands for
“investment’’ and “saving’’. LM, on the other hand, stands for “liquidity’’ and “money,’’
and the LM curve summarizes the activities in the supply and demand for money. Interest rate
serves to establish a linkages between the IS and LM curves. The model shows how
interactions between these markets determine the position and slope of the aggregate demand
curve and, therefore, the level of national income in the short run.
Goods Market and the IS Curve.
It refers to a market where planned investment is equal to saving. It is represented by the IS-
curve that shows different combination of interest rate and income levels that equate
investment and saving. The higher the interest rate, the lower the level of planned investment;
and thus the lower level of income. For this reason the IS curve slopes downward.
The IS-curve is derived as follows. Consider the following four panels of figures.
Saving (C) Saving (B)
S=f(Y) S=I
S1
S0
0 Y0 Y1 Income 0 I0 I1 Investment
Interest (D) Interest (A)

. r0 r0
r1 r1
IS curve I=f(r)
0 Y0 Y1 Income 0 I0 I1 Investment
In panel (A), investment is defined as a function of interest rate and it is shown that when
interest rate falls from r0 to r1 investment increases from I0 to I1. These are associated with S0
and S1 levels of saving in panel (B) where they are defined as a function of income in panel
(C) i.e. S0 is saved when income is at Y 0 level and S1 is saved at income level Y. Dropping
32
these income levels to panel (D) and bringing interest levels from panel (A), yields a function
that defines income as a function of interest rate i.e. the IS curve.
The Money Market and the LM Curve
The money market refers to a market where the demand for and the supply of money are in
equilibrium. It is represented by the LM curve which shows different combination of interest
rates and income levels that equate demand for and supply of money.
The Lm-curve is derived as follows. Consider the following four panels of figures.
Mdt (C) Mdt (B)
Mdt=f(Y) Mdt ~
Y1t
Y0t
0 Y0 Y1 Income 0 Y0s Y1s Mds
Interest (D) Interest (A)

. r0 r0
r1 r1
LM curve Mds=L(r)
0 Y0 Y1 Income 0 Y0s Y1s Mds
In panel (A), the speculative demand for money is defined as a function of interest rate and it
is shown that when interest rate falls from r 0 to r1 the demand for money for speculative
purpose (Mds) increases from Y0s to Y1s. These are associated with a fall in the demand for
money for transaction motive (Mdt) from Y1t to Yot in panel (B) as they are derived from the
same source of income. In panel (C), the demand for money for transaction motive (Md t) is
defined as a function of income. Dropping these levels of income to panel (D) and bringing
interest levels from panel (A), yields a function that defines income as a function of interest
rate i.e. the LM curve.
33
Conclusion: we now have all components of the ISLM model. The two equations of this
model are
Y =C(Y −T )+I(r )+G.............................................................................IS

(M/P)s =(M /P)d ⇒(M/P)s=L( r,Y).................................................... LM
The model takes fiscal policy, G and T, monetary policy M, and the price level P as
exogenous variables where as income or output level (Y) and interest rate are endogenous
variables. Given these variables, the IS curve provides the combination of r and Y that satisfy
the equation representing the goods market, and the LM curve provides the combinations of r
and Y that satisfy the equation representing the money market. These two curves are shown
together in the figure below.
r LM
r*
IS
Y*
The equilibrium of the economy is the point at which the IS curve and the LM curve cross.
This point gives the interest rate r and the level of income Y that satisfy both the goods
market equilibrium and the money market equilibrium condition. In other words, at this
intersection, actual expenditure equals planned expenditure, and the demand for real money
balances equals the supply i.e. when LM and/or IS curve(s) shift(s) the equilibrium income or
output Y* and r* change.
-------------//--------------
34
CHAPTER FOUR
4. Aggregate Demand and Supply Analysis
4.1. Aggregate Demand Analysis
4.1.1. Derivation of the aggregate demand curve
Aggregate demand-aggregate supply model is developed as alternative policy analysis since
ISLM model has limitations. Some of the limitations of the ISLM model are that:
- It doesn’t entertain or consider supply shock.

- It assumes that price is fixed
- It is highly aggregated.
ISLM model is highly aggregated. Because from IS, we consider only market of goods and
services. All other sorts of transaction of goods and services are ignored for instance labour
market. From the LM function we analyze only market for money balances. Other
possibilities of money transaction are ignored. The assumption behind the ISLM model is the
abrasion law which says that if n-l markets clear the nth market also clears. Suppose the ISLM
model considers three major groups of market: 1) goods and services market, 2) money
market and 3) other markets. Then the ISLM approach implicitly assumes that if markets
number 1 and 2 clear the 3rd market also clears.
Owing to the high aggregation parameters of analysis would be biased and it would not be
relevant for policy making. Thus, although it is a core of macroeconomic analysis, it is not as
such useful for empirical estimation.
The most important limitation of the ISLM model is that it assumes passive supply. It
assumes that sellers produce whatever is demanded and all adjustments to change in demand
are in the form of changes in output. None of the adjustment is in the form of changes in
price. That is adjustment cannot be in the form of price changes since prices do not enter into
the model. Even if price is one factor of market adjustment it is ignored by the model.
As a long run model (the ISLM model):
 It doesn’t incorporate the adjustment of all other markets.

 It doesn’t show the market adjustment through prices
35
As a short run model it doesn’t show the inflation dynamics. The short run objectives are to
have lower inflation, lower unemployment etc. But ISLM model doesn’t show how such
conditions are managed. Thus, these limitations are addressed in aggregate demand and
aggregate supply model.
In this chapter, we consider how the ISLM model can also be viewed as a theory of aggregate
demand and supply. We defined the IS and LM curves in terms of equilibrium in the goods
and money markets, respectively. Aggregate demand summarizes equilibrium in both of
these markets.
Aggregate demand curve describes a negative relationship between the price level and the
level of national income. Recall that the ISLM model is constructed on the basis of a fixed
price level. For a given value of the price level and the nominal money supply, the position of
the LM curve is fixed. The real money supply changes if either the nominal money supply or
the price level changes. Thus we can see that changes in the price level are associated with
change in the equilibrium level of output and interest rates. This is the relationship that is
summarized by the aggregate demand curve.
If the price level is high, other things equal, the real money supply is low. This implies high
interest rates, and thus low investment and output. If the price level falls, then the real money
supply increases. Equilibrium in the money market implies that interest rates must fall.
Equilibrium in the goods market thus implies that output must rise, since investment rises.
Thus we find that the aggregate demand curve is downward sloping; high values of the price
level are associated with low level of output, and vice versa.
To derive the aggregate demand from the ISLM model, assume that price has fallen from P 1
to P2. This increases the real money supply in the money market. It is accompanied by
decrease in interest rate and increase in income/output (notice that the equilibrium points
moves along the IS curve). Dropping the levels of income (Y1 and Y2) to the second figure
and recognizing that they are associated with P1 and P2 (P1>P2), we can construct the
aggregate demand curve.
36
LM (P1)
LM (P2)
r1 E1
r2 E2
r2
IS
L(r,Y)
Y1 Y2 Y
P1
P2
AD
Y1 Y2
Because the aggregate demand curve summarizes the results of the ISLM model, shocks that
shift the IS curve or the LM curve cause the aggregate demand curve to shift. Thus, the result
can be summarized as follows: A change in income in the ISLM model resulting from a
change in the price level represents a movement along the aggregate demand curve. A change
in income in the ISLM model for a fixed price level represents a shift in the aggregate
demand curve.
4.2. Aggregate Supply Analysis

4.2.1. Derivation of the aggregate supply curve
Aggregate supply refers to the interaction between the total quantities of output firms are
willing to supply at various prices. The aggregate supply curve takes different shapes
depending on the time period involved. In the long run, prices are fairly flexible and the
economy is able to use all of its existing resources. Thus, with full employment and flexible
prices, the long run aggregate supply curve can thus be taken to be vertical. In the short run,
however, prices are sticky. The short run aggregate supply curve is upward sloping. In the
extreme case where all prices are sticky, the short run aggregate supply curve will be
horizontal. There are four major aggregate supply models:
37
 Sticky wage model
 Workers misperception model
 Imperfect information model
 Sticky price model
These models differ from one another depending on the market (labour market or commodity
market) to which they gave emphasis and on their beliefs whether these markets clear or not.
The analysis in this course is based on the first model, the sticky wage model. This model
focuses on the wage setting process in the labour market. This process has impact on the
shape of the aggregate supply curve. According to this model, wage is set based on long term
contracts. So wage is sticky in the short run.
i) Apriori (at the beginning): producers of government organization argue for some target
real wage rate (w) which clears the market (which avoids unemployment). But since
product prices may changes during the contract period, the negotiated wage cannot be
Nominal wage rate (W N ) WN

e
=
expressed in real terms. Real wage rate (w) = expected product price ( P ) Pe
ii) Ex-post (after starting production): firms are interested in marginal productivity of
labour which will be compared with the real wage rate.
a) If actual price after production started is found to be equal to the expected price p e i.e.
P = Pe, the economy is at full employment and output is at full capacity (Y =Y ) . If

price is not changing output doesn’t change.
b) If the actual is greater than the expected price ( P> Pe ) , the real wage will be lower
than the agreed one. This implies that labour becomes cheaper, labour demand
increases and this increases output. So the higher the price the higher output and so
the higher aggregate supply (Y).
c) If the actual price is lower than the expected price ( P< Pe ) , the actual real wage
rate will be higher than the agreed real wage rate. This implies that labour gets
expensive and labour demand decreases. This reduces output and aggregate supply
(Y).
Assume that the situation in the labour market is represented by (b) i.e. the actual price is
38
greater than the expected price ( P> Pe ) and real wage has been lowered. This implies that
labour becomes cheaper, labour demand increases and this increases output.
Labour
Ls = labour supply Y=f(L)
L2
L1 L2
L1
Ld = Labour demand
Y1 Y1
W/ P2 W/P1 Real wage
P2
P2
P1
Y1 Y2
Increase in price from P1 to P2 reduces real wage rate W/P1 to W/P2. This increases labour
demand from L1 to L2 which in turn increases aggregate supply from Y1 to Y2. So this
increase in price from P1 to P2 leads to increase in output (Y) from Y 1 to Y2. This implies
upward sloping aggregate supply curve.
The basic message of this model is that given wages are fixed/sticky; a rise in price level
would lead to a lower real wage rate and hence higher labour demand which again increases
output.
39
Equilibrium in terms of Aggregate demand and Aggregate supply
Analysis
The ISLM model shows the equilibrium in the economy between the goods market and the
money market. It helps to determine the equilibrium level of interest rate and national
income. The aggregate demand and supply analysis, on the other hand shows the equilibrium
level of price in the economy associated with the equilibrium level of national income/output
which is determined in the ISLM. This is given by the intersection between the aggregate
demand and aggregate supply curves shown below.
Price
Pe
0 Ye income/output
The impact of change in Aggregate demand and Aggregate supply curves

on the equilibrium price and output
1. Shifts in the aggregate demand curve
Price
P1 E1
P0 E0
AS AD0 AD1
0 Y0 Y1 income/output
Assume that one of the factors/determinants of demand other than price has brought change
(increase) in demand as shown by an outward shift of the aggregate demand curve on the
figure above. This increase in aggregate demand increases both the equilibrium price and the
40
equilibrium output.
2. Shifts in the aggregate supply curve
Price
P0 E1
P1 E0
AS0 AS1
AD
Assume that one of the factors/determinants of supply other than price has brought change
(increase) in supply as shown by an outward shift of the aggregate supply curve on the figure
above. This increase in aggregate demand decreases the equilibrium price while it increases
the equilibrium output.
3. Shifts in both the aggregate demand and aggregate supply

curves
a) When both shift in the same direction
i) When both increases by the same amount
Price
P* E1 E0
AS0 AS1
AD0 AD1
Assume that the factors/determinants of demand as well as supply other than price has
brought change (increase) in both demand and supply at the same time by the same amount as
shown by an outward shift of the aggregate demand and supply curves on the figure above. If
this increase in aggregate demand is matched by an increase in aggregate supply, the
41
equilibrium price will not be affected while it increases the equilibrium output.
ii) When the increases in aggregate demand exceeds the increase in

aggregate supply
Price
P1
P0 E1 E0
AS0
AS1 AD0 AD1
brought change (increase) in both demand and supply at the same time but increases the
former by a greater amount than the latter as shown by a wider outward shift in the aggregate
demand curve than the aggregate supply curve on the above figure. This results in a higher
equilibrium price and output.
iii) When the increases in aggregate supply exceeds the increase in

aggregate demand
Price
P0 E0
P1 E1
AS0
AS1 AD0 AD1
brought change (increase) in both demand and supply at the same time but increases the latter
by a greater amount than the former as shown by a wider outward shift in the aggregate
42
supply curve than the aggregate demand curve on the above figure. This results in a lower
equilibrium price and higher equilibrium output than the initial level.
b) When both shift in the opposite direction

i) When both changes by the same amount
Price
P0 E0
P1 E1
AS0 AS1
AD1 AD0
0 Y* income/output
brought change in both demand and supply at the same time by the same amount but in
opposite direction as shown by an inward shift of the aggregate demand curve (decrease) and
outward shift of the aggregate supply curve (increase) on the figure above. If this is the case,
the equilibrium price increases while the equilibrium output will not be affected.
ii) When aggregate demand decreases by more than the increase in

aggregate supply
Price
P0 E0
P1 E1
AS0 AS1
AD1 AD0
43
opposite direction as shown by a wider inward shift of the aggregate demand curve (decrease)
than outward shift of the aggregate supply curve (increase) on the figure above. If this is the
case, both the equilibrium price and the equilibrium output decrease.
iii) When aggregate supply increases by more than the decrease in

aggregate demand
Price
P0 E0
P1 AS0 E1
AS1 AD1 AD0
0 Y0Y1 income/output
opposite direction as shown by a wider outward shift of the aggregate supply curve (increase)
than inward shift of the aggregate demand curve (decrease) on the figure above. If this is the
case, the equilibrium price decreases while the equilibrium output increases.
4.3. Fiscal and Monetary Policy Analysis on aggregate demand

and supply models
4.3.1.The impact of Fiscal policy
The IS curve shows the relationship between the interest rate and the level of income that
arises from the market for goods and services. The IS curve is drawn for a given fiscal policy.
Changes in fiscal policy that raise the demand for goods and services and shift the IS curve to
the right. Changes in fiscal policy that reduce the demand for goods and services (such as an
increase in tax) shift the IS curve to left.
We begin by examining how changes in fiscal policy (government purchases and taxes) alter
44
the economy’s short-run equilibrium. Recall that changes in fiscal policy influence planned
expenditure and thereby shift the IS curve. The IS–LM model shows how these shifts in the
IS curve affect income and the interest rate.
Consider an increase in government purchases of ΔG and/or decrease in taxation. The

government-purchases multiplier tells us that, at any given interest rate, this change in fiscal
policy raises the level of income by ΔG/(1-MPC).Therefore, as the figure below shows, the
IS curve shifts to the right by this amount. The equilibrium of the economy moves from point
E0 to point E1. The increase in government purchases raises both income and the interest rate.
Interest rate
r1 E1
r0 E0
LM IS0 IS1
0 Y0 Y1 national income/output
When the government increases its purchases of goods and services or reduces tax or did
both, the economy’s planned expenditure rises. The increase in planned expenditure
stimulates the production of goods and services, which cause total income Y to rise. Now
consider the money market, as described by the theory of liquidity preference. Because the
economy’s demand for money depends on income, the rise in total income increases the
quantity of money demanded at every interest rate. The supply of money has not changed;
however, so higher money demand causes the equilibrium interest rate r to rise. Changes in
taxes affect the economy much the same as changes in government purchases do, except that
taxes affect expenditure through consumption. The tax cut encourages consumers to spend
more and, therefore, increases planned expenditure. The IS curve shifts to the right by this
time.
4.3.2. The impact of Monetary policy

We now examine the effects of monetary policy. Recall that a change in the money supply
alters the interest rate that equilibrates the money market for any given level of income and,
thereby, shifts the LM curve. The IS–LM model shows how a shift in the LM curve affects
income and the interest rate. Consider an increase in the money supply. An increase in M
leads to an increase in real money balances M/P, because the price level P is fixed in the
45
short run. The theory of liquidity preference shows that for any given level of income, an
increase in real money balances leads to a lower interest rate. Therefore, the LM curve shifts
downward, as shown by the following figure.
Interest rate LM0
LM1
r0 E0
r1 E1
IS
0 Y0 Y1 national income/output
The equilibrium moves from point E0 to point E1. The increase in the money supply lowers
the interest rate and raises the level of income. This is because when the monetary authority
increases the supply of money, people have more money than they want to hold at the
prevailing interest rate. As a result, they start depositing this extra money in banks or use it to
buy bonds. The interest rate r then falls until people are willing to hold all the extra money
that the monetary authority has created; this brings the money market to a new equilibrium.
The lower interest rate, in turn, has ramifications for the goods market. A lower interest rate
stimulates planned investment, which increases planned expenditure, production, and income
Y. Thus, the IS–LM model shows that monetary policy influences income by changing the
interest rate.
4.3.3. The interaction between Fiscal and Monetary

policy
When analyzing any change in monetary or fiscal policy, it is important to keep in mind that
the policymakers who control these policy tools are aware of what the other policymakers are
doing. A change in one policy, therefore, may influence the other, and this interdependence
may alter the impact of a policy change. For example, suppose government was to raise taxes.
What effect should this policy have on the economy? According to the IS–LM model, the
answer depends on how the monetary authority responds to the tax increase.
The following figure shows three of the many possible outcomes.

 In case 1, the monetary authority holds the money supply constant. The tax increase shifts
the IS curve to the left. Income falls (because higher taxes reduce consumer spending), and
the interest rate falls (because lower income reduces the demand for money). The fall in
income indicates that the tax hike causes a recession.
46
 In case 2, the monetary authority wants to hold the interest rate constant. In this case,
when the tax increase shifts the IS curve to the left, the monetary authority must decrease
the money supply to keep the interest rate at its original level. This fall in the money
supply shifts the LM curve inward. The interest rate does not fall, but income falls by a
larger amount than if the monetary authority had held the money supply constant.
 In case 3, the monetary authority wants to prevent the tax increase from lowering income.
It must, therefore, raise the money supply and shift the LM curve outward enough to offset
the shift in the IS curve. In this case, the tax increase does not cause a recession, but it
does cause a large fall in the interest rate. The higher taxes depress consumption while the
lower interest rate stimulates investment as a result income is not affected.
From these, we can see that the impact of a change in fiscal policy depends on the policy the
monetary authority pursues—that is, on whether it holds the money supply, the interest rate,
or the level of income constant. More generally, whenever analyzing a change in one policy,
we must make an assumption about its effect on the other policy. The most appropriate
assumption depends on the case at hand and the many political considerations that lie behind
economic policymaking.
Y
LM2
LM
LM1
r1 Calse 1
Case 2
r
r2
IS1
IS1
IS2 IS2
Y2 Y1 Y Y2 Y2
LM1
r1 LM2
Case 3
r2 IS1
IS2
However, change in government purchases and/or taxes may not bring about change in
47
interest rate o income. Let us consider the following general case.
Interest rate
Classical range
Intermediate Zone
r* Keynesian range IS4 IS5
IS0 IS1 IS2 IS3
0 Y0 Y1 Y2Y3Y4Y5 Y6Y7Y8
Keynesian believes that government should play a key role in the economy as the market may
not function properly by itself. This is shown a fiscal policy implemented in the Keynesian
range that is fully effective in increasing national income without affecting interest rate
(increase in government expenditure represented by a shift from IS 0 to IS0 increases income
from Y0 to Y1). Monetary policy is ineffective in this zone. Classical economists, on the other
hand, believe that the market is efficient when allowed to work by itself. Fiscal policy (such
as a shift from IS4 to IS5 along LM0) does not affect national income. Thus, only monetary
policy (such as a shift from LM0 to LM1 along IS4) affects income (increases income from Y6
to Y7). In the intermediate zone both policies may bring change in income and are partially
effective as they are not as effective as they are independently in the extreme cases.
Fiscal and Monetary policies in AD-AS model in comparison with

ISLM model
1. Monetary Policy
P AD-AS model ISLM Model
AS LM1 (P1)
r1 LM3 (P2)
P2
r3
LM2 (P1)
P1
AD2 r2
AD1
Y
Y1 Y2 Ya Y1 Y2 Ya
As money supply increases the LM curve shifts from LM1 (P1) to LM2 (P1) when price is
48
fixed at P1. But the higher output Ya resulting from the shift in LM curve increases the
aggregate demand and so the price level. An increased price level reduces the real money
supply and shifts the LM curve back to LM3 (P2) even in short run.
So assuming the price level is constant, the ISLM model over predicts the impact of monetary
policy. So one advantage of moving from ISLM model to Aggregate demand-Aggregate
supply model is to remove the over prediction of ISLM. So AD-AS model tell us more
realistic condition.
2. Fiscal Policy
As expansionary fiscal policy is made (for instance if government expenditure is increased),

the IS curve shifts to the right and income increases. Thus, aggregate demand increases
(shifts to the right) leading to higher price. Because of higher price level, the real money
supply (M/P) declines and the LM curves shifts to the left.
In the following figure, the equilibrium temporarily moves to point b and then moves to point
e2. (b is not stable equilibrium).
IS-LM model
AD-AS model LM2(M2/P2)
P r
AS
e2 e2
LM1(M1/P1)
P2 r2
b
e1
b r1 e1
P1 IS2
AD2 IS1
AD1
Y Y1 Y2 Yb Y
Y1 Y2
The IS-LM model over predicts the effect of fiscal and monetary policies. The solution to
such problem is to use AD-AS model which as opposed to ISLM model, accounts for price
change. The ISLM model assumes constant price and the supply curve is passive, i.e. it
49
doesn’t account for supply shocks. But in AD-AS model, supply shocks can be analyzed by
shifting the aggregate supply (AS) curve.
Yet AD-AS model has got its own limitations. Some of these are that there is confusion
between short run and long run AD-AS model. Specifically so far the expositions of AD-AS
model have been fuzzy about what is fixed in the short run and about what is not fixed in the
long run. There is no clear cut between what is fixed and what is not fixed in the short run
and so in the long run. These depend on the economy condition. For instance tax prices may
be fluctuating from a given hour to another in Nairobi while it is almost fixed in Addis Ababa
throughout the 24 hours of a day.
-------------//--------------
CHAPTER FIVE
5. Macroeconomics in an Open Economy
5.1.Extension of the basic model
The key macroeconomic difference between open and closed economies is that, in an open
economy, a country’s spending in any given year need not equal its output of goods and
services. A country can spend more than it produces by borrowing from abroad, or it can
spend less than it produces and lend the difference to foreigners.
In an open economy gross domestic product (GDP) differs from that of a closed economy
because there is an additional injection- export expenditure which represents foreign
expenditure on domestically produced goods. There is also an additional leakage, expenditure
on imports which represents domestic expenditure on foreign goods and which raises foreign
national income. The identity for an open economy is given by:
Y = C + I + G + X – M …………………………........................................................... (1)
Where Y is national income, C is domestic consumption, I is domestic investment, G is
government expenditure, X is export expenditure and M is import expenditure.
We can deduct taxation from the right-hand side of equation [1] to get disposable income
(Yd).
50
Yd = C + I + G + X – M –T ………………….......................................................….… (2);
If we denote private savings as S = Yd – C we can rearrange equation [2] to obtain:
(X – M) = (S – I) + (T-G).......................... (3)
Current account balance Net (dis)saving of private sector Government fiscal surplus
Equation [3] says that a current account deficit has a counterpart in either private dissaving-
that is private investment exceeding private saving -and/or a government deficit- that,
government expenditure exceeding government taxation revenue. The equation is merely an
identity and says nothing about causation. Nonetheless, it is often stated that the current
account deficit is due to lack of private savings and/or the government budget deficit.
However, it is possible that the causation runs the other way, with the current account deficit
being responsible for the lack of private savings or budget deficit.
In an open economy, the equilibrium level of national income is determined where the
domestic balance is equal to the external balance. The starting point would be equation [3]
Y = C + I G + X –M; and we would make certain additions to this equation.
Domestic consumption is partly autonomous and partly determined by the level of national
income. This is denoted algebraically by:
C = Ca + cY ………………………………………………………………………… (4)
Where Ca is autonomous consumption and c is the marginal propensity to consume, that is the
fraction of any increase in income that is spent on consumption. In this simple model,
consumption is assumed to be a linear function of income. An increase in consumers’ income
induces an increase in their consumption.
Import expenditure is also assumed to be partly autonomous and partly a positive function of
the level of domestic income;
M = Ma + mY …………………………………………………………….………….. (5)
Where Ma is autonomous import expenditure and m is the marginal propensity to import,
which is the fraction of any increase in income that is spent on imports. In this simple
formulation, import expenditure is assumed to be a positive linear function of income. There
are several justifications for this; on the one hand increased income leads to increased
expenditure on imports, and also more domestic production normally requires more imports
51
of intermediate goods.
Government expenditure and exports are assumed to be exogenous; government expenditure

being determined independently by political decisions, and exports by foreign expenditure
decisions and foreign income.
Substituting equations [4] and [5] into equation [1] we obtain:
Y = Ca + cY + I + G + X – (Ma + mY) ……...……............................................……… (6)

Rearranging equation [6], we have Y- (Ca + cY + G) = X – (Ma + mY)
Y – AD(Y) = NX(Y) ………………………….............................................……………(7)

Where AD is aggregate demand which is equals to Ca + cY + I + G and NX is net export
defined as X – (Ma + mY).
Equation [7] tells us that the economy would be in equilibrium where the internal balance-
i.e. Y–AD is equals to the external balance i.e. NX(Y) as net export balance associated with
this condition is the equilibrium levels of output and trade balance. The equilibrium condition
stated in equation [7] is depicted in the figure below.
Y-AD(Y) NX(Y) Y-AD(Y)
NX*
0 Y* NX(Y)
The above figure shows the equilibrium condition in an open economy. The (Y-AD) curve is
upward sloping since its slope is given by 1–c which is equal to marginal propensity to save
and hence positive; the NX curve is downward sloping with the slope of –m. That is
d [ y− AD(Y )] d [ y−Ca−cY −I−G ]

= =1−c
dy dy
d [ NX (Y )] d [ X−Ma−mY ]
= =−m
dy dy
At the intersection of the two curves, the economy would be in equilibrium as the internal
balance is bridged up by the external balance or vice versa. Y * and NX* are the equilibrium
level of national income and trade balance or net export.
52
John Maynard Keynes in his classic work “The General Theory of Employment, Interest and
Money” (1936) pioneered the use of multiplier analysis to examine the effects of changes in
government expenditure and investment on output and employment. However, his work was
concerned almost exclusively with a closed economy. It was not long, however, before the
ideas of Keynes’ work were applied to an analysis of open economies, most notably by Fritz
Machlup (1943). The assumptions underlying basic multiplier analysis are:
 Both domestic prices and the exchange rate are fixed

 The economy is operating at less than full employment so that increases in demand
results in an expansion of output, and
 The authorities adjust the money supply to changes in money demand by pegging the
domestic interest rate.
The implication of the last assumption is that increases in output that lead to a rise in money
demand would, with a fixed money supply, lead to a rise in the domestic interest rate. But it
is assumed that the authorities passively expand the money stock to meet any increase in
money demand so that interest rates do not have to change. There is no inflation resulting
from the money supply expansion because it is merely a response to the increase in money
demand.
Y = Ca + cY + I + G + X – (Ma + mY)
(1- c + m) Y = Ca + I + G + G + X – Ma ……………………………………………..(8)
Given that (1-c) is equal to the marginal propensity to save s, that is, the fraction of any
increase in income that is saved, then we obtain:
1
( Ca+ I +G+ X−Ma )
Y = s+ m ………………………………………………………
[9]
Equation [9] can be transformed into difference form to yield:
1
dY = (dCa+dI +dG+dX −dMa )
s+m …………………………………………….
[10]
The Government Expenditure Multiplier
The first multiplier of interest is the government expenditure multiplier, which shows the
increase in national income resulting from a given increase in government expenditure. This
is given by:
53
dY 1
>0
dG = (s +m) …………………………………………………..……………….
[11]
Equation [11] says that an increase in government expenditure will have an expansionary
effect on national income, the size of which depends upon the marginal propensity to save
and the marginal propensity to import. Since the sum of these is less than unity, an increase in
government expenditure will result in an even greater increase in national income.
Furthermore, the value of the open-economy multiplier is less than the closed-economy
multiplier which is given by 1/s. The reason for this is that increased expenditure is spent on
both domestic and foreign goods rather than domestic goods alone, and the expenditure on
foreign goods raises foreign rather than domestic income.
Export Multiplier
In this simple model, the multiplier effect of an increase in exports is identical to that of an
dY 1
=
increase in government expenditure and is given by dX (s +m) . In practice it is often
the case that government expenditure tends to be somewhat more biased to domestic output
than private consumption expenditure, implying that the value of m is smaller in the case of
the government expenditure multiplier than in the case of the export multiplier. If this is case,
an increase in government expenditure will have a more expansionary effect on domestic
output than an equivalent increase in exports.
The Current Account Multiplier
The other relationships of interest are the effects of an increase in government expenditure
and of exports on the current account balance. The current account (CA) is given by:
CA = X – Ma – mY ………………………………………………………………. [12]
Totally differentiating equation [12]
d(CA) = dX – dMa – mdY
Substituting equation [10] for dY, we obtain:
54
m
dCA =dX -dMa- (dCa+dI +dG+dX −dMa )
s+m ……………………………. [13]
From equation [13] we can derive the effects of an increase in government expenditure on the
current account balance which is given by d(CA)/dG = -m/(s + m)<0. That is, an increases in
government spending leads to a deterioration of the current account balance which is some
fraction of the initial increase in government expenditure. This is because economic agents
spend part of the increase in income on imports.
The other multiplier of interest is the effect of an increase in exports on the current account
d (CA ) m s
=1− = >0 .
balance. This is given by the expression dX s+m s+ m Since s/(s +m) is
less than unity, an increase in exports leads to an improvement in the current account balance
that is less than the original increase in exports. The explanation for this is that part of the
increase in income resulting from the additional exports is offset to some extent by increased
expenditure on imports.
5.2. Policy Issues

Although economic policy-makers generally have many macroeconomic objectives, the
discussion in the 1950s and 1960s was primarily concerned with two objectives; the internal
and external balance. Internal balance is concerned with achieving full employment and
stable price while external balance focuses on achieving equilibrium in the balance of
payment account. Balance of payment account refers to an account in which a country
records the transactions it makes with the rest of the world.
International transactions involve the use of different currencies among different countries
which requires the expression of one currency in terms of the other to make exchanges. The
rate at which one currency is exchanged for the other is called exchange rate. The exchange
rate between currencies may determined by the government/monetary authority or market
forces. If the rate of exchange between the domestic currency and a foreign currency is
determined and strictly observed by the government, the system is called fixed exchange rate
system. In this case, the government reduces the supply of domestic currency or supplies
foreign currency for increase in the exchange rate. It does the reverse for a decrease in the
exchange rate. If the rate of exchange between the domestic currency and a foreign currency
is determined by the market forces, the demand for and the supply of foreign currency, the
55
system is said to be flexible/floating exchange rate system.
Y-AD[Y]
NX[Y] Y-AD[Y1]
Y-AD[Y2]
NX*
NX**
Y* Y**
NX[Y]
The above figure shows the above problem of maintaining both internal and external balance
simultaneously. As a result of expansionary fiscal policy the [Y-AD(Y)] Curve shifts from
[Y-AD(Y1)] to [Y-AD(Y2)] and the new equilibrium point is achieved with a higher level of
output (Y**) but the current account balance has deteriorated simultaneously. The multipliers
also tell us the same thing i.e.
dY 1
− > 0 while d (CA )/dG=−m/s +m<0 .
dG (s+m)
A major lesson of this simple model is that the use of one instrument to achieve two targets-
internal and external balance-is most unlikely to be successful. The idea that a country
generally requires as many instruments as it has target was elaborated by the Nobel Prize-
winning economist Jan Tinbergen (1952), and is popularly known as Tinbergen’s
instruments-targets rule.
A model that incorporates international capital movements into formal macroeconomic

models based on the Keynesian ISLM framework is known as Mundell-Fleming model. It
owes its origins to three papers published by James Flemming (1962) and Robert Mundell
(1962, 1963). Their papers led to some dramatic implications concerning the effectiveness of
fiscal and monetary policy for the attainment of internal and external balance.
Both the IS and LM curves have their usual shape. At this point our emphasis would be to
introduce the balance of payments (BP) curve. The balance of payments schedule shows
different combinations of rates of interest and income levels that are compatible with
equilibrium in the balance of payments. The overall balance of payment is made up of three
major components: the current account balance (CA), the capital account (K) and the change
in the authorities’ reserve (dR).
56
By maintaining balance in supply and demand for the currency-that is external balance-we
mean that there is no need for the authorities to have to change their holdings of foreign
exchange reserves. This implies that if there is a current account deficit there needs to be an
offsetting surplus in the capital account so that the authorities do not have to change their
reserve. Conversely, if there is a current account surplus there needs to be an offsetting deficit
in the capital account to have equilibrium in the balance of payment.
Since exports are determined exogenously and imports are a positive function of income, the
higher the level of national income the smaller will be any current account surplus of the
larger any current account deficit. The net capital flow (K) is a positive function of the
domestic interest rate. Assuming that the rate of interest in the rest of the world (r f) is fixed,
the higher the domestic interest rate (r) the larger the capital inflow in to the country or the
smaller (if any) capital outflow. This relationship is expressed as:
K = f(r-rf ) ………………………......................................................................……… [1]

Since the balance of payment schedule shows various combinations of levels of income and
the rate of interest for which the balance of payments is in equilibrium, then
X – M + K = 0 ………………….......................................................................……… [2]
A positive K indicates a net inflow of funds, whereas a negative K indicates a net outflow of
funds. The BP schedule is depicted in the figure below.
r2 C BP
r* A B
r1 D
0 Y1 Y* Y2
Let us compare point A and B. For a given r*, there is a current account surplus at income
level Y1 [point A] whereas at income level Y2 [point B] there is a current account deficit. This
is because of the fact that higher income calls for additional demand for imports as the latter
is a function of the former. Similarly, Comparing points C and D in terms of interest rate, one
can see that point C represents a capital account surplus and point D shows a capital account
deficit. This is because higher domestic interest rate invites capital inflow. In general, we can
conclude that points to the left and above the BP curve are points of surplus while points to
the right and below the BP curve are points of deficit.
57
The BP schedule is upward sloping because higher levels of income cause deterioration in the
current account; this necessitates a reduced capital outflow/higher capital inflow requiring a
higher interest rate. Every point on the BP schedule shows a combination of domestic income
and rate of interest for which the overall balance of payments is in equilibrium.
The slope of the BP schedule is determined by the degree of capital mobility internationally.
The higher the degree of capital mobility then the flatter the BP schedule would be. This is
because for a given increase in income which leads to a deterioration of the current account,
the higher the degree of capital mobility, the smaller the required rise in the domestic interest
rate to attract sufficient capital inflows to ensure overall equilibrium. When capital is
perfectly mobile, slight rise in the domestic interest above the world interest rate leads to a
massive capital inflow making the BP schedule horizontal at the world interest rate. At the
other extreme, if capital is perfectly immobile internationally then a rise in the domestic
interest rate will fail to attract capital inflows making the BP schedule vertical at the income
level that ensures current account balance. Between these two extremes, that is, when we
have an upward sloping BP schedule, we say that capital is imperfectly mobile.
When the BP curve is introduced to the ISLM model it becomes ISLMBP model and the
simultaneous equilibrium of internal and external balances is given below.
Interest rate
LM
BP
r*
IS
0 Y* Income
There are two types of policies to maintain both internal and external balances [equilibrium]
in the economy. These are:
 Expenditure changing policies, and

 Expenditure switching policies
1) Expenditure Changing Policies
Expenditure changing policies: refer to policies that change expenditure (increase or
decrease) to affect the current and/or capital accounts to bring about change in the balance of
58
payment account. This is possible mainly by using expansionary and contractionary fiscal
and monetary policies.
The model assumes a small country facing imperfect capital mobility. Any attempt to raise
the domestic interest rate leads to capital inflow until the interest rate return to the world
interest rate. Conversely, any attempt to lower the domestic interest rate leads to capital
outflow as international investors seek higher world interest rates. The implication of
imperfect capital mobility is that the BP schedule for a small open economy becomes upward
sloping straight line.
a) Small Open Economy With Imperfect Capital Mobility and Fixed Exchange Rate
Monetary Policy
The figure below depicts a small open economy with a fixed exchange rate. The initial level
of income and interest rate is where the IS, LM and BP curves intersect i.e. rf andY0.
Interest rate Interest rate
LM1 BP LM2 LM1 LM0

rf E r1 BP
r1 rf E
IS IS
0 Y0 Y1 Income 0 Y1 Y0 Income
Panel (A): Expansionary Monetary Policy Panel (B): Contractionary Monetary
Policy
If the authorities attempt to raise output by a monetary expansion, the LM curve shifts to the
right from LM1 to LM2; there is downward pressure on the domestic interest rate and this
results in capital outflow. This capital outflow means that there is pressure for a devaluation
of the currency (as shown in the above figure), and the authorities have to intervene in the
foreign exchange market to purchase the home currency with reserves. Such purchases result
in a reduction of the money supply in the hands of private agents, and the purchases have to
continue until the LM curve shifts back to its original position at LM 1 where the domestic
interest rate is restored to the world interest rate. The reverse is true for a contractionary
monetary policy as shown by panel B. Hence, with imperfect capital mobility and fixed
exchange rates, monetary policy is ineffective at influencing output.
59
Fiscal Policy
Fiscal expansion shifts the IS schedule to the right from IS 0 to IS1. This puts upward pressure
on the domestic interest rate and leads to a capital inflow. To prevent an appreciation, the
authorities have to purchase the foreign currency with domestic currency. This means that the
amount of domestic currency held by private agents increases and the LM 0 schedule shifts to
the right to Lm1. The increase in the money stock continues until the LM curve passes
through the IS1 curve at the initial interest rate. The reverse is true for a contractionary fiscal
policy as shown by panel B. If the fiscal policy is expansionary, it results in a deficit for the
balance of payment account (E1 is below and to the right of the BP curve in panel A) and if it
is contractionary, it results in a surplus for the balance of payment (E 1 is above and to the left
of the BP curve in panel B). Hence, under fixed exchange rates and imperfect capital mobility
an active fiscal policy alone has the ability to achieve both internal and external balance.
Interest rate LM0 LM1 Interest rate LM1 LM0
r1 BP r1 BP
rf E0 E1 rf E1 E0
IS0 IS1 IS1 IS0

0 Y0 Y1 Y2 Income 0 Y2 Y1 Y0 Income
Panel (A): Expansionary Fiscal Policy Panel (B): Contractionary Fiscal Policy
b) Small Open Economy With Imperfect Capital Mobility and Floating Exchange Rate
Monetary policy
A monetary expansion in panel (A) shifts the LM curve from LM 0 to LM1 leading to
downward pressure on the interest rate [a capital outflow] and a depreciation of the exchange
rate. The depreciation leads to an increase in exports and reduction in imports so shifting the
IS curve to the right [IS0 to IS1] and the LM curve to the left [LM1 to LM0], so that final
equilibrium is obtained at a higher level of income and interest rate. Higher interest rate
results in surplus for the capital account while higher income results in deficit for the current
account. The total effect on the balance of payment account depends on the elasticity of the
BP curve. If the BP curve (BP 1) is less elastic than the LM curve (LM 0), expansionary
monetary policy results in balance of payment deficit (E1will be below and to the right of the
60
BP curve [BP1] in this case). If the BP curve (BP 2) is more elastic than the LM curve (LM 0),
expansionary monetary policy results in balance of payment surplus (E 1will be above and to
the left of the BP curve [BP2] in this case). The reverse happens to a contractionary monetary
policy in panel (B).
Interest BP1 LM0 LM1 Interest BP1 LM1 LM0
r1 E1 BP2 rf E0 BP2
rf E0 r1 E1
IS0 IS1 IS1 IS0
0 Yo Y1 Income 0 Yo Y1 Income
Panel (A): Expansionary Monetary Policy Panel (B): Contractionary Monetary
Policy
If the elasticity of the BP curve is known, the monetary authorities could obtain both internal
and external balance with appropriate monetary policy.
Fiscal policy
Expansionary fiscal policy in panel (A) shows a shift in the IS schedule to the right from IS 0
to IS1 leading to upward pressure on the domestic interest rate resulting in capital inflow and
an appreciation of the exchange rate. The appreciation of the exchange rate results in a
reduction of exports and an increase in imports, and this forces the IS schedule back to its
original position. The reverse is true for a contractionary fiscal policy in panel (B). Hence,
with imperfect capital mobility and a floating exchange rate, fiscal policy is ineffective in
influencing output.
Interest LM Interest LM BP
r1 BP rf E
rf E r1
IS0 IS1 IS1 IS0
0 Y0 Y1 Income 0 Y1 Y0 Income
Panel (A): Expansionary Fiscal Policy Panel (B): Contractionary Fiscal Policy
61
The result that fiscal policy is very effective at influencing output under fixed exchange rates
and monetary policy is very effective under floating exchange rates with imperfect capital
mobility is of considerable relevance to economic policy design. Under fixed rates, policy
makers will pay more attention to fiscal policy than under floating rates when more emphasis
will be placed on monetary policy. The degree of capital mobility and the exchange rate
regime both demonstrate that appropriate economic policy design in an open economy is very
different from that in a closed economy context.
2) Expenditure Switching Policies

Expenditure switching policies: refer to policies that change expenditures from one type of
commodity to another type of commodity. This is possible mainly by manipulating the
exchange rate. These policies change expenditure from foreign to domestic goods and
services and vice versa. This is done by varying the exchange rate. To maintain the external
balance, devaluation would be a good candidate. By making imports expensive in the
domestic market and by making exports cheaper in the foreign market, devaluation can
improve the current account balance and hence the country can maintain its external balance.
As the figure below shows, devaluation shifts the demand for exports curve outward (Dx 0 to
Dx1) and the supply of imports curve inward (Sm0 to Sm1) both of which improve the current
account balance.
Birr/$ Birr/$
Sx Sm1
Px1 Pm1 Sm0
Px1 Pm0
Dx0 Dx1 Dm
0 X0 X1 0 M1 M0
However, the effectiveness of devaluation in yielding the above solution depends on the
Marshall-Lerner condition (MLC). The MLC can be derived as follows. The current account
balance (CA) when expressed in terms of the domestic currency is given by:
CA = X – eM …………………………………………………………………….. [14];
Where e is the nominal exchange rate.
Totally differentiating equation [14] we obtain
62
d(CA) = dX – edM – Mde
Dividing by ‘de’ throughout
d (CA ) dX edM
= − −M
de de de ……………………………………………………………
[15]
At this point we introduce two definitions; the price elasticity of demand for exports ŋ x is
defined as the percentage change in exports over the percentage change in price as
represented by the percentage change in the exchange rate; this gives:
dX e
.
ŋx = de X ………………………..........................................................………..
[16]
dX X
=
So that de ŋx. e
And the price elasticity of demand for imports ŋ m is defined as the percentage change in
imports over the percentage change in their price as represented by the percentage change in
the exchange rate;
dM e
.
ŋm =- de M …………………………………………………………………………
[17]
dM M
So that de =-ŋm. e
Substituting [16] and [17] into [15] we obtain
d (CA ) X
=
de ŋx. e + ŋm.M – M …………………………………………………………..
[18]
Multiplying [18] by 1/M throughout we get
d (CA ) X
+
de.. M = ŋx. e.M ŋm-1 …………………………………………………………..
[19]
Assuming that we initially have balanced trade X = eM and hence X/eM = 1 and rearranging
[19] yields:
63
d (CA )
=M (
de ŋx + ŋm -1) …………………………………………………………. [20]
Equation [20] is known as the Marshall-Lerner Condition and says that starting from a
position of equilibrium in the current account, a devaluation will improve the current account;
d (CA )
>0 ,
that is, de only if the sum of the foreign elasticity of demand for exports and the
home country elasticity of demand for imports is greater than unity, that is (ŋ x + ŋm >1). If the
sum of these two elasticities is less than unity (ŋx+ŋm<1) then devaluation leads to a
deterioration of the current account.
The possibility that devaluation may lead to a worsening rather than improvement in the
balance of payment led to much research into empirical estimates of the elasticity of demand
for exports and imports. Economists divided up into two camps popularly known as elasticity
optimists who believed that the sum of these two elasticities tended to exceed unity. It was
argued that devaluation may be better for industrialized countries than for developing
countries. Many developing countries are heavily dependent upon imports so that their price
elasticity of demand for imports is likely to be very low. While for industrialized countries
that have to face competitive export markets, the price elasticity of demand for their export
may be quite elastic. The implication of the Marshall-Lerner condition is that devaluation
may be a cure for some countries balance of payment deficits but not for others.
Even for countries that devaluation is a solution for the BOP deficit, the initial J-curve effect
(see the figure below) may not be precluded. The J-curve shows that the deficit may initially
rise but after a lag of sometime the trend would be reversed so that the BOP would be in
surplus. The J-curve effect arises mainly as elasticities are lower in the short run than in the
long run, in which case the Marshall–Lerner condition may only hold in the medium to long
run.
Current account
Surplus
0 Time
Deficit
64
The possibility that in the short run the Marshall-Lerner condition may not be fulfilled
although it generally holds over the long run leads to the phenomenon of what is popularly
known as the J-curve effect. The idea underlying the J-curve effect is that in the short run
export volumes and import volumes do not change much, so that devaluation leads to
deterioration in the current account. However, after a time lag, export volumes start to
increase and import volumes start to decline; consequently the current deficit starts to
improve and eventually moves into surplus. The issue then is whether the initial deterioration
in the current account is greater than the future improvement so that overall devaluation can
be said to work.
There have been numerous reasons advanced to explain the slow responsiveness of export
and import volumes in the short run and why the response is far greater in the longer run; two
of the most important are:
 A time lag in consumer responses- It takes time for consumers in both the devaluing
country and the rest of the world to respond to the changed competitive situation.
 A time lag in producer response-Even though devaluation improves the competitive
position of exports it will take time for domestic producers to expand production of
exportable goods.
Limitations of the Mundell-Fleming Model
1. The Marshal Lerner condition: the model assumes that the Marshall Lerner condition
holds even though it is essentially of a short term model which is the time scale under
which the Marshall-Lerner conditions are least likely to be met.
2. Interaction of stocks and flows: the model ignores the problem of the interaction of stocks
and flows. According to it a current account deficit can be financed by a capital inflow.
While such a policy is feasible in the short run, a capital inflow over time increases the
stock of foreign liabilities owed by the country to the rest of the world, and this factor
means a worsening of the future current account as interest is paid abroad. Clearly, a
country cannot go on financing a current account deficit indefinitely as the country
becomes an ever-increasing debtor to the rest of the world.
3. Neglect of the long run budget constraints: the model fails to take account of long run
constraints that govern both the private and public sector. In the long run, private sector
65
spending has to equal its disposable income, while in the absence of money creation
government expenditure has to equal its revenue from taxation. This means that in the long
run, the current account has to be in balance. One implication of these budget constraints
is that a forward looking private sector would realize that increased government
expenditure will imply higher taxation for them in the future, and this will induce
increased private sector savings today that will undermine the effectiveness of fiscal
policy.
4. Wealth Effect: the model does not allow for wealth effects that may help in the process of
restoring long run equilibrium. A decrease in wealth resulting from a fall in foreign assets
associated with a current account deficit will ordinarily lead to reduction in import
expenditure which should help to reduce the current account deficit. While such an
omission of wealth effects on the import expenditure function may be justified as being
small significance in the short run, the omission nevertheless again emphasizes the
essentially short-term nature of the model.
5. Neglect of supply side factors: one of the obvious limitations of the model is that it
concentrates on the demand side of the economy and neglects the supply side. There is an
implicit assumption that supply adjust in accordance with changes in demand. In addition,
because the aggregate supply curve is horizontal up to full employment, increases in
aggregate demand do not lead to changes in the domestic price level, rather they are
reflected solely by increases in real output.
6. Treatment of capital flows: the model assumes that a rise in the domestic interest rate
leads to a continuous capital inflow from abroad. However, to expect such flows to
continue indefinitely is unrealistic because after a point international investors will have
rearranged the stocks of their international portfolios to their desired content and once this
happens the net capital inflows into the country will cease unless accompanied by a further
rise in its interest rate. Hence a country that needs a continuous capital inflow to finance
its current account deficit has to continuously raise its interest rate i.e. capital inflows are a
function of the change in the interest differential rather than the interest itself.
7. Exchange rate expectations. A major problem with the model is the treatment of
exchange rate expectations. The model does not explicitly model these and implicitly
presumes that the expected change is zero, which is known as static exchange rate
expectation. While this might not seem to be an unreasonable assumption under fixed
exchange rates, it is less tenable under floating exchange rates. According to the model a
monetary expansion leads to a depreciation of the currency under floating exchange rates-
66
in such circumstances it seems unreasonable to assume that economic agents do not expect
depreciation as well. If agents expect depreciation this may require a rise in the domestic
interest rate to encourage them to continue to hold the currency which will have an
adverse effect on domestic investment-implying a weaker expansionary effect of monetary
policy than is suggested by the model. Indeed, the need to maintain market confidence in
exchange rates can severely restrict the ability of government to pursue expansionary
fiscal and monetary policies.
-------------//--------------
CHAPTER SIX
6. Behavioural Foundations of
Macroeconomics
6.1. Consumption
So far we have seen that macroeconomics helps us to understand how the aggregate economy
behaves. In addition, understanding the behaviour of aggregate output and its component contained in
the national income accounting identity, Y=C+I+G+X-M, is very crucial. The first component of this
identity is consumption by households, which accounts the largest share of GDP, roughly 2/3 of it.
Household’s consumption decision affect the way the economy as a whole behave both in the short
run and in the long run.
In the short run analysis, consumption decision is crucial in its role in determining aggregated
demand. Fluctuations in consumption are the main elements of booms and recessions i.e. it can be a
67
shock to the economy. The marginal propensity to consume is the determinant in fiscal policy
multiplier. In the long run consumption decision is important in its role in economic growth. The
saving rate measures how much present of income is put aside by present generation for its own future
and for future generation.
6.1.1. Theories of Consumption

Some of the major consumption theories so far developed are Keynesian Consumption
Theory, Modegliani Life Cycle Hypothesis, Friedman Permanent Income hypothesis and
Fisher’s Intertemporal Model of Consumption. The first three are discussed in this course.
These theories try to identify different determinants of consumption, i.e. factors that affect
decision of individuals on the amount and path of consumption over time (under different
circumstances).
A. Keynesian Consumption Theory (Keynes’s conjecture)

The term ‘conjecture’ in this theory refers to an inference made based on incomplete
information. Keynes proposed that consumption is a function of income [C= f(Y)]. In simple
form, the consumption function can be stated as; C = C + cY. Where; c is the marginal
propensity to consume (the percentage change in consumption due to change in income), but
by the time Keynes didn’t interpreted it in this sense.
Keynes has made three major conjectures.
1. The value of ‘c’ or the marginal propensity to consume ranges between zero and one
i.e. 0 ¿ ‘c’ ¿ 1. This is because our consumption (C) doesn’t increase by
hundred percent of an increase in income (Y). But as income increase we save some
part. But he didn’t make an attempt to prove this by the time.
2. Average propensity to consume (APC) = C/Y falls as income (Y) increases. Because
consumption (C) increases at a lower rate than income (Y) following from conjecture
number 1 above.
3. Income is the most important explanatory variable of consumption and interest rate is
irrelevant in explaining consumption. Some economists by the time say interest rate
determines consumption level. As interest rate in the banks increases people save
more money in banks to receive the higher interest income and thereby consume less.
But Keynes didn’t consider this effect.
B. Modigliani Life Cycle Hypothesis ( Ando - Modigliani Approach)

68
There was a conflict between earlier findings (for instance of Keynes theory and Kuznet’s
findings called consumption puzzle). For Keynes, the average propensity to consume (APC)
is a declining function of income; whereas for Kuznet the average propensity to consume
(APC) is stable or constant over time.
During the dawn of 1950s, F. Modigliani, Ando Albert and Richards Brumberg explained the
declining APC function based on Fisher’s consumption model. They classified the society
into different age groups. The main argument is that income varies systematically over these
age groups; saving and borrowing allow consumers to move income from those times in life
when income is high to those times when income is low.
A typical individual has an income stream that is relatively low at the beginning and high at
the end of her/his life. The individual might be expected to maintain more or less constant or
perhaps slightly increasing level of consumption (See the figure below).
Consumption/Income
Saving Consumption
Dissaving
Borrowing Income
0 Time
The model classified ages of individuals into three paths of age (young, middle and old age)
and so called life cycle hypothesis. An individual is a net borrower in earlier years of his/her
life and saves during the middle age to repay young age loans and to provide for old age
consumption. In the model, consumption is linear while income is non linear over time.
This hypothesis tries to give justification for the two conflicting results about the trend of
APC (consumption puzzle). Modigliani concluded that the Keynes and Kuznet’s results are
not conflicting. But both findings are valid in different time frames. So, the life cycle
hypothesis support the Keynes’s idea that average propensity to consume (APC) is a
declining fusion of income and the marginal propensity to consume (MPC) is less than the
average propensity to consume (APC) in the short run, while it supports the Kuznet’s idea
that the average propensity to consume (APC) is constant in the long run. The former
relationship can easily be seen from the fact that marginal propensity to consume (MPC) is
69
the slope of the total consumption curve while average propensity to consume (APC) is
measured by the slope of a line from the origin to a point on the consumption curve. Since
there is some consumption even at zero level of income implying positive intercept, the
marginal propensity to consume (MPC) is less than the average propensity to consume
(APC).
According to life cycle hypothesis, cross sectional data shows that high-income groups are
the middle age group. During middle age there is higher savings relative to consumption and
so lower APC. Furthermore, the hypothesis explicitly added (included) wealth (asset) as
explanatory variable of consumption trend (function).
C. Permanent Income Hypothesis (Friedman Approach)

According to permanent income hypothesis, income doesn’t have a predictive trend; rather
people experience random and temporary changes in their income from time to time. In
earlier theories consumption is taken as a function of current income.
C = f (Y)
But for Friedman consumption is not a function of current income, but a function of
permanent income. Income has two components: permanent income (Y P) which is part of the
income expected to persist over time and transitory income (Y T), part of the income which is
not expected to persist over time.
Y= YP+ YT and C = CP + CT
Major assumptions of this hypothesis are:
1. Permanent income and transitory income are uncorrelated.

2. There is no systematic relationship between permanent consumptions and transitory
consumptions.
3. There is no systematic relationship between transitory income and transitory
consumption.
These assumptions are based on the idea that a sudden increase in income (a rise in transitory
income) will not immediately contribute to an individual’s consumption. The second
assumption means that when we classify population by income levels, for each income class
the transitory variations in consumption will cancel out so that average transitory
t
consumption is zero ( C = 0). But the validity of these assumptions and the validity of the
70
model itself depend on the level of permanent income. For instance, the Keynesian model is
more relevant for less developed countries (LDCs) like Ethiopia. Because under depressed
consumption level (very low permanent income), there is no much saving and any rise in
income goes to consumption. In this case consumption is a function of current income rather
than permanent income.
In Friedman’s permanent income hypothesis one should not confuse consumption with
consumption expenditure. Consumption includes non-durables and consumed part and/or
depreciated part of durable goods while consumption expenditure represent current
expenditure on both durable and non-durable goods including part of which may be
consumed in the future. The focus of this hypothesis is on consumption (not consumption
expenditure).
Consumption is a function of permanent income: C = f (YP). Assuming linear relationship,

the consumption function will take the form, C = YP where ‘’ is a constant.
YP and YT
YP
YT
0 Time
The extra transitory income (YT) above the trend of permanent income (YP) goes to savings
or purchase of durables for future consumption i.e. people usually save the transitory income
rather than consume. Thus, transitory income doesn’t explain consumption. According to
Friedman consumption puzzle arises because of error in variables (because of using wrong
variables).
αY P αY P
T P
APC = Y = ( Y +Y ) , From this identity it is clear that the value of average
propensity to consume (APC) is somewhat stable if there changes only in the permanent
component of income (YP). But, if there is an increase in the transitory component of income
(YT) which is a short run phenomenon, the average propensity to consume (APC) tends to
decline.
71
Thus, a fall in average propensity to consume (APC) is a short run phenomenon because
transitory income is not something that sustain in the long run.
Friedman along with A. Modigliani assumes that consumers want to smooth their actual
income stream into a more or less flat consumption pattern. This gives a level of permanent
consumption that is proportional to permanent income.
The individual ratio of permanent consumption to permanent income presumably depends on:
the interest rate (return on saving), individual tastes (shapes of indifference curves), and
variability of expected income.
Friedman’s model is less satisfactory than Modigliani’s model in that assets are only
implicitly taken into account as a determinant of permanent income. In addition it relies on
less observable aspects of income (permanent and transitory income) than the modillion’s
model which identifies the observable components labour income and value of assets.
Nevertheless, the two models are closely related. Families with high transitory income in
Friedman’s analysis could be families in the middle age years in Modigliani’s life cycle
model; and families with negative transitory income could be one at the beginning (young
age) or at the end (old age) of their life cycle. Thus, the life cycle hypothesis could be one
explanation of the distribution of Friedman’s transitory incomes.
6.2. Investment
Investment is the most unstable component of aggregate demand, and defined as the action of putting
something in to some venture in expectation of some returns; or alternatively it is the formation of
real capital, tangible or intangible, that will produce a stream of goods and services in the future. Most
of the decline in expenditure on goods and services is usually caused by a decrease in investment
spending. The simple Keynesian function relates investment to real interest rate; I=I (r). This function
states that investment is inversely related to the real interest rate. That is an increase in the real interest
rate reduces investment and a decrease in the real interest rate increases investment.
6.2.1. Types of Investment

There are different types of investments, which are included in the national income accounting.
Investment in the national income accounts includes:
72
i. Business fixed investment: the term “business” means that the investment goods are bought by
firms for future production. The term “fixed” means that this spending is for capital that will
remain fixed for a while, as opposed to inventory investment, which will be used or sold shortly
later. Business fixed investment includes machines, factories, computers and cars used for the
production of outputs. Business fixed investment is important in two respects. First, investment
spending is a significant component of aggregate demand. The importance of investment to
cyclical movements in income is ever more than in proportion to its size as the share of GDP.
The second important macroeconomic role for business fixed investment follows from the fact
that the net fixed business investment measures the amount by which the stock of capital
increased in each period.
ii. Residential Investment: another type of investment which is made on the construction of
houses and included in the national income accounting and involving large expenditure is the
residential investment. This type of investment also varies with the business cycle.
iii. Inventory Investment: this type of investment is made in the form of production. Money
is put into the production process while the produce is not brought to the market. The
produced goods are kept in the warehouses for future sale. It is not as such large enough
compared to the other forms investment. However, there is a strong relationship between charges
in inventory investment and change in output over the business cycle. Firms would invest in
inventory for different reasons. Some of these are:
1) To smooth the level of production over time: the demand for goods may highly
fluctuate and producers or sellers fill the gap created through inventory investment.
Because fluctuating or changing production along with demand may be costly. And
the remedial measure is called product smoothening.
2) To operate more efficiently: goods on hand to show customers (for display) and
keeping spare parts to replace damaged machines would be efficiency improving.
3) To avoid stock out: that means to avoid running out of stock for sudden increase in
demand. The process is called stock out avoidance.
4) To help production process. When production involves a number of steps, partially
processed goods are stored as inventory, called work-in-process.
6.3. Issues of Inflation and Unemployment

6.3.1. Inflation
By inflation we mean a general rise in prices. To be more correct, inflation is a persistent rise in the
73
general price level rather than a once-for-all rise in it. On the other hand, deflation represents
persistently falling prices. These days all the economies of the world, underdeveloped as well as
developed, suffer from inflation. Inflation or persistently rising prices is a major problem in world
including Ethiopia today. Rate of inflation during the seventies and eighties was very high as
compared to the rates of inflation experienced earlier during peace periods. Since the late nineties, and
early the twenty first century, rate of inflation in several countries (including Ethiopia) remain very
high.
Let us understand how the inflation originates or what causes it. Depending upon the specific causes,
three types of inflation have been distinguished. These are (1) Demand–pull inflation (2) Cost-push
inflation (3) Structural inflation.
A. Demand-pull Inflation
This represents a situation where the basic factor at work is the increase in aggregate demand for
output either from the government or the entrepreneurs or the households. The result is that the
pressure of demand is such that it cannot be met by the currently available supply of output. Keynes
explained that inflation arises when there occurs an inflationary gap in the economy which comes to
exist when aggregate demand exceeds aggregate supply at full employment level of output.
Basically, inflation is caused by a situation whereby the pressure of aggregate demand for goods and
services exceeds the available supply of output (both being counted at the prices ruling at the
beginning of a period). In such a situation, the rise in price level is the natural consequence. Now, this
imbalance between aggregate demand and supply may be the result of more than one force at work.
As we know aggregate demand is the sum of consumers’ government spending on consumer goods
and services and net investment being contemplated by the entrepreneurs. The ordinary functioning of
an economy should result in distributing and spending income in such a manner that aggregate
demand for output is equivalent to the cost of producing total output including profits and taxes. At
times, however, the government, the entrepreneurs or the households may attempt to secure a large
part of output that would thus accrue to them. If other sectors are not prepared to acquiesce in this
increase in the share of output used by any one sector, all of the sectors together will be trying to get
more of the national output than production has provided. This is the basic cause for inflation to start.
When aggregate demand for all purposes-consumption, investment and government, expenditure-
exceeds the supply of goods at current prices, there is a rise in prices.
It is important to note that Keynes in his booklet ‘How to Pay’ for the War published during the
Second World War explained inflation in terms of excess demand for goods relative to the aggregate
supply of their output. His notion of the inflationary gap which he put forward in his booklet
represented excess of aggregate demand over full-employment output. This inflationary gap,
according to him, leads to the rise in prices. Thus Keynes explained inflation in terms of demand-pull
74
forces. Therefore, the theory of demand-pull inflation is associated with the name of Keynes. Since
beyond full-employment level of aggregate supply, output cannot increase in response to increase in
demand, these results in rise in prices under the pressure of excess demand.
If the total claims on output exceed the available supply of output, prices will rise. The rise in prices
provides the necessary mechanism whereby the real resources being currently used by inactive sectors
are reduced so that they should be used by the more active sectors. If, for example, the initiative for
the inflationary pressure comes from the government demand for more resources, the only way that
the government can have more resources is by the consumers and private entrepreneurs having less of
them (assuming that all the resources are fully employed already). If they are not willing to reduce
their claims on resources voluntarily, the prices will rise and the result will be that the value of
spending by these sectors will be reduced and to that extent resources will be made available for use
by the government. But that will not be the end of the story. A rise in prices reduces the real
consumption of the wage earners. They will, therefore, press for higher money wages to compensate
them for the higher cost of living. Now, an increase in wages, if granted, will raise the prime cost of
production and, therefore, entrepreneurs will be tempted to raise the prices. This adds fuel to the
inflationary fire. A further rise in prices raises the cost of living still further and the workers ask for
still higher wages. In this way, wages and prices chase each other and the process of inflationary rise
in prices gathers momentum. If unchecked, this may lead to hyper-inflation which signifies a state of
affairs where wages and prices chase each other at a very quick speed. This process is called wage-
price spiral.
B. Cost-Push Inflation
We can visualize situations where even if there is no increase in aggregate demand, prices may still
rise. This may happen if there is increase in costs independent of any increase in aggregate demand.
Three such autonomous increases in costs which generate cost-push inflation have been suggested.
They are:
 Wage-push inflation
 Profit-push inflation
 Increase in prices of raw materials, especially energy inputs; as rise in crude oil prices.
It may be noted that rise in prices of raw materials, especially of energy inputs (petroleum products)
which have a cost push effect are also called supply shocks.
i) Wage-push inflation: - It has been suggested that growth of powerful trade union is responsible
for the spread of inflation, especially in the industrialized countries. When trade unions push for
75
higher wages which are not justifiable either on grounds of aprior rise in productivity or of cost
of living they produce a cost-push effect. The employers in a situation of high demand and
employment are more agreeable to concede to these wage claims because they hope to pass on
these rises in costs to the consumers in the form of high in prices. If this happens we have cost-
push inflation. It may be noted that as a result of cost-push effect of higher wages, aggregate
supply curve of output shifts inward and, given the aggregate demand curve, this results in higher
price of output.
ii) Profit-Push Inflation: besides the increase in wages of labour without any increase in its
productivity, there is another factor responsible for cost-push inflation. This is the increase in the
profit margin by the firms working under monopolistic or oligopolistic conditions and as a result
charging higher prices from the consumers. In the former case when the cause of cost-push
inflation is the rise in wages it is called wage-push inflation and in the latter case when the cause
of cost-push inflation is the rise in profit margins, it is called profit-push inflation. The increase
in profit margins also produces a cost-push effect and results in shift in the aggregate supply
curve to the left.
iii) Rise in Raw Material Prices or Oil Price Shock:- In addition to the rise in wage rate of labour
and increase in profit margins, in the decade of 1970s and in the mid of 2008 the other supply-
shocks causing increase in marginal cost of production became more prominent in bringing about
cost-push inflation. During the seventies and 2008, rise in prices of raw materials, especially
energy inputs (hike in crude oil price made by OPEC resulting in rise in prices of petroleum
products). The sharp rise in world oil prices during 1973-75, again in 1979-80, and 2008
produced significant supply shocks resulting in cost-push inflation.
Many economists think inflation in the economy is generally caused by the interaction of the demand
pull and cost-push factors. The inflation may be started in the first instance either by cost-push factors
or by demand pull factors both work and interact to cause sustained inflation over time. Thus,
according to Machlup, “there cannot be a thing as cost push inflation because without an increase in
purchasing power and demand, cost increases will lead to unemployment and depression, not to
inflation.’’ Likewise, Cairncross writes, “there is no need to pretend that demand and cost inflation do
not interact or that excess demand does not aggregate wage inflation, of course it does.”
C. Structuralist Theory of Inflation

The structuralist argues that increase in investment expenditure and the expansion of money supply to
finance it are the only proximate and not the ultimate factors responsible for inflation in the
developing countries. According to them, one should go deeper into the question as to why aggregate
output, especially of food grains, has not been increasing sufficiently in the developing countries to
match the increase in demand brought about by the increase in investment expenditure, and money
supply. Further, they argue why investment expenditure has not been fully financed by voluntary
76
savings and as a result excessive deficit financing has been done. Structural theory of inflation has
been put forward as an explanation of inflation in the developing countries especially of Latin
America. The well-known economists, Myrdal and Streeten who have proposed this theory have
analyzed inflation in these developing countries in terms of structural features of their economies.
Kirkpatrick and Nixon have generalized this structural theory of inflation as an explanation of
inflation prevailing in all developing countries.
Myrdal and Streeten have argued that it is not correct to apply the highly aggregative demand-supply
model for explaining inflation in the developing countries. According to them, there is a lack of
balanced integrated structure in them where substitution possibilities between consumption and
production and inter-sectoral flows of resources between different sectors of the economy are not
quite smooth and quick so that the inflation in them cannot be reasonably explained in terms of
aggregate demand and aggregate supply. In this connection it is noteworthy that Prof. V.N. Pandit of
Delhi School of Economics has also felt the need for distinguishing price behaviour in the Indian
agricultural sector from that in the manufacturing sector.
Thus, it has been argued by the exponents of structural theory of inflation that economies of the
developing countries are structurally underdeveloped as well as highly fragmented due to the
existence of market imperfections and structural rigidness of various types. The result of these
structural imbalances and rigidities is that whereas in some sectors of these developing countries, we
find shortages of supply relative to demand, in others under-utilisation of resources and excess
capacity exist due to lack of demand. According to structuralists, these structural features of the
developing countries make the aggregate demand-supply model of inflation inapplicable to them.
They therefore argue for analyzing disaggregative and sectoral demand-supply imbalances to explain
inflation in the developing countries. They mention various sectoral constraints or bottlenecks which
generate the sectoral imbalances and lead to rise in prices. Therefore, to explain the origin and
propagation of inflation in the developing countries, the forces which generate these bottlenecks or
imbalances of various types in the process of economic development need to be analyzed. A study of
these bottlenecks is therefore essential for explaining inflation in the developing countries. These
bottlenecks are of three types:
1. Agricultural Bottlenecks: The first and foremost bottlenecks faced by the developing countries
relate to agriculture and they prevent supply of food grains to increase adequately. Of special mention
of the structural factors are disparities in land ownership, defective land tenure system which act as
disincentives for raising agricultural production in response to increasing demand for them arising
from increase in people’s incomes, growth in population and urbanization. Besides, use of backward
agricultural technology also hampers agricultural growth. Thus, in order to control inflation, these
bottlenecks have to be removed so that agricultural output grows rapidly to meet the increasing
demand for it in the process of economic development.
77
2. Resources Gap or Government’s Budget Constraint: Another important bottleneck mentioned
by structuralists relate to the lack of resources for financing economic development. In the developing
countries planned efforts are being made by the government to industrialise their economies. This
requires large resources to finance public sector investment in various industries. But socio-economic
and political structure of these countries is such that it is not possible for the government to raise
enough resources through taxation, borrowing from the public, surplus generation in the public sector
enterprises for investment in the projects of economic development. Revenue rising from taxation has
been relatively very small due to low tax base, large scale tax evasion, inefficient and corrupt tax
administration. Consequently, the government has been forced to resort to excessive deficit financing
(that is, creation of new currency) which has caused excessive growth in money supply relative to
increase in output year after year and has therefore resulted in inflation in the developing countries.
Besides, resources gap in the private sector due to inadequate voluntary savings and
underdevelopment of the capital market have led to their larger borrowings from the banking system
which has created excessive bank credit for it. This has greatly contributed to the growth of money
supply in the developing countries and has caused rise in prices.
3. Foreign Exchange Bottleneck: The other important bottleneck which the developing countries
have to encounter is the shortage of foreign exchange for financing needed imports for development.
In the developing countries ambitious programme of industrialization is being undertaken.
Industrialisation requires heavy imports of capital goods, essential raw materials and in some cases
even food grains have been imported. Besides, imports of oil on a large scale are being made. On
account of all these imports, import expenditure of the developing countries has been rapidly
increasing. On the other hand, due to lack of export surplus, restrictions imposed by the developing
countries, relatively low competitiveness of exports, the growth of exports of the developed countries
has been sluggish. As a result of sluggish exports and mounting imports, the developing countries
have been facing balance of payment difficulties and shortage of foreign exchange which at times has
assumed crisis proportions. This has affected the price level in two ways.
1. First, due to foreign exchange shortage domestic availability of goods in short-supply could not
be increased which led to the rise in their prices.
2. Secondly, to solve the problem of foreign exchange shortage through encouraging exports and
reducing imports devaluation in the national currencies had to be made. But this devaluation
caused rise in prices of imported goods and materials which further raised the prices of other
goods as well due to cascading effect. This brought about cost-push inflation in their economies.
Further, the structuralists point out various bottlenecks such as lack of infrastructural facilities i.e.,
lack of power, transport and fuel which stands in the way of adequate growth in output. Sluggish
growth of output on the one hand, and excessive growth of money supply on the other have caused
what is now called stagflation, that is inflation which exists along with stagnation or slow economic
78
growth. According to the structuralist school of thought, the above bottlenecks and constraints are
rooted in the social, political and economic structure of these countries. Therefore, in its view a broad-
based strategy of development which aims to bring about social, institutional and structural changes in
these economies is needed to bring about economic growth without inflation. Further, many
structuralists argue for giving higher priority to agriculture in the strategy of development if price
stability is to be ensured. Thus, structuralist view is greatly relevant for explaining inflation in the
developing countries and for the adoption of measures to control it.
Measures to Control Inflation

1. Fiscal Policy: Reducing Budget Deficit
The budget deals with how a government raises its revenue and spends it. If the total revenue raised
by the government through taxation, fees, surpluses from public undertakings is less than the
expenditure it incurs on buying goods and services to meet its requirements of defence, civil
administration and various welfare and developmental activities, there emerges a deficit in its budget.
It may be noted here that the budget of the government has two parts: in the revenue budget, revenue
is raised through taxes, interests, fees, surpluses from public undertakings to be spent on defence, civil
administration, education and health services, subsidies on food, fertilizers and exports, and interest
payments on the loans taken by it in the previous years. In the capital budget, the main items of
receipts are market borrowings by the government from the Banks and other financial institutions,
foreign aid, small savings. The important items of expenditure in the capital budget are defence, loans
to public enterprises for developmental purposes, and loans to states and union territories.
The deficit may occur either in the revenue budget or capital budget or both taken together. When
there is overall budget deficit of the government, it has to be financed by borrowing from the National
Bank. Thus, to finance its budget deficit, the government borrows from central bank against its own
securities. This is only a technical way of creating new money because the government has to pay
neither the rate of interest nor the original amount when it borrows from central bank against its own
securities. It is thus clear that budget deficit implies that government incurs more expenditure on
goods and services than its normal receipts from revenue and capital budgets. This excess expenditure
by the government financed by newly created money leads to the rise in incomes of the people. This
cause the aggregate demand of the community to rise to a greater extent than the amount of deficit
financing undertaken through the operation of what Keynes called income multiplier.
In the opinion of many economists, the expansion in money supply caused by deficit financing leads
to the excess aggregate demand in the economy, especially when aggregate supply of output is
inelastic. To some extent deficit financing may not generate demand-pull inflation because if the
aggregate output increases, the extra demand arising out of newly created money would be matched
by extra supply of output. There is no wonder that this has contributed a good deal to the general rise
79
in prices and is an important factor responsible for current inflation.
To reduce budget deficits and keep deficit financing within a safe limit, the government can mobilize
more resources through rising:
(a) Taxes, both direct and indirect,

(b) Market borrowings, and
(c) Raising small savings such as receipts from Provident Funds.
It is often argued that there is a large scope for pruning down non-planned expenditure on defence,
police and general administration and on subsidies being provided on food, fertilizers and exports.
Though it is easy to suggest cutting down of government expenditure, it is difficult to implement it in
practice. However, there is a large-scale inefficiency in resources use and also a lot of corruption
involved in the spending by the government expenditure which can be curtailed to some extent. Thus,
both by greater resources mobilization on the one hand and pruning down of wasteful and inessential
government expenditure on the other, budget deficit and deficit financing can be reduced.
2. Monetary Policy: Squeezing Credit

Monetary policy refers to the adoption of suitable policy regarding interest rate and the availability of
credit. Monetary policy is another important measure for reducing aggregate demand to control
inflation. As an instrument of demand management, monetary policy can work in two ways.
 First, it can affect the cost of credit and

 Second, it can influence the credit availability for private business firms.
The higher the rate of interest, the greater the cost of borrowing from the banks by the business firms.
As anti-inflationary measure, the rate of interest has to be kept high to discourage businessmen to
borrow more and also to provide incentives for saving more. The cheap credit policy (i.e., lower
interest rates) recommends on the ground that lower rate of interest will promote more private
investment which is an important factor determining economic growth.
It is noteworthy that a recent monetary theory emphasizes that it is the changes in the credit
availability rather than cost of credit (i.e., rate of interest) that is a more effective instrument of
regulating aggregate demand. There are several methods by which credit availability can be reduced.
 First, it is through open market operations that the central bank of a country can reduce the
availability of credit in the economy. Under open market operations, the central bank sells
government securities. Those, especially banks, who buy these securities, will make payment
for them in terms of cash reserves. With their reduced cash reserves, their capacity to lend
money to the business firms will be curtailed. This will tend to reduce the supply of credit or
loanable funds which in turn would tend to reduce investment demand by the business firms.
80
 Another instrument for affecting credit availability is the Statutory Liquidity Ratio (SLR).
According to SLR, banks have to keep a certain minimum proportion of their deposits in the
form of specified liquid assets. And the most important specified liquid asset for this purpose
is the government securities. To mop up extra liquid assets with banks which may lead to
undue expansion in credit availability for the business class, the central bank has often raised
statutory liquidity ratio.
3. Supply Management through Imports

To correct excess demand relative to aggregate supply, the latter can also be raised by importing
goods in short supply. To check the rise in food prices, the government has been frequently importing
them to enlarge their available supplies. At times of inflationary expectations, there is a tendency on
the part of businessmen to hoard goods for speculative purposes. The attempt by the government to
import goods in short supply would compel the hoarders to release their hoarded stocks. Overall
excess demand relative to supply will be reduced if total imports of goods exceed the exports so that
there is a net import surplus. At times of inflationary pressures, efforts are to be made to enlarge
import surplus as far as possible. However, the country can achieve and enlarge this import surplus if
it has either enough foreign exchange reserves which can be used to spend on imports/if sufficient
foreign aid is available to import the goods in short supply.
4. Incomes Policy: Freezing Wages

Another anti-inflationary measure which has often been suggested is the avoidance of wage increases
which are unrelated to improvements in productivity. This requires exercising control over wage-
income. It is through wage-price spiral that inflation gets momentum. To check this vicious circle of
wages-chasing prices, an important measure will be to exercise control over wages. If wages are
raised equal to the increase in the productivity of labour, then it will have no inflationary effect. The
proposal has been to freeze wages in the short run and wages should be linked with changes in the
level of productivity over a long period of time. According to this, wage increases should be allowed
to the extent of rise in labour productivity only. This will check the net growth in aggregate demand
relative to aggregate supply of output.
5. Raising Aggregate Supply through Fuller Utilization of Productive Capacity

If productive capacity in the economy is not fully utilized; then excess demand can also be reduced by
adopting measures for utilizing fully the idle productive capacities in various industries of the
economy. This would augment the aggregate supply of output and reduce the gap between aggregate
demand and output and will therefore tend to check the inflationary potential. With various measures,
the aggregate demand can be reduced on the one hand and the aggregate supply of output can be
increased on the other. This would help in bridging the gap between aggregate demand and aggregate
supply which would enable us to contain the inflationary pressures in the economy.
81
6.3.2. Unemployment
Unemployment
Unemployment is a key indicator of economic performance. An economy with persistent

high unemployment is wasting its productive resources: its level of output is below its
production potential. Such an economy will have lower level of social welfare than otherwise
might easily be attained.
People of working age in an economy could be classified into four categories:
1. Those who are employed in some sort of job.
2. Those who are out of the labour force and do not want job immediately.
3. Those who are not employed and want a job immediately but have given up looking
for one because they do not think they could find one.
4. Those who are not employed and want a job immediately and are looking for one.
The labour force comprises of group 1 and group 4. With the labour force defined this way
the unemployment rate is the ratio of group 4 to the labour force.
those looking for work

Unemployment=
labor work
Inflation, unemployment and Phillips curve
Phillips curve is a curve which shows an inverse relationship between the rate of
unemployment and the rate of increase in money wages (wage inflation) i.e. the higher the
rate of unemployment, the lower the rate of inflation. The curve suggests that less
unemployment can always be attained by incurring more inflation and that the inflation rate
can always be reduced by incurring the costs of more unemployment. In other words the
curve suggests there is a trade-off between inflation and unemployment.
Letting Wt be wage rate of this period and W t+1 the wage of next period, the rate of wage
inflation, gw, is given as:
gw = Wt+1 – Wt ……………………………………………………........................…… (1)

Wt
With natural rate of unemployment, U* we can write simple Phillips curve as
82
gw = - ε (U-U*) ……………………………………….......………………… (2)
Where ε is the measures the responsiveness of wage rate to deviation of unemployment from
the natural rate.
This equation states that wages are falling when the unemployment rate exceeds the natural
rate, that is, when U>U*, and rising when unemployment is below the natural rate.
Combining equations (1) and (2), we have
ε (U-U*) = Wt+1-Wt Rearranging

Wt
Wt+1- Wt = Wt(-ε (U-U*))
Wt+1= Wt + Wt(-ε (U-U*))
= Wt – Wt ε (U-U*)
Wt+1 = Wt [1- ε (U-U*)]
Inflation Rate
Phillips curve
0 Unemployment rate
Such relationship between inflation and unemployment raise the idea of policy trade off. The
Phillips curve rapidly becomes a cornerstone of macroeconomic policy analysis. It suggested
that policymakers could choose different combinations of unemployment and inflation rates.
That is we could have low unemployment as long as we put up with high inflation. The
policy measures to reduce unemployment always lead to higher inflation rate and policy
measures which reduce inflation rate always contribute to higher unemployment.
Types of unemployment
There are three major types of unemployment namely frictional unemployment, structural
unemployment and cyclical unemployment.
1) Frictional unemployment
Frictional unemployment arises because of constant flow of people between jobs, into and out
of labour force. This is so because of imperfect information among employees and
83
employers. The main characteristics of such unemployment are that:
- It affects large number and wide range of people.

- It tends to be of short period.
- Certain amount of frictional unemployment is unavoidable. One of
policy options to solve such unemployment is improving labour market information
(e.g. establishment of information office about workers and vacancies).
2) Structural unemployment
This problem arises from mismatch between the types of jobs that are available and type of
job seekers. Such mismatch may be related to skill, education level, geographical area, age,
etc. For instance some skills may not be more demanded (for instance, typing machines are
replaced by computers). Type writers would be the victim of such unemployment.
The characteristics of this type of unemployment are:
- It tends to be concentrated among certain group, which is adversely affected by

technological change.
- It tends to be long lasting (e.g. until they train themselves under new situation or
new technology).
The policy option in this case are training workers and improving labour mobility.
3) Cyclical unemployment
This is also known as demand deficient unemployment. Cyclical unemployment is the result
of insufficient aggregate demand in the economy to generate enough jobs for those seeking
them. It occurs during cyclical contraction of an economy (recession).
The policy instrument to solve this problem is fiscal policy (for instance increasing
government expenditure and reducing tax rates) and monetary policy (such as reducing
interest rate and increasing money supply).
With frictional and structural unemployment there could be enough jobs, but the problem is
to match job seekers with job vacancies. But with cyclical unemployment there are no
enough jobs for job seekers. The duration of cyclical unemployment is between frictional and
structural unemployment (not as short duration as frictional and not as long duration as
structural unemployment).
84
-------------//--------------
CHAPTER SEVEN
7. Macroeconomic Policy Debates
7.1.Stabilization Policy
7.1.1. Fiscal Policy
The economy does not always work smoothly. There often occur fluctuations in the level of
economic activity. At this time, the economy finds itself in the grip of recession when levels
of national income, output and employment are far below their full potential levels. During
recession, there is a lot of idle or unutilized productive capacity, that is, available machines
and factories are not working to their full capacity. As a result, unemployment of labour
increases along with the existence of excess capital stock. On the other hand, at times the
economy is ‘overheated’ which means inflation (i.e., rising prices) occurs in the economy.
Thus, in a free market economy there is a lot of economic instability. The classical
85
economists believed that an automatic mechanism works to restore stability in the economy;
recession would cure itself and inflation will be automatically controlled. However, the
empirical evidence during the 1930s when severe depression took place in the Western
capitalist economies and also the evidence of post Second World War-II period amply shows
that no such automatic mechanism works to bring about stability in the economy. That is why
Keynes argued for intervention by the Government to cure depression and inflation by
adopting appropriate tools of macroeconomic policy. The two important tools of
macroeconomic policy are fiscal policy and monetary policy.
According to Keynes, monetary policy was ineffective to lift the economy out of depression.
He emphasized the role of fiscal policy as an effective tool of stabilizing the economy.
However, in view of the modern economists both fiscal and monetary policies play a useful
role in stabilizing the economy. Fiscal policy is of two kinds:
 Discretionary fiscal policy and
 Non-discretionary fiscal policy of automatic stabilizers.
1) Discretionary fiscal policy

By discretionary policy we mean deliberate change in the government expenditure and taxes
to influence the level of national output and prices. Fiscal policy aims at managing aggregate
demand for goods and services. On the other hand, non-discretionary fiscal policy of
automatic stabilizers is a built-in tax or expenditure mechanism that automatically increases
aggregate demand when recession occurs and reduces aggregate demand when there is
inflation in the economy without any special deliberate actions on the part of the government.
At the time of recession the government increases its expenditure or cuts down taxes or
adopts a combination of both. On the other hand, to control inflation the government cuts
down its expenditure or raises taxes. In other words, to cure recession expansionary fiscal
policy and to control inflation contractionary fiscal policy is adopted. Fiscal policy is mainly
a policy of demand management. When the government adopts expansionary fiscal policy to
cure recession, it raises its expenditure without raising taxes or cuts down taxes without
changing expenditure or increases expenditure and cuts down taxes as well. With the
adoption of any of these types of expansionary fiscal policy government’s budget will have a
deficit. Thus expansionary fiscal policy to cure recession and unemployment is a deficit
budget policy. To control inflation, government reduces its expenditure or increases taxes/
adopts a combination of the two; it will be planning for a budget surplus. Thus policy of
86
budget surplus, or at least reducing budget deficit is adopted to remedy inflation.
a) Fiscal Policy to cure recession
The recession in an economy occurs when aggregate demand decreases due to a fall in
private investment. Private investment may fall when businessmen become highly pessimistic
about making profits in future, resulting in decline in marginal efficiency of investment. As a
result of fall in private investment expenditure, aggregate demand curve shifts down creating
a deflationary or recessionary gap. It is the task of fiscal policy to close this gap by increasing
government expenditure, or reducing taxes. Thus there are two fiscal methods to get the
economy out of recession.
 Increase in Government Expenditure

 Reduction of Taxes
(I) Increase in Government Expenditure to Cure Recession: For a discretionary fiscal
policy to cure depression, the increase in Government expenditure is an important tool.
Government may increase expenditure by starting public works, such as building roads,
dams, ports, telecommunication links, irrigation works, electrification of new areas etc.
For undertaking all these public works, Government buys varies types of goods and
materials and employs workers. The effect of this increase in expenditure is both direct
and indirect. The direct effect is the increase in incomes of those who sell materials and
supply labour for these projects. The output of these public works also goes up together
with the increase in incomes. Not only that, Keynes showed that increase in Government
expenditure also has an indirect effect in the form of the working of a multiplier. Those
who get more incomes spend them further on consumer goods depending on their
marginal propensity to consume. As during the period of recession there exists excess
capacity in the consumer goods industries, the increase in demand for them brings about
expansion in their output which further generates employment and incomes for the
unemployed workers and so the new incomes are spent and re-spent further and the
process of multiplier goes on working till it exhausts itself. The size of expenditure
required to establish equilibrium depends on the magnitude of GNP gap caused by
deflationary gap on the one hand and the size of multiplier on the other. It may be
recalled that the size of the multiplier depends on the marginal propensity to consume.
The impact of increase in expenditure in a recessionary condition is illustrated below.
Suppose to begin with the economy is operating at full-employment or potential level of
87
output Yf with aggregate demand curve C+I2+G2 intersecting 45°line at point E2. Now, due to
some adverse happening (say due to the crash in the stock market), investor’s expectations of
making profits from investment projects become dim causing a decline in investment. With
Expenditure (C+I+G)
the decline in investment, say equal to Y1Yf, aggregate demand curve will shift down to the
new position C+I1+G1 which will bring the economy to the new equilibrium position at point
E1 and thereby determine Y1 level of output or income. The fall in output will create
involuntary unemployment of labour and also excess capacity (i.e. idle capital stock) will
come to exist in the economy. Thus emergence of deflationary gap equal to E2H and the
reverse working of the multiplier have brought about conditions of recession in the economy.
Y
C+I2+G2
H E2
ΔG C+I1+G1
1
Δy=ΔG
1 1−MPC
E GNP gap
450 ΔY
0 Y1 Yf Potential Output
It will be observed from the figure that, to overcome recession if the government increases its
expenditure by E1H, the aggregate demand curve will shift upward to original position
C+I2+G2 and as a result the equilibrium level of income will increase to the full-employment
or potential level of output and in this way the economy would be lifted out of depression.
Note that the increase (∆Y) in national income/output by Y1Yf is not only equal to the increase
in Government expenditure by ∆G or E1H but a multiple of it depending on the marginal
propensity to consume. Thus, increase in national income is equal to ∆Gx1/1-MPC where
1/1-MPC is the value of multiplier. It may also be further noted that increase in government
expenditure without raising taxes (and therefore the policy of deficit budgeting) will fully
succeed in curing recession if rate of interest remains unchanged.
With the increase in government expenditure and resultant increase in output and
employment, demand for money for transactions purposes is likely to increase as is shown in
the figure below where demand for money curve shifts to right from Md1 to Md2 as a result of
increase in transactions demand for money. Money supply remaining constant, with increase
in demand for money rate of interest is likely to rise which will adversely affect the private
investment. The decline in private investment will tend to offset the expansionary effect of
88
rise in Government expenditure. Therefore, if fiscal policy of increase in Government
expenditure (or of deficit budgeting) is to succeed in overcoming recession, the Central Bank
of the country should also pursue expansionary monetary policy and take steps to increase the
money supply so that increase in Government expenditure does not lead to the rise in rate of
interest.
Interest rate R
E1 E2
Md1 Md2
0 Ms1 Ms2 Quantity of Money Supply
It will be noticed from the above figure that if money supply is increased from Ms1 to Ms2, the
rate of interest does not rise despite the increase in demand for money. With rate of interest
remaining unchanged, private investment will not be adversely affected and increase in
government expenditure will have full effect on national income and employment.
Financing Increase in Government Expenditures and Budget Deficit
An important question is how to finance the increase in Government expenditure which is

undertaken to cure recession. This increase in Government expenditure must be financed by
raising taxes because rise in taxes would reduce disposable incomes and consumers’ demand
for goods. As a matter of fact, rise in taxes would offset the expansionary effect of rise in
Government spending. Therefore, proper discretionary fiscal policy at times of recession is to
have the budget deficit if expansionary effect is to be realized.
Borrowing: A way to finance budget deficit is to borrow from the public by selling interest-
bearing bonds to them. However, there is a problem in adopting borrowing as a method of
financing budget deficit. When the Government borrows from the public in the money
market, it will be competing with businessmen who also borrow for private investment. The
Government borrowing will raise the demand for loanable funds which in a free market
89
economy, if rate of interest is not administered by the Central Bank, will drive up the rate of
interest. The rise in rate of interest will reduce/crowd out private investment expenditure and
interest-sensitive consumer spending for durable goods.
Creation of New Money: The more effective way of financing budget deficit is the creation
of new money. By creating new money to finance the deficit, the crowding out of private
investment can be avoided and full expansionary effect of rise in Government expenditure
can be realized. Thus, creation of new money for financing budget deficit or what is called
monetization of budget deficit has a greater expansionary effect than that of borrowing by the
Government.
(II) Reduction in Taxes to Overcome Recession: Alternative fiscal policy measure to

overcome recession and to achieve expansion in output and employment is reduction of taxes.
The reduction in taxes increases the disposable income of the society and causes the increase
in consumption spending by the people. If along with the reduction in taxes, the Government
expenditure is kept unchanged, aggregate demand curve C + I+G will shift upward due to rise
in consumption function curve. This will have an expansionary effect and the economy will
be lifted out of recession, and national income and employment will increase and as a result
unemployment will be reduced. Note that reduction in taxes, with Government expenditure
remaining constant, will also result in budget deficit which will have to be financed either by
borrowing or creation of new money. It is worth noting that reduction in taxes has only an
indirect effect on expansion and output through causing a rise in consumption function.
Increase in Government Expenditure or Reduction in Taxes:

Is it better to use Government expenditure or changes in taxes to stabilize the economy at full
employment and potential-level of output? The answer depends to a great extent upon one’s
view regarding the role of public sector. Those who think that public sector should play a
significant role in the economy to meet various failures of a free market system will
recommend the increase in Government expenditure during recession on public works to
achieve expansion in output and employment. On the other hand, those economists who think
that public sector is insufficient and involves waste of scarce resources would advocate for
reduction in taxes to stimulate the economy. The choice between tax reduction and increase
in Government expenditure depends on the basis of another factor, namely, the magnitude of
the effect of expenditure multiplier and tax multiplier. The value of tax multiplier is less than
the Government expenditure multiplier. Ignoring the signs of the multiplier, it should be
noted that whereas expenditure multiplier is equal to 1/1-MPC, the tax multiplier equals
90
MPC/1-MPC which is less than 1/1-MPC. Thus, the effect of reduction in taxes by an equal
amount as the increase in Government expenditure has a smaller impact on national income
than that of increase in Government expenditure. This difference in the effects of the two
methods of expanding output has implications for the size of the Government deficit. If we
want to achieve expansion in income by the same amount, we need to cut taxes by more than
we would need to increase Government expenditure because the size of the tax multiplier is
less than that of expenditure multiplier. In other words, in case we adopt the policy of tax
reduction, to achieve expansion by a given amount the budget deficit planned will to have to
be much greater. However, the size of expenditure multiplier relative to the size of the tax
multiplier is not the sole deciding factor for the choice of a policy option. For example,
reductions in taxes are greatly welcomed by the people as it directly increases their
disposable incomes. Further, it is individual or households who themselves decide how to
spend their extra disposable income made possible by a tax cut, while in case of increase in
expenditure the Government decides how to spend it.
b) Fiscal Policy to Control Inflation

When due to large increases in consumption demand by the households or investment
expenditure by the entrepreneurs, or bigger budget deficit caused by large increase in
Government expenditure, aggregate demand increases beyond what the economy can
potentially produce by fully employing its given resources, it gives rise to the situation of
excess demand which results in inflationary pressures in the economy. This inflationary
situation can also arise if too large an increase in money supply in the economy occurs. In
these circumstances inflationary gap occurs which tend to bring about rise in prices. If
successful steps to check the emergence of excess demand or close the inflationary gap are
not taken, the economy will experience a period of inflation or rising prices. For the last some
decades, problem of demand pull inflation has been faced by both the developed and
developing countries of the world. An alternative way of looking at inflation is to view it
from the angle of business cycles. After recovery from recession, when during upswing an
economy finds itself in conditions of boom and become overheated prices start rising rapidly.
Under such circumstances, anti cyclical fiscal policy calls for reduction in aggregate demand.
Fiscal policy measures to control inflation are:
 Reducing Government Expenditure and

 Increasing Taxes
If in the beginning the Government is having balanced budget, then increasing taxes while
91
keeping Government expenditure constant will yield budget surplus. The creation of budget
surplus will cause downward shift in the aggregate demand curve and will therefore help in
easing pressure on prices. If there is a balanced budget to begin with and the Government
reduces its expenditure, say on defence, subsidies, transfer payments, while keeping taxes
constant, this will also create budget surplus and result in removing excess demand in the
economy. It is important to mention that in the developing countries, the main factor
Expenditure (C+1+G1)
responsible for inflationary pressures is heavy budget deficit of the Government for the last
several years resulting in excess demand conditions. Rate of inflation can be reduced not
necessarily by planning for budget surplus which is in fact impracticable but by trying to take
steps to reduce budget deficits. How the reduction in Government expenditure will help in
checking inflation is shown in the following figure.
Y Inflationary A H C+1+G2
Gap E B ΔG C +1+G1
1
Δy=ΔG
1−MPC
Yf Y2
It will be seen from this figure that an aggregate demand curve C+I+G1 intersect 45° at point
E and determines equilibrium national income at full-employment level of income Yf.
However, if due to excessive Government expenditure and a large budget deficit, the
aggregate demand curve shifts upward to C+I+G2, this will determine Y2 level of income
which is greater than full employment or potential output level Yf. Since output cannot
increase beyond Yf. Income will rise only in money terms through rise in prices, real income
or output remaining unchanged. To put in other words, while the economy does not have
labour, capital and other resources sufficient to produce Y2 level of income or output, the
households, businessmen and Government are demanding Y2 level of output. This excess
demand pushes up the price level so that level of only nominal income increases while real
income or output remains constant. It is thus clear that with the increase in aggregate demand
beyond the full-employment level of output to C+I+G2, causes excess demand equal to EA to
emerge in the economy. It is this excess demand EA relative to full-employment output Yf
92
Which causes the price level to rise and thus creates inflationary situation in the economy.
This excess demand EA at full-employment level has therefore been called inflationary gap.
The task of fiscal policy is to close this inflationary gap by reducing Government expenditure
or raising taxes. With equilibrium at point H and nominal income equal to Y2, if Government
expenditure equal to HB (which is equal to inflationary gap AE) is reduced, aggregate
demand curve will shift downward to C+I+G1 which will restore the equilibrium at the full-
employment level Yf. The reduction in Government expenditure equal to HB through the
operation of multiplier will result in a multiple decline in the level of national income or
output. It will be seen from the figure that the decrease in Government expenditure by HB has
led to a much bigger decline in output by Y2Yf. Ideally Government expenditure should cut
down its expenditure on unproductive heads such as defence.
Raising Taxes to Control Inflation: As an alternative to reduction in Government

expenditure, the taxes can be increased to reduce aggregate demand. For this purpose
especially personal direct taxes such as income tax, wealth tax, and corporate tax can be
raised. The hike in taxes reduces the disposable incomes of the people and thereby forces
them to reduce their consumption demand.
Disposing of Budget Surplus:
We have seen above to control demand-pull inflation; the Government either reduces its
expenditure or raises taxes to lower aggregate demand for goods and services. Reduction in
expenditure or hike in taxes results in decrease in budget deficits (if occurring before such
steps) or in the emergence of budget surplus if the Government was having balanced budget
prior to the adoption of anti-inflationary fiscal policy measures. Anti-inflationary impact of
budget surplus depends to a good extent on how the Government disposes of this budget
surplus. There are two ways in which budget surplus can be disposed of:
1. reducing or retiring public debt and
2. impounding public debt
Reducing or retiring public debt: The budget surplus created by anti-inflationary policy can
be used by the Government to pay back the outstanding debt. However, using budget surplus
for retiring public debt will weaken its anti-inflationary effect. In paying off the debt held by
the public the Government will be returning the money to the public which it has collected
through taxes. Further this will also add to the money supply with the public. The general
public will spend a part of the money so received which will raise consumption demand.
93
Besides, retiring of public debt will result in the expansion of money supply in the money
market which will tend to lower the rate of interest.
Impounding of Public Debt: The impounding surplus funds means that they should be kept
idle. Thus by impounding the budget surplus, the Government shall be withdrawing some
income or purchasing power from the income expenditure stream and thus will not create any
inflationary pressures to offset the deflationary impact of the budget surplus. To, conclude,
the impounding of budget surplus is a better method of disposing of budget surplus than of
paying off public debt.
2) Non-discretionary fiscal policy of automatic

stabilizers.
There is an alternative to the use of discretionary fiscal policy which generally involves
problems of lags in recognizing the problem of recession or inflation and lag of taking
appropriate action to tackle the problem. In this non-discretionary fiscal policy, the tax
structure and expenditure pattern are so designed that taxes and Government spending vary
automatically in appropriate direction with the changes in national income. That is, these
taxes and expenditure pattern without any special deliberate action by the Government and
Parliament automatically raise aggregate demand in times of recession and reduce aggregate
demand in times of boom and inflation and thereby help in ensuring economic stability.
These fiscal measures are therefore called automatic stabilizers or built-in stabilizers. Since
these automatic stabilizers do not require any fresh deliberate policy action or legislation by
the government, they represent non-discretionary fiscal policy. Built-in-stability of tax
revenue and Government expenditure of transfer payments and subsidies is created because
they vary with national income. These taxes and expenditure automatically bring about
appropriate changes in aggregate demand and reduce the impact of recession and inflation
that might occur in an economy at some times. This means that because of the existence of
these automatic or built-in stabilizers recession and inflation will be shorter and less intense
than otherwise. Important automatic fiscal stabilizers are personal income taxes, corporate
income taxes, and transfer payments such as unemployment compensation, welfare benefits,
and corporate dividends.
Personal Income Taxes: The tax rate structure is so designed that revenue from these taxes
directly varies with income. Moreover, personal income taxes have progressive rates; the
higher rates are charged from the upper income brackets. As a result, when national income
94
increases during expansion and inflation, increasing percentage of the people’s income are
paid to the Government. Thus, through causing a decline in their disposable income these
taxes automatically reduce people’s consumption and therefore aggregate demand. This
decline in aggregate demand because of imposition of progressive personal income taxes
tends to check inflation from becoming more severe. On the other hand, when national
income decline at times of recession, the tax revenue declines as well this prevents aggregate
demand by the same proportion of income.
Corporate Income Tax: Companies or corporations as they are called now also pay a
percentage of their profits as tax to the Government. Like personal income taxes, corporate
income tax rate is also generally higher at higher levels of corporate profits. As recession and
inflation affect corporate taxes greatly, they have a powerful stabilizing effect on aggregate
demand; the revenue from them rises greatly during inflation and boom which tends to reduce
aggregate demand, and revenue from them falls greatly during recession which tends to offset
the decline in aggregate demand.
Transfer Payments: When there is recession and as a result unemployment increases, the
Government has to spend more on compensation for unemployment and other welfare
programmes such as food stamps, rent-subsidies, subsidies to farmers. This hike in
Government expenditure tends to make recession short-lived and less intense. On the other
hand, when at times of boom and inflation national income increases and therefore
unemployment falls. The Government curtails its programme of social benefits which results
in lowering Government expenditure. The smaller Government expenditure helps to control
inflation.
7.1.2. Monetary Policy
Monetary policy is concerned with the measures taken to regulate the supply of money, the
cost and availability of credit in the economy. Further, it also deals with the distribution of
credit between uses and users and also with both the lending and borrowing rates of interest
of the banks. In developed countries the monetary policy has been usefully used for
overcoming depression and inflation as an anti-cyclical policy. However, in developing
countries it has to play a significant role in promoting economic growth. Further, along with
encouraging economic growth, the monetary policy has also to ensure price stability.
Monetary policy is concerned with changing the supply of money stock and rate of interest
for the purpose of stabilizing the economy at full employment or potential output level by
95
influencing the level of aggregate demand. At times of recession monetary policy involves
the adoption of some monetary tools which tend the increase the money supply and lower
interest rates so as to stimulate aggregate demand in the economy. On the other hand, at times
of inflation, monetary policy seeks to contract the aggregate spending by tightening the
money supply or raising the rate of interest. In the context of developing countries the
following three are the important goals or objectives of monetary policy:
 to ensure economic stability at full employment or potential level of output;
 to achieve price stability by controlling inflation and deflation; and
 to promote and encourage economic growth in the economy.
Tools of Monetary Policy
There are four major tools or instruments of monetary policy which can be used to achieve
economic and price stability by influencing aggregate demand or spending in the economy.
These are:
 Open market operations;
 Changing the bank rate;
 Changing the cash reserve ratio; and
 Undertaking selective credit controls.
In times of depression, expansionary monetary policy is adopted which raises aggregate

demand and thus stimulates the economy. In times of inflation and excessive expansion,
contractionary monetary policy is adopted to control inflation and achieve price stability
through reducing aggregate demand.
a) Expansionary Monetary Policy to Cure Recession or Depression
When the economy is faced with recession or involuntary cyclical unemployment, which
comes about due to fall in aggregate demand, the central bank intervenes to cure such a
situation. Central Bank takes steps to expand the money supply in the economy and/or lower
the rate of interest with a view to increase the aggregate demand which will help in
stimulating the economy. The following three monetary policy measures are adopted as a part
96
of an expansionary monetary policy to cure recession and to establish the equilibrium of
national income at full employment level of output.
 The central bank undertakes open market operations and buys securities in the open
market. Buying of securities by the central bank, from the public, mainly from commercial
banks will lead to the increase in reserves of the banks or amount of currency with the
general public. With greater reserves, commercial banks can issue more credit to the
investors and businessmen for undertaking more investment. More private investment will
cause aggregate demand curve to shift upward. Thus buying of securities will have an
expansionary effect.
 The Central Bank may lower the bank rate or what is also called discount rate, which is
the rate of interest charged by the central bank of a country on its loans to commercial
banks. At a lower bank rate, the commercial banks will be induced to borrow more from
the central bank and will be able to issue more credit at the lower rate of interest to
businessmen and investors. This will not only make credit cheaper but also increase the
availability of credit or money supply in the economy. The expansion in credit or money
supply will increase the investment demand which will tend to raise aggregate output and
income.
 Thirdly, the central bank may reduce the Cash Reserve Ratio (CRR) to be kept by the
commercial banks. With lower reserve requirements, a large amount of funds is released
for providing loans to businessmen and investors. As a result, credit expands and
investment increases in the economy which has an expansionary effect on output and
employment.
The use of all tools of monetary policy leads to an increase in reserves or liquid resources
with the banks. Since reserves are the basis on which banks expand their credit by lending,
the increase in reserves raises the money supply. An appropriate monetary policy at times of
recession can increase the available ability of credit and also lower credit cost.
b) Tight Monetary Policy to Control Inflation
When aggregate demand rises sharply due to large consumption and investment expenditure
due to the large increase in Government expenditure relative to its revenue resulting in huge
budget deficits, a demand-pull inflation occurs in the economy. Besides, when there is too
much creation of money for one reason or the other, it generates inflationary pressures in the
economy. To check the demand-pull inflation which has been a major problem in several
97
countries in recent years the adoption of contractionary monetary policy which is popularly
called tight monetary policy. The following monetary measures which constitute tight money
policy are generally adopted to control inflation:
 The Central Bank sells the Government securities to the banks, other depository
institutions and the general public through open market operations. This action will
reduce the reserves with the banks and liquid funds with the general public. With less
reserve with the banks, their lending capacity will be reduced. Therefore, they will have
to reduce their demand deposits by refraining from giving new loans as old loans are
paid back. As a result, money supply in the economy will shrink.
 The bank rate may also be raised which will discourage the banks to take loans from the
central bank. This will tend to reduce their liquidity and also induce them to raise their
own lending rates. Thus this will reduce the availability of credit and also raise its cost.
This will lead to the reduction in investment spending and help in reducing inflationary
pressures.
 The most important anti-inflationary measure is the raising of statutory Cash Reserve
Ratio (CRR). To meet the new higher reserve requirements, banks will reduce their
lendings. This will have a direct effect on the contraction of money supply in the
economy and help in controlling demand-pull inflation.
 Lastly, an important anti-inflationary measure is the use of qualitative credit control,

namely, raising of minimum margins for obtaining loans from banks against the stocks of
sensitive commodities such as food grains, oilseeds, cotton, sugar, vegetable oil.
7.2. Government Debt and Measurement Problems

There are two views regarding the impact of government indebtedness; the traditional and the
Ricardian views. According to the traditional view, a government budget deficit expands
aggregate demand and stimulates output in the short run but crowds out capital and depresses
economic growth in the long run. According to the Ricardian view, a government budget
deficit has none of these effects, because consumers understand that a budget deficit
represents merely the postponement of a tax burden.
The traditional view of government debt presumes that when the government cuts taxes and
runs a budget deficit, consumers respond to their higher after-tax income by spending more.
An alternative view, Ricardian equivalence, questions this presumption. According to the
Ricardian view, consumers are forward-looking and, therefore, base their spending not only
98
on their current income but also on their expected future income. If the government is cutting
taxes without any plans to reduce government spending, then it is financing the tax cut by
running a budget deficit. At some point in the future, the government will have to raise taxes
to pay off the debt and accumulated interest. A forward-looking consumer understands that
government borrowing today means higher taxes in the future. A tax cut financed by
government debt does not reduce the tax burden; it merely reschedules it. It therefore should
not encourage the consumer to spend more.
The general principle of the Ricardian approach is that government debt is equivalent to
future taxes, and if consumers are sufficiently forward-looking, future taxes are equivalent to
current taxes. Hence, financing the government by debt is equivalent to financing it by taxes.
This view is called Ricardian equivalence after the famous nineteenth-century economist
David Ricardo, because he first noted the theoretical argument. The implication of Ricardian
equivalence is that a debt-financed tax cut leaves consumption unaffected. Households save
the extra disposable income to pay the future tax liability that the tax cut implies. This
increase in private saving exactly offsets the decrease in public saving. National saving—the
sum of private and public saving—remains the same. The tax cut therefore has no effect.
The government budget deficit equals government spending minus government revenue,
which in turn equals the amount of new debt the government needs to issue to finance its
operations. This definition may sound simple enough, but in fact debates over fiscal policy
sometimes arise over how the budget deficit should be measured. Some economists believe
that the deficit as currently measured is not a good indicator of the stance of fiscal policy.
That is, they believe that the budget deficit does not accurately gauge either the impact of
fiscal policy on today’s economy or the burden being placed on future generations of
taxpayers. In this section we discuss four problems with the usual measure of the budget
deficit.
1. Inflation: The least controversial of the measurement issues is the correction for
inflation. Almost all economists agree that the government’s indebtedness should be
measured in real terms, not in nominal terms. The measured deficit should equal the
change in the government’s real debt, not the change in its nominal debt. The budget
deficit as commonly measured, however, does not correct for inflation.
2. Capital Assets: Many economists believe that an accurate assessment of the
government’s budget deficit requires accounting for the government’s assets as well
as its liabilities. In particular, when measuring the government’s overall indebtedness,
99
we should subtract government assets from government debt. Therefore, the budget
deficit should be measured as the change in debt minus the change in assets. A budget
procedure that accounts for assets as well as liabilities is called capital budgeting,
because it takes into account changes in capital. For example, suppose that the
government sells one of its office buildings or some of its land and uses the proceeds
to reduce the government debt. Under current budget procedures, the reported deficit
would be lower. Under capital budgeting, the revenue received from the sale would
not lower the deficit, because the reduction in debt would be offset by a reduction in
assets. Similarly, under capital budgeting, government borrowing to finance the
purchase of a capital good would not raise the deficit.
3. Uncounted Liabilities: Some economists argue that the measured budget deficit is
misleading because it excludes some important government liabilities. For example,
consider the pensions of government workers. These workers provide labour services
to the government today, but part of their compensation is deferred to the future. In
essence, these workers are providing a loan to the government. Their future pension
benefits represent a government liability not very different from government debt. Yet
this liability is not included as part of the government debt, and the accumulation of
this liability is not included as part of the budget deficit. According to some estimates,
this implicit liability is almost as large as the official government debt. Similarly,
consider the Social Security system. In some ways, the system is like a pension plan.
People pay some of their income into the system when young and expect to receive
benefits when old. Perhaps accumulated future Social Security benefits should be
included in the government’s liabilities. A particularly difficult form of government
liability to measure is the contingent liability—the liability that is due only if a
specified event occurs. For example, the government guarantees many forms of
private credit, such as student loans, mortgages for low- and moderate-income
families, and deposits in banks and savings-and-loan institutions. If the borrower
repays the loan, the government pays nothing; if the borrower defaults, the
government makes the repayment. When the government provides this guarantee, it
undertakes a liability contingent on the borrower’s default. Yet this contingent
liability is not reflected in the budget deficit, in part because it is not clear what dollar
value to attach to it.
4. The Business Cycle: Many changes in the government’s budget deficit occur
automatically in response to a fluctuating economy. For example, when the economy
100
goes into a recession, incomes fall, so people pay less in personal income taxes.
Profits fall, so corporations pay less in corporate income taxes. More people become
eligible for government assistance, such as welfare and unemployment insurance, so
government spending rises. Even without any change in the laws governing taxation
and spending, the budget deficit increases. These automatic changes in the deficit are
not errors in measurement, because the government truly borrows more when a
recession depresses tax revenue and boosts government spending. But these changes
do make it more difficult to use the deficit to monitor changes in fiscal policy. That is,
the deficit can rise or fall either because the government has changed policy or
because the economy has changed direction. For some purposes, it would be good to
know which is occurring. To solve this problem, the government calculates a
cyclically adjusted budget deficit (sometimes called the full-employment budget
deficit).The cyclically adjusted deficit is based on estimates of what government
spending and tax revenue would be if the economy were operating at its natural rate
of output and employment. The cyclically adjusted deficit is a useful measure because
it reflects policy changes but not the current stage of the business cycle.
Economists differ in the importance they place on these measurement problems. Some
believe that the problems are so severe that the measured budget deficit is almost
meaningless. Most take these measurement problems seriously but still view the measured
budget deficit as a useful indicator of fiscal policy.
-------------//--------------
CHAPTER EIGHT
8. Recent Issues in Macroeconomics
8.1. Rational Expectation and the Lucas Critiques
8.1.1. Rational Expectations
There were three main developments in macroeconomics after Keynes. These are
Monetarism, Supply-side Economics and Rational Expectations Theory.
The Monetarist group was led by Milton Friedman who started by criticizing Keynes’s
macroeconomics and forwarded a new view. Friedman and Anna Schwartz published “A
Monetary History of the US” in which they argued ‘monetary policy is the prime engine in
causing fluctuations’ in economic activity by bringing about changes in aggregate demand.
101
Friedman criticized Keynes’s view that monetary policy was quite ineffective instrument in
bringing about economic stability. He asserted that monetary policy contributed to almost all
recessions. He stressed that even the Great Depression of 1930s was primarily caused by the
tight monetary policy adopted at that time. He further argued that the Great Depression of the
1930s did not show the failure of free-market system, but the failure of Government’s
interventionist policy, especially monetary policy of the Central Bank which landed the U.S.
economy into depression. According to Friedman, it is the excessive contraction of money
supply by the Federal Reserve Bank System that caused depression in the U.S. economy.
Supply-side Economics advocators argued that for the expansion in aggregate supply and
thereby increase in employment opportunities, incentives to work, save and invest more were
required to be promoted. According to them, more work or labour, and higher investment will
lead to the increase in aggregate supply. The increase in aggregate supply, given the
aggregate demand curve, will lead to the increase in employment on the one hand and
reduction of inflation on the other. According to them, high rates of income tax serve as
disincentives to work, save and invest more. Therefore, to encourage more saving, work and
investment, they advocated for the reduction in the then prevailing high rates of income tax.
As a result of more work and investment, aggregate supply will increase which will not only
cause employment to rise and unemployment to decrease but also lower the rate of inflation.
Besides, in the opinion of the supply-side economists the reduction in tax rates will increase
income and output to such an extent that even with lower rates of taxes, the Government
revenue will increase which would tend to reduce Government’s budget deficit.
The Rational Expectations Theory put as a new macroeconomic theory by the new classical
economists has been forwarded based on the concept of aggregate demand for goods and
services to oppose the Keynesian theory. According to this new classical macroeconomic
theory, consumers, workers and producers behave rationally to promote their interest and
welfare. On the basis of their rational expectations, they make quick adjustments in their
behaviour. Therefore, according to the supporters of rational expectations theory, involuntary
unemployment cannot prevail. They argue that producers and consumers collect all the
necessary information about economic situation and policies and determine their behaviour
according to the rational expectations formed on the basis of all information collected.
However, the actual empirical evidence did not fit well in the above simple Keynesian macro
model. A noted British economist, A.W. Philips published an article in 1958 based on his
good deal of research using historical data from the U.K. for about 100 years in which he
102
arrived at the conclusion that there in fact existed an inverse relationship between rate of
unemployment and rate of inflation. This inverse relation implies a trade-off, that is, for
reducing unemployment, price in the form of a higher rate of inflation has to be paid, and for
reducing the rate of inflation, price in terms of a higher rate of unemployment has to be
borne.
Friedman’s adaptive expectations theory assumes that nominal wages lag behind changes in
the price level. This lag in the adjustment of nominal wages to the price level brings about
rise in business profits which induces the firms to expand output and employment in the short
run and leads to the reduction in unemployment rate below the natural rate. But, according
rational expectations theory, which is another version of natural unemployment rate theory;
there is no lag in the adjustment of nominal wages consequent to the rise in price level. The
advocators of this theory further argue that nominal wages are quickly adjusted to any
expected changes in the price level so that there does not exist Phillips curve showing trade-
off between rates of inflation and unemployment. According to them, as a result of increase
in aggregate demand, there is no reduction in unemployment rate. The rate of inflation
resulting from increase in aggregate demand is fully and correctly anticipated by workers and
business firms and get completely and quickly incorporated into the wage agreements
resulting in higher prices of products. Thus, it is the price level that rises, the level of real
output and employment remaining unchanged at the natural level. Hence, aggregate supply
curve according to the rational expectations theory is a vertical straight line at the full-
employment level.
The work of new classical school economists was based on the joint acceptance of three
major hypotheses namely; rational expectation, continuous market clearing assumption and
Aggregate supply hypothesis. The major contributors to the issue were Robert Lucas, Thomas
Surgent, Robert Baro, Neil Wellas and others.
The rational expectation hypothesis was developed based on the belief that using publicly
available information economic agents make rational expectations about future market
developments. Rational expectation has two versions the weak version and the strong version.
The weak version: - says that in forming forecasts or expectations about future value of a
variable, rational economic agents will make the best (most efficient) use of all publicly
available information about the factors which they believe determine that variable. The
weakness of this version is that most of the time economic agents may not be able to make
103
the “best” or “the most efficient” use of available information owing to various reasons. For
instance the given information may be wrong or there may be misinterpretation of correct
information.
The strong version: - says that economic agents’ subjective expectations about the future
value of a variable will coincide with the true of objective mathematical conditional
expectations of those variables. This is represented by the identity
e
Pt =E ( P t|I t−1 ) Where Pet = the expected rate of inflation from t to t-1 and
E ( Pt|I t−1 )
= the expected rate (average of) inflation rate
conditional on the set of information available for economic agent at
period t-1 (Previous period)
This doesn’t mean that people have perfect foresight, rather in order to make (form) a rational
expectation of a certain variable agents need to take into account what they believe to be the
“correct” macroeconomic model of the economy. In making forecast agents may make
forecast error because the information they have may be incomplete. But the agents will not
systematically make forecast error i.e. there is no correlation between the forecast errors. The
error has no trend increase or decrease rather its mean is zero.
More formally the strong version of rational expectation can be give by Pet =P t + E t
Where
Et = random error, its mean ∑ ( Et ) = 0 and cov ( Et , Et+1 ) =0
Compared with adaptive expectation, the rational expectation is usually unbiased. Adaptive
expectation is back ward looking. Being back ward looking to make predications, one of the
main problems of this approach is that until the variable being predicted is stable for
considerable period of time, expectations formed of it will be repeatedly wrong. This makes
people make systematic error and the error terms will be serially correlated.
The systematic bias in adaptive expectation results from two sources:
 The assumption that economic agents only partially adjust their expectation by a
fraction of the last error made and
 The failure of agents to take into consideration additional information available to
them other than past value of the variable concerned despite making repeated errors.
104
In contrast the forward looking approach (rational expectations) is based on the use of all
publicly available information with the crucial. Implication of the strong version of the
hypothesis being that economic agents will not form expectations which are systematically
wrong over time; i.e. such expectations will be unbiased. The strong version of the rational
expectation is not yet free from problem. The major weaknesses are:
 The rational expectation hypothesis does not recognize the costs (in time, effort and
money) of acquiring and processing all publicly available information in order to forecast
the future value of a variable. If an agent is rational he or she collect information until its
marginal benefit equals its marginal cost (MB=MC).
 People may not use the whole information available with the public. The marginal cost of
doing that may be greater than its marginal benefit. So people may optimize the use of
information instead of maximization. There is constraint to the use of information.
 The rational expectation hypothesis assumes that agents know the correct model of the
economy. But, ever among economists there is dispute about correct economic models.
8.1.2. Lucas Critiques

Lucas S. (1976) emphasized the limitations of the ISLM model. He says that the model
doesn’t include any form of expectation. He said we can’t use such multipliers as
dY 1
=
dG 1−C because everything is in a dynamic change so we need to sue micro
foundation and include some elements of expectations. Lucas critique, thus, attacked the
established practice of using large scale macro models to evaluate the consequences of
alternative policy canaries, given that such policies simulation are based on the assumption
that the parameter of the model remain unchanged when there is a policy change. Lucas
argued that the parameters of large scale macroeconomic models may not remain constant in
the phase of policy changes, since economic agents may adjust their behaviour to new
environment.
The Lucas critique has profound implications for the formulation of macroeconomic policy.
Since policy makers cannot believe the effects of new and different economic policies on the
parameter of their models, simulations using existing model cannot in turn be used to predict
the consequences of alternative policy regimes. In Lucas’s view, the invariability of the
parameters in a model to policy changes cannot be guaranteed as in Keynesian type
105
disequilibrium models. In contrast, the advantage of equilibrium theorizing (the new classical
approach) is that by focusing attention in individual objectives and constraints, it is much
more likely that the result in model will consist entirely of structural relations which are
invariant to change in policy.
Lucas identified the treatment of expectations as a major defect of the standard large scale
macroeconomic models. We cannot use Keynesian type of ISLM models because the
parameters are policy variant. But in practice the micro foundation and rational expectation is
not a celebrated one, except in stock market where expectations play a great role. All things
in the new classical approach are to show that policies are ineffective. Still, these are not able
to solve complex economic problems because of their unrealistic assumptions such as rational
expectation, agents knowing the correct economic model and so on. So, at best, their policy
implications are weak.
If we violate the rational expectation assumption, the parameters of macroeconomic models

are stable and we observe that policies are effective. Thus, the new classical theory or model
is not as such important especially in less developed countries such as Ethiopia.
8.2. Real Business Cycle
Business cycles refer to fluctuation in output and employment with alternating periods of
boom and recession. In boom periods both output and employment are at high levels, whereas
in recession periods both output and employment fall and as a consequence large
unemployment come to exist in the economy. When these recessions are extremely severe,
they are called depressions. The economic history of the free market capitalist countries has
experienced great depression during the 1929-33, 1980s and the last decade of 90s and the
first decade of the 21st century.
The objective of macroeconomic policy is to achieve economic stability with equilibrium at

full employment level of output and income. During a period of depression many workers
lose their jobs and as a result large-scale unemployment, which causes loss of output that
could have been produced with full-employment of resources, come to prevail in the
economy. Besides, during depression many businessmen go bankrupt and suffer huge losses.
Depression causes a lot of human sufferings and lowers the levels of living of the people.
Even boom when it is accompanied by inflation has its social costs. Inflation erodes the real
incomes of the people and makes life miserable for the poor people and favours the rich.
106
Inflation distorts the allocation of resources by drawing away scarce resources from
productive uses to unproductive ones.
Phases of Business Cycles

Business cycles have shown distinct phases the study of which is useful to understand their
underlying causes. The following phases of business cycles have been distinguished:
 Peak/Boom (upper turning point)

 Contraction/Recession (Downswing)
 Trough/Depression (lower turning point)
 Expansion/Recovery (Upswing or Prosperity)
Cycles
without
Y growth trend
Peak
Contractionn
Expansion
n Trough
Level of GNP
time
Boom/Peak: In this phase, both output and employment increase till we have full
employment of resources and production at the highest possible level with the given
productive resources. There is no involuntary unemployment and whatever unemployment
prevails is only of frictional and structural types. The gap between potential GNP and actual
GNP is zero, that is, the level of production is at the maximum production level. A good
amount of net investment is occurring and demand for durable consumer goods is also high.
Prices also generally rise during this phase but due to high level of economic activity, people
enjoy a high standard of living. Then something may occur, whether banks start reducing
credit or profit expectations change adversely and businessmen become pessimistic about the
future state of the economy that bring an end to the prosperity phase.
Contraction and recession: As stated above, prosperity is followed by contraction. During

contraction, not only there is a fall in GNP but also level of employment is reduced. As a
107
result, involuntary unemployment appears on a large scale. Investment also decreases causing
further fall in consumption of goods and services.
At times of contraction prices also generally fall due to fall in aggregate demand. A
significant feature of this phase is the fall in rate of interest. With lower rate of interest
people’s demand for money holdings increases. There is a lot of excess capacity as industries
producing capital goods and consumer goods work much below their capacity due to lack of
demand. Capital goods and durable consumer goods industries are especially hit hard during
recession.
Trough/Depression: occurs when there is a severe contraction or recession of economic

activities. The depression of 1929-33, and 2007-till date (especially in USA) are still
remembered because of its great intensity which caused a lot of human suffering. There is,
however, a limit to which level of economic activity can fall. The lowest level of economic
activity, generally called trough, lasts for some time. Capital stock is allowed to depreciate
without replacement.
Expansion/Recovery: the banking system starts expanding credit or there is a spurt in

investment activity due to the emergence of scarcity of capital as a result of non-replacement
of depreciated capital and also because of new technology coming into existence requiring
new types of machines and other capital goods. The stimulation of investment brings about
the revival or recovery of the economy. The recovery is the turning point from depression
into expansion. As investment rises, this causes induced increase in consumption. As a result
industries start producing more and excess capacity is now put into full use due to the revival
of aggregate demand. Employment of labour increases and rate of unemployment falls. With
this the cycle is complete.
There are different types of patterns of cyclic changes. One pattern is shown in the above
figure where fluctuations occur around a stable equilibrium position as shown by the
horizontal line. It is a case of dynamic stability which depicts change but without growth
trend. The second pattern of cyclical fluctuations is shown by the following figure where the
economy is characterized by change and growth trend.
Cycles with Growth Trend

Level of GNP
108
Peak
Expansion contraction
Trough
Features of Business Cycles
 Business cycles occur periodically. Though they do not show same regularity, they
have some distinct phases such as expansion, peak, contraction or depression and
trough. Further the duration of cycles varies a good deal from minimum of two years
to a maximum of ten to twelve years.
 Secondly, business cycles are Synchronic. That is, they do not cause changes in any
single industry or sector but are of all embracing character. For example, depression
or contraction occurs simultaneously in all industries or sectors of the economy.
Recession passes from one industry to another and chain reaction continues till the
whole economy is in the grip of recession. It has also been observed that fluctuations
occur not only in level of production but also simultaneously in other variables such
as employment, investment, consumption, rate of interest and price level.
 Thirdly, another important feature of business cycles is that investment and

consumption of durable consumer goods such as cars, houses, refrigerators etc are
affected most by the cyclical fluctuations while the consumption of non-durable
goods and services does not vary much. As stressed by Keynes, investment is greatly
volatile and unstable as it depends on profit expectations of private entrepreneurs.
These expectations of entrepreneurs change quite often making investment quite
unstable. Since consumption of durable consumer goods can be deferred, it also
fluctuates greatly during the course of business cycles.
 Fourthly, the immediate impact of depression and expansion is on the inventories of

goods. When depression sets in, the inventories start accumulating beyond the desired
level. This leads to cut in production of goods. On the contrary, when recovery starts,
the inventories go below the desired level. This encourages businessmen to place
more orders for goods whose production picks up and stimulates investment in capital
109
goods.
 Fifthly, another important feature of business cycles is profits fluctuate more than any
other type of income. The occurrence of business cycles causes a lot of uncertainty for
businessmen and makes it difficult to forecast the economic conditions. During the
depression periods, profits may even become negative and many businesses go
bankrupt. In a free market economy profits are justified on the ground that they are
necessary payments if the entrepreneurs are to be induced to bear uncertainty.
 Lastly, business cycles are international in character. That is, once started in one
country they spread to other countries through trade relations between them. For
example, if there is a recession in the USA, which is a large importer of goods from
other countries, will cause a fall in demand for imports from other countries whose
exports would be adversely affected causing recession in them too.
8.2.1. Theories of Business Cycles

1) Sun-Spot Theory:
This is the oldest theory of business cycles. Sun-spot theory was developed in 1875 by
Stanley Jevons. Sun-spots are storms on the surface of the sun caused by violent nuclear
explosions there. Jevons argued that sunspots affected weather on the earth. Since economies
in the olden world were heavily dependent on agriculture, changes in climatic conditions due
to sun-spots produced fluctuations in agricultural output. Changes in agricultural output
through its demand and input-output relations affect industry. Thus, swings in agricultural
output spread throughout the economy. Other earlier economists also focused on changes in
climatic or weather conditions in addition to those caused by sun-spots. According to them,
weather cycles cause fluctuations in agricultural output which in turn cause instability in the
whole economy. Even today weather is considered important in a country like Ethiopia and
other African countries where agriculture is still important. In the years when there is due
lack of monsoon there are drought in the African agriculture which affects the income of
farmers and therefore reduce demand for the products of industries.
Critical Appraisal
The theories of business cycles which emphasize climatic conditions, especially in countries
like Ethiopia where agriculture still remains important; there is no doubt that climate affects
agricultural production. But the climate theory does not adequately explain periodicity of the
trade cycle. If there was truth in the climatic theories, the trade cycles may be pronounced in
110
agricultural countries and almost disappear when the country becomes completely
industrialized. But this is not the case. Highly industrialized countries are much more subject
to business cycles than agricultural countries which are affected more by famines rather than
business cycles.
2) Hawtrey’s Monetary Theory of Business Cycles:

An old monetary theory of business cycles was put forward by Hawtrey. His monetary theory
of business cycles relates to the economy which is under gold standard. It will be
remembered that economy is said be under gold standard when either money in circulation
consists of gold coins or when paper notes are fully backed by gold reserves in the banking
system. According to Hawtrey, increases in the quantity of money raises the availability of
bank credit for investment. Thus, by increasing the supply of credit, expansion in money
supply causes rate of interest to fall. The lower rate of interest induces businessmen to borrow
more for investment in capital goods and also for investment in keeping more inventories of
goods. Thus, Hawtrey argues that lower rate of interest will lead to the expansion of goods
and services as a result of more investment in capital goods and inventories. Higher output,
income and employment caused by more investment induce more spending on consumer
goods. Thus, as a result of more investment made possible by increased supply of bank credit,
the economy moves into the expansion phase. The process of expansion continues for some
time. Increases in aggregate demand brought about by more investment also cause prices to
rise. Rising prices lead to the increase in output in two ways. First, when prices began to raise
businessmen think they would raise further which induces them to invest more and produce
more because prospects of making profits increase with the rise in prices. Secondly, the rising
prices reduce the real value of idle money balances with the people which induce them to
spend more on goods and services. In this way rising prices sustain expansion for some time.
Critical Appraisal
Hawtrey maintains that the economy under gold standard and fixed exchange rate system
makes his model of business cycles self generating as there is built in tendency for the money
supply to change with the emergence of trade deficit and trade surplus which cause
movements of gold between countries and affect money supply in them. Changes in money
supply influence economic activity in a cyclical fashion. However, Hawtrey’s monetary
theory does not apply to the present-day economies which have abandoned gold standard in
1930s. However, Hawtrey’s theory still retains its importance because it shows how changes
in money supply affect economic activity through changes in price level and rate of interest.
111
3) Under-Consumption Theory:
Under-consumption theory of business cycles is a very old one which dates back to the
1930s. Malthus and Sismodi criticized Say’s Law which states ‘supply creates its own
demand’ and argued that consumption of goods and services could be too small to generate
sufficient demand for goods and services produced. They attribute over-production of goods
due to lack of consumption demand for them. This over-production causes pilling up of
inventories of goods which results in recession. Under-consumption theory as propounded by
Sismodi and Hobson was not a theory of recurring business cycles. They made an attempt to
explain how a free enterprise economy could enter a long-run economic slowdown. A crucial
aspect of Sismodi and Hobson’s under-consumption theory is the distinction they made
between the rich and the poor. According to them, the rich section in the society receives a
large part of their income from returns on financial assets and real property owned by them.
Further, they assume that the rich have a large propensity to save, that is, they save a
relatively large proportion of their income and therefore, consume a relatively smaller
proportion of their income. On the other hand, less well-off people in a society obtain most of
their income from work, that is, wages from labour and have a lower propensity to save.
Therefore, these less well-off people spend a relatively less proportion of their income on
consumer goods and services. In their theory, they further assume that during the expansion
process, the incomes of the rich people increase relatively more than the wage-income. Thus,
during the expansion phase, income distribution changes in favour of the rich with the result
that average propensity to save falls, that is, in the expansion process saving increases and
therefore consumption demand declines. According to Sismodi and Hobson, increase in
saving during the expansion phase leads to more investment expenditure on capital goods and
after some time lag, the greater stock of capital goods enables the economy to produce more
consumer goods and services. But since society’s propensity to consume continues to fall,
consumption demand is not enough to absorb the increased production of consumer goods. In
this way, lack of demand for consumer goods or what is called under-consumption emerges
in the economy which halts the expansion of the economy. Further, since supply or
production of goods increases relatively more as compared to the consumption demand for
them, the prices fall. Prices continue falling and go even below the average cost of production
bring losses to the business firms. Thus, when under-consumption appears, production of
goods becomes unprofitable. Firms cut their production resulting in recession or contraction
in economic activity.
112
Critical Appraisal
The view that income inequalities increase with growth or expansion of the economy and
further that this causes recession or stagnation is widely accepted. Therefore, even many
modern economies suggest that if growth is to be sustained (that is, if recession or stagnation
is to be avoided), then consumption demand must be increasing sufficiently to absorb the
increasing production of goods. For this deliberate efforts should be made to reduce
inequalities in income distribution. Further, under-consumption theory rightly states that
income redistribution schemes will reduce the amplitude of business cycles. Besides, the
suggested behaviour of average propensity to save and consume of the property owners and
wage earners in this theory have been found to be consistent with the observed phenomena.
But the average propensity to consume is constant in the long run.
4) Over-Investment Theory:
It has been observed that over time investment varies more than that of total output of final
goods and services and consumption. This has led economists to investigate the causes of
variation in investment and how it is responsible for business cycles. Two versions of over
investment theory have been put forward. One theory offered by Hayek emphasizes monetary
forces in causing fluctuations in investment. The second version of over investment theory
has been developed by Knut Wickshell which emphasizes spurts of investment brought about
by innovation.
Hayek’s Monetary Version of Over-investment Theory: Hayek suggests that it is

monetary forces which cause fluctuations in investment which are prime cause of business
cycle. The economy is in recession and businessmen’s demand for bank credit is therefore
very low. Thus, lower demand for bank credit in times of recession pushes down the money
rate of interest below the natural rate. This means that businessmen will be able to borrow
funds, that is, bank credit at a rate of interest which is below the expected rate of return in
investment projects. This induces them to invest more by undertaking new investment
projects. In this way, investment expenditure on new capital goods increases. This causes
investment to exceed saving by the amount of newly created bank credit. With the spurt in
investment expenditure, the expansion of the economy begins. Increase in investment causes
income and employment to rise which induces more consumption expenditure. As a result,
production of consumer goods increases. According to Hawtrey, the competition between
capital goods and consumer goods industries for scarce resources causes their prices to rise
which in turn push up the prices of goods and services. But this process of expansion cannot
113
go on indefinitely because the excess reserves with the banks come to an end which forces
the banks not to give further loans for investment, while demand for bank credit goes on
increasing. Thus, the inelastic supply of credit from the banks and mounting demand for it
causes the money rate of interest to go above the natural rate of interest. This makes further
investment unprofitable. But at this point of time there has been over investment in the sense
that savings fall short of what is required to finance the desired investment.
Wicksell’s over investment Theory: Over investment theory developed by Wicksell is of

non monetary type. Instead of focusing on monetary factors it attributes cyclical fluctuations
to spurts of investment caused by new innovations introduced by entrepreneurs themselves.
The introduction of new innovations makes some investment projects profitable by either
reducing cost or raising demand for the products. The expansion in investment is made
possible because of the availability of bank credit at a lower money rate of interest. The
expansion in economic activity ceases when investment exceeds saving. Again, there is over-
investment because the level of saving is insufficient to finance the desired level of
investment. However, another set of innovations occurs/more new markets are found which
stimulates investment. Thus, when investment picks up as a result of new innovations, the
economy revives and moves into the expansion phase once again.
Critical Appraisal
Though the over-investment theory does not offer an adequate explanation of business cycles,
it contains an important element that fluctuations in investment are the prime cause of
business cycles. However, it does not offer a valid explanation as to why changes in
investment take place quite often. Many exponents of this theory point to the behaviour of
banking system that causes diverges between money rate of interest and natural rate of
interest. However, as Keynes later on emphasized, investment fluctuates quite often because
of changes in profit expectations of entrepreneurs which depends on several economic and
political factors operating in the economy. Thus, the theory fails to offer adequate
explanations of business cycles.
5) Keynes’ Theory of Business Cycles:
According to Keynes theory, in the short run, the level of income, output or employment is
determined by the level of aggregate effective demand. In a free private enterprise, the
114
entrepreneurs will produce that much of goods as can be sold profitably. Now, if the
aggregate demand is large, that is, if the expenditure on goods and services is large, the
entrepreneurs will be able to sell profitably a large quantity of goods and therefore they will
produce more. In order to produce more they will employ a larger amount of resources, both
human and material. In short, a higher level of aggregate demand will result in greater output,
income and employment. On the other hand, if the level of aggregate demand is low, smaller
amount of goods and services can be sold profitably. This means that the total quantity of
national output produced will be small. And a small output can be produced with a small
amount of resources. As a result, there will be unemployment of resources, both labour and
capital. Hence, the changes in the level of aggregate effective demand will bring about
fluctuations in the level of income, output and employment. Thus, according to Keynes, the
fluctuations in economic activity are due to the fluctuations in aggregate effective demand.
Fall in aggregate effective demand will create the conditions of recession or depression. If the
aggregate demand is increasing, economic expansion will take place.
The Critical Appraisal of Keynes’ Theory

Keynes has made three important contributions to the business cycle theory.
 First, it is fluctuations in investment that cause changes in aggregate demand which

bring about changes in economic activity.
 Secondly, fluctuations in investment demand are caused by changes in expectations of

businessmen regarding making of profits.
 Thirdly, Keynes forwarded a theory of multiplier which indicates how changes in

investment bring about magnified changes in the level of income and employment.
But the Keynesian theory of multiplier alone does not offer a full and satisfactory explanation
of the trade cycles. A basic feature of the trade cycle is its cumulative character both on the
upswing as well as on the downswing i.e., once economic activity starts rising or falling, it
gathers momentum and for a time feeds on itself. Thus, what we have to explain is the
cumulative character of economic fluctuations. The theory of multiplier alone does not prove
adequate for this task.
6) Samuelson’s Model of Business Cycles:

Samuelson says, it is the interaction between the multiplier and accelerator that gives rise to
cyclical fluctuations in economic activity. The multiplier alone cannot adequately explain the
cyclical and cumulative nature of the economic fluctuations as stated by Keynes. An
115
autonomous increase in the level of investment raises income by a magnified amount
depending upon the value of the multiplier. This increase in income further induces the
increases in investment through the acceleration effect. The increase in income brings about
increase in aggregate demand for goods and services. To produce more goods we require
more capital goods for which extra investment is undertaken. Thus, the relationship between
investment and income is one of mutual interaction; investment affects income which in turn
affects investment demand and in this process income and employment fluctuate in a cyclical
manner.
Critical Appraisal
A major weakness of Samuelson’s Theory is based on the principle of acceleration in its rigid
form. If the rigid form of acceleration principle is not valid, then the interaction of the
multiplier and accelerator is not valid. Thus, Duesenberry writes, “the basic concept of
multiplier-accelerator interaction is important one but we cannot really accept to explain
observed cycles by a mechanical application of that concept’’.
8.3. Inflation and Expectations
Inflation has force of inertia because of expectation. There are three major types of
expectation; Naïve expectation: the situation where people expect that things will continue as
they are; Adaptive expectation: is backward looking, the case where people take past
experience in to account; and Rational expectation: is forward looking expectation, where the
expectation is not related to what happened in the past and in the present but in the future.
Under adaptive expectation, expected inflation is given as π e=π t−i where “i” is the
number of memorial period in the past. If we consider only one past period, the expected
e
inflation is given by π =π t−1 . This is because people form their expectation of inflation on
recently observed inflation. In this case the Phillips curve can be rewritten as follows.
π t =π t −1−β ( ¿−¿ n ) + v t
116
This equation states that inflation depends on past inflation ( π t−1) , cyclical unemployment
( ¿−¿n ) and supply shock (Vt).
a) The first term

π t−1 implies that inflation is inertial. If unemployment is at its natural
rate and if there is no supply shocks, prices will continue to rise at the prevailing rate
of inflation. Such inertia arises because past inflation influences expectation of future
inflations and these expectations influence the wage rates and the prices people set.
In Aggregate demand-Aggregate supply (AD-AS) model inflation inertia is interpreted as

persistent upward shifts in both aggregate demand and aggregate supply curves. If price level
is increasing people expect to continue to rise and this cause aggregate supply to shift
backward over time. Until some event such as recession, supply shock and/or change in
inflation and thereby change in expected inflation occur. Aggregate demand must also shift
backward in order to confirm expectation of inflation by increasing equilibrium price. This is
the result of persistent growth in money supply. If the central banks suddenly halt money
growth, aggregate demand would be stabilized and upward shift in aggregate supply cause a
recession. The high unemployment in recession would reduce inflation and expected
inflation, causing inflation inertia to subside.
b) The second term β ( ¿−¿n ) , cyclical unemployment exerts upward or downward

pressure on inflation. Low unemployment pushes inflation up called demand pull
inflation because high aggregate demand is responsible for this type of inflation. On
the other hand, high unemployment pulls the inflation rate down. The constant β
measures how responsive inflation is to cyclical unemployment.
c) The third term “Vt” shows that inflation also rises and falls because of supply shocks.
An adverse supply shock such as rise in world oil price of 1970s implies positive
value of Vt and courses inflation to rise. This is called cost push inflation because
adverse supply shocks are typically events that push up the costs of production and so
price level. A beneficial supply shock such as the oil glut (discovery and huge
extraction) of 1980s led to a fall in oil prices implies negative value of “V t” and
causes inflation to fall.
117
Wish you all the best!
Fentahun Baylie (MSc.)
-------------//--------------
118

1.1. Introduction To Macroeconomics: Chapter One

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

1.1. Introduction To Macroeconomics: Chapter One

Uploaded by

Copyright:

Available Formats

COMBINED MACROECONOMICS FOR AcFN STUDENTS

 The determination of the prices of particular commodities.

 The income of individuals, etc.

 The level and rate of growth of national level of output.

 The level of national un/employment, investment, wage and economic growth.

 Approach: microeconomics studies the problems of each of the constituents of circular

1.2. Evolution and Developments in

 Classical school (1776-1870): In this period, the distinction between microeconomics

 Keynesian school (1936-1970): The great depression of the 1930s compelled

The Aims of Government Policy

External Balance: what is a satisfactory balance of payments depends on the situation a

The Instruments of Government Economic Policy

The Incompatibility of Objectives

 The Traditional view

In the traditional view, national income is defined as follows:

''The national income or dividend consists solely of services as received by ultimate

GNP = GDP + Factor Receipts From Abroad - Factor Payments to Abroad.

GNP = GDP + Net Factor Income.

2.1. Approaches to National Income Accounting Process

2. The Treatment of Inventories

3. Intermediate Goods and Value Added

2.2.1. The Output Approach

2.2.2. The Expenditure Approach

Expenditure Components Value (in million Birr)

6) Income to Foreigners 14769.5

Gross National Income 60000.00

 Compensation of employees: The wages and fringe benefits earned by workers.

NNP = GNP - Depreciation.

National Income = NNP - Indirect Business Taxes + Subsidy

- Social Insurance Contributions

+ Government Transfers to Individuals

+ Personal Interest Income

Real GDP versus Nominal GDP

GDP = (Price of Apples × Quantity of Apples) + (Price of Oranges × Quantity of Oranges).

Real GDP for 2002 would be

+ (2002 Price of Oranges/ 2002 Price of Oranges× 2002 Quantity of Oranges)

Similarly, real GDP in 2003 would be

+ (2003 Price of Oranges/2002 Price of Oranges × 2003 Quantity of Oranges)

And real GDP in 2004 would be

+ (2004 Price of Oranges/2002 Price of Oranges × 2004 Quantity of Oranges).

Importance of National Income Statistics

Consumption constitutes significant share (part) of GDP in most economies. It is important to

APC+APS=1 and MPC+MPS=1

C=C+cY , C>0, 0<c <1 ,

Similarly, the saving function would be:

Where C is a constant [autonomous consumption], c is the marginal propensity to consume,

40 50 -10 1.25 -0.25 0.75 0.25

120 110 10 0.92 0.08 0.75 0.25

200 170 30 0.85 0.15 0.75 0.25

240 200 40 0.83 0.17 0.75 0.25

280 230 50 0.82 0.18 0.75 0.25

The concept of Multiplier

K=ΔY/ΔI since Y= C+I

Consumption is defined as C=Ca+cYd where Yd=disposable income given by =Y-T

.............................................................. This is called balanced

Where T=Tg-TR and TG=Ta+tY i.e. T=Ta+tY-TR

Y= Ca+c(Y-( Ta+tY-TR)) +I+G

The equilibrium output will be as follows in this case.

3.3. Money, Interest rate and Income

Demand for money

General equilibrium in the Economy

Goods Market and the IS Curve.

Saving (C) Saving (B)