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Advanced Macroeconomics for Africa I: Short-run Macroeconomics (MSc Level,

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The Historical Central Bank of Ethiopia

Advanced Macroeconomics for Africa I:
Short‐run Macroeconomics

Alemayehu Geda

Department of Economics
Addis Abeba University

Preface and Table of Content Alemayehu Geda 2

Advanced Macroeconomics for Africa I: Short-run

Macroeconomics
Alemayehu Geda
© Alemayehu Geda, 2020
DEPARTMENT OF ECONOMICS
ADDIS ABABA UNIVERSITY


For
John Weeks
(My dear & close friend whom we lost on July 26, 2020)
Prof. Jon Weeks (1941-2020)
Right top: John’s books which shaped my

thought a lot
Right bottom: Appearing with John in his

Economic Weekly Radio Program
“The Weeks Update” in London, 2018


Brief Table of Content

Advanced Macroeconomic for Africa I: Short-run Macroeconomics
Chapter 1 Historical Excursion in Macroeconomics & The African Macro Policy Discourse
Chapter 2 A Review of Dynamic Aggregate Demand and Aggregate Supply Analysis
Chapter 3 Rational Expectation in Macroeconomics
Chapter 4 Open Economy Macroeconomics and Its Application: The Mead-Mundell-Fleming Model
Chapter 5 Sectoral Demand Functions: Consumption and Saving Theories
Chapter 6 Sectoral Demand Functions: Investment Theories
Chapter 7 Sectoral Demand Functions: The Labour Market and Labour Market Theories
Chapter 8 Short-run Macroeconomic Policies and the African Context
Chapter 9 Ethiopia’s Macroeconomic Policy Challenges in Practice, 2000-2020 (in Amharic/በአማርኛ)
Advanced Macroeconomic for Africa II: Long-run Macroeconomics

Chapter 1 Introduction: African Economic Growth in Historical Perspective
Chapter 2 Neoclassic Growth Models: The Solow-Swan & the Ramsey-Kass-Koopman Theories
Chapter 3 The New Neoclassical Growth Model: The Endogenous Growth Theory
Chapter 4 Heterodox Growth Models I: The Kaleckian Growth Model & Financing Development
Chapter 5 Heterodox Growth Models II: The Kaldorian & the Thirlwall Growth Models
Chapter 6 Macroeconomics in Fragile States of Africa: Growth, Conflict and Macroeconomics
Chapter 7 Macroeconomic, Growth, Trade and Industrial Policies in East-Asian and African Successful
Developmental States and the Lesson for Africa


Detailed Table of Content

1. Introduction
2 Schools of Thought in Macroeconomics
2.1. The Keynesian Revolution over the Neoclassicals: The Birth of Modern Macroeconomics
2.2. The Neoclassical Synthesis Keynesians [NCSK]: Mr Keynes and the Classics
2.3 The New Classical Macroeconomics [NCM]
2.4 The New Keynesian Macroeconomics [NKM]
2.5 The Post-Keynesian Macroeconomics [PKM]
2.6 Structuralist Macroeconomics: The Kaleckian wing of the Post-Keynesian Macroeconomics
3. Macroeconomic Schools of Thought and the Macro Policy Discourse about African Economic Crisis
4. The 2008/09 Financial and Economic Crisis and the Future of Macroeconomics
Important Concepts for Review
Review Questions
References for Further Reding
Chapter 2 A Review of the IS-LM and Aggregate Demand and Aggregate Supply (AD-AS)
Analysis and their Dynamics
2.1 Mr. Keynes and the Classics: IS-LM and AD-AS Models
2.1.1 The IS-LM Model: The Goods and Money Markets
2.1.2 The Aggregate Demand and Aggregate Supply (AD-AS) Model and Policy Analysis
A. Short-term Policy Analysis using the AD-AS Model
B. Convergence and Stability Analysis
2.2 Towards Dynamic AD-AS and Dynamic Stochastic General Equilibrium (DSGE) Models
2.3 Applied Dynamic AD-AS Macroeconometric Models in Eastern and Southern Africa
Review Questions

3.1 The Concept of Rational Expectation in Macroeconomics
3.1.1 Definition: Types of Expectation
3.1.2 The Basics of Adaptive and Rational Expectation
A]. The Simple Income-Expenditure Model
B] A Microeconomic Example: A Demand and Supply Model for A Commodity
3.2 A Dynamic Aggregate Demand (AD) and Aggregate Supply (AS) Model with Rational Expectation
3.2.1 Building Blocks of The Dynamic AD-AS Model
3.2.2 Summary of The Dynamic AD-AS Model
3.2.3 Adaptive Expectation Version of the Model and Its Solution
3.3 Rational Expectation Version of the Model and The Policy Ineffectiveness Proposition (PIP).
3.3.1 Rational Expectation and the Policy Ineffectiveness Propositions (PIP)


3.3.2 Illustration using the above Dynamic AD-AS Model.
3.3.3 The Main Message of the Model
3.4 The Lucas Critique.
3.5 Policy Effectiveness with Rational Expectation: A New Keynesian Perspective
3.4 Application of Expectation in African Context: Expectations in an Exchange Rate Model for Zambia
Review Questions
Chapter 4 Open Economy Macroeconomics: The Mundell-Fleming Model & Weeks’ Critique
4.1 The Accounting Framework for Open Economy Macroeconomics (OEM)
4.1.1. The Accounting Framework in Brief
4.1.2. The Implications for the Global Economy: The World Accounting Matrix
4.1.3. The Implications for Macro Modelling and the Two and Three Gap Models
A.
Implications for Modelling and Policy Analysis
B.
Implications for the Theoretical Approaches: The Two-and Three-Gap Models and Africa
(i) The Two-Gap Model
(iii) The Three-Gap Model
(ii) Gap Models in African Context
4.2 The Mead-Mundell-Fleming Model (MMF/MF)
4.2.1 Introduction
4.2.2 Details of the MMF/MF Model
4.3 Weeks’ Critique of the MF Model
4.4 The Aggregate Supply Side of OEM with Armington Formulation
A. The Armington Approach
B. The Marshall-Learner Condition
4.5 A Brief Look at Exchange Rate Models and The Dornbusch Over-Shooting Model
4.5.1 Introduction
4.5.2 Models of Exchange Rate Determination
A. The Flexible Monetary Approach (FMA)
B. The Portfolio Balance Approach [PBA]
C. The Dornbusch Over-Shooting Model
D Example: The Overshooting Model and the Dutch Disease
4.6 Application: Open Economy Macroeconomics & the Macro Policy Framework in Africa
4.6.1 The World Bank- IMF [Bank-Fund] Growth and Adjustment Macro Framework for Policy use in Africa
A. The IMF Model (The Fund Model)
B. The World Bank Model
4.6.2 The Kaleckian/Structuralists Alternative Model of Growth and Financing Development in LDCs
4.6.3 An African Application of Open Economy Macroeconomics: The African Global Model
Review Questions
References for Further Redbug


Chapter 5 Consumption and Saving Theories
5.1 The Keynesian Consumption Function & Background to the Evolution of Other Consumption Theories
5.1.1 Keynes’s Consumption Function
5.1.2 The Data and Debate about the Keynesian Consumption Function: The Keynesian Consumption Puzzle
5.2 The Fisher Intertemporal Utility Optimization Framework as Micro Foundation
5.2.1 The General Micro-based Utility Maximization Approach to Consumption
5.2.2 The Consumption Function and Its Relation with Present Value of Income
5.3 The Life-Cycle Hypothesis: The Anod-Modigliani Approach
5.3.1 A Simple Formulation of the Ando-Modigliani Approach
5.3.2 The Ando-Modigliani Approach and Present Value of Income
5.4 The Permanent Income Hypothesis: The Friedman Approach
5.4.1 The General Formulation
5.4.2 A Two Period Model of Freidman’s Permanent Income Hypothesis
5.5 The Relative Income Hypothesis: The Duesenberry Approach
5.6 Shaik’s Critique of Deriving Aggregate Consumption Function from the Representative Agent Model
5.7 Saving and Consumption Theories in the African Context
5.7.1 Saving and Consumption Smoothing in Developing Countries
5.7.2 Saving and the External Sector
i) Saving, Aid and Borrowing
ii) Saving and Terms of Trade
5.7.3 Saving, Growth and Macroeconomic Policies
i) Economic Growth
ii) Fiscal Policy
iii) Financial Reform and Monetary Policy
iv) Macroeconomic Instability and Uncertainty
5.7.4 Demographic and Institutional Issues
i) Saving and Demographic Factors
ii) Saving and Institutional Issues
Review Questions
Chapter 6 Investment and Investment Theories

6.1 The Neoclassical Theory of Investment: The User-Cost Model
i) The Rental Price of Capital: The Rental and Producer Firms
ii) The Cost & Benefit of Capital: From the Rental Firm to Producer Firm
6.2 The Tobin-q Theory of Investment
6.3 The Acceleratory Theory of Investment
6.3.1 The Naïve Accelerator Model
6.3.2 The Flexible Accelerator Model
6.4 The Kaleckian Investment Theory: A Heterodox Approach
6.5 Investment Theories and Developing Countries: The crowding-in/out Hypothesis
6.5.1 The Crowding-in Crowding-out Hypothesis
6.5.2 Empirical Studies of Determinants of Private Investment in Africa (and other Developing Countries)


6.5.3 [Private] Foreign Direct Investment (FDI) and its Determinants in Africa
Review Questions
Chapter 7 The Labour Market & Labour Market Theories

7.1 The Aggregate Labour Market
7.1.1 The Demand for Labour
7.1.2 The Supply of Labour
7.1.3 The Expectation Augmented Philips Curve: The Aggregate Supply Curve and Labour Supply
7.2 Real and Nominal Wage Rigidities and Related Theories
7.2.1 Implicit Contracts
7.2.2 Efficiency Wage: A Simple Model
i) A Simple Model of Efficiency Wages
ii) Summers’ (1988) Reservation Wage
7.3 Other Theories of the Labour Market for Your Further Readings: Union and Search Models
7.4 Labour Market in Developing Countries with a Focus on Africa
7.4.1 The Theory
A. The Harris-Todaro Model
B. The Lewis Dual Economy Model
7.4.2 The Informal Labour Market in Africa
7.4.3 The Rural Labour Market in Africa
Review Questions
Chapter 8 Macroeconomic Policies and the African Context

8.1 Technical Aspects of Short-run Macroeconomic Policy
8.1.1 Fiscal Policy, Financing Development and Government Debt
A. Public/Government Revenue
B. Public/Government Expenditure
C. External Debt and Financing Development
8.1.2 Monetary Policy, Financing Development and Inflation
i) The Demand for and Supply of Money
A. The Demand for Money
B. The Supply of Money
ii) Financing Development: Monetization of Deficit, Domestic Debt and Inflation
8.2 Political Aspect of Macroeconomic Policy Making in Africa
8.2.1 The Washington Consensus and the Structuralist Critique of Macro Policy in Africa
8.2.2 History, Politics and Institutions in Policy Making: Why Nations Fail?
8.2.3 Macro Policy as Part of Industrialization Policy: The East Asian Success Story
Review Questions


Chapter 9 Macroeconomic Policies in Practice: The ‘Developmental State” Policy of the Ethiopian
Government and Its Macroeconomic Effect, 2000-2020 (in Amharic)
ምዕራፍ 9 የኢትዮጵያ ዐብይ-ኢኮኖሚ ሁኔታና መንግስት ወደፊት በኢኮኖሚዉ ዉስጥ ሊኖረዉ
የሚገባ ሚና
9.1 መግቢያ
9.2. የዐብይ ኢኮኖሚዉ (የማክሮኢኮኖሚዉ) መናጋት
9.2.1. የልማት ወጪ አሸፋፈንና የዐብይ ኢኮኖሚዉ መናጋት
9.2.2 የዉጭ ንግድና የክፍያ ሚዛን ክፍተትና የወጪ አሸፋፈኑ
9.2.3 “ልማታዊ መንግስቱ” የጠራ የንድፈሀሳብ መሰረት አልነበረዉም
9.3. የኢኮኖሚ ዕድገቱ መዋቅራዊ ለዉጥ አላመጣም፡ በመሆኑም ስራ-አጥነትና ድህነት የሚባለዉን ያህል አልቀነሱም
9.4. የ “ልማታዊ መንግስቱ” ሚናና ችግሩ ምን ነበር?
9.4.1 የኢህአዲግ የፖለቲካና-ኢኮኖሚ ገፅታና የዐብይ-ኢኮኖሚዉ መናጋት ያለዉ ትስስር
9.4.2 የሰለጠነ የሰዉ ሃይልና ቢሮክራሲ የሌለዉ “ልማታዊ መንግስት”
9.5. ማጠቃለያ፡ የመንግስት ሚና በኢኮኖሚዉ ዉስጥ ምን ሆነ አለበት
9.6 የጠቅላይ ሚኒስትር ዐቢይ የኢኮኖሚ ማሻሻያና ችግሩ፣2018:
ዋቢ መፅሃፈትና ፅሁፎች


Preface
This book is the result of my frustration about what kind of textbook to use in teaching macroeconomics for MSc level
students in African universities. My frustration comes from two angles. First, existing textbooks are either too basic and
relevant for undergraduate students (such as G. Mankiw’s ‘Macroeconomics’) or are too difficult for MSc level studies in
Africa, and perhaps also worldwide, and, hence, are usually reserved for PhD students (such as D. Romer’s or B. Heijdra’s
‘Advanced/Foundation of Macroeconomics’). This calls for advanced textbook that is neither basic nor difficult. The other source
of my frustration is the limited relevance of existing textbooks for developing countries in general and African countries in
particular. This book attempts to address these gaps in the teaching of macroeconomics in the continent.
I have a plan to produce this book in two volumes. The first volume, which is this book, will focus on short-run macroeconomic
issues. Short-run macroeconomics is generally related to fluctuation in economic activity and on how to manage that. That
in turn requires understanding theories behind the behaviour of major economic agents in the economy and the aggregate
(macroeconomics) consequences of their individual actions. This volume covers these issues. In volume two of the book I will
focus on long-run macroeconomic issues. The latter refers to theories about economic growth and the political economy of
growth in Africa.
So far, we African educators normally pick standard textbooks that are developed in the advanced countries and teach them
as such, without questioning their relevance in African context. Such books are, however, meant primarily for students of the
advanced countries. In addition, we also never question these theories by comparing them with possible alternative theories
that could be more relevant in the context of developing countries. This, I observed, is also frustrating some of the bright
African students that began to question the relevance of their study for their own reality. Thus, in this book I have attempted
to redress such weaknesses by adding sub-sections in each chapter that will examine the relevance of the theories expounded
in that particular chapter in African context. For the latter, I have used relevant research done on African economies. I also
provided alternative theories when that is possible. This makes the book a bit different from standard textbook because it is
the result of a cross-fertilization of the standard textbook approach and a research book. I hope that once students have
gone through this book, they will not be frustrated about the relevance of their graduate studies for their work out there in
the real world. Students will not miss the standard basic theories thought in advanced countries either, because these are
also discussed rigorously in the book. This is done because to question them one has to know them first.
This book is part of my continuous effort to make economics relevant for Africa and African problems through textbook
development by focusing on my areas of expertise. Two of my previous works on “International Trade for Africa” and “Applied
Timeseries Econometrics for Africa” are part of this endeavor. The latter book is written with my friend Prof. Njuguna Ndung’u
of AERC, University of Nairobi and former governor of the Central Bank of Kenya. These books are published by AERC and the
University of Nairobi Press and are being in use by many students and educators across the continent. For Ethiopian students,
the current book has one additional chapter about the evolution of the Ethiopian macro economy in the last two decades. It
also critically reviews the ‘developmental state’ policy of the Ethiopian government and its recent reform. The chapter is
written in Amharic, perhaps for the first time in economics textbooks. My 2019 Amharic translation of Kalecki’s famous and


classic development macroeconomics book, “Essay on Developing Countries”, by relating it to Ethiopian/African economic
thinkers such as Gebre-Hiwot Baykedagn’s macroeconomic theory developed nearly 100 years ago is also part of this effort
to ground economics on African reality, original thinking and the aim of making it more accessible to Ethiopian readers and
students. As a continuation of such endeavor, my next ambition is to work on the second volume of this book and also to
develop this first volume to another PhD level textbook of short-run macroeconomics for Africa which is dearly missing in
African universities and research centers. The latter is very important because the relevance of current textbooks used in
advanced and African countries alike, such as “Foundation of International Macroeconomics” by Obstfeld and Rogoff is
extremely limiting in African context. I am currently using the draft of this PhD level textbook that I have developed based on
my 2002 book on the Macroeconomics of Finance and Trade in Africa (Palgrave) for teaching my PhD students. I hope to
develop and bring this to you soon. I hope other African and Africanist scholars will follow me on this journey by developing
such African-relevant textbooks in their area of expertise (I would like to acknowledge here Prof Mukas’, formerly University
of Nairobi and Prof. Ddumba-Ssentamu’s ,of Makerere University in Uganda, effort on this by producing economics textbooks
for undergraduate students in Africa). It is important to encourage the young generation to look deeper and critically on
his/her continent’s problem starting from their time in the universities by producing such textbooks. This helps to produce
graduates and researchers tuned to solve the continent’s problem. Without that, our ambition for industrialization and
development as a country and as a continent may not be successful.
I dedicated this book to my close friend, excellent boss and mentor Prof. John Weeks whom we lost this year on July, 26. I
met John while he was introducing the publication of his excellent book “Critique of Neoclassical Macroeconomics” at my
former university (ISS, Erasmus University) in the Netherland while I was a first year PhD student. Then he came for the
second time from the University of London, School of Oriental and African Studies (SOAS), being my PhD thesis external
examiner. I, together with my friend, fellow PhD student Alex Izurieta, were impressed with the book and began reading it line
by line and marking nearly all the book, for you couldn’t find a sentence that you do not want to mark on it. Many years later,
I gave that book to one of my brightest students at Addis Abeba University, Kibrom Taffer (who recently finalized his PhD at
Cornel university and currently working at the World Bank, in Washington, D.C) and advised him to read it. After reading it,
Kibrom told me that the book has dismantled all his study in macroeconomics while doing his BA degree at Addis Abeba
University (AAU). This is understandable because at AAU, even today, we religiously teach mainstream (neoclassical)
economics. That book is that good and shaped me in many ways.
I met John later, after I finished my PhD study and began working in Ethiopia and Kenya. John later became my boss when he
was the Chair of the Department of Economics, SOAS, University of London (2003-2005) during which time I was a senior
lecturer at the same department. Since then, we have done a number of policy studies on African economies together until
his last days. As you will see later in this book, John has left his intellectual imprint on many, myself included, and the result
of his critical mind is already incorporated in Chapter 4 while I discuss his penetrating critique on the relevance of the
Mundell-Fleming model in the context of developing countries. John was not only a brilliant heterodox economist and prolific
writer and educator; he was also a super human being. I remember one time, John and myself were to travel to South Africa
to do some research. He told me that he always feels uncomfortable when he travels to South Africa. I asked him why? He
said, ‘it reminds him of home’. You see, John grew up in old Texas in US where he was disgusted by the racism on black
Americans that he saw growing up. Rest in peace. Another giant African economist that we lost this year and to whom I was
close is Prof. Thandika Mkandawire of the London School of Economics, UK, and former executive secretary of the Council for


Development of Social Science Research in Africa (CODESERIA), Dakar, Senegal. I always put his 2001 article on the “African
developmental state” as a must-read paper to my students. We will miss his penetrating analysis but we will live with his
legacy, a legacy of critical thinking of received wisdoms about African underdevelopment and come up with alternatives
grounded on history, politics and economics. Rest in peace Thandika.
Finally, I must say that in book of this kind it is difficult to be original. Thus, I would like to acknowledge and thank some superb
textbook authors such as G. Mankiw, W. Branson, Agénor, Pierre and P. J. Montiel, Peter R. Sorensen and Hans J. Whitta-
Jacobsen, Ben Heijdra and my former professors, Prof. E. V. K Fitzgerald (University of Oxford), Prof. Rob Vos (IFPRI) and
Prof. M. Wuyts (Erasmus University, IISS) for using their ideas and their books in the course of writing this book, which is
difficult to acknowledge specifically as some of their contribution is in shaping my thinking about economics, applied
econometrics and economic research. Dr Addis Yimer, Belen T. Sadik, Mikael-Belen Alemayehu, Addis Tedela and Aklil Geda
were supporting me when writing this book, sometimes without knowing it. Addis Yimer, in particular, was also behind the
first draft of Chapter 5 and I am especially grateful.
Alemayehu Geda
Addis Abeba University, Ethiopia
September, 2020,
(Back Cover, next)


About the Author
Alemayehu Geda is currently Professor of Macroeconomics and
International Economics at the Department of Economics, Addis Abeba
University, Ethiopia. He is also a Research Professor at the University of
London, SOAS, UK where he had served as Senior Lecture between 2003-
2005. He is also a Research Associate at the African Economic Research
Consortium (AERC) in Nairobi and Economic Policy Research Center
(EPRC), Makerere University, Kampala. He also served as a scientific board
member of the Council for Development of Social Science Research in
Africa (CODESERIA), Dakar, Senegal between 2016-19. His research interest areas include International Trade, Development
Finance, Macroeconomic Policy, Macro Econometric Modelling and the Political Economy of Conflict in Africa. He is the author
of over 60 research journal articles and chapters in a book and 6 books on African economies that are published, among
others, by Palgrave-Macmillan, Addis Abeba University and University of Nairobi Presses. He has also worked for a number
of international organizations and African governments that includes the governments of Ethiopia, Kenya, Uganda, Zambia,
Sudan and South Africa as a consultant. Among other expert services, he has served as macroeconomic expert for African
Union (AU) high level panel on the economic negotiation between the North and South Sudan which was led by the former
South African president Tambo Mbeki by preparing and presenting for the negotiating parties the macroeconomic framework
for the negotiation between the two countries.

 Bridges the gap in the current textbook levels of rigor where popular textbooks are appropriate either for first
degree students or PhD level students. The middle level is missing. This book bridges this gap.
 Covers standard short-run macroeconomic topics such as consumption, saving, investment, aggregate demand and
aggregate supply models, rational expectation, labour market, macro policy, open economy macroeconomics that
are rigorously dealt with in the book. Thus, students will not miss the standard theories. In addition, these chapters
are accompanied by alternatie and critical heterodox theories so that students can have different perspective about
macroeconomic issues discussed in the book.
 Makes macroeconomics relevant to Africa by adding in each chapter a section on how each of the theories discussed
in each chapter are related and relevant to the African context. This is done based on macroeconomic research
conducted on Africa by many researchers that includes research done by members of the African Economic
Research Consortium (AERC), the prime economic research and training center in the continent.
 In the Ethiopian version of the book, the macroeconomic evolution of the Ethiopian economy in the last two decades
(2000-2018) of the EPRDF period, as well as the reform policy of the new government is also included. This chapter
is written in Amharic to make it more accessible to Ethiopian students and general readers in Ethiopia.
 Through these efforts the book makes teaching of macroeconomics in Africa at graduate (MSc) level rigorous yet
accessible; theoretically advanced, yet relevant to concrete reality in Africa. The book can also serve as a good
introductory macroeconomics book for first year PhD students and macro researchers.
The National Bank of Ethiopia

ADVANCED MACROECONOMICS FOR
AFRICA I: Sort‐run Macroeconomic

Alemayehu Geda


1
Ch 1: Historical Excursion in Macroeconomics Alemayehu Geda
ADVANCED MACROECONOMICS FOR AFRICA I: THE SHORT-RUN

With a Focus on Africa & Developing Countries
Alemayehu Geda

© 2020
2

Chapter 8 Short-run Macroeconomic Policies and the Africa Context

3
Chapter 1: Historical Excursion in Macroeconomics & The

African Macro Policy Discourse
…..As for foreign expertise, this is one variable that is often conveniently forgotten in looking at
the malaise of the African state. Nevertheless, international institutions do, on occasion, admit
that their role in African policy-making has been a major [negative] contributory factor to the
policies African countries have pursued. Most policies that are today attributed to
neopatrimonialism and rent seeking were the orthodoxy of the day brough to Africa in well-
funded and well-manned packages. The lack of ‘policy ownership’ is not a new thing in Africa and,
alas, not a thing of the past either.
Thandika Mkandawire (2001), Thinking about the Developmental State in Africa
1.1 Introduction
This is an introductory chapter that attempts to give the background for the study of short -run macroeconomics. Broadly,
macroeconomics could be divided into short run and long-run macroeconomics. The latter refers to growth issues which are
usually given in a separate course. The focus of this book is on the former. The starting point for short-run macroeconomic
analysis is to understand the factors behind short-run macroeconomic fluctuation and what policies need to be pursued to
have a stable macroeconomic environment directed at fulfilling the objective of raising the standard of living of the population
through sustainable growth. This short-run aspect of macroeconomics is sometimes referred as business-cycle theory in
advanced countries. Thus, if we agree with Keynes’s famous statement that “in the long-run we all are dead”, short-run
macroeconomics is crucial. Macroeconomists have different views about what causes such short-run macroeconomic
fluctuations and what policy needs to be pursued to stabilize the economy. Thus, it is important to give a brief background
about such different schools of thought in macroeconomics to get a perspective about concepts and theories discussed in
the book.
Although it is sensible to argue that classical economists such as Ricardo, Mill and Marx were concerned with aggregate
trends of the economy, David Hume and Cantillon, building their argument on an earlier work of Thomas Mun (1630), could be
regarded as the earliest macroeconomists who wrote about linkage between money supply, the trade balance and price
(called the specie-flow mechanism) in eighteen century (Blaug, 1996). Similarly, the works of quantity theory of money in
eighteen and nineteen centuries by people like the British philosopher David Hume (see Chapter 8), were important
macroeconomic works before the recognition of macroeconomics as an important discipline in the twentieth century. Three
events are found to be important for the development of this branch of economics as we know it today – as Modern
Macroeconomics. First, the development of collecting and systematizing aggregate economic data. Second, the identification
4
of business cycles as recurrent phenomena; and finally, the event of the great depression that started in 1929 where the
Western (industrialized) economies were characterized by unprecedented level of decline in output and rising unemployment.
The great depression knocked the underling notion of the neoclassical economists, who believed that a free market economy
(guarded from state intervention) will ensure continuous equilibrium and prevent large-scale and sustained unemployment.
This belief is essentially based on Say’s law which states that supply creates its own demand. This was contrary to what
happened in 1930s in the industrialized countries, popularly termed as the ‘great depression’. The great depression was
characterized by unparalleled level of unemployment and declining level of output (see Figure 1.2). In the aftermath of this
event, the British economist J.M. Keynes (1883-1946) wrote a path breaking work in 1936 termed The General Theory of
Employment, Interest and Money. In this book, Keynes argued that market economies are not self-regulating and cannot
guarantee low level of unemployment and higher level of output. He, continued, events such as the great depression cannot
be corrected by market forces alone. Keynes also noted the major cause of the great depression is lack of ‘effective demand’
(effective demand refers to demand that is backed by purchasing power; see Box 1.1). Thus, for Keynes, the government needs
to intervene through appropriate policies. Since Keynes regarded the major cause of the crisis to be aggregate demand
deficiency, he recommended fiscal policies designed to raise demand (such as lower taxes and higher government spending
and relevant monetary policy). Interestingly, the Polish economist Michael Kalecki discovered the basic ideas of Keynes before
Keynes, yet not given due consideration for his penetrating analysis partly because he was writing in Polish and was also not
as famous as Keynes (see Kalecki, 1933, 1934, 1935). For nearly 25 years following World War II, Keynes’ paradigm was
accepted throughout the world. It is also re-emerging following the 2008-09 global financial-cum-economic crisis as well as
the economic effect of the 2020 global COVID-19 pandemic and the policy response required to stimulate the economy. In
both events, governments throughout the world resorted to the Keynesian policy of fiscal policy, coined now as “stimulus
packages”.
Box 1.1 Effective Demand and the Fallacy of Micro Thinking at Macro Level
I had this brilliant macroeconomics teacher when I was an undergraduate student at the department of Economics, Addis Abeba
University. His name was Ahmed (latter he did his PhD in UK and came back to Ethiopia; and, sadly, died soon after. He used to teach us
with a projector, even at that time, for he had an accident from which he lost his walking ability and has to use a wheel chair). In one of
his classes he read for us a news paper clip with an interesting story about effective demand (and also a micro level rationality with
macro level irrational implications). I heard this story when I was a 3rd year undergraduate student at the age of 19 and still it is in my
mind after decades. The story runs as follows. Two entrepreneurs were having a coffee and they were talking about their factories and
workers. The first entrepreneur Mr John has a shoe factory and was talking to the second one, Mr Taylor.
Mr. John: Good morning Mr Taylor, have you heard about the new robot that I have installed in my shoes factory?
Mr Taylor: No, I haven’t, what are its advantages?
Mr John: Well, as you know my workers were bothering me in many ways: they always ask for higher pay through their union; they don’t
come on time; once in the factory they go to the cafeteria and spend a lot of time there and many more. Now, since the robot
completely replaced them, I do not need them anymore.
Mr. Taylor: Well, that is good; but do the robots wear shoes? Who will buy your shoes?
5
Thus, macroeconomics had been completely forgotten for over one to two centuries since the works of classical
macroeconomists, which were referred as political economists at that time (and their subject Political Economy). Until the
great depression of 1929, the market clearing model (the free market philosophy) was the dominant economic thinking and
teaching. This is exemplified by the famous textbook in use just before the great depression -Alfred Marshall’s ‘Principle of
Economics”. This Marshallian economics is essentially what we call microeconomics or neoclassical economics today. It is
based on understanding of different markets (the product, the labour, and the money markets) and how excess demand and
supply in these markets clears through prices. When all markets clear we have the general equilibrium – referred sometimes
as the Walrasian general equilibrium, following the works of the French economist Leon Walras (1834-1910) who developed
the market clearing general equilibrium system. This market clearing model is guided by Say’s law. J. B. Say was said to be
the intellectual ancestor of Walras (se Schumpeter, 1954). Say’s law says “supply creates its own demand”. According to the
latter, demand is not, thus, a problem and the market is self-regulating if we avoid intervening in its operation. Figure 1.1
shows the evolution of this economic thinking in the last two centuries.
Figure 1.1 Schools of Thought in Macroeconomics
Neoclassical School
Pigou
structuralists
Source: Marc Lavoie (2006). Introduction to Post-Keynesian Economics

The 1929 great depression was characterized by below capacity operation of firms due to aggregate demand failure (a fall in
effective investment and consumption demand) on the grand scale. This has led to output collapse and created huge
unemployment and human misery in developed Western economies (Figure 1.2). This economic crisis was so dramatic that
made the famous American economist G. Mankiw to say ‘even the viability of capitalism as a system was questioned’. The
effect of the great depression has been even felt in Africa which were colonies of the Western countries during this time (see
Alemayehu 2002; 2019). The great depression has shown that the market clearing (the free market) based economics of the
time – the Marshallian economics - is wrong because if supply creates its own demand, such demand failure on the grand
scale wouldn’t have occurred. In addition, if markets were self-regulating, the excess demand or supply in these markets
6
(such as the unemployment in the labour market) would have been corrected automatically and we wouldn’t have seen the
huge unemployment of the time. It is at this point in time Keynes questioned this economics and came up with his 1936 path
breaking book noted.
Thus, unlike the teaching of the Marshallian economics – to whom Keynes referred as “classical” economists (he should have
said neoclassical economists) - , for Keynes, supply couldn’t create its own demand and markets couldn’t clear automatically
as envisaged by them. That is why unemployment was rampant since 1929 and this in turn was the result of aggregate demand
failure that led to output failure (Figure 1.2). At the time, this idea of Keynes was a radical idea. As a result, his economic
thinking is referred as “the Keynesian revolution”. With this view and analysis, Keynes’ book gave birth to what we call today
“Modern Macroeconomics”.
Be that as it may, various group of economists (or schools of macroeconomics) began to offer diffident interpretation to
Keynes’ book or his macroeconomics. One of the famous interpretations is that of Hicks in 1937 (and latter Modigliani, 1944).
Hick’s article, entitled “Mr. Keynes and the Classics”, laid the foundation for what is called the IS-LM model today. In section
two below1 we will briefly discuss the salient features of each of these different schools of thought beginning in 1936. In
section three an attempt to offer the macroeconomic framework and macro policy discourse in Africa since the 1980s is
made. The later was informed by neoclassical economics and was the source of the liberalization policy that was imposed on
Africa by the World Bank, the IMF and rich countries (the West), with disastrous effect on African growth and poverty
reduction effort. Finally, section four will discuss where modern macroeconomics stands today, especially following its failure
to predict, explain and provide remedial solution to the 2008/09 global financial and economic crisis in advanced countries
(or the West). In this chapter we will not dwell upon the details of each school of thought in macroeconomics. Rather, we will
briefly note the salient features of the major schools to give a context for the rest of the book.
Figure 1.2 The Unemployed during the great depressor waiting for a free meal, New York, 1931, from John Weeks (2012)
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2.1 Schools of Thought in Macroeconomics

2.1.1. The Keynesian Revolution over the Neoclassicals: The Birth of Modern Macroeconomics
John Maynard Keynes Michal Kalecki
Keynes and Kalecki are the founders of modern macroeconomics. For Keynes, as a famous British economist that grew up
learning the Marshallian economics (or the market clearing model/neoclassical model), it was difficult for him to break out of
this neoclassical thinking. This was not a problem for Kalecki who was an engineer in Poland and not trained in economics of
any sort. Notwithstanding that, with the publication of his 1936 book Keynes has shown that price flexibility (especially wage
flexibility) is not a remedy for the great depression and markets are not self-regulating. That is, even if you can push, say, the
wage rate downward as much as you can to eliminate the unemployment problem, output and employment will not increase.
Thus, the huge unemployment that occurred during the great depression and lasted between 1929-1933 couldn’t be relived
automatically through the operation of the free market advocated by neoclassical economists.
For Keynes and Kalecki the fundamental problem that led to the great depression was aggregated demand failure. Keynes
examined this aggregate demand failure by looking deeper at its components which are investment and consumption. Thus, the
foundation for the investment and consumption theories that we will learn in Chapters 5 and 6 is laid by Keynes. There are two
important points that we need to note from Keynes’ economics. The first relates to the way he perceived his economics. Keynes
thought that his theory is a general theory and the economics before him – the Marshallian or neoclassical market clearing
economics – is a special case of his theory that emerges when Say’s law holds. The real existing world for Keynes is far from
the Say’s law; and the market-clearing model for him is a theoretical postulate only. The second important point relates to the
policy implications of his theory. The economic thinking before Keynes was informed by a market clearing model and its
proponents strongly believed in the self-regulating capacity of the market. This means if there is excess demand in a certain
market (be it in goods or labour or financial market) the price of that commodity in question, including wage, will go up and
economic agents will increase supply in the subsequent period. If the market is such self-regulating, government intervention
in the working of the market is distortionary as it spoils the optimal allocation of resources that follows the law of demand and
supply. Keynes’s major departure is that for him markets are not self-regulating and government can play an important role
to tackle the aggregate demand failure problem through policy interventions, especially fiscal policy intervention. For instance,
by reducing taxes or directly increasing government spending such as by using public works, the government can raise
8
aggregate demand which in turn raises aggregate output and employment. These basic ideas were developed independently and
before Keynes by Kalecki since 1932.
Notwithstanding the similarities of their ideas, there is also a fundamental difference between Kalecki and Keynes. For instance,
the importance of distribution of income in macroeconomics and the class nature of such distribution was important for Kalecki
but not that important for Keynes. As the famous heterodox British economist Joan Robinson once noted, quoting Kalecki, for
Kalecki through a policy of raising aggregated demand, “capitalists get what they spend and works spend what they get”. Such
issues are picked latter by Post Keynesian and Structuralist economists, discussed briefly below. Commenting also why
Keynesian economics was picked in the US universities but not Kalecki’s, she said, “both were holding a mirror up to modern
capitalism, but Keynes’ mirror was somewhat misty while Kalecki’s was too bright for comfort”.
2.1.2. The Neoclassical Synthesis Keynesians [NCSK]: Mr Keynes and the Classics
John Hicks James Tobin Paul Samuelson Franco Modigliani
Many of the best students who went to the economist profession during the great depression (such as P. Samuelson, J. Tobin,
J.R. Hicks, J. Mead) recognized that the unemployment problem witnessed during the 1929 depression was not a temporary
event that should be left to the ‘self-adjusting’ market forces (or to the invisible hand of Adam Smith). Yet, they had been trained
in the neoclassical economics tradition. The latter forced them to hold on to the fundamental neoclassical/classical axioms that
Keynes had managed to drop. These classical axioms are (Davidson, 1994):
1. The neutrality of money or simply Say’s law - supply creates its own demand (and, hence, change in money supply
affects only nominal values, through change in price, not real values)
2. The gross substation axiom -everything is a substitute for everything else (e.g. labour for capital)
3. The axiom of ergodic economic environment -i.e.; the future can readily be predicted by studying past data.
For these economists the classical axioms are by definition universal truth (Davidson, 1994: 8-17). The dilemma in which they
found themselves forced these economists to try to translate and formalize Keynes’ conclusions that are offered in the General
Theory’ in the neoclassical theoretical framework. This became popular in many universities, following the IS-LM model of these
economists - specially of Hicks and Modigliani. The title of Hicks’ famous article - “Mr. Keynes and the classics” that led to the
famous IS-LM model encapsulates this thinking. Thus, these economists attempted to develop Keynes’ insight through
9
neoclassical theory that they had been brought up by introducing ad hoc supply constraints (such as fixed wages and fix-prices)
on the workings of the ‘invisible hand’ (Davidson, 1994: 9). This school of thought which dominated the macroeconomic discourse
for nearly three decades following W.W.II is termed as the Neoclassical Synthesis Keynesianism (NCSK). To underscore the
distortion of Keynes’ original views by this school, the famous critical economist Joan Robinson termed the NCSK as ‘bastard
Keynesianism’. We will discuss this model and its famous IS-LM framework and Aggregate demand (AD) and Aggregate Supply
(AS) model in Chapter 2. This school of thought is also sometimes termed as the Old Keynesian, as oppose to the New Keynesian
discussed below.
We need to take two important points from NCSKs. The first point is that they believe in the classical system of market clearing
model. However, they also found Keynes’s argument compelling. Thus, they attempted to cast Keynes’ system as a special case
of the classical system, which for them is the general system. The second point about them is to see how they attempted to
explain the emergence of this special case of Keynes. They came up with the special case argument by arguing that Keynes’
system is nothing different from the neoclassical market clearing model. It appeared different, they argued, simply because of
the existence of rigidities in some markets which gave birth for it. For instance, if a country has a minimum wage policy and
there is excess supply of labour in the labour market, the related unemployment problem of that nature cannot be solved by
downward flexibility of wages because of this minimum wage law (the wage rigidity) – thus resulting in unemployment problem
that Keynes is talking about. In this argument, they basically say that had it not been for this rigidity called minimum wage, the
self-regulating market would have solved the unemployment problem through lower wages that would have led to an increase
in employment. Thus, the important point in the NCSK is that ad hock rigidities such as this are causes of economic miseries
such as the unemployment problem observed during the great depression.
The foundation for this school is laid by Hicks in his classic 1937 article “Mr Keynes and the Classics” as well as Modigliani (1944)
in his article ‘Liquidity preference, interest and money”. These articles laid the foundation for what we today call the IS-LM
model. The Hicksian IS-LM model did not explicitly include other markets such as the labour market in its general equilibrium
set up. This was left to Modigliani (1944) who completed the Hicksian analysis by incorporating the labour market and many
more improvements (see Chapter 8). Thus, before Modigliani (1944) the Hicksian IS-LM framework was basically in line with
Keynes’ idea because it contains no supply constrained point of equilibrium advocated by classical and New classical economists.
This Hicks-Modigliani IS-LM framework (but customarily called Hicksian framework though Modigliani contributed as much, if
not much more) shows a continuum of possible equilibria constrained by aggregate demand. However, behind this formulation
lays an implicit general equilibrium model. Thus, the Keynesian model is placed under the Wallrasian framework (see Palley,
1996: 34). Modigliani’s incorporation of the labour market in the Hicksian framework offered an interpretation of the General
Theory as ‘special case’ of the general equilibrium model in which nominal wages are downward inflexible in. The latter implies
the existence of involuntary unemployment which Keynes was claiming is the result of deficiency of aggregate demand while
the NCSK blames it on downward inflexibility of wages. For the latter wage flexibility would have eliminated this involuntary
unemployment. This idea of the NCSK that looks at Keynes’ system as special case is not acceptable for many economists. Below,
we will see the Post-Keynesian school of thought that is critical of this idea and argue that the Keynesian system is not a special
case of the classical. Rather, it is a General system and a revolution over neoclassicals which is aborted by the NCSK as well
as by New Keynesians and New classicals.
Snowdon and Vane (2005) well summarized the NCSK by saying that, this “… synthesis of the ideas of the classical economists
with those of Keynes dominated mainstream economics at least until the early 1970s. The standard textbook approach to
10
macroeconomics from the period following the Second World War until the early 1970s relied heavily on the interpretation of
the General Theory [of Keynes] provided by Hicks (1937) and modified by the contributions of Modigliani (1944), Patinkin (1956)
and Tobin (1958). Samuelson’s bestselling textbook [Economics] popularized the synthesis of Keynesian and classical ideas,
making them accessible to a wide readership and successive generations…”. “It was Samuelson who introduced the label
‘neoclassical synthesis’ into the literature in the third edition of Economics, in 1955”.
Another lasting impact of the NCSK approach is the development of large scale macroeconometric models that are being used
as tools for policy analysis until today. Even today, a number of African countries such as Kenya, Zambia, Namibia have such
models in their ministries of finance and central banks for use in policy analysis and forecasting (these African applied
macroeconometric models are briefly discussed in Chapter 2).
The end of the NCSK dominance could be related to the Phillips-curve which itself is related to the NCSK thought. Until the 1970s
it was believed that there was a trade-off between unemployment and inflation. That is, there was a belief that if attempt to
tackle inflation through policy, say, through contractionary fiscal or monetary policy, is made, it will lead to lower output and a
rise in unemployment and vice-versa - this is what is called the Phillips-curve. By the 1970s, researchers observed that both
inflation and unemployment were rising simultaneously in industrialized countries. This is termed as “stagflation”
(stagnation/unemployment and inflation). This and Freidman’s theoretical attack on it (see Chapter 7) has put an end to the
Phillips curve. This has also contributed to the end of the NCSK dominance and the emergence of the New Classical and New
Keynesian schools and their dominance in the macroeconomic discourse since then.
2.1.3 The New Classical Macroeconomics [NCM]
J. R. Lucas Milton Friedman Edward C. Prescott Thomas J. Sargent
By the end of the 1970s, NCSK is declared dead by younger generation of technically trained classical scholars who called
themselves New Classical (NC) economists (Davidson 1994). These economists basically go back to the invisible hand doctrine
and emphasize the importance of ‘lassies-faire’ (or ‘free market’, the market clearing model). As that of the NCSKs, the NCs
obey to the three classical axioms stated above and emphasized the use of advanced mathematics to specify their model. In
the words of Paul Davidson, these economists emphasize,
the beauty of an intellectually precise, highly mathematical system that would demonstrate with hi-tech
precision that the economic system could always achieve a full employment equilibrium as long as
mechanisms consistent with classical axioms are the fundamental analytical building blocks. One of the
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founders of this school, Robert Lucas [the 1996 Nobel prize winner for his application of the rational
expectation hypothesis to macroeconomics], agreed that the axioms required made New Classical analysis
‘artificial, abstract, patently unreal’1, [yet] Lucas insisted that these postulates were necessary. They
embodied the only scientific method of doing economics (Davidson, 1994:11)
This approach is implemented by searching for what are called deeper parameters (parameters of agents’ behavior and
technological relations) that are grounded on micro-foundation. Thus, in NC approach the macro (aggregate) need to be a
generalization of the behavior of a “representative agent” which will be modelled adequately in terms of consumer and firm
behavior. As a result, since the surge of New Classical macroeconomics, the “representative agent” based micro foundation
for macro analysis became the work-horse of modern macroeconomics (both for NCs and New Keynesians). Note that this
a fundamental departure from the classical (say Ricardo and Marx) as well as Keynes’ approach to macroeconomic analysis
where macro aggregates are not simply the aggregation of individual behavior and that macroeconomics was concerned
about the relationship between aggregates. For Keynes as well as classical economists such as Ricardo and Marx, the macro
is more than the sum of individuals. This is sometimes referred as “emergence” or “emergence properties” (see Shaikh,
2016; Alemayehu, 2017 for details of this methodological approach). Having such methodological approach, the attack on the
NCSK by NCs in the 1970s is also associated with NC macroeconomists’ doubt about the effectiveness of the Keynesian
aggregate demand management policies and, hence, government intervention to stabilize the economy.
This school is associated with the works of, inter alia, Robert E. Lucas Jr., Thomas Sargent, Neil Wallace, Robert Barro, Edward
Prescott and Patrick Minford (see Hoover, 1988; Snowdon and Vane, 2005). The schools’ basic ideas are formulated by
combining the rational expectations hypothesis (first developed by John Muth in the context of microeconomics in the early
1960s), the assumption that markets continuously clear, and Friedman’s natural rate of unemployment hypothesis. Like that
of the neoclassical economists, they believe that the economy is inherently stable and self-regulating if government
intervention is kept at bay. Thus, they are known for what is called the “Policy Ineffectiveness Proposition” (PIP) which
basically says that because economic agents are rational, they can anticipate policies and act accordingly, making the policy
ineffective. As a result, only unanticipated and random monetary actions should be taken by governments to have a short-
run effect because they may not be anticipated by rational economic agents (see Sargent and Wallace, 1975, 1976; Snowdon
and Vane, 2005). These issues are discussed in detail in Chapter 3 of this book.
An influential idea which is related to the rational expectation revolution in macroeconomics of the NCs with implications for
the PIP is what is called the “Lucas Critique”. The latter is related to critique of using large scale macroeconometric models
that were based on the IS-LM and aggregate demand and aggregate supply approaches for policy use. Large scale
macroeconometric models were popular in developed countries until the 1970s.The Lucas critique says that such models
have parameters that are estimated using adaptive expectations that are based on information available in the previous
regime. If we were to assume rational expectation, such models cannot be used for policy analysis because the parameters
of the models cannot be used to predict economic behavior under new policy regime. This is because the change in policy
regime (or the policy simulation to be carried out using these models) will affect economic agents’ behavior and, hence, the

1
Note that there is a philosophical justification for this approach. For instance, Friedman (1953) argues that as long as the prediction of a
theory is right the realism of assumptions used in the theory is not important to judge. the theory. This methodological approach is referred as
‘positive economics’ (see Alemayehu, 2018 for detail and the implication of this methodology for policy research in Africa).
12
parameters themselves that formed the model will change when the policy changes (or simulated). These issues are
discussed in Chapter 3.
Another, final, influential idea related to policy in the NCs approach is the idea of Kydland and Prescott’s (1977) about “dynamic
time inconsistency” which eventually won them the Nobel prize in Economics in 2004. Dynamic inconsistency refers to a
situation in which a decision-maker’s preference changes over time, thus, his/her preference becoming inconsistent over
time. The policy implication drawn for monetary policy was that economic performance can be improved if discretionary
powers are taken away from the authorities so as to avoid the frequent political intervention which is bad for the economy
and its stability. This offered another argument for monetary policy to be conducted by rules rather than discretion (Snowdon
and Vane, 2005) – an idea initially developed by Freidman in a paper presented to American Economic Association in 1967
and published in 1968. These, in nutshell, are the basic ideas behind the NC macroeconomics schools of thought.
2.1.4 The New Keynesian Macroeconomics [NKM]
G. Mankiw John B. Taylor Joseph Stiglitz Allan Blinder
Starting in the 1980’s a new school of macroeconomics, named ‘New Keynesian’ (NK) has developed. This school obeys to the
three axioms of classical theory that we have stated above. It also adheres to the methodology of the representative agent
based micro foundation for macroeconomics as that of the NC school. Like that of the NCSK, the NK believe that rigidities
could be behind the problems of high unemployment and low level of economic growth. However, the New Keynesian advance
over the Old Keynesians (the NCSK) relates to the development of sophisticated (and hence non-ad hock) rigidities or
constraints on the condition of aggregate supply and demand which are grounded on economic agents’ behavior as well as
the condition of the market in which these economic agents function. The list of such constraints includes, among others,
fixed nominal and real values that include sticky prices, menu costs, coordination failure and asymmetric information in the
context of which supply and demand decisions are made (Davidson, 1994: 9). If prices were perfectly flexible and information
is freely available, their idea coincides with that of the free market force advocators such as the NC school followers. Both
Old and New Keynesian models accept that the classical (market clearing) system is the general system while the Keynesian
system (such as the unemployment problem during the great depression) is a special case that occurs in the short-run
because of some unfortunate market imperfections (Davidson, 1994: 9-10, Palley, 1996: 216-221). Note that the latter view, as
noted above, is contrary to Keynes’ belief who explicitly named his work as The General Theory.
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Important figures with significant contribution to these school include George Akerlof, Janet Yellen, Olivier Blanchard,
Gregory Mankiw, Edmund Phelps, David Romer, Joseph Stiglitz and Ben Bernanke (see Gordon, 1989; Mankiw and Romer, 1991,
cited in Snowdown, 2005; Figure 1.1). New Keynesian models have incorporated the rational expectations hypothesis, the
assumption that markets may fail to clear due to wage and price stickiness, and Friedman’s natural rate hypothesis. In terms
of policy, the NK believe there is a need for stabilization policy as capitalist economies are subjected to both demand- and
supply-side shocks which cause inefficient fluctuations in output and employment (Snowdon and Vane, 2005).
In sum, the methodology of deriving the macro aggregates using the representative agent model grounded in micro foundation,
the use of rational expectation hypothesis, the centrality of rigidities that are endogenous to the nature of markets and the
behaviour of economic agents in these markets as well as their belief in the role of policy in a general equilibrium framework
has led to the wide use of their models called Dynamic Stochastic General Equilibrium Models (DSGEs) as tools for macro policy
analysis and forecasting. The DSGEs are widely in use by central banks of the developed countries. These models are discussed
in brief in Chapter 2.
Before concluding this sub-section, it is imperative to note what Goodfriend and King (1997; cited in Snowdown and Vane, 2005)
have termed the emergence of a ‘New Neoclassical Synthesis’ at the end of the twentieth century. This new synthesis is the
attempt to combine the main ideas of New Classical and New Keynesians that was observed during the last decade of the
twentieth century. In this synthesis, macroeconomics began to evolve by taking the following views on board (see Snowdown,
2005, The Economist, July, 25, 2020):
1) the need for macroeconomic models to take into account intertemporal optimization
2) the widespread use of the rational expectation hypothesis and ‘representative agent’ based modelling
3) recognition of the importance of imperfect competition in goods, labour and credit markets
4) incorporating costly price adjustment into macroeconomic models.
Summarizing this, Mankiw (2006) has also noted, like the NCSK of an earlier generation, the new synthesis attempts to merge
the strengths of the NC approaches to the NK. From the New Classical models, it takes the tools of dynamic stochastic general
equilibrium theory. Preferences, constraints, and optimization are the starting point, and the analysis builds up from these
microeconomic foundations. From the New Keynesian models, it takes rigidities and uses them to explain why monetary policy
has real effects in the short-run. The most common approach, Mankiw (2006) noted, is to assume monopolistically competitive
firms that change prices only intermittently, resulting in price dynamics and aggregate supply schedule which is sometimes
referred as the New Keynesian Phillips curve. The heart of the synthesis is the view that the economy is a dynamic general
equilibrium system that deviates from a Pareto optimum because of sticky prices (and perhaps a variety of other market
imperfections),
Therefore, many mainstream economists believed that at the turn of the 21st century economists have moved beyond the
macroeconomic debates that began in the 1970 and have reached a consensus on what constitutes a ‘core of practical
macroeconomics’ than was the case 25 years ago (see Blanchard, 1997b, 2000; Blinder, 1997a; Eichenbaum, 1997; Solow, 1997;
Taylor, 1997b all cited in, Snowdown and Vane, 2005). However, Mankiw’s (2006) take at this view was a bit different. He says,
what has occurred is not so much a synthesis but an intellectual combatant, followed by a face-saving retreat on both sides.
Both New classical and New Keynesians can look to this new synthesis and claim a degree of victory. However, essentially,
14
according to Mankiw, NC’s attempt to discard the NCSK and replace it with the market clearing models was a failure. However,
in this process they have developed tools such as the DSGE models that are used by NK to develop the sticky prices-based
models that resemble the models that the NC were discarding. The new synthesis discards the market-clearing assumption and
used the stick price feature, yet the NK can be criticized, according to even Mankiw (2006) himself who is NK macroeconomist,
“ for having taken the new classicals’ bait and, as a result, pursuing a research program that turned out to be too abstract and
insufficiently practical”. Be this as it may, this optimistic view about an emerging new synthesis, however, was frustrated
following the events of the 2008/09 global financial and economic crisis and the policy response to the COVID-19 pandemic in
2020. The implication of this for macroeconomics is briefly discussed in section 1.4 below.
2.1.5 The Post-Keynesian Macroeconomics [PKM]
Joan Robinson Paul Davidson Nicholas Kaldor John Weeks
In contrast to all of the schools discussed above, specially of the New Classical Macroeconomists, Post Keynesian
Macroeconomists (PKs) argue that the original Keynesian revolution over the neoclassical school was aborted by the NCSK’s
attempt to interpret him that went wrong. PKs take Keynes, Kalecki, Kaldor and Joan Robinson as their intellectual ancestors.
The core proposition of the Post Keynesian approach, according to Palley, are: (1) the significance of social conflict over
income distribution, (2) the centrality of aggregate demand in the determination of the level of output, (3) the inability of
nominal wage adjustment to ensure full employment, (4) the endogenous nature of money, (5) the importance of debt finance
in the macrocosmic process and (6) the fundamental mutable nature of expectation about the uncertain future called ‘non-
ergodic economic environment’ (Palley, 1996:9; Shaikh, 2016).
Although the Post Keynesians work is one of the interpretations of Keynes’ work which stands in quite contrast with old and
new Keynesians, PKs are taken by mainstream economists as critical by nature and lacking systemic program. A charge
many Post Keynesians (see Palley 1996, Davidson, 1994 for instance) strongly disagree with. Theoretically, the Post Keynesian
are concerned with both recovery and extension of the works of Keynes. The recovery is from the NKSC’s interpretation of
Keynes and their IS-LM model. There are many issues that escaped the IS-LM framework-based interpretations of Keynes,
according to PKs. Most important among these, the PKs reject the division between the product and money market of IS-LM
model as artificial. For PKs the IS and LM curves cannot fluctuate independently. For PKs, in a monetized economy, disturbance
15
to either the real or financial sector will have a counterpart on the other.2 PKs also reject the assumption of an exogenous
money supply which characterize the IS-LM model. This is replaced by the assumption of endogenous money, according to
which the money supply is determined by the actions of the banking system and financial intermediaries. In other words, in
the process of accommodating the loan demand, banks could have a role in the determination of money supply, subject to
monetary stance (such as reserve ratio). (see Palley, 1996:104 for detail). Another recovery effort by PKs relates to the
treatment of investment function. In the IS-LM model the marginal efficiency of investment (MEI) schedule is treated as
technologically given. PKs reject this and model MEI being dependent on future anticipated demand conditions. This implies
both aggregate demand and uncertainty are given central position in macroeconomic analysis, as intended by Keynes. The
sequence of causation for PKs is as follows: expectation of future demand conditions matters for investment spending, which
impacts current aggregate demand and output. Thus, expectation of future demand conditions matters for current output.
The PKs are also concerned with extension of Keynes’ idea. The key extension is the recognition that all economies are social
systems, and capitalist (the industrialized) economies should be analyzed as such. In the capitalist system the two critical
forces are conflict and accumulation. The forces of conflict are particularly evident in the labour market and relevant for
understanding issues of income distribution, downward nominal wage rigidity, and inflation. The forces of accumulation are
manifested in deficiency of aggregate demand and speculation. To the extent that such accumulation takes financial form, it
provides a link between the real and financial sectors that is potentially destabilizing. To finalize this brief portrayal of the
school, let us reinstate the core proposition of the PKs (see Palley, 1996; Davidson, 1994):
(1) The Keynesian concept of effective demand determined equilibrium: this gives the PKs their Keynesian dimension
and basically underscores the existence of continuum of possible equilibrium outcomes, the ultimate selection of
which depends on the level of aggregate effective demand. This stand is in contrast to the neoclassical supply
constrained vision of equilibrium, in which the level of output is determined by supply side conditions.
(2) Related to the above point is the proposition which says that generalized price deflation (such as lower nominal
wage and price) are ineffective as a means of eliminating mass unemployment. It might rather exacerbate it
because: (a) it has adverse impact on aggregate demand through inside debt burden - low prices increase the
burden of debtors [Debt/Price] and benefits creditors [ their real receivable, Debt/Price, increases] and if the
marginal propensity to spend of debtors is generally higher than creditors, aggregate demand hence output could
fall; (b) the time-consuming nature of production implies that firms are unable to recover their costs in a
deflationary environment.
(3) Labour market bargains determine nominal wages, and that real wages are determined by economy wide process
outside the control of workers. For some of the PKs it is determined being contingent on profit (Sraffian) and for
other PKs, who adopt the production function approach, it is derived from the equilibrium level of output and
employment. Note that this is again in contrast to the neoclassical model in which the real wage is the object of the
bargain between workers and firms; and finally
(4) A fourth proposition of the PKs is that money is endogenously determined (as explained above). This endogenous
finance has implication for: (a) business cycle analysis, (b) inflation and (c) economic growth which are beyond the
scope of these introductory chapter.

2
Those of you who are interested on advances treatment of this issues may consult Davidson’s (1965) “Keynes’s finance motive” article.
Davidson has shown that when this effect is included, the IS-LM curves will co-move.
16
In sum, from the discussion so far, the fundamental organizing principle of the PKs is the notion of aggregate effective
demand. Understanding it and its cause, through understanding conflict and accumulation in a social system, is fundamental
to understand the capitalist economy.
2.1.6 Structuralist Macroeconomics: The Kaleckian wing of the Post-Keynesian Macroeconomics3
Lance Taylor Krishna Dutt E.V. K. FitzGerald Raul Prebisch
The structuralist macroeconomics school is sometimes presented as part of the Post Keynesians school. Shaikh (2016)
described them as the “Kaleckian Wing of Post Keynesians”, which is a sensible description. Structural macroeconomists are
basically similar with the Post Keynesians. However, they emphasize, among others, the importance of class and distribution of
income in affecting macroeconomic outcomes (political economy), importance of institutions and related structural features in
shaping agents’ behavior; the possibility of both quantity and price clearing. They also focus more on developing countries (See
Taylor 1983, 1991; FitzGerald, 1993; Dutt, 1992). The Structuralist approach begins from the premise that,
…an economy has a structure if its institutions and the behaviour of its members make some patterns of resource
allocation and evolution substantially more likely than others.... Economic analysis is structuralist when it takes these
factors as the foundation stones for its theories (Taylor 1983).
Having this broad definition4, the structuralist approach embraces two premises (Taylor 1983, 1991, 2004; FitzGerald and Vos
1989; Dutt 1992; FitzGerald 1993, 2003; Foley and Taylor 2004; Weeks 2012; Shaikh 2016). First, economies are built up from
agents such as firms, governments and households who are not simple optimisers because their behaviour depends on the
context of institutions, economic structure, production organisation in which they operate as well as the social class in which
they belong. These agents interact with each other in the market in the setting of macro accounting restrictions and in an ever-

3
This sub-section is based on Alemayehu (2018) and refences cited here can be obtained from this article.
4
How to define this fabulous term called "structure" in our analysis or economic research is very important. This can be done by unpacking
the term. To do so we need to identify the unique features (structures) of an economy from: a) composition of GDP or sectoral share of GDP and the
nature of informality; b) the nature of external trade (e.g. commodity dependence or not), the nature of its financial sector and its relation with the
state and major classes or interest groups; c) the nature of the land tenure; e) the nature of technology [& infrastructure] across sectors; f) the
nature of the state/political system (e.g. elites, class interest; democracy, autocracy, state fragility etc.) including its international relation; g) its
'sociological features' such as culture, religion, etc. (see also Alemayehu, 2018 for detail and African implications; and Kay (1989) and Palma (1978)
for the history of structural macroeconomics in Latin America).
17
changing institutional structure. This is how macro-level behaviour emerges from micro interaction (Foley and Taylor, 2004;
Shaikh, 2016). Thus, the emphasis is to think through macro foundation for micro behaviour. Second, markets may show
rigidities, perverse responses to price owing to institutional conditions, macroeconomic effects, market power, imperfect
information and class interest. Institutional setting and related market rigidities are basic structural features but are not
unchangeable over time.
In addition, and more concretely the structuralist approach (Kalecki 1976; Taylor 1983, 2004; FitzGerald 1993; Foley and Taylor
2004): (i) emphasises the role of interest groups/class and distribution of income as well as distributive conflicts in
macroeconomics. Thus, it pursues a political economy approach in its analysis of economic issues; (ii) emphasises that agents
are heterogeneous and hence their behaviour, as in saving propensities for instance, are assumed to differ by class; (iii) notes
the possibility of both quantity and price clearing in markets; prices could be formulated either competitively (flexi-price) or as
mark-up over prime cost (fix-price) depending on the degree of monopoly firms have (Kalecki 1976); (iv) short-run models are
setup in variables normalised by capital stock (to emphasise growth and profit as opposed to levels of investment and payment
to factors). Thus, different short-term and long-term responses are important. Long-run issues are investigated by setting up
transitions between steady states in which all variables grow at a constant rate; (v) macro balance is decomposed sectorially
(stability is attained by minimising sectoral excess demand to zero). Imports, as an important sector in developing countries,
are split in several ways (capital goods as a function of investment; intermediate goods as a function of output etc.) as different
types of imports might have different impact across sectors and social groups. Such differentiated characterisation and
analysis need to be done for all sectors (Taylor 1979,1983, 1990, 1991); and (vi) finally, direction of causality varies from model
to model – “that is what analysis is all about”, as noted by Foley and Taylor (2004). Model closure will depend on relevant factors,
the judgment on structure, and will therefore be country-specific and time-dependent. As model closure is temporal and
specific, it cannot be expanded to an all-encompassing theory of economic phenomena (Foley and Taylor, 2004).
According to Alemayehu (2018), the structuralist approach is an alternative heterodox approach that may be a fruitful approach
for economic research in Africa. It is relevant for Africa because African economies have unique structures that emerged from
their colonial history. It has been shown (Alemayehu 2002,2019) that African nations had an integrated and autonomous
economic structure prior to their intensive interactions with Europeans. It is hard to speculate what the future of such a
structure might have been in the absence of colonialism. However, it goes without saying that it would not have been what it is
now, since clearly the present is the result of a specific historical process. More specifically, historical interaction with today’s
developed countries has shaped the structure of the economic activity of African nations. Thus, given such historical legacy, it
is not surprising, for instance, that in their external economy, almost all African nations had become exporters of a limited
range of primary products and importers of manufactured goods with a weak human capital base by the time of political
independence in the 1960s. This was further accompanied by a demand for external finance when export earnings were not
sufficient to finance the level of public expenditure required for maintaining and expanding the commodity exporting economy.
This structure has not changed in any meaningful way today and has significantly shaped and shaping African growth and poverty
reduction effort to date (Ibid).
With regard to the internal economy, the historical legacy also shows that African countries generally inherited extractive
rather than developmental institutions by the end of the colonial period in the 1960s (Mamdani, 1996,2018; Alemayehu 1998,
2002, 2019; Acemoglu et al. 2001; Mkandawire 2001). This structure basically shaped the behaviour of economic agents, as well
as their political regimes and hence the economic and political outcome in Africa to date. It is imperative to take such unique
18
structures on board in any meaningful economic research and policy analysis in the continent. If that is carried out, the
approach used could be described as a ‘structuralist' approach.
This approach is what Lin (2011) termed as an ‘old structuralist’ approach, as opposed to his ‘new structuralist’ approach. His
‘new structuralist’ approach (which could be better termed as ‘neoclassical structuralism’) appears inadequate for Africa for
two reasons. Firstly, it is extremely dependent on the significance of the theory of comparative advantage for developing
countries. This is ironic because his own county’s (China) experience shows that comparative advantage is not given but could
be created. Thus, his ‘new structuralist’ approach is based on static comparative advantage which I have shown elsewhere as
not conducive for Africa’s sustained and sustainable growth (Alemayehu 2002, 2019). Moreover, it is theoretically challenged
as it is not important for developing countries compared to its rival approach which is 'the absolute advantage theory’ (Porter
1995; Shaikh 1984, 2016; Alemayehu 2015). Secondly, although Lin's approach recognises the role of active government and the
importance of infrastructure provision, it is completely devoid of the political economy analysis such as the role of interest
groups stressed in the structuralist tradition. Given Lin’s central position as chief economist for the World Bank at the time of
his writing, this might be an understandable omission5. Thus, what Lin (2011) called ‘old structuralist’ and what is referred here
as a ‘structuralist’ approach is the approach suggested as a relevant to Africa in Alemayehu (2018).
1.3. Macroeconomic Schools of Thought and the Macro Policy Discourse about African
Economic Crisis (African Development Challenges)6
Claude Ake Samir Amin Walter Rodeny Gébré-Hiwot Baykédagn Déressa Amente
Thandika Mkandawire Mahamood Mamdani

5
Incidentally, although the government was not well-informed and hence Lin’s ‘soft infrastructure’ is largely missing, my home country,
Ethiopia, has been experimenting with this structuralist approach – called ‘growth and structural transformation plan’ - with significant Chinese
support for the last couple of decades. This strategy has brought some success in Lin’s ‘hard infrastructure’ and growth terms - although this growth
has lately been thwarted and went into negative political development. This partly shows lack of political analysis (along the ‘structuralist’ route) in
its design from analytical perspective. This is discussed in detail in Chapter 9 of the current book (for Ethiopian readers).
6
This section is based on Alemayehu (2019) and refences cited here can be obtained from this book.
19
Theoretical ideas coming from the macroeconomic schools of thoughts briefly discussed above are usually the basis for
macroeconomic policies adopted in different countries. For instance, International Financial Institutions (IFIs) such as the World
Bank (WB), the International Monetary Fund (IMF) and the World Trade Organization (WTO) believe in the market clearing models
of neoclassical economics. The policy implication of such belief is a policy of liberalization and ‘lassies-faire’. economics. Such
belief is also, implicitly, an ideological and political position. In this sub-section we will examine the implications of such beliefs
for understanding and addressing the growth and poverty challenges of Africa (or the African economic crisis).
Before our discussion about the macro-theoretical approach and the resulting macro policy employed to address the African
economic crisis, a working definition of the ‘African economic crisis’ is in order. The African economic crisis here is
understood as the failure to achieve sustained growth, a macroeconomic stability and structural transformation that ensure
significant poverty reduction in the short-run and its elimination in the long run. In addition to domestic shortcomings in
designing and implementing appropriate policies and hence problems of economic and political governance, the continent
was and still is confronted with a hostile external environment. Both led to this African economics crisis. One major indicator
of this African economic crisis is poverty. Poverty in Africa has been on the rise from the 1980s to date. During the period
1980-2020 there was a sharp contrast between Sub-Saharan Africa (SSA) and East and South Asia in this respect. Between
1981 and 2008, the region’s poverty rate declined by 4 percentage points only. In contrast, East Asia saw dramatic drops in
poverty, from 77% of the population in 1981 to 14% in 2008 (63 percentage points!), and South Asia saw the percentage of
its population in poverty decline from 61% to 36% (McKay, 2012). Thus, the absolute number of the poor living on less than a
dollar per day in SSA rose from 163 million in 1981 to nearly 313 million by 2000 (McKay, 2004). In addition, despite the
impressive economic growth registered in Africa since 2002, 47% of the population of sub-Saharan Africa still live below the
$1.25-a-day poverty line today (2018); and this figure will jump to a staggering 70% with $2 a day poverty line.
With such a working definition established, there are three sets of contending explanations for Africa’s economic crisis in
the post-independence period. The first was set originally out by the World Bank (1981) – also known as ‘the Berg Report’ –
and a number of subsequent World Bank publications (World Bank, 1989; 1994). An alternative explanation for Africa’s
economic crisis, which could be described as the ‘African structuralist approach’7 is associated with the United Nations’
Economic Commission for Africa (ECA) in early 1990s. This is outlined in the African Alternative Framework to Structural
Adjustment Programs (AAF-SAP; ECA, 1989). Finally, there exists a third view, which is less clearly associated with any
particular institution and largely held by academics of a Marxist orientation (see inter alia Lawrence, 1986; Sutcliffe, 1986;
Amin, 1996). This latter position is often offered as a critique to the other two explanations. The scope of all three sets of
explanations is general, encompassing every aspect of the African economic crisis.
The World Bank argues that, in spite of external shocks, associated particularly with a rise in oil prices in the periods 1973-
74 and 1978-80 and a decline in world demand for primary commodities, the balance of payments related economic problems

7
The African structuralist view seems to begin with this ECA (1989/1990) publication under the then ECA General Secretary Adebayo Adedeje
of Nigeria. The 1989/90 document appears to draw its main perspective from the structuralist macroeconomics tradition of Latin America, in
particular that of ECLAC (Economic Commission for Latin America and the Carbines) economists (Prebisch, Signer, Sunkel, Furtado, Cardoso etc.; see
Palma, 1978; Kay, 1989) and other structuralist and/or progressive economists that include Lance Taylor, Duncan Foley, E.V.K Fitzgerald, Rob Vos,
Karel Jansen, Marc Wuyts, Ashewani Saith, Krishna Dutt, John Weeks, Marc Lavoie, Francis Stewart, Sanjay Lall, Howard Stien and Fantu Cheru, among
others. In African macro and trade studies the approach of economists such as Jorn Rattso, Raphiel Kaplenski, Mike Morris, Ademola Oyedeji, Olu
Ajakaiye, Tony Addison, Leonce Ndikumana, John Sender, and Marc Wuyts, inter alia, as well as the broader political economy tradition of CODSERIA
such as the works of Samir Amin, Archie Maife and Thandika Mkandawire, as well as the early works of Claude Ake, Walter Rodney, M. Mamdani and
Collin Leys could be taken in this African-heterodox tradition.
20
experienced by most African nations since the 1970s cannot generally be attributed to a deterioration in terms of trade. With
the exception of mineral exporters, it is suggested that terms of trade for most African nations have, in fact, either been
favourable or neutral. The main cause of the balance of payments problem, according to the World Bank, was a decline in the
volume of exports, which is attributed to three factors. Firstly, structural changes in the composition of world trade, with
trade in commodities growing at a slower rate than that of manufactured goods. This has resulted in a decline in the African
share of total world trade. Secondly, drought and civil strife have negatively affected Africa’s supply capacity. Thirdly, the
trade restrictions and agricultural subsidy policies of industrial countries represent a barrier to African trade.8 The World
Bank goes on to argue that the failure of Africa’s export sector may be explained in terms of three main factors. Firstly,
government policies have tended to be biased against agricultural and export production. Secondly, increased consumption
associated with rapid population growth has placed a burden on resources, which might otherwise have been used by the
export sector. Thirdly, inflexibilities in African economies are seen as representing an obstacle to diversification. The main
problem for African economic crisis for the World Bank, however is policy failure and needs a policy reform as given in Table
1.1. The World Bank’s insistence that policy failure represents the main explanation for Africa’s economic crisis, and
consequent emphasis on the need for reforms, continued with the publication of its long-term perspective study at the end
of the 1980s (World Bank, 1989). Moreover, in the mid-1990s, the World Bank continued to argue that orthodox macroeconomic
management, as given in Table 1.1 represented the road to economic recovery in Africa and, hence, that more adjustment, not
less, is required (World Bank, 1994). This assertion has been the subject of various criticism, coming from a host of different
angles (see inter alia ECA, 1989; Adam, 1995; Mosley et al, 1995; Lall, 1995; White, 1996a; Alemayehu, 2002).
Table 1.1: The Washington and Augmented Washington Consensus: The Orthodox Policies Advocated by IFIs in Africa
Rs
Source: Dani Rodrik (2006), Journal of Economic Literature, Vol, XLIV (December)

8
However, according to the World Bank, the effects of the protectionist policies of developed nations may be rendered less significant due
to the low capacity of African manufacturing, an inability to produce temperate products as well as the continent’s preferential status within the EEC.
See Amjadi et al (1996), another WB study, for a similar argument along this line, as well as an argument for a possible policy conditionality plan for
privatizing African shipping lines during that time.
21
A number of other analysts have arrived at conclusions in line with those of the World Bank too. Van Arkadie (1986), while
sympathetic to the problems posed by external shocks, argues that stagnating or falling output has had an important impact
on export earnings. On the latter point, the World Bank (1989) argues, rather vigorously, that declining export volumes, rather
than declining prices, account for Africa's poor export revenue which is crucial for its growth. Grier and Tullock’s (1989)
analysis support this view. Based on their survey of empirical studies into the causes of the African economic crisis, Elbadawi
et al (1992) also found domestic policies to be important. White (1996b), citing the case of Zambia, argues that economic
decline following Zambia’s independence may largely be attributed to economic mismanagement. Using a pooled multiple
regression equation for 33 African countries, Ghura (1993) also found significant support for the World Bank/IMF viewpoint.
Easterly and Levine (1996) suggest that political instability, low levels of schooling, deterioration in infrastructure as well as
policy failures represent possible causes of Africa’s growth problems. They conclude, however, that policy improvements
alone are likely to boost growth substantially. Similar views are also expressed in Collier and Gunning (1999). Although this
brief survey is not exhaustive, the aforementioned works tend to lend strong support to the World Bank/IMF’s viewpoint. The
logical conclusion to be drawn from this, therefore, is that the remedy to Africa’s economic crisis is to implement structural
adjustment programs (SAPs) as given in Table 1.1 above, more vigorously.
In contrast, the ECA (1989) prefers to explain Africa's problems in terms of deficiencies in basic economic and social
infrastructure (especially physical capital), research capability, technological know-how and human resource development,
compounded by problems of socio-political organization – in short, structural problems. The ECA sees inflation, balance of
payments deficits, a rising debt burden and the instability of exports, which are focused on in the World Bank/IMF’s view, as
resulting from a lack of structural transformation and unfavorable physical and socio-political environments, as well as
excessive outward orientation and dependence. The ECA study suggests that weaknesses in Africa’s productive base, the
predominant subsistence and exchange nature of the economy and its openness have all conspired to perpetuate the external
dependence of the continent. Hence, one of the striking features of the African economy is the dominance of the external
sector. This has had the effect of rendering African countries quite vulnerable to exogenous shocks.9 Consequently, according
to the ECA’s viewpoint, perceiving African problems in terms of internal and external balance problems and seeking a solution
within that framework (most notably through the implementation of SAPs) implies not only the wrong diagnosis but also the
wrong treatment. The ECA study argues that “both on theoretical and empirical grounds, the conventional SAPs (as given in
Table 1.1) are inadequate in addressing the real causes of economic, financial and social problems facing African countries
that are of a structural nature” (ECA, 1989a: 25).
Based on this alternative diagnosis, and the major objectives of The Lagos Plan of Action (OAU, 1981), the ECA formulated an
African alternative framework to the World Bank/IMF’s policy recommendations, which is also effectively endorsed by the
OAU. The ECA framework focuses on three dynamically interrelated aspects, which need to be taken into account. First, the
operative forces (political, economic, scientific and technological, environmental, cultural and sociological10); second, the
available resources (human and natural resources, domestic saving and external financial resources); and third, the needs
to be catered for (i.e. focusing on vital goods and services as opposed to luxuries and semi-luxuries). The adoption of this
general framework would allow the different categories of operative force to influence not only the level and structure of

9 In sharp contrast to this view, Collier and Gunning (1999), along the lines of IMF and the World Bank, argued that a lack of openness, not
openness, represents one of the major causes of the poor performance of African economies.
10
This basically includes the system of government, public enterprises, the private sector, domestic markets, research and development,
forces of nature and climate, ethnicism and society's value system, external commodity markets and finance and transnational corporations.
22
what is produced but also the distribution of wealth. Moreover, these forces may then influence the nature of needs to be
catered for and the degree of their satisfaction. At a concrete level this is envisaged as taking a number of policy directions.
Firstly, improving production capacity and productivity, the mobilization and efficient use of resources, human resource
development, strengthening the scientific and technological base, and vertical and horizontal diversification. Secondly,
improving the level and distribution of income, adopting a pragmatic balance between the public and private sectors, putting
in place ‘enabling conditions’ for sustainable development (particularly economic incentives and political stability), the shifting
of (non-productive) resources, and improving income distribution among various groups. Finally, focusing on the required
needs, particularly in relation to food self-sufficiency, reducing import dependence, the re-alignment of consumption and
production patterns and the managing of debt and debt servicing (ECA, 1989).
Just as many have argued in favour of the Bank/IMF’s view, so, too, have many analysts come out in support of the ECA’s
‘structuralist’ line of reasoning (Ngwenya and Bugembe, 1987; Fantu, 1992; Adedeji, 1993; Stefanski, 1990; Ali, 1984; Wheeler,
1984; Stein, 1977; Alemayehu, 2002). Setting this discussion in a broader historical context, these studies have highlighted
the impact of colonialism in establishing the rules by which Africa might participate in the world economy. According to these
rules, African nations produced raw materials and agricultural goods for Europe's industries. Further, it is argued that this
pattern of trade has changed very little since the time of political 'independence' (Fantu, 1992: 497-500; Adedeji, 1993: 45).
Indeed, Stefanski (1990) argues that, understood in the context of a direct continuum with the colonial experience, Africa’s
economy still depends on external factors to a much greater degree than any other developing region. As a result of this
dependence, Africa’s economic crisis is seen as being intricately interconnected with external factors such as falling terms
of trade, declining demand for African exports and related external shocks (Stefanski, 1990: 68-77; Adedeji, 1993: 45). Collier
(1991) also argues that abrupt external shocks (be they negative or positive) have represented important causes of the poor
long-term economic performance of Africa.11 Ali (1984) has touched on another dimension of the problem. He argues that, for
most African nations, the mitigation of their problems depends not only on the characteristics of the commodities they export
(and specifically their elasticities) but also on the presence or absence of the necessary market staying power. Wheeler
(1984) has made an exploratory econometric analysis of the sources of stagnation and suggests that ‘environmental’ factors
(especially terms of trade and the international conditions of demand) have had a greater impact on growth than policy
variables. Indeed, based on Ghura’s (1993) econometric analysis, world interest rates represent a further significant variable,
which should be added to Wheeler’s list of adverse ‘environmental’ factors.12
The third view differs from the other two in its understanding of what crisis means in the African context. For these analysts,
crisis “has a connotation of systemic breakdown, but more generally it can refer to a moment or a specific time period in
the history of a system at which various developments of a negative character combine to generate a serious threat to its
survival” (Lawrence, 1986: 2). Sutcliffe (1986), for instance, argues that the African crisis represents the continuation of a
complex process of polarization trends. It emanates from Africa's economic dependence. For him, the African crisis is best

11 Collier (1991) cites the Zambian economy and copper prices as classic examples of negative shocks. In Collier’s opinion two errors are
made. Firstly, the price fall was treated as temporary, and, secondly, foreign exchange shortages were handled by rationing. Notwithstanding an
acknowledgment of the effect of negative shocks, he emphasized poor policies in what he called ‘controlled’ economies as representing a major
problem. However, it could be argued that the root cause of these policy problems lies in the structure of the economy of these countries, and in their
external trade in particular. Taken in this light, policy problems, per se, may be of only secondary importance.
12
However, Ghura (1993) seems extremely optimistic in stating that judicious macro and trade policies may stimulate growth in Africa, even
if external conditions do not improve. This viewpoint is essentially similar to the types of empirical studies undertaken in support of World Bank/IMF-
type policies.
23
understood in terms of the combined result of the long-term secular effects of imperialism, suddenly aggravated by the
impact of the world capitalist crisis. Thus, according to these viewpoints, Africa's problems are best understood as resulting
from long-term underdevelopment, following dependency theory,13 and short-term vulnerability, following international
aspects of crisis theory (see Amin 1974a, 1974b; Ake, 1981, cited in Ofuatey-Kadjoe, 1991; Sutcliffe, 1986: 19-20; Harris, 1986:
93; Onimode, 1988: 13; Moyo et al, 1992: 210). In general, these writers are against the view that there is a ‘norm’ from which
African countries are in a state of temporary deviation, with the associated implications that these countries may return to
that norm given a particular adjustment measure (Harris, 1986: 84). Harris (1986) and Mamdani (1994), for instance, argue
that the IMF and the World Bank’s ultimate objective (using SAPs) is not to correct distortions in a free market international
system, but to construct such a system (Harris, 1986: 88). In so doing, these institutions may undermine any attempt to
create an independent, integrated and self-sustained African economy (Mamdani, 1994: 129).
While there are areas where the first two approaches both converge and diverge, the third explanation for Africa’s economic
crisis stands firmly in opposition to both. The core of the disagreement between the World Bank/IMF and the ECA’s views
centers on the role of the market mechanism (Oskawe, quoted in Asante, 1991: 179). While the World Bank believes in the
market mechanism as representing the fundamental instrument of resource allocation and income distribution, the ECA
questions this viewpoint. Thus, while the World Bank focuses mainly on financial balances, the ECA considers a much broader
transformation as an enabling condition for the former. While the World Bank emphasizes the export sector, the ECA strategy
advocates selectivity (see Asante, 1991: 180). While the World Bank expresses concern about anti-export bias and population
policy, the ECA prefers to emphasize the need to ensure total structural transformation and food self-sufficiency. While the
World Bank places more emphasis on short-term policies than on Africa’s long-term needs, the ECA’s strategy, as defined in
The Lagos Plan of Action, stresses the importance of also addressing issues of long-term transformation, alongside these
short-term policies (See Stewart (1993) for a discussion of this issue). Mkandawire (1989, cited in Elbadawi et al, 1992)
summarizes the two contending views about the cause of the African economic crisis as structuralist and neoclassical. He
noted,
The structuralist view is one which highlights a number of features and ‘stylized facts’ that almost every point
contradicts the neoclassical view...class based distribution of income rather than marginal productivity based
distribution of income; oligopolistic rather than the laissez-faire capitalist market; increasing returns or fixed
proportion production functions rather than ‘well-behaved’ production functions with decreasing returns and
high rates of substitution; non-equivalent or ‘unequal exchange’ in the world rather than competitive,
comparative advantage based world system; low supply elasticities rather than instantaneous response to
price incentives.
However, these institutions do agree on some major issues, such as the need for human resource development, improving
the efficiency of parastatals, and sound debt management. In my judgment, the ECA analysis is quite comprehensive in
addressing the causes of the crisis and in suggesting not only short-term solutions but also a framework for long-term
structural transformations.14 In addition, we note today, with the benefit of hindsight, the obsession of the World Bank and the
IMF with macroeconomic stability through SAPs in 1980s and 1990s Africa came at the expense of the structural
transformations (raising productivity in agriculture, industrialization, exports, infrastructure, and human capital formation

13
See Leys (1996) and Ofuatey-Kodjoe (1991) for critiques of dependency theory in the African context.
14
See, however, Helleiner (1993), who argued for an emerging consensus on this issue in the early 1990s.
24
– supply side policies) that the ECA was arguing for from the outset. That led to deterioration of the African economy from
the 1980s until the year 2000. From this chapter’s perspective it is important to note the role of different schools of thought
in macroeconomics in informing policies that affect human lives.
Finally, it is worth looking at the recent comprehensive study about the political economy of growth in post-independence
Africa and the role of policy in that process. This study was conducted by the African Economic Research Consortium (AERC),
based on the case studies of 27 countries (Ndulu et al, 2008a; 2008b). The AERC study identified four political regimes that
characterized the political and policy landscape of post-independence Africa. These are countries characterized by: State
Controls (SC), Adverse Redistribution (AR), Inter-temporally Unsustainable Spending (IUS), and State Breakdown (SB) – the
authors called these ‘Syndromes’. Thus, in addition, there is the complementary Syndrome-Free (SF) category (see Fosu,
2008; Ndulu et al, 2008a). The study noted that the quality of economic policy pursued by each of these regimes has a
powerful effect on whether countries seize the growth opportunities implied by global technologies and markets and by their
own initial conditions (Fosu, 2008). The evidence that the syndromes reduce growth is strong in the AERC studies. Fosu and
O’Connell (2006) found, for example, that avoiding the syndromes is simultaneously a necessary condition for attaining
sustainable growth in SSA and a nearly-sufficient condition for preventing growth collapse. Indeed, being syndrome-free may
add as much as 2 to 2.5 percentage points per year to per capita income growth (see Fosu, 2008; Fosu and O’Connell, 2006).
This is an excellent and comprehensive study on Africa’s growth and policy problems since independence. However, one of
its main weaknesses lies in its failure to look at the deeper historical reasons for having a structure that is vulnerable to
syndromes. One of the significant elements of this structure is the hostile external sector which was established during the
colonial period and which has hardly changed today. Hence, the resulting growth and developmental policy problems (or
syndromes) could largely be the legacy of this structure15 (Alemayehu 2018a; 2019). The second weakness of the AERC study
is to delink the policy regime analysis from the internal and external political-economy context of African countries (this
includes the weakening of the African state by IFIs using SAPs) which is a widely-examined issue in the literature about ‘the
nature of the Africa state’. The latter includes: ‘state-civil society’ relation, ‘the nature of the African state that includes the
potential for African developmental state’, ‘global capitalist development and the African dependent state’, and ‘the African
elite and class relation’, among others (see, inter alia, Hyden, 1983; Sender and Smith, 1986; Mkandawire 2001, 2010; Routely,
2012; Mamdani, 2018).
Today, despite this history of the SAPs, and PRSPs policies and their detrimental effect on the continent, despite the history of
its early ardent critiques that provided an alternative to SAPs such as the then ECA (1989), it is sad to see that the IFIs
“Augmented-Washington Policy Consensus” is still the macro policy framework that is currently informing policy making in
Africa, especially when the IFIs are involved through aid with African governments – the latest example of this being the Ethiopian
government reform policy (2018-21). It is time for critical African economists to come up with an alternative macro policy
framework that is grounded on African reality, relevant for the continent and effective to address the problems of growth,

15
This ‘structure’ also has implications for the internal political regimes (the African state) witnessed in the post-independence period and
documented in AERC studies. The ECA (1989) broadly defined what does ‘structure’ mean in this context. It lists the following as its features: the
predominance of subsistence and commercial agriculture; a narrow and disarticulated production base; a large and neglected informal sector; a
fragmented economy; openness and excessive dependence on external sectors and factors; and weak institutional [and human] capability and a
related socio-political structure, among others (ECA 1989, cited in Alemayehu, 2019). Bates’ analysis noted here goes to an excellent degree in this
political-economy direction, though it neglected the external political-economy dimension as well as the structural features noted here.
25
poverty and inequality that still engulfed the continent. I hope this book will give you the theoretical perspectives to do that (see
Box 1.1 for originality of some macro theories in Africa).
Box 1.1 Development Economics Might have Its Roots in Africa: Gebre-Hiwot Baykedagne and Deresa Amente
There were articulator development thinkers at the turn of the 20th century in Ethiopia. This articulated development thinkers of the
early 20th century (1920-1930) Ethiopia had captured the imagination of prominent Ethiopian historians and their students. Ethiopian
economists seem to lag behind in appreciating the theoretical insight of these pioneer development thinkers. Alemayehu (2005) argues
that some important development ideas and concepts such as the deterioration of the terms of trade of developing countries, the vicious
circle of poverty and structuralist analysis of North-South macroeconomic interaction has, contrary to the statement in existing
development literature, has its origin in early 20th century Ethiopian development thinking. To motivate you search for African original
economic thinkers, a short bio and idea of two of the prominent thinkers in the 1920s Ethiopia is given here.
Negadras Gebre-Hiwot Baykedagn was born on 30th of July 1886 in the village of May Masha in the district of Adwa, Tigray region of
Northern Ethiopia. That period, according to Bahru (2002), was exceptionally turbulence in Tigray: the political disintegration and
psychological void created by the death of emperor Yohannes who came from that region, the ravages of one of the longest and most
devastating famines the country had ever known, and the depredation that attended emperor Menelik’s campaign of 1890 to assert his
new authority – all combined to produce great instability in Tigray (Bahru 2002; Chaulk 1978). It was at this period he fled to Hamasen
(todays Eritrea) at the age of seven (see Bahru 2002; Alemayehu 2002, Sosena 1999, Tinker 1995; and Chaulk 1978). As noted in Bahru
(2003), in a trip to the port of Massawa (today’s Eritrea), Gebre-Hiwot and his friends got permission from a captain of a German ship
to visit the ship. On departure, Gebre-Hiwot stowed away (this may not be deliberate and this is a very curious kid, see also Ayele 1980).
On arrival, the captain entrusted the young boy to a rich Austrian family, who adopted him. He learned the German language and gone
on to study medicine at Berlin University (Bahru 2002; Chaulk 1978).After completion of his study he returned to Ethiopia as part of a
medical team sent from Germany to attend emperor Menelik (apparently being unable to get employment in Europe because of the color
of his skin, see Ayele 1980). After his arrival Gebre-Hiwot learned the Amharic language and reportedly made the private secretary and
interpreter to the emperor. In November 1909 he chose to exile himself in the British colony of the Sudan, apparently having difficulty
with empress Taytu (emperor Menelik’s influential wife). He returned from the Sudan felling critically ill. He recovered, after being
hospitalized at Massawa and subsequently wrote two of his writings: Emperor Menelik and Ethiopia, 1912 and Government and Public
Administration 1924 (Bahru 2002). According to Bahru (2002) and also Gebre-Hiwot (1912), he was ‘disappointed by Menelik as a
modernizing monarch ... [and] ... apparently pinned his hopes on the young prince – Iyyasu. “He was soon to be disillusioned, as Iyyasu
failed to demonstrate the resolution and consistency necessary for the social and economic change that Gebre-Hiwot and fellow
intellectuals recommended” (Bahru, 2002). This has forced him to bank his hopes on another young prince, Tafari Mekonnen (latter Haile
Selassie I) in whose reign he held two major administrative posts: inspector of the Addis Ababa-Djibouti railway in 1916 and the title or
Negadras (Chief of Commerce) of Dre Dawa in 1919, before his untimely death on 1st of July 1919 (Bahru 2002).
Gebre-Hiwot’s work is not only published (in Amharic) but also translated in to English (see Tinker 1995). In Gebre-Hiwot’s model, every
nation is capable of developing. He noted that division of labour is central for accumulation; and need to be accompanied by efficient
resource allocation both within and across sectors as well as through inter-generational transfer of knowledge. Notwithstanding this,
he mentioned human capital (i.e. educated work force) and infrastructure development as the prime prerequisites for development. All
such efforts, he argues, should be accompanied by balanced management of potential and actual conflicts across ethnic groups through
maintaining law and order. In such national project, the role of state for Gebre-Hiwot is to govern the market (including desirable
protection against the inflow of processed goods from abroad) in a pragmatic and flexible manner. If a country is capable of initiating
such a process, it will follow the path of development subject to an array of constraints that he classified as internal (related to conflict)
26
and external (related to deterioration of the terms of trade). Thus, for Gebre-Hiwot, the degree (of severity) of constraints would
determine the level of development a country may attain. His basic ideas are formalized in Alemayehu (2002). A linearized version of his
model is given in Alemayehu (2005) and a Dynamic optimization version is given in Alemayehu and Abreham (2020, forthcoming in
Alemayehu (2020) Reading on Ethiopian Economy II).
Blatta Déréssa Amente was the other prolific development economists of early 20th century Ethiopia. According to Bahru (2002) Blatta
Déréssa had neither went abroad for education nor attended any of the celebrated educational institutions (traditional or modern) in
Ethiopia. He was the member of the Léqa Näqamté aristocracy (Wellega, South-Western Ethiopia), being cousin of the local ruler Däjjach
Kumsa (Gäbrä-Egizbhér) Moroda. In the 1920s he emerged as one of the creative contributors to the weekly Berehanena Salam
newspaper, which was the intellectual mouth piece of the time. As noted by Bahru (2002) Blatta Déréssa combined intellectual pursuit
with exceptional entrepreneur drive. In 1930 he was given the rank of Blatta (a title given to an educated person), having been a fitawrari,
a military title, until then and made the director in the Ministry of Agriculture. In exile in the Sudan, during the Italian brief occupation,
he pursued his entrepreneur drive. After 1941, Blatta Déréssa developed a reputation as an Oromo oral historian (Bahru 2002). As early
20th century development thinker, Blatta Déréssa has written on the importance of Japan’s experience as a model for Ethiopia’s
development. He characterized this model as ‘safe modernization’ (BS, 1925) and emphasized the significance of institutions for
development. He also made an impressive analysis of inflation in Ethiopia of that time. Déréssa made a link between his idea of institution
and his utmost determinant of development – education - by illustrating it using the expansion of modern education not only in Japan
but also in some of the European colonies of African countries of the time (such as Tunisia and Algeria). His insightful analysis began
when he examines the issue of how to finance this modern education. Here, he offered probably the first analysis of the vicious cycle of
poverty, and most interestingly, how to break out of it (BS Tikimet 29, 1921:354; see Diagram below). Perhaps this could also be related
to Amartya Sen’s idea of poverty as lack of capability that includes education. Note that, the development economics literature attributes
the idea of vicious circle of poverty to the post-World War II works of Rosenstein-Rodan (1943) and Nurkse (1953) (see Basu 1997).
Lack of Poverty
Education
Low capacity
to Expand
Education
Diagram 1: Déréssa’s Vicious Cycle of Poverty (1921 Ethiopian calendar [1928 European calendar]).
Another thread that Déréssa discussed relates to the role of the external sector and inflation in Ethiopia’s development. In one of his
articles he attempted to resolve the apparent trade-off between rural and urban welfare following a surge in export of agricultural
output (live animals) from Ethiopia in 1920s. In his analysis of inflation in Ethiopia of the time, he examined the sources of inflation both
from global and national perspective. His inflation analysis is written in 1931. This was also the period of the great depression in the
industrial world. Déréssa made an impressive analysis of inflation in Ethiopia during this period. He stated that hoarding (of the then
commodity money) is common in many countries and is a problem created by rich people. This hoarding reduces the amount of money
in circulation (hence excess of transaction demand over money in circulation). This, according to Déréssa, is aggravated by over
production and the use of capital-intensive technology in industrialized countries that led to losses and unemployment which further
reduced the effective demand (compare with Keynes 1936 and Kalecki 1933). He noted that this global condition has repercussion on
27
Ethiopia. He said inflation problem in Ethiopia comes from a decline in world price of silver (the commodity money in Ethiopia of that
time). Since the Ethiopian money was also silver-based and was not backed by gold, its value has declined in tandem with world price of
silver. This has led to depreciation of the Ethiopian money since Ethiopians need nearly double of what they used to require for the same
items that they import, according to him. This has also led to concentration of currency in the hands of few merchants leading to a
shortage of money in rural areas. This is aggravated by a decline in the price of Ethiopia’s exportables, further reducing the commodity
money supply in Ethiopia. These two, according to Déréssa, are the external dimension of the inflation problem in Ethiopia. Déréssa then
went on discussing what he calls the ‘internal cause of inflation’ that is created by the Ethiopian themselves and came up with a story of
inflation that combines both the external and internal dimension. Both Blata Deresa and Negadras Gebre-Hiwot used available data about
exports, imports, tax revenue, loan disbursement etc. when making their points. In addition, most of the economic thinkers of the time
including Derese and Geber-Hiwot used Japan as their model of development to emulate and are referred as the “Japanaizers” in
Ethiopian history of Economic thought (Details of his analysis is given in Alemayehu, 2005).
Extracts from Alemayehu (2005)
1.4. The 2008/09 Financial and Economic Crisis and the Future of Macroeconomics16
In 2008/09 the advanced economies of the world saw the worst economic crisis since WWII. This crisis started in the US
housing market but had a ripple effect even in African countries where the content’s growth decelerates by nearly 50%
following the crisis (see Chapter 4). What is interesting from the macroeconomics perspective is that mainstream
macroeconomics (the NC and NK) neither predicted the crisis nor explained its causes. As a result, they cannot also offer a
remedial policy direction to abate the effect of the crisis. Thus, their DSGE models utterly failed to help them. In fact, it is the
PKs’ kind of fiscal policy (called the stimulus package in USA and Europe) that took these countries out of the crisis. Below,
we offer David Romer’s and Paul Romer’s reflection (looks confession) on the 2008/09 economic crisis and its implications
for macroeconomics. David Romer’s view is important not only because he is a prominent economist that belongs to these
mainstream schools, but also, perhaps more importantly, almost all departments of economics in the world use his “Advanced
Macroeconomics” textbook to teach their doctoral students.
According to David Romer (2012), from mid-1980s to 2007 unprecedented macroeconomic stability is observed in advanced
industrialized countries. For instance, the USA went through only two recessions in this period, both of them mild; the
unemployment rate never exceeded 8% and there were only five quarters in which real GDP fell. According to Romer (2012),
there are three reasons for this: the first is simply good luck in the form of smaller shocks hitting the economy (Stock and
Watson, 2003). The second is change in the structure of the economy, such as a larger role of services and improvements
in inventory management (McConnell and Perez-Quiros, 2000; see also Ramey and Vine, 2004; both cited in Romer, 2012).
The third is improved policy.
According to Romer (2012), this period of stability ended with the 2007/08 crisis. The crisis began in the US housing market
first. House prices in the US had been rising rapidly since the late 1990s till 2006. This is accompanied by new types of
mortgages (repackaging/insurance), many of them issued on the basis of little or no documentation because financial sector

16
This section is based on David Romer’s reflection on the future of macroeconomics following the 2008/09 global economic crisis. Romer
is the author of the widely used graduate macroeconomics textbook in the world: “Advanced Macroeconomics” . He offered this reflection in the 2012,
4th edition of this book. The section will also use Paul Romer’s article and The Economist’s (2020) recent view on the same issue.
28
regulations had been pretty much dismantled just before this time. House prices started falling in 2007, and the
macroeconomy weakened thereafter. The decline in the value of houses reduced the net worth of many related financial
institutions. In September 2008 Lehman Brothers, a major investment bank, declared bankruptcy. In the aftermath, financial
markets suffered dramatic turmoil, and the recession changed from mild to severe. Equity prices fell by more than 25 % in
just 4 weeks. The 2008/09 crisis was the largest since World War II. According to Davide Romer’s as well as Paul Romer’s
confession, the events of the years since the crisis were a profound shock not just to the macroeconomy, but also to the field
of macroeconomics. David Romer noted, “short-run aggregate fluctuations, which we thought we had largely tamed, have
reemerged dramatically. Thus, our models [i.e., Real Business Cycle, RBC and DSGE models] and analysis will surely change.
But how is not clear. In many ways, macroeconomics today is in a position similar to where it stood in the early 1970s, when
the emergence of the combination of high unemployment and high inflation [called stagflation] challenged accepted views”
such as the Philips curve. Paul Romer’s confession is even more dramatic as he argued that macroeconomics and
macroeconomic models became useless. For David Romer, one possibility was that the unexpected developments would lead
only to straight forward modifications of the existing framework/models. But another possibility—and the one that in fact
occurred—was that the developments would lead to large and unexpected changes in the field of Macroeconomics such as
the failure of macroeconomics to understand and model financial markets and their effect on the real economy.
We may conclude this chapter by quoting from Paul Romer’s (the 2019 Nobel Prize winner, and briefly the Chief Economist of
the World Bank in 2018) recent famous article about the future of macroeconomics entitled “The Trouble with
Macroeconomics” [Today]. This article, as should be expected, is not liked by many mainstream economists. P. Romer noted,
I agree with the harsh judgment by Lucas and Sargent (1979) that the large Keynesian macro models of the day [the
1970s NCSK models] relied on identifying assumptions that were not credible. The situation now is worse. Macro models
make assumptions that are no more credible and far opaquer ……, the financial crisis of 2008-9 shows that Lucas’s
[i.e. The NCs and NKs] prediction is far more serious failure than the prediction that the Keynesian models got wrong.
So what Lucas and Sargent wrote of Keynesian [NCSK] macro models applies with full force to post-real macro models
[modern macroeconomics that is not based on realistic assumption - the DSGEs] and the program that generated them:
.. that these predictions were wildly incorrect, and that the doctrine on which they were based is fundamentally flawed,
are now simple matters of fact ...... the task that faces contemporary students of the business cycle [modern
macroeconomics] is that of sorting through the wreckage ... (Romer, 2016)
Romer has to struggle hard with himself and potentially with anticipated feelings of his fellow mainstream economists when
writing the above. Yet, he has courageously said it. This can be read from this quotation from the same article,
Some economists counter my concerns by saying that post-real macroeconomics is a backwater that can safely be
ignored; …the trouble is not so much that macroeconomists say things that are inconsistent with the facts. The real
trouble is that other economists do not care that the macroeconomists do not care about the facts. An indiﬀerent
tolerance of obvious error is even more corrosive to science than committed advocacy of error. It is sad to recognize
that economists who made such important scientific contributions in the early stages of their careers followed a
trajectory that took them away from science. It is painful to say this so when they are people I know and like and when
so many other people that I know and like idolize these leaders. But science and the spirit of the enlightenment are
the most important human accomplishments. They matter more than the feelings of any of us…..some of the
economists who agree about the state of macro in private conversations will not say so in public…. yet some of them
also discourage me from disagreeing openly... they may feel that they will pay a price too if they have to witness the
29
unpleasant reaction that criticism of a revered leader provokes. There is no question that the emotions are intense.
When the person who says something that seems wrong is a revered leader of a group…., there is a price associated
with open disagreement. This price is lower for me because I am no longer an academic. I am a practitioner, by which
I mean that I want to put useful knowledge to work. I care little about whether I ever publish again in leading economics
journals or receive any professional honour because neither will be of much help to me in achieving my goals. As a
result, the standard threats that members of a group can make do not apply [to me] [Interestingly, he got the Nobel
Prize after this article; thus, did not cost him at least the professional honour].
Thus, if modern macro models as epitomized by DSGE models have failed in their home country as described above, one can
imagine how they could utterly fail in developing countries in general and in African economies in particular that have different
features and structures compared to advanced countries.
In addition, the modern synthesis of NC and NK models (the DSGE) have emphasized the use of interest rate as a policy
instrument to stabilize the economy. This is because interest rates were believed to be more reliable determinants of
consumption and investment than, say, money supply. Interest rates are also generally handled by central banks which are
independent and hence help avoid fiscal policy which was taken to be subject to pollical influence. In addition, as critics of the
Keynesian system, the new synthesis macro models do not have room for fiscal policy too. However, in the wake of the current
(2020) COVID-19 pandemic, interest rate, even being near zero and negative in some countries, came to be ineffective. As a
result, every rich country has resorted to fiscal policy of ‘stimulation packages’ (a policy neglected in the DSGE models and
their policy rule equation) as was the case in 2008/09 crisis. The worsening inequality in advanced countries since the 1980s
is also believed to depress demand more than the pandemic’s disruption of supply. The COVID-19 crisis hit the poor harder
too. Thus, despite the pandemic’s supply disruption effect price did not surge in industrial countries because demand was hit
much harder (The Economist, 2020). Rather, saving (not investment) began to increase despite the significant decline in
interest rate because of expectation of future inflation and a further fall in interest rate. It appears that such situations
couldn’t be handled by the interest rate-based policy tools given in the DSGE models.
Thus, contrary to the preference of the synthesis’s DSGE models for monetary policy, the rich countries announced fiscal
stimulus of about US4.3 trillion (a deficit of up to 17% of GDP in some countries) to abate the economic effect of the pandemic.
This has calmed markets, stopped business from collapsing and protected household income, according to the Economist
(July, 23, 2020). Now authorities from US to European central banks are calling for fiscal policy. It looks that Keynes (and the
PKs’ idea) is being resurrected again. As The Economist (2020) noted, central banks in advanced countries are now becoming
enablers of the fiscal policy by monetization of the deficit (by keeping public borrowing cheap and purchasing gov’t bonds).
They are also being relegated to the back sit and becoming ‘the operation arm of the treasure’, as the former deputy governor
of the Bank of England, Paul Tucker, commented (The Economist, July 23, 2020).
The moral of this story is that both the 2008/09 financial-cum-economic crisis as well as the COVID-19 pandemic’s economic
effect show mainstream macroeconomics (i.e., NC and NK) and their DSGE models are neither able to predict and explain
such shocks nor could suggest the way out of it. This underscores the need to rethink about their relevance in today’s world.
We should also note in passing that though they are not openly given credit, the explanation as well as the policy prescription
of heterodox economists such as the Post Keynesians are the ones that are actually in use in today’s rich countries (You may
think about: why then are NC and NK, instead of PK, are dominant in industrialized countries today, despite their failure?).
30

Market Clearing Models Say’s Law & macroeconomics
Aggregate Demand Failure Ad hock versus Endogenous Rigidities
Keynes’s Macroeconomics Neoclassical Synthesis Keynesian
New Keynesian Macroeconomics New Classical Macroeconomics
Post Keynesian Macroeconomics Structural Macroeconomics
Structural Adjustment Programs (SAPs) Poverty Reduction Strategy Programs (PRSPs)l
Micro-foundation Representative Agent Model vs Emergence
Review Questions
[1] Keynes argues that his theory is a general theory and the classical/neoclassical modes as a special case while the
NCSK think their model is a general model while Keynes’ theory as a special case of theirs. Discuss.
[2] Compare and Contrast the New Keynesian and New Classical schools
[3] How different is the New Keynesian Macroeconomics is from NCSK
[4] Will African countries’ balance of payment deficit could be resolved by devaluation if the Marshal-Learner condition
is satisfied? Explain your answer.
[6] Compare & contract the policy implications of Keynes theory and New Classical theory of
[7] Is there a different between SAPs and PRSs from macroeconomics policy perspective? Discuss?
[[8] What are the salient feature of Structural Macroeconomics and how relevant this approach is to Africa.
References for Further Reading
Agénor, Pierre-Richard (2000). The Economics of Adjustment. San Diego: Academic Press.
Alemayehu Geda (2002). Finance and Trade in Africa: Macroeconomic Response in the World Economy Context. London. Basingstoke:
Palgrave-McMillan.
Alemayehu Geda (2005), ‘Ethiopian Macroeconomic Modeling in Historical Perspective: Brining Gebre-Hiwot and His Contemporaries to
Ethiopian Macroeconomics Realm’, Journal of North East Africa,
31
Alemayehu Geda (2018), ‘African Economies and Relevant Economic Analysis: A Structuralist Approach, Journal of African
Transformation, 2 (1&2): 1-34.
Alemayehu Geda (2019). The Historical Origin of African Economic Crisis: From Colonialism to China. Cambridge: Cambridge Publishers.
Blaug, Mark (1996). Economic Theory in Retrospect, fifth edition. Cambridge: Cambridge University Press.
Davidson, Paul (1994). Post Keynesian Macroeconomics Theory. Cheltenham: Edward Elgar Publisher.
FitzGerald, E.V.K. (1993). The Macroeconomics of Development Finance: A Kaleckian Analysis of the Semi-Industrialized Economy.
London: St. Martin’s Press
Friedman, Milton (1953), ‘The Methodology of Positive Economics’, in Daniel M. Hausman (ed.) (1990). The Philosophy of Economics: An
Anthology. Cambridge: Cambridge University Press.
Heijdra, Ben (2009). Foundation of Modern Macroeconomics. Oxford: Oxford University Press
Lavoie (2006). An Introduction to Post Keynesian Economics.
Mammdani, Mahmood (2018, 1996). Citizen and Subjects: Contemporary African and the Legacy of Late Colonialism. Princeton and
Oxford: Princeton University Press.
Mkandawire, Thandika (2001), ‘Thinking about Developmental States in Africa’, Cambridge Journal of Economics, 25(3):289-313.
Mankiw, N. Gregory (2006),’ The Macroeconomist as Scientist and Engineer, Journal of Economic Perspectives,20 (4): 29–46
Palley, Thomas I. (1996). Post Keynesian Economics: Debt, Distribution and the Macro Economy. London: Macmillan Press Ltd.
Romer, David (2012). Advanced Macroeconomics, 4thnd edition. London: McGraw-Hill.
Romer, Paul (2016), ‘The Trouble with Macroeconomics’, (Delivered January 5, 2016 as the Commons Memorial Lecture of the Omicron
Delta Epsilon Society. Forthcoming in The American Economist).
Shiak, Answar (2016). Capitalism, Competition and Conflict. Oxford: Oxford University Press
Snowdon, Brian and Howard R. Vane (2005). Modern Macroeconomics: Its Origins, Development and Current State. Cheltenham: Edward
Elgar.
Taylor, Lance (2004). Reconstructing Macroeconomics: Structuralist Proposal and Critiques of the Mainstream. Cambridge, Mass:
Harvard University Press.
Taylor, Lance (1983). Structuralist Macroeconomics: Applicable Models for the Third World. New York: Basic Books.
Taylor, Lance (1991). Income Distribution, Inflation, and Growth: Lectures on Structuralist Macroeconomic Theory. Cambridge: MIT
Press.
The Economist (2020) ‘Starting over again-the COVID 19 pandemic is forcing a rethink in macroeconomics, The Economics, July 25,
2020
Weeks, John (1989). Critique of Neoclassical Macroeconomics. New York: Palgrave Macmillan.
Weeks, John (2012). The Irreconcilable Inconsistencies of Neoclassical Macroeconomics: A False Paradigm. New York, USA: Routledge,


AFRICA I: THE SHORT RUN

Alemayehu Geda


1
Ch 2: Review of IS-LM and AD-AS Models Alemayehu Geda

Alemayehu Geda
© Alemayehu Geda, 2020

2



3
Chapter 2 Review of the IS-LM and Aggregate Demand

and Supply Models and their Dynamics
Shantayanan Devarajan of the World Bank, and Sherman Robinson of the International Food
Policy Research Institute, pointed out that “policymakers need not grasp exactly how a model
works, any more than ‘a pilot needs to understand the insides of a flight simulator’. This may be
true. But too many policymakers never even ‘fly’ their models”.
The Economist, July 13, 2006
Macroeconomic models are important tools that can be used for macroeconomic analysis. This macro modelling tradition
emerged following the birth of modern macroeconomics with Keynes’ book, The General Theory of Employment, Interest and
Money. This is latter given a particular form called the IS-LM model by Hicks and Modigliani and dominated economic textbooks
until today. This has evolved over time to a dynamic aggregate supply and aggregated demand (AD-AS) model and recently
to what are called to dynamic stochastic general equilibrium models (DSGE). This chapter will briefly review the IS-LM and
AD-AS models by way of revision. It also attempts to see this development and its relevance in African context. The chapter
thus will offer us the skeleton of macroeconomics, its modelling and use for policy analysis. The rest of the book will be
devoted to giving flesh and blood to this Skelton so as to enrich our understanding of macroeconomic theory and policy.
2.1 Mr. Keynes and the Classics: IS-LM & AD-AS Models
The IS-LM model has dominated macroeconomics textbooks throughout the world. The idea behind this innovative device that
attempts to capture the basic ideas of Keynes’s path breaking book “The General Theory, Employment and Interest” in 1936
came from Hick’s article in 1937 titled “Mr Keynes and the Classics” as well as critical contribution of Modigliani in 1944. As
we have seen in Chapter 1 this doesn’t mean that other economists, such as the Post-Keynesian, agree with this “neoclassical
synthesis” interpretation of Keynes that uses the IS-LM model. It is for this reason the famous Cambridge economist Joan
Robinson, for instance, labeled it “Bastard Keynesianism”.
Be that as it may, its development up to the early 1970s has been instrumental for the development of applied
macroeconometric models. Such models are used in many ministries of finance (Treasure) and central banks of the world
for policy analysis and forecasting. They are also still in use in many countries, including in Africa (see below). We will briefly
revise this IS-LM model and its extension to an aggregate demand and aggregate supply model (AD-AS model) and its use for
policy analysis in algebraic form. The starting point for the IS-LM/AD-AS models is the national income identity which is given
by,

4
Y=C+I+G+X-IM [1]
Where: Y is the Gross Domestic Product; I is investment; C is private consumption; G is government consumption; IM and X are
imports and exports of goods and services, respectively.
These national income identity shows one of the key relationships in macroeconomics because the left hand-side of the
equation “Y” shows aggregate supply while the right-hand side shows the aggregate demand for this output which is divided
into consumption (C), investment (I) and net export (X-IM) demands. Since Keynes’ theory came out of the great depression
where the Western economies were functioning below their capacity (that is, Y was below its capacity) due to lack of effective
demand, if demand (i.e. the right side of equation [1]) is raised somehow, output (the left hand side, Y) will increase
continuously till it reaches its full capacity. This basically means the Keynesian formulation doesn’t bother about how to
specify the left-hand side variable, “Y”, but rather on how to specify and understand the right-hand side (aggregate demand)
variables. That is why we will be spending one chapter (e.g. Chapter 5 for “C”) to each of the variables in the right-hand side
of equation [1] in this book. Algebraically, we can further specify each of the right-hand side variables of equation [1] to form
the IS-LM and AD-AS model. The IS-LM model, in its simplified form, can be given by equations [2] to [5] which are divided
into goods market and money market conditions.
2.1.1 The IS-LM Model: The Goods and Money Market
The Goods Market: the right-hand side of equation [1] could also be labeled as “goods market” equilibrium condition since
we are not talking about money but rather about consumer, investment, import and export goods in that equation. The goods
market equation begins by specifying consumption as a function of disposable income (i.e., income less taxes, Y-T) in equation
[2]. The disposable income, in turn, is specified in equation [2b] while tax (T) is specified as a function of the tax rate (t),
income (Y) and other determinants of tax and depicted by TO in equation [2c]. In equation [3] we have specified the other
component of aggregate demand, investment, as a function of income (Y) and real interest rate, r (r being nominal interest
rate [i] less ‘inflation’). Chapter 5 about consumption and Chapter 6 about investment will explain in detail why we have
specified these equations in this manner.
Goods Market
[2]
[2b]
[2c]
[3]
[4]
∗
[5]
[6]
Equation [4] specifies the government expenditure to be exogenous by denoting it by GO. In equation [5] export (X) is specified
as a function of income of our trading partners (Y*) and the real exchange rate (Q). Real exchange rate is defined as nominal

5
exchange rate (e) adjusted by relative foreign (P*) and domestic (P) prices, and hence Q=e(P*/P). Both Q and Y* are assumed
exogenous in this model. Similarly, in equation 6 imports (IM) are specified as the function of real exchanger rate (Q) and
income (Y). These exogeneity assumptions about imports and exports are relaxed and discussed in detail in Chapter 4 which
is devoted for open-economy macroeconomic issues.
Given these equations which basically elaborated the right-hand side of equation [1], we can get the goods market equilibrium
condition by inserting equations [2] to [7] in the national income identity equation that is given by equation [1], which basically
says aggregate supply, “Y” equals “aggregate demand” (C+I+G+X-IM). This procedure will leave us with one equation in two
endogenous variables which are “Y” and “i”. The equation shows a combination of “Y” and “i” at which the goods market is
in equilibrium. A locus of such points in a “Y” – “i” plane gives us what is the called the IS schedule which is a downward
sloping line. Why downwards sloping? Because, say, if “i” declines it leads to an increase in investment which means an
increase in aggregate demand which in turn increases “Y” – thus “i” and “Y” are moving inversely (Figure 2.1). Having this
goods market equilibrium, we cannot have a general equilibrium solution because we have two endogenous variables (i and
Y) in one equation. We need another equation with same endogenous variables to solve the model simultaneously – i.e. as a
general equilibrium model. In addition, the IS equation describes only the real/goods market side of the economy. Thus, we
also need to see the nominal side of the economy. For this, we need the money market condition.
The Money Market: In order to see the nominal side of the economy we need to introduce the money market. The money
market is a market where the demand for and the supply of money do interact. This is given by the demand for and the supply
of money equations (equations [7] and [8]) and the money market equilibrium condition given by [9].
Money Market
[7]
, [8]
[9]
Equation [7] defines the demand for money as a function of income (Y) and interest rate (i). As income increases the demand
for money for transaction purpose will increase while it will decline as interest increase because it means the opportunity
cost of holding money is increasing. In equation [8] the real money supply (Ms/P) is assumed exogenous (Mo/P), where P is
the general price level. Why these equations are specified as they appeared here is discussed in detail in Chapter 8. By
inserting equations [7] and [8] in [9], which is the money market equilibrium condition, we will equate the demand for money
with supply of money. This is the LM equation. Like that of the IS equation, we have two endogenous variables “Y” and “i” at
which the money market is in equilibrium. A locus of such points forms a schedule in a “Y”-“i” plane which is upward sloping.
We call this the LM schedule. Why it is upward sloping? Because, say, if output (Y) increases, this will lead to a rise in demand
for money for the given level of interest rate. This demand could be lowered only if the interest rate has increased. Thus,
output and interest rate would move in the same direction - thus leading to a positive association between “i” and “Y” shown
by upward slopping schedule.

6
Figure 2.1 Graphical re-presentation of three equations
i LM (M0, P)
LM’
e*
i.0
IS’
IS (C0, T0, X0, I0, G0, IM0,Y*,Q)
Y0 Y
Since both the IS and LM schedules show the combination of “Y” and “i” at which each of these markets are in equilibrium,
we can bring both together in one “i”-“Y” plane to have a general equilibrium solution- a point where the two schedules
cross each other, shown by e* in Figure 2.1. At e*, we have a general equilibrium because both the money and goods markets
are in equilibrium. Algebraically, this is a simultaneous equation solution for the final reduced form two equations for the two
markets that have two endogenous variables, “i” and “Y” each. Since now we have two equations (goods market equilibrium
equation and the money market equilibrium equation) in two variables “i” and “Y”, this is a system of simultaneous equations
that will have a unique solution that corresponds to e* in Figure 2.1.
Given this model, as depicted by Figure 2.1, we can analyze the impact of fiscal policy (say an increase in G) which will shift
the IS curve to the right (to IS’) on “Y” and “i” plane. Similarly, we can also analyze the effect of monetary policy, such as
change in MO which shifts the LM curve to the right (to LM’) on the “Y” and “i” plane (these policy shifts are given by the dotted
lines, IS’ and LM’). This basically summarizes the IS-LM model.
Before concluding this section, it is worth mentioning De Vroey’s (2000) review of Hicks' famous article "Mr. Keynes and the
'Classics'" (1937), which is one of the most influential articles in modern macroeconomics that laid the foundation for the IS-
LM model. According to De Vroey (2000), in addition to this paper, there were also two other papers, written by Harrod and
Meade that were aiming at clarifying the content of Keynes' General Theory. Despite the fact that these three contributions
were similar, Hicks's article was the most influential. Hick’s SI-LL model, as he originally labeled it, is different from the
subsequent IS-LM models found in macroeconomics textbooks and that we have discussed above, argues De Vroey. De Vroey
(2000) noted Hicks’ article was fundamental as the conceptual tool for the textbook version of the IS-LM model is laid by it.
However, De Vroery (2000) argued, that there is a breach of continuity between his work and the standard textbook version
for the following reasons. First, in Hicks' account, involuntary unemployment or non-market clearance exists in both the
classical and the Keynesian models. However, in the textbook account of IS-LM this occurs only in the Keynesian model.
Second, in Hicks's article, monetary expansion has real effect in the classical model, whereas this is not necessarily so in
the Keynesian model. In contrast, in the textbook version of the IS-LM model monetary policy is ineffective in the classical

7
model, the opposite being true in the Keynesian model. The transition from Keynes' economics to the neoclassical synthesis
version of the IS-LM model is, rather, a two-step process: in the first step there is the transition from The General Theory
to Hicks' model; and its second stage refers the shift from Hicks' use of the IS-LM framework to its modern textbook version
that we have discussed so far. In this regard, I agree with De Vroey’s (2000) claim that F. Modigliani's article "Liquidity
Preference and the Theory of Interest and Money", that was published in Econometrica in 1944, played a decisive role in this
second transition (see also Chapter 7). Thus, it is this, not Hicks' version, that is found in standard Textbooks. You may examine
the above-mentioned original articles to look into the correct reinterpretation of such seminal papers. It is also worth
consulting the excellent article by Puu (2006) which used a different graphical construction than the standard IS-LM model
that is based on the works of Palander (1942) who wrote it in Swedish, and hence, not accessible to many. However, the
Palander (1942) device is more useful for detecting features of the Keynesian system that the IS-LM model failed to capture,
according to Puu (2006).
We may finalize our exposition about the IS-LM model by noting two important issues. First, the model above assumes the
import and export equations are almost exogenous. It doesn’t also talk about the balance of payment and its effects. Thus,
our discussion there was based on closed-economy model. We will relax these assumptions when we discuss the open
economy model in Chapter 4. Second, you might have noticed that we haven’t talked about prices in our discussion so far.
Thus, the IS-LM model is essentially a fixed price model. This formulation makes sense for Keynes because he was developing
the idea during the great depression where the major problem was deficiency of effective demand and producers have excess
capacity. The latter implies that producers can increase output if effective-demand increases without an increase in prices
(i.e., at a given prices). However, this fixed price assumption could be relaxed by introducing aggregate supply and a general
price level in the IS-LM model. This will give us the aggregate demand and aggregate supply models, discussed next.
2.1.2 The Aggregate Demand and Aggregate Supply (AD-AS) Model and Policy Analysis
We will do the extension of the above IS-LM model into an AD-AS model by introducing one additional equation that specify an
aggregate supply equation which relates output with price. This additional equation is referred as the “Phillips Curve” or the
“Expectation-augmented Phillips Curve” and developed since the mid-1960s (see Chapter 7 for detail derivation of the
expectation augmented-Phillips curve). Leaving its detail derivation to Chapter 7, we simply specify it here as relationship
between inflation, output (output-gap) and expected inflation. Not to stick to a specific functional form as that of the linear
IS-LM model above, the AD-AS model below is specified in a generic functional form, using equations [10] to [14].
Y C I G Where: , 0; [10]
0 1 [11]
, 0 [12]
, Where: 0 & 0 [13]
,
Where: H 0 & is expected inflation [14]
Y and actual and potential (full-employment) output, respectively.

8
A sub-script (say, y) attached to a variable such as C shows the first derivative of that function (C) with respect to the
variable denoted by the subscript (Y), which is given by CY.
Equations [10] to [12] represent the IS relationship. Here, aggregate demand is defined as the sum of consumption (C) which
is a function of income, investment (I) which is a function of real interest rate (r) and government expenditure (G) which is
assumed fixed at GO, that is assumed exogenous as in the previous IS-LM model. Real interest rate (r) is defined as the
difference between nominal interest (i) and the expected inflation rate, .
Equation [13] is the real demand for money which is equated to real money supply in equilibrium. The derivative of the demand
for money (L) with respect to “Y” and “i” is positive and negative, respectively, and given in equation [13]. Equation [14] is the
new addition to our IS-LM model above and referred as the “Augmented Phillips curve”. It is a summary representation of
the aggregate supply side of the model. Note that, if we assume all prices to be fixed, equation [14] will be reduced to zero
and the model becomes a short-run Keynesian IS-LM model that we discussed above. With the fixed price assumption relaxed,
and given a production function of a particular form, there is a particular level of “Y” associated with full-employment that
is denoted by – you may think of this as the trend value of “Y” or the full-employment level of output for simplicity. In the
long run, prices do change to eliminate the deviation of “Y” from . The fact that “H” is a positive function of the output gap
(Y- ) summarizes this feature. Thus, H’>0 means, if actual output is above the full-employment level, it leads to an increase
in prices. The in this equation represents the expected inflation rate which is positively related to change in prices
(inflation). In full-employment (Y= .), this equation says actual and expected inflation are equal. Since is exogenous, the
full-employment value of inflation is, thus, determined by demand side considerations. To simplify the model, we will ignore
agent’s expectation for now and set 0 (we will discuss this expectation formation in detail in Chapter 3). This implies,
(a) we have a single short-run Phillips curve and (b) there is no difference between real and nominal interest rate.
We can now reduce the five equations in five variables model described so far into three equations characterized by a
recursive system. A recursive system is very handy because subsequent equations in the system could be solved by
substituting the solution of one of the equations in the subsequent equation recursively. Let us chose “Y” and “r” as our
variables of interest and assume further that all the equation could have a linear approximation or representation (assuming
we are analyzing a small change). With this assumption, we can take the total differential of the IS, LM and Phillips equations
that are given by equations [10] to [14] (Note that the IS equation used in equation [15] is derived by substituting equations
[11] and [12] into [10]).
[15]
[16]
[17]
Note that:
i) Equation [16] is simplified using our assumption that dπ=0
ii) Equation [17] is also simplified using the same assumption dπ=0 and the condition that the natural rate of output is
constant, =0

9
iii) The dP term in equation [17] can be dropped because its coefficient is zero in full-employment.
A. Short-term Policy Analysis using the AD-AS Model

Our equation system given above is a recursive system at a point in time. This means, once we have solved for “dY” and “dr”
using equation [15] and [16] and the exogenous and predetermined variables in the two equations (ie. dG, dM, and the
predetermined price by assumption (i) above, dP), we can use one of the solutions from this simultaneous equation, “dY”, and
insert it in equation [17] to solve for “ ”.
Alternatively, instead of such substitution, we can also use matrix algebra and employ Cramer’s rule to compute the
equilibrium values and various policy multipliers. Using this later method, equations [15] and [16] can be written as,
1 1 0 0
[18]
0
Matrix A Endogenous variables Matrix B Exogenous variables

The first row of Matrix A shows the IS equation while the second row shows the coefficient of the LM equation. Similarly,
Matrix B shows the coefficients of the exogenous variables as given in equations [15] and [16]. From this set-up we can
compute six multipliers, each of them computed as the ratio of the endogenous variable (dY and dr) with respect to the
exogenous variables (dG, dM and dP). You will note here that the multiplier with respect to dG shows the impact of fiscal
policy on income (dY) and real interest rate (dr) while that with respect to dM shows the impact of monetary policy on income
(dY) and real interest rate (dr).
Going to the solution of the model, equation [18] can be solved for the endogenous variables (dY, and dr) by multiplying both
sides of this equation by the inverse of the coefficient matrix of the endogenous variables, Matrix A. For this we need the
determinant of Matrix A, which will be the denominator of all the six multipliers. The numerator for each of the multipliers,
say for dY/dG, could be obtained by computing the determinants of a modified Matrix A that wills be formed by replacing the
column coefficients of the endogenous variable of interest (dY in our example – ie. column 1 of Matrix A) by the column
coefficients of the exogenous policy variable of interest (dG, a fiscal policy indicator, in our example -ie column 1 of Matrix B).
Thus, the denominator of the multipliers which is the determinant of matrix A and the determinant of the numerator for fiscal
policy, dG can be given by,
| | 1 Denominator of the multipliers [19a]
1
The numerator of dG [19b]
0
Thus, the multiplier for the change in autonomous expenditure, dG, becomes,
[19c]
Equation [19c] basically tells us what will be the multiplier effect of change in G, dG (fiscal policy) on output, dY. You may
carry similar policy experiments and could get the rest of the (five) multipliers. Since the result shows the change in the

10
endogenous variables (say, Y) due to change in exogenous variable (say, G) by comparing the new result with the situation
before this policy change, such analysis is termed as ‘comparative static’ analysis. This matrix approach has the advantage
of determining the sign of the multipliers based on the restrictions we imposed when we formulated the model using equations
[10] to [15]. These restrictions were:
0 1; , , 0; , 0 [20]
However, these restrictions are not enough to sign the determinants of the matrices used by multipliers like equation [19c].
This means we need actual quantitative values of the parameters to see whether, say, equation [19c] is positive or negative
(though we know the numerator since Li is negative). Moreover, the full equilibrium values such as [19c] assume stability of
the model. This means when the model is solved it is assumed that it will converge, not diverge. Thus, we need to specify the
condition for convergence or stability of the model and check that those conditions will hold. An interesting aspect of this
convergence (or stability) analysis is that we can use those stability conditions to sign the multipliers. This procedure is
referred as the ‘correspondence principle’ (Scarth, 1988).
B. Convergence and Stability Analysis
Our approach to the derivation of multipliers above assumes that the economy will reach full-employment equilibrium
eventually (ie., Y= ). To see this, we need to examine the dynamic equation in our AD-AS model. This happens to be “the
Phillips curve” which is given either by equation [14] or [17]. Let us then examine what the implications of the full-employment
equilibrium assumption would be for convergence or stability of the model using this dynamic part of the model, equation
[17]. From this we have,
, using the long-run condition of dP=0 [21a]
From the matrix-based equation given by equation [18], we can have the following using Cramer rule,
[21b]
Combining [21a] and [21b] (multiplying one by the other), we can get,
[22]
Equation [22] is the dynamic equation at the full-employment equilibrium solution that could be used to examine the stability
or convergence condition. In Figure 2.2, and P are drawn in such a way that they are inversely related. The full-employment
equilibrium point is given by “A” where 0.
From Figure 2.2 we can see that 0 is the necessary condition for stability. Why? This is because if P is below OA,
convergence (to A) requires P to increase. This means movement along the line CB, from C to A. On the other hand, if P is
above OA, convergence (to A) requires P to decrease. This means movement along the line CB, from B to A. Thus, for
convergence to occur, the observations must be on some lines, such as CB, that passes through the area that is not shaded.
This implies the slope of is negative. By implication, the shaded area on either side of A shows an area of divergence.

11
Figure 2.2 The Stability Requirement of the Model
C

+ve

A
0
P
A
‐ve
Equation [22] is the expression for of our model. This expression could be negative so as to fulfill the convergence
condition noted, only if the last part of its expression (ie.,, ) is negative. This is so because the rest of the
expressions (ie., in this equation is positive, since Ir is negative and MH’ and are positive. Thus, this must
be the stability condition which is implicitly assumed when the full equilibrium multipliers are calculated. Based on this result,
internal consistency requires that the denominators for all multipliers to be negative. Using this final result, we can now re-
examine our multiplier for fiscal policy which was given by equation [19c] which becomes now,
0 0 [23]
Thus, we managed to sign the fiscal multiplier thanks to the ‘correspondence principle’. We may conclude this analysis by
showing this stability condition using AD and AS graph. Since the aggregate demand curve is a summary of the IS and LM
relationship, Equation [21b] gives us the inverse of the slope of the AD schedule. The convergence requirement, which says
0, is the necessary and sufficient condition for the aggregate demand curve to be negatively slopped.
For the long-run full employment (fixed) level of supply, this aggregate demand and the convergence condition is depicted in
Figure 2.3
Figure 2.3 shows that convergence occurs only when the condition about the negative slope of the aggregate demand defined
above (equation [23]), which is now depicted in panel (a) of Figure 2.3, is satisfied. In panel (b) of Figure 2.3, we have shown
the unstable case which doesn’t satisfy the convergence condition specified above because the aggregate demand curve is
positively slopped. As shown in panel (a), it is only when the aggregated demand is downward sloping, a rise in price that will
occur in the event of output being greater than its long run sustainable level ( could lead to the dampening of this
gap and leads to the convergence of the model. Panel (b) shows the opposite scenario where rising level of price leads to the

12
divergence of the output gap – showing the model is unstable when the stability condition shown in equation [23] is not
satisfied.
Figure 2.3 Convergence (Stability) Condition in AD-AS Model
P Long run supply
Short‐run supply
Demand
Short‐run supply
Demand
Y
[ (a) Stable Case] [(b) Unstable Case]
2.2 Towards Dynamic Aggregate Demand and Supply (AD-AS) and Dynamic Stochastic General
Equilibrium (DSGE) Models
Current advance in the use of macroeconomic models for policy analysis is based on the use of what are called dynamic
stochastic general equilibrium models (DSGE). DSGE’s are the state-of-the-art tools in macroeconomics and many central
banks in advanced countries are using them for policy analysis. However, as we saw in Chapter 1, their relevance is being
questioned following their failure to predict and explain the 2008/09 financial and economic crisis (and also their failure to
suggest on how to deal with the COVID 19 related economic slowdown in Advanced countries today). In particular, in relation
to COVID 19, it is fiscal policy, which is the opposite of the monetary policy suggested by DSGE models, that is currently in use
by governments all over the world to stimulated their economies. Be that as it may, these are models that you will study when
you pursue your advanced studies (such as PhD level studies). Here my objective is just to try to show you the evolution of
macro modelling from the above AD-AS models above to dynamic AD-AS models and then to the DSGE models, using the
excellent approach of Mankiw (2013) which definitely needs to be improved a lot to make it relevant in African context.
Let us begin transforming the above AD-AS model given by equations [10] to [14] to Dynamic AD-AS model first by introducing
three innovations: (a) we will make each of the equations dynamic by introducing time to each of the variables, (b) we will
make the aggregate demand and aggregate supply equations stochastic by introducing random error (stochastic) terms in
each of them, and finally (c) we will introduce one additional equation that shows a policy rule or a policy function that will be
pursued by monetary authorities such as central banks. Note that the latter is replacing the assumption of exogenous money
supply that was given as part of the IS-LM model equations given by equation [13]. In addition, the dynamic AD-AS model also
incorporates expectation, defined to be adaptive as given by equation [27] which is also used in equation [25]. The adaptive
expectation is used here for simplification; otherwise modern DSGE models use rational expectation which is discussed in
detail in Chapter 3. These three innovations will transform the previous static AD-AS model to a dynamic and stochastic

13
general equilibrium model – and hence the name, a simplified DSGE model. This modification is shown by the set of equations
given in equations [24] to [29].
Aggregate Demand [24]
The Fisher real interest equation [25]
The Phillips Curve/Aggregate Supply [26]
Adaptive Expectation [27]
∗
The Monetary Policy Rule [28]
Where: all variables as defined before; and the newly introduced variables represent aggregate demand and aggregate
supply shocks, respectively; and is a parameter which shows the real interest rate at natural rate of employment (at full-
employment). This can be read from equation [28]. when the two terms in bracket are reduced to zero at full-employment.
This dynamic AD-AS model is pretty much similar, in a simplified form, to the modern DSGE models (the New Keynesian
models) which are in use in many central banks and research institutions in developed countries. One main distinguishing
feature of the modern DSGE models from this dynamic AD-AS model is that the aggregate relationships given by equations
[23] to [28] are derived from micro foundations by assuming a representative consumer and firm that carry out optimization
in an inter-temporal optimization framework in modern DSGE models. This is crucial as it was central, among other things, in
addressing what is called the “Lucas Critics” in the use of large-scale Keynesian macroeconometric models (discussed in
Chapter 3 when we study the rational expectation hypothesis). It is also praised for building macro models on micro
foundation with deep parameters (parameters of agents’ behaviour and technological relation) Note, however, that micro
foundation-based aggregation from a representative agent-based model is a serious deviation from the original Keynes’
formulation where he was concerned at the aggregate relationship macro variables as such. The basic structure and the
workings of the modern DSGE modes are summarized in Figure 2.4 that is adopted from Sbordone et al (2010).
Figure 2.4 The Basic Structure of the Modern DSGE Models
Source: Sbordone et al (2010).

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We may conclude our discussion about the dynamic AD-AS and DSGE models by looking at their relevance in African context.
There are about five issues that we may need to think about in the use of such models in African context. First, as has been
discussed in Chapter 1 macro policy in Africa to date has been informed by IFIs’ liberalization policy. These IFIs used what is
called the RMSX models that is discussed in detail in Chapter 4. Increasingly, the IFIs are advising and giving training to many
central bank experts in Africa to implement the use of DSGE models for policy analysis and forecasting. The DSGEs are
essentially market clearing models that may not be relevant in the context of Africa where markets hardly function. In
addition, it is important to examine how different this is from the RMSX models that had been in use by IFIs and many African
governments for policy analysis. Second, going to the detail of these models, if such models are to be used, the inflation
equation given in equation [26] may need to be disaggregate in to food and non-food in African context. It also needs to be
linked with agriculture (food supply) sector as well as with the nominal exchange rate and money supply which are crucial
variables for explaining inflation in Africa (see Chapter 8). This, in turn, may need to be linked with the policy rule equation,
especially how money supply could be handled there. Third, the key relationship between the demand for goods and services
and real interest rate in advanced countries, which is given in equation [24], may not depict the condition in Africa where
capital markets are missing and open market operations are problematic (see Chapter 8). In addition, the role of the external
sector which is neglected in this model is central in African context (see Chapter 4). Fourth, the policy rule equation (equation
[28]) also relies on nominal interest rate as policy instrument which is hardly important in Africa setup. For instance, nominal
interest rate was not found to be a good instrument to attain the target rate of inflation even in countries such as Kenya,
which is a relatively an advanced African economy; rather, direct credit and exchange rate are found to be more important
as instruments of policy. Thus, one way to change this equation is to change the instrument of policy towards other
instruments such as exchange rate, direct credit, money supply target and the like. Fifth, in general, this dynamic AD-AS (and
also the DSGE) models are essentially a demand management models as specified here because the real interest rate (and
hence nominal interest rate and inflation) is believed to stabilize aggregate demand in response to inflation and output gap.
Thus, the modelers are essentially attempting to respond to Keynes’ concern of aggregate demand failure in advanced
countries. The question is, what if output doesn't respond to such demand management in Africa as that of the advanced
countries because of structural supply bottlenecks? In this latter case, a rise in AD could be inflationary, will not raise AS
(see Chapter 8). I think these are important issues that we need to take onboard to come up with a macro model relevant to
African condition. To conclude, the dynamic AD-AS model discussed here could be a good starting point for building applied
macroeconomic models for Africa that could serve as a tool for policy analysis. However, it needs to be adopted to reflect
the concrete reality in each African country. In the next sub-section, I have briefly reviewed some of such attempts in East
and Southern African countries in which I myself participated. This is aimed at: (a) motivating you to engage in similar
research, and (b) to show you that the theories you will be learning in this book are relevant for applied work.
2.3 Applied Dynamic AD-AS Macroeconometric Models in in Eastern and Southern Africa1
Following the economic events of the 1970s and 1980s, a large number of macro-economic models have been constructed for
many African countries.2 In the heated debate of the 1970s and early 1980s about the role of additional external resources and

1 This brief survey focuses on applied macro models and in Eastern and Southern African countries mainly to save space. It is taken from Alemayehu
and Addis (2016) and you can get all the refences cited here in that article.
2
A survey of modelling efforts in Africa in the past by Harris (1985) showed that there were about 184 macroeconomic models on various
African economies at the time, and 33 of these were on Nigeria.

15
domestic adjustment measures in economic recovery of Africa, Horton and McLaren (1989) constructed a supply constrained
macro-econometric model of the Tanzanian economy to examine (using model simulation) the effects of several alternative
strategies using this model. Their results highlight the problems of either a strategy of devaluation or of more external aid alone
(Horton and McLaren, 1989). In terms of the use of macroeconometric model that is grounded on the specific supply problem
condition of Tanzania, this was an excellent model that shows the use that can be made of such models for policy analysis.
Elliott et al (1986) built a macro-economic model of the Kenyan economy, as a small and open developing economy that is
vulnerable to conditions in world commodity and credit markets. The theoretical structure of the model consists in markets
for domestic output, labour, money and the balance of payments. Elliott et al (1986) provided a complete listing of the model
equations with numerical results of the estimated equation. The authors used the model for forecasting and policy simulations
exercise using alternative policies. Similarly, Musila and Rao (2002) developed a demand-oriented macro-econometric model
of the Kenyan economy, whose equations are estimated using the co-integration technique. The model is used to perform
various policy simulation experiments to determine the sensitivity of key macro-economic variables to changes in exchange
rate, net government current expenditure, and nominal interest rate. The results reveal that exchange rates and fiscal
policies are relatively more effective than monetary policy (via interest rate) in influencing the level of economic activity in
Kenya (Musila & Rao, 2002).
Notwithstanding Elliott’s (1986) and Musila and Rao’s (2002) type of models, which are academic-based works, two applied macro-
econometric models are currently in use in Kenya: the Central Bank of Kenya Macroeconometric Model (CBKMM) (see Were et al.,
2013), and the KIPPRA–Treasury Macro Model (KTMM) (see Huizinga et al., 2001). The theoretical basis of both models is the Keynesian
demand-driven model that is set up in a dynamic aggregate demand (AD) aggregate supply (AS) framework. Their fundamental
difference lies in the fact that the KTMM consolidates the monetary aspect of the model while having a detailed government (fiscal)
sector. This is because it was designed to meet government needs in the national budgetary and planning process. On the other
hand, the CBKMM has a more detailed monetary sector tailored to the needs of the central bank of Kenya, while consolidating the
fiscal block of the model. Both models were in use for forecasting, policy analysis and budget preparation by CBK and Kenyan
Treasury for many years until recently.
Asmerom (1991) developed a detailed economic-demographic model for Ethiopia and tried to study the interaction between
the two, considering various demographic variables as endogenous. The model aims, inter alia, to assess the effect of changes
in these demographic indicators on some economic parameters. Asmerom (1991) developed the economic-demographic
interactions in a schematic form by identifying the directions of associations among his variables and then deriving the
various structural equations and identities from that scheme. He, then, estimated the parameters of the model using time-
series data. He presented alternative simulation outcomes of the model under different assumptions.
Asmerom’s model was built for an academic study. Coming to applied models in Ethiopia, Alemayehu and Huizinga (2004) developed
a supply-constrained macro-econometric model for Ethiopia, for use by the Ministry of Finance and Economic Development. The
core behavioral equations of the model are estimated using an error-correction modelling approach. The model is similar to that
of the KTMM of Kenya where the fiscal, balance of payment and money supply block of the model is fairly disaggregated to offer an
adequate picture of the macro economy. It also differs from KTMM as it focusses on supply-constrained nature of the Ethiopian
economy which is similar to the Rwandan macroeconometric model developed by Alemayehu and Addis (2016).

16
Musila (2002) estimated a small-open economy macro-economic model for Malawi. The model consists of production,
expenditure, government, monetary, employment sectors and prices. The short-run version of the model was estimated using
the co-integration estimation technique. The model is used for various policy analysis. For instance, the dynamic simulation
results indicate that a sustained devaluation of the Malawi’s Kwacha improves the real trade balance, but leads to higher inflation
and reduces real GDP growth. Bond-financed increases in government consumption expenditures are less inflationary, leads to
higher real GDP growth, but worsen the real trade balance position (Musila, 2002).
Tjipe et al (2004) developed a macro-econometric model for the Namibian economy that is based on historical evolution of
the different sectors of the economy. The model equations are estimated using error correction modelling approach and
their forecasting performance is assessed. Tjipe et al. (2004) used the model to carry out policy analysis and external shocks
using a simulations exercise for evaluating different scenarios. This is aimed at giving insight in the future path of the main
economic variables of the model.
The Bank of Uganda (2010) has also built a small scale macro-economic model for Uganda. The model consists of five
equations: a price equation, an aggregate demand equation (IS curve), a money demand equation (LM), an exchange rate
equation and a policy rule. These equations are estimated using quarterly data for the period 1999-2009. The model is used
to conduct policy simulation experiments and to analyze the effect of different external shocks on inflation, output, exchange
rate and interest rates. The simulation results suggest that government expenditure (fiscal policy) is quite effective in raising
aggregate demand, while money supply (monetary policy) has little impact on inflation and interest rates and no effect on
output.
To sum up, as this cursory look at applied macroeconomic models in the East and Southern Africa region shows, despite the
growing importance of such applied macro-econometric models in many Africa countries, which is an encouraging trend, there
are a number of problems associated with these models and their use. The first important challenge relates to the limited
emphasis most applied macro models make on the supply constrained nature of African economies, and the importance of the
informal sector in such countries. Another problem that is widespread in most of African macro-econometric models relates to
the macro-economic modelling tradition that is largely framed without a consistent analytical and data consistency framework,
but is used both for policy analysis or model-based forecasting exercises. As Haris (1985) argued, equation specifications have
also been an exercise in the search for those that can give better explanatory power, rather than rooted in any framework of
economic behaviour. The emphasis of the models is on 'tracking history', and the long-run sustainability of policy actions is
largely ignored. Thus, issues such as the inter-temporal budget constraints are not observed, and these models are not robust
for analyzing the consequences of major policy shifts ether (Haris, 1985). In addition, although a large number of macro-
economic models have been constructed for Africa, most of the models on individual African countries (see, e.g., Horton &
McLaren, 1989; Elliott et al., 1986; Soludo, 1989; Musila, 2002; Musila & Rao, 2002) are either the products of doctoral theses,
represent one-shot research efforts to write journal articles, or the models are built to analyze specific issues and not
maintained thereafter. This shows the challenge of moving from academic modelling work towards applied macro modelling
work for policy analysis and its institutionalization.

17

The IS-LM Model The Aggregate Demand and Supply Model (AD-AS Model)
The Dynamic AD-AS Model Dynamic Stochastic General Equilibrium Model
Model convergence (Stability) condition The Money and Product Markets
The correspondence principle
Review Questions
[1] What is the main difference between the IS-LM and AD-AS Models?
[2] What is the main difference between AD-AS models and dynamic AD-AS models? And also, between Dynamic AD-AS
model and DSGE Models?
[3] How relevant do you think is the IS-LM model in African context?
[4] Given your knowledge of the IS-LM and AD-AS models, which of the two macro policies (monetary and fiscal) do you
think are effective in African condition? Explain your answer.
[6] Do you think all the models discussed in this chapter (IS-LM, AD-AS, Dynamic AD-AS and DSGE) equally relevant for
Advance and developing countries? Explain your answer.
[7] How do you think is Central Banks and Ministries of Finance in your respective countries design and use short run
macroeconomic policy? Do they have any such policy instruments that we discussed in this chapter? If not, how do
they handle policy analysis and forecasting.
[8] Is fluctuation in major macro variables [e.g. GDP] which is one of the basic ideas behind building these models the
same in advanced and African countries? If not, how should we model short run fluctuation in LDCs/Africa.
[9] What major features do you think an African macroeconomic model needs to incorporate?
[10] How important is the stability or convergence condition for macroeconomic models? What will happen if the model
is not stable?

Abel, Andrew B. and Ben S. Bernanke (2001). Macroeconomics, 4th edition. USA: Addison Wesley Longman, Inc.
Alemayehu Geda and Daniel Zerfu (2004). Review of Macro Modelling in Ethiopian with Lessor from Published African Models’, MOFED
Working Paper No. WP-01-2004, Addis Ababa (www.Alemayehu.com). Also, in Alemayehu Geda (2011). Reading on Ethiopian
Economy.
Alemayehu Geda and Addis Yimer (2016), ‘An Applied Macro-Econometric Model for Supply Constrained African Economy: A Rwandan
Macro Model, Tanzanian Economic Review, Vol. 4 Nos. 1 & 2, 2014: 24–55.

18
Alemayehu Geda, E.V.K. FitzGerald, K. Saramad and R. Vos.1992."Trends of public and private capital account variables in developing
countries", Institute of Social Studies, Erasmus University. The Hague (mimeo).
Branson W. (1989). Macroeconomic Theory and Practice. Third edition, New York Harper and Row Publishers.
De Vroey, Michel (2000, ‘IS-LM à la Hicks versus IS-LM à la Modigliani’, History of Political Economy, 32(2):293-316.
Heijdra, Ben (2009). Foundation of Modern Macroeconomics, 2nd edition. Oxford: Oxford University Press.
Hicks, J.R., (1937), ‘Mr Keynes and the Classics: A Suggested Interpretation’, Econometrica, 5: 147-149.
Keynes, J.M (1936). The General Theory of Employment, Interest and Money. New York: Prometheus Books.
Mankiw, G. (2013). Macroeconomics, 8th edition. New York: Worth publishing.
Modigliani, F (1944), ‘Liquidity Preference and the theory of interest and money’, Econometrica, 12 (1): 45-88.
Palander, T.F., 1942, ‘Keynes allmänna teori och dess tillämpning inom ränte-, multiplikator- och pristeorien’, Ekonomisk Tidskrift 44:233-
72.
Sbordone, Argia M., Andrea Tambalotti, Krishna Rao and Kieran Walsh (2010), ‘Policy Analysis Using DSGE Models: An Introduction, FRBNY
Economic Policy Review, October, 2010.
Scarth, William (1988). Macroeconomics: An Introduction to Advanced Methods. Toronto: Harcourt Brace Jovanovich Canada Inc.


Alemayehu Geda


Ch 7 The Labour Market Alemayehu Geda 1

Alemayehu Geda

© 2020


Chapter 7 The Labour Market & Labour Market Theories
For if one had a hundred thousand acres of land and as many Pounds in money, and as many
cattle, without a labourer, what would the rich man be, but a labourer… but it is the interest of
all rich nation, that the greatest part of the poor should almost never be idle, and yet continually
spend what they get. Those that get their living by their daily labour… have nothing to stir them
up to be serviceable but their wants which it is prudence to relieve, but folly to cure. The only
thing then that can render the labouring man industrious, is a moderate quantity of money, for
as too little will, according as his temper is, make him either dispirit or make him desperate, so
too much will make him insolent and lazy...
Karl Marx, 1867, Capital, quoting Bernard de Mandeville at the beginning of the 18th Century.
Despite its common use, [the use of the term ‘labour market’] is actively misleading and
inherently invalid. It is a false metaphor embodying an erroneous generalization. The term
should not be used because what is “marketed” is the capacity to work…. [labour] is not bought
and sold in a manner remotely resembling other commodities…The labour market is beyond
fiction, [is] a gross misrepresent that portray a social activity as something it is not…To achieve
analytical progress we have to banish ’labour market’ from our vocabulary. ‘Jobs’ market’
offers a considerable improvement with the great advantage of explicitly identifying the
exchange as one between employer and employees.,
John Weeks, The Economics of the 1%, 2014.
The labour market is an important market that needs to be understood by students in developing countries, perhaps more
important than it is in advanced countries. This is because the labour market is the market through which households earn
their income which is the major factor for poverty reduction. In addition, it is one of the main channels through which
government macro policy could influence poverty reduction. The huge unemployment problem in developing countries such
as those in Africa does also underscore the need to emphasize the labour market.
From the supply side, the labour market is one of the key markets to understand the effect of the supply of both skilled and
unskilled labour as an important factor of production (or resource) that needs to be mobilized for economic development.
The fact that most developing countries characterized by shortage of capital and abundance of unskilled labour means this
focus on the labour market much more imperative. Details about such skill supply and its effect on growth is discussed in
volume of II of this book.
The labour market in developing countries is also unique, compared to its counterpart in advanced countries, because it is
characterized by significant rural-urban divide and the related issue of rural-urban migration. This raises the issue of
whether the labour market theories that are discussed in this chapter are relevant to urban or rural areas or both of these
developing countries?
Thus, it is imperative to understand this market and the theories behind its operation and the behaviour of its actors.
Box 7.1 Is the Labour Market like any other Market? Ideas to critically think about
Despite its common use, [the use of the term ‘labour market’] is actively misleading and inherently invalid. It is a false
metaphor embodying an erroneous generalization. The term shouldn’t be used because what is “marketed” is the capacity to
work…. [labour] is not bought and sold in a manner remotely resembling other commodities. The term ‘automobile market’ is
a fiction of some limited use for understanding the economics, production and distribution of automobiles. The labour market
is beyond fiction, a gross misrepresent that portray a social activity as something it is not. It is a term misrepresents what
actually happens, presenting the search and acquisition of work as what the agents and principals of politically reactionary
capital wish it to be, and do all in their power to bring about. To achieve analytical progress we have to banish ’labour market’
from our vocabulary ….”jobs’ market” offers a considerable improvement [by] explicitly identifying the exchange as one
between employers and employees…..because a person is inseparable from his or her capacity to work, it is fundamentally
different from all other commodities… you cannot separate yourself form the work you do. You must be there to do it, and
doing it requires that you be there. This is profound and impacts on all aspect of the exchange between employer and
employees…The overwhelming concern of the sellers of all [commodities] but the capacity to work is price and revenue.
Concern about its quality, durability and suitability the seller leaves to the buyers. Because a person accompanies himself or
herself to work, the condition of work, pace and duration are important, along with price (wage or salary)….Employees usually
find themselves broke because they sell [their work effort or time] in order to by necessities of life while the employer buys
[the work effort] in order to sell [ie., buying the working time to produce goods and sell those goods for profit]]. …. The effort
that an employer extracts from an employee is not technically determined. An inherently conflictual social process
determines how an employee works and at what intensity. The process is inherently conflictual because the employer’s costs
decrease when people work longer and harder for the same pay. In contrast the employee’s income per hour worked declines
and so too may his or her state of health. The actual duration and pace of work reflect in great part the relative bargaining
power of the employer and employee….The impossibility to separate work form worker means that, unlike the producer of a
commodity, it can never be in the interest of a person to sell cheaper. If an apple farmer cannot sell all apples harvested, a
reduction in the price will in general add more to revenue than to cost, so profit increases…The same can never be true for
the sale of the capacity to work. A wage or salary cut with the same working hour and conditions leaves the employee worse
off. A pay cut and longer hours is a double blow. The employee’s time worth less with more of it to deliver.
Extracted from John Weeks, 2014, ‘The Economics of the 1%’
7.1 The Aggregate Labour Market

7.1.1 The Demand for Labour
The demand for labour in the standard (neoclassical) theory is based on a perfectly competitive market set-up with a profit
maximizing entrepreneur generating the demand for labour from its profit maximizing objective function. This can be shown
by using a production function of the following form,
, [7.1]
Where Y is real output, L labour and K is capital stock which is assumed to be constant.
Assuming constant return to scale, the short run profit function of the entrepreneur is given by,
Π [7.2]
Where: ∏ is profit; P is the price that the firm charges and W is the nominal wage rate.
Having equations [7.1] and [7.2] the firm choses the level of employment (L) that maximizes its profit, Once the labour
input/employment is chosen, the level of optimal output will be generated automatically using the production function given
by equation [7.1]. This is given by the following maximization problem as,
Π , [7.31]
The first derivative of this function with respect to labour, for a given constant level of capital, being,
, 0 , 0 - [7.4]
Figure 7.1 The Profit Maximization and the Optimal level Demand for Labour
PY, WN
WL
B
Pf(L,K)
A
L, Labour
Profit
L, Labour
Equation [7.4] shows that the firm expands its production until the marginal product of labour (the first derivative of the
production function given by f’(L, K)) equals real wage, W/P. This is also depicted in Figure 7.1. Note that at point “A”, the line
tangent to the production function is parallel to the WL function (the total wage bill or cost), showing thereby at that point
the distance between the two curves, the profit, is the highest – which in turn corresponds to the highest profit level in
second part of the diagram, the profit function. Such tangent becomes zero at “B” at which profit is zero and negative beyond
that. This is also shown in panel (b) of Figure 7.1
Equation [7.4] also shows the demand for labour. This is because it implicitly shows the relationship between demand for
labour, LD, and real wage, W/P, for a given level of capital, K. Using the implicit function theorem, the partial derivative of this
function can be obtained by total differentiation of equation [7.4] where a subscript “L” or “K” shows the derivative is taken
with respect to that particular variable.
, ⇒ ′′ , ′′ , [7.5]
.
From this we can get the demand for labour by solving equation [7.5] for dLD,
,
[7.6a]
, ,
Since , 0, the marginal product of labour (MPL) falls as more units of “L” are employed. Thus, equation [7.6a]
shows that higher real wage (d(W/P)>0) diminishes the demand for labour (dLD<0). It also shows that is the partial
,
derivative of the implicit function LD with respect to real wage (W/P). (The same procedure also offers the partial derivate
,
with respect to capital which will be 0, given , 0 as we noted above).
,
In sum, the demand for labour could be given as,

,
, : / 0; 0 [7.6b]
, ,
7.1.2 The Supply of Labour

The supply function is specified from the household perspective. The household is earning an income designated as “W” above.
The household knows what she earns, which is “W”, but doesn’t know how much she can buy with this wage income. The latter
requires some forecast about the price level, P, she or he is going to face. This expected price (Pe) is key in deriving the
labour supply equation because it determines the expected real wage (W/Pe). Let us examine this issue in detail. Having the
expected price denoted by “Pe”, the household is confronted with a choice of either supplying her labour (L) and earn wage,
“W”, with which she consumes “C” goods or spends her time relaxing and enjoying leisure (1-L), instead. Where (1-L) is a
proportion of a unit of time of the household spent on leisure, while “L” being that proportion of a unit of time spent on work.
Assuming wage, “W”, as the only income, the household will have the following utility function for maximization subject to a
budget constraint which is given by,
,1 [7.7a]
This could be simplified by solving the budget constraint given in equation [7.7a] for “C” and substituting the resulting
expression in the utility function given in the same equation [7.7a].
,1 [7.7b]
The first order condition for this maximization problem is given by,
0 [7.8]
The first part of equation [7.8], , shows the marginal benefit of supplying one extra unit of labour to the labour
market. It shows that an increase in labour supply leads to an increase in income which in turn increases the expected
consumption of good “C” that raises the utility of the household.
The second part of equation [7.8], , shows the marginal cost (disutility) of suppling that one unit of labour in terms
of reduced consumption of leisure, (1-L), which reduces the level of utility of the household in question. At the optimum level,
these two components of the derivative of the utility function (the marginal benefits and costs) need to be equal which can
be discovered by taking to the righ hand side of equation [7.8]. With these characteristics, equation [7.8] is
important because it offers us the aggregate supply of labour as a function of expected real wage as depicted in Figure 7.2.
Figure 7.2 The Derivation of the Labour Supply Schedule
Panel (a)
C2 Substitution effect
larger than [>]
E2 The income effect
C1
U2
E1 U1
L2 L1 1 (1‐L)
Panel (b)
(W/ Pe)
(W/ Pe 1)
(W/Pe2)
L
L2 L1
Figure 7.1, panel (a), shows that at the initial level of expected real wage (W/ Pe 1), the corresponding budget line goes through
line [1, C1] in the goods (Y-axis) and leisure (X-axis) plane. Optimal choice of the two goods means that the indifference curve
for the two goods needs to be tangent to this budget line, which is shown at E1. Here, we can plot the implied labour and
expected real wage relationship at this point in panel (b) part of the diagram by relating or taking as a coordinate “L1” and
(W/ Pe 1). Suppose the expected real wage is higher (or lower). This implies a rotation of the budget line to [1, C2] upward
(downward). The implied labour supply is “L2”. The latter is plotted in panel (b) at point E2. Connecting these two points gives
us an upward sloping curve which is the labour supply schedule.
It is imperative to note two important issues about the upward slopping nature of this supply curve that we developed above.
The first point is that the labour supply curve is not necessarily upward slopping as we did it here because there are two
potentially offsetting effects when the expected real wage is increasing: the income and substitution effects (i.e., the
substitution effect refers we substitute towards the cheaper good, “C” away from leisure, “1-L”. The income effect relates to
the fact that for a given previous level of labour supply, real income has increase which leads to the purchase of more, not
less, leisure goods). We managed to get upward slopping supply curve because we have assumed the substitution effect is
larger than the income effect as shown in panel (a) of Figure 7.2 and the size of the red-arrows in the same figure (see Box
7.1, however). The second point relates to the expected price we used and the nature of the expectation hypothesis employed
for the purpose. In this set-up, we have implicitly assumed the household is employing adaptive-expectation. In some related
models it is also conceivable to employ a rational expectation hypothesis, instead. If the latter is the case, we will get a supply
curve which is close to a vertical one (and in the case of prefect foresight, that will be perfectly vertical supply curve). Note
in passing that this expectation assumption has, in turn, implications to the kind of aggregate supply curve too (see next sub-
section).
Algebraically, the labour supply schedule (curve) can be given by,
0 if the substation effect is the income effect. [7.9a]
A better formulation of equation [7.9a] could be obtained by dividing both the sides of the equation by “P” to get,
[7.9b]
Equation [7.9b] shows that if the households’ expected price is larger than the actual price (Pe>P), they will demand a higher
level of real wage (W/P) compared to what they would have asked if they were able to forecast it correctly (for the same
given supply of labour). Thus, expectation is important in determining the supply curve in this setup.
7.1.3 The Expectation Augmented Philips Curve: The Aggregate Supply Curve and Labour Supply
The Phillips curve was the dominant model about inflation and unemployment trade-off in the 1960s. It was developed by an
economist from New Zealand named A. W. Phillips. Using data for UK, Phillips (1958) came up with the idea that there is an
inflation-unemployment trade-off. This means, if you carry out a policy to reduce inflation it will lead to a lower level of output
which leads to high unemployment. On the other hand, if you carried out a policy to reduce unemployment instead (say by
stimulating the economy), it could lead to a heating of the economy and, hence, inflation. Although he used unemployment
rate and the rate of wage-inflation in his original work, since the rates of wage inflation in advanced countries are closer to
general inflation levels, these variables are used interchangeably. What is interesting in the context of this chapter is how
the Phillips curve relates aggregate supply with wage and the labour market condition that we have discussed above. This
theory was latter (in the 1970s) abandoned because, among other things, the Western economies failed to show the trade-
off and economist began to observe, instead, both unemployment and inflation going up at the same time – called “stagflation”.
Modern Phillips curve -called the “expectation-augmented Phillips curve” - is different from this historical form in several
ways. This includes, first (i) price inflation instead of wage inflation is used today, (ii) the modern version uses expected
inflation and (iii) it also includes supply shocks in its functional form. The major theoretical contribution to the modification
of the original Phillips model is made by Friedman in 1968 in his critique of the use of nominal wage by Phillips’ specification
of the model. He, instead, emphasized the use of expected real wage (nominal wage divided by expected inflation). Since, this
modern Phillips curve, called “the expectation-augmented Phillips Curve”, is very important in modern macroeconomic
modelling, we have developed it here briefly based on Mankiw (2013) and Abel and Beranke (2001).
We will assume that the economy is populated by two types of firms: firms that instantly adjust their price in response to
change in demand and other firms who do not do that. The latter type of firms, instead, are characterized by sticky prices
for various reasons such as high adjustment costs that make such change not worth doing. This are referred as “menu
costs”. Another reason could be the existence of long-term contracts to which such firms are already committed etc. Firms
with such characteristics are usually assumed in what are called the “sticky-price models” which are generally used by the
New-Keynesian economists. Such firms generally assumed to announce their price in advance based on what they expect the
economic donation to be. With these assumptions, the general price level in the economy would be the weighted average of
the prices of these two types of firms.
The desired price (P*) of the first type of firms that have “flexible prices” and the second type of firms that are characterized
by “sticky prices” are given by equations [7.10a] and [7.10b], respectively,
∗
[7.10a]
∗
[7.10b]
Where: E is expectation, “P” genera level of prices, Y the level of output and is the full-employment level of output;
is referred as the “output gap”.
Assuming the level of current output is at potential level for the firms with the stick prices [ for Eqn. 7.10b], the weighted
average price of the above two prices is given by (the weight for the firms with the sticky price being λ, and, hence, (1- λ)
for the flexible one),
1 [7.11]
It is interesting to note that each type of firms has an impact on the general price level given by equation [7.11] in a different
manner. If firms with the sticky prices expect the general prices to increase (EP rises), this will make them to expect high
costs that will lead them to raise their prices. This high price, in turn, leads the other group of firms (firms with the flexi-
price) to raise their prices too. The combined effect, hence, raises the general price level. Note that, this effect doesn’t
depend on the fraction of firms with sticky prices since both raise their prices of today. The other component of equation
[7.11] is the demand part given by . If this demand increases, firms with flexible price will raise their price but this
is not followed by firms with stick prices as their expectation and price formation approach is different (they have already
announced their price based on expectation today’s condition). As a result, unlike the previous situation, the increase in the
general price level will depend on the proportion of firms with sticky price. The higher the latter’s number, the lesser the
increase in the general price.
Moving further, subtracting [(1-λ)P] from both sides of equation [7.11] and solving the result for “P” gives us
[7.12]
Denoting 1/ and solving for “Y” we can get the aggregate supply equation as,
[7.13]
By solving equation [7.13] for “P” and subtracting P(t-1) from both sides of the resulting equation we can get the modern
version of the Phillips curve called the “Augmented-Phillips” curve as,
[7.14]
Which could be simplified by denoting (P-Pt-1) by “π” and adding a supply shock denoted by “ε” as,
≡ [7.15a]
The output gap in the above equation, , could also be replaced by unemployment gap related to this output
gap, , using what is called Okun’s Law. Okun’s law is a rule of thumb offered by Arthur Okun who in the 1960s was
the chairman of the US’s ‘Council of Economic Advisors’ (CEA) that advises the US government on economic policy issues. In
his study, Okun found that the gap between an economy’s full-employment output and its actual level of output increases by
3 percentage points for each percentage point decline in the unemployment rate (recent US studies put this at 2 to 2.5
percentage points according to Abel and Beranke, 2001 and Mankiw, 2013). Thus, Okun’s law, for the US, could be given by,
(“u” being the unemployment rate in percentage points),
2.5 [7.15b]
According to Mankiw (2013), using data from 1951-2009, this relationship for the US, with a correlation value of 89 percent,
is given by (with 2, not 2.5 value of the parameter, 1/β in equation 7.15b],
Percentage Change in Real GDP %
If the US unemployment rate increases from 5% to 7%, this implies a decline in real GDP of 1%,
Percentage Change in Real GDP % % % %
7.2 Real and Nominal Wage Rigidities and Related Theories

As we have discussed in Chapter 2, the Hicksian formulation of Keynes’s idea by inventing the IS-LM framework has led not
only to emergence of the neoclassical synthesis Keynesian (NCSK) school of thought but also influenced generation of
economists until today, through its adoption in Textbooks across the world. One of the key contributions to this IS-LM model
formulation was Modigliani’s’ (1944) interpretation of Keynes’s work that includes the labour market which became part of
the IS-LM model implicitly. This formulation basically developed a demand for and supply of labour schedules where
employment is set as a function of nominal wage, for a given price level. This nominal wage is set not to be downward inflexible
but flexible upward above a certain level wage such as a minimum wage level set by government. Thus, in his 1944 classic
article, Modigliani noted, “in the Keynesian system the supply of labor is assumed to be perfectly elastic at the historically
ruling wage rate, say WO”. For him, “for every value of W and P, the corresponding value of employment gives the maximum
amount of labor obtainable in the market. As long as the demand is less than this, the wage rate remains fixed at WO. But as
soon as all those who wanted to be employed at the ruling real wage rate, WO/P, have found employment, wages become
flexible upward”. After this point, Modigliani noted, “the supply of labour will not increase unless the money wage rate rises
relative to the price level” (Modigliani, 1944). Such downward inflexibility of wage is the hallmark of the NCSK understanding
of employment and unemployment issues in their reformulation of the Keynesian system using the IS-LM model.
In general, in relation to the Keynes’ idea and its formulation using the IS-LM model by NCSK, it has to be noted that although
Keynes explicitly stated that his system described in The General Theory is a general theory whereas the perfectly
competitive neoclassical market clearing model is a special case of his system when Say’s law – supply creates its own
demand – holds. On the other hand, the Hicksian formulation of his idea in the IS-LM framework claims the opposite; i.e., for
the NCSK, the market clearing neoclassical model is a general framework and the Keynes’ system is a special case of the
neoclassical market clearing system when there are rigidities -one of the key rigidities being “wage rigidity”. For Hicks,
Modigliani and many in that school the nominal wage is downward inflexible (is rigid) due to various reasons. One of the most
important reasons being minimum wage set by the government which hinders wage’s downward flexibility when that is need
(such as when the demand for labour falls). If there were no rigidities, the competitive market clearing model would have
eliminated the unemployment problem by lowering wage’s downward, following the fall in demand for labour. In this situation,
you might have frictional unemployment in the meantime, but that is not a major issue as that is the natural rate of
unemployment that occurs, say, when workers are in-between jobs. Two things are worth noting here: first, it is precisely
this NCSK’s blame of rigidities for the unemployment problem that Keynes was arguing against. He stated that the problem
of unemployment during the great depression of the 1930s was not a temporary one that will be fixed by market forces but
rather a serious problem that was caused by aggregate demand failure, not rigidity of wages. Second, note also that the
nominal wage rigidity idea in the NCSK formulation of the IS-LM model is “ad hock” (i.e.; added from outside the model) as it
is not rooted in economic agent’s behaviour.
Going beyond nominal wage rigidity, recent macroeconomic research, especially, what is called the “Real Business Cycle”
(RBC) research and its latest development called the “Dynamic Stochastic General Equilibrium Models” (DSGEs) approach
shows that unemployment does fluctuate following exogenous shocks such as technological innovation which is incorporated
in such models. On the other hand, micro level studies suggest that the labour supply curve is inelastic with respect to wage
and hence nearly horizontal. This macro-micro puzzle has led to a new research and new theoretical development about the
labour market. Latest development about this issue, thus, goes beyond nominal wage rigidities to explain the observed
phenomena of ‘real wage rigidities”. These recent theories have focused on explaining such wage rigidities and their
macroeconomic implications. Interestingly, such rigidities are no longer considered as ‘ad hoc’ as in NCSK school, but rather
are thought to be deeply rooted in economic agent’s behaviour as well as the economic environment in which they function.
The latter is the basic idea that inspired the New-Keynesian macroeconomists that we have discussed in Chapter 1. We will
briefly discuss two of the widely offered explanations (implicitly contracts and efficiency wage) for the phenomenon of real
wage rigidity next.
7.2.1 Implicit Contracts

The implicit contact theory is one of the theories forwarded to explain the real wage rigidity problem noted above. The theory
is attributed to early works of Azaridis (1975) in an article published in the Journal of Political Economy, JPE. The article was
based on one of the chapters of his PhD dissertation that he submitted to Carnegie Mellon University, USA, in the same year.
Without getting in to the details of its demanding technical presentation, we can briefly summarize his ideas. His study is
aimed at providing micro based explanation for the possibility of real wage rigidity that is observed in developed countries
and we noted above.
He noted, today’s economic environment is full of uncertainty for many reasons that includes random productivity shocks
that generally create uncertainty. In the face of such shocks, he assumed that households dislike such uncertainty and are
risk averse. He also presumed firms in such situation do operate in an industry with demand uncertainty. He, thus, assumed
such firms to not care much about such uncertainty and hence are risk neutral. As a result, they act as employers and
insurers of the homogenous, risk averse labourers in his model.
Employees’ uncertainty also implies, they could pay something akin to insurance premium to employers by agreeing to work
at lower real wage in exchange for stable real wage. This means wages in equilibrium could be lower compared to the level
that would have been obtained under the Walrasian (free market auction like market clearing situation) condition owing to
this implicit contract. In short, Azaridis (1975) noted, since workers face variability in their income owing to stochastic nature
of the wage schedule or uncertainty over employment status, it is preferable for both sides (both workers and firms) to
engage in removing such uncertainty through a stable (rigid) real wage rate, even if this rate is lower than the level that
would have been obtained under free market Walrasian condition. Note also that compared to the Walrasian situation, the
level of employment could be higher in this scenario thanks to this implicit contract.
Finally, it is worth noting that the implicit contract theory provides a rationale for real wage rigidity but not for the existence
of involuntary unemployment. As a result, according to Hidijdra (2009) it was not a focus of research recently, compared to
other theories such as the efficiency wage theory which is discussed next.
7.2.2 Efficiency Wage: A Simple Model
Efficiency wage theory is one of the celebrated theories about real wage rigidity. The basic idea behind the efficiency wage
theory is that if workers are well paid, they will be productive because they will be motivated when they are well treated.
Thus, it might be worth it to pay high real wage even if this might be above the Walrasian market clearing level of real wage.
This means firms will not reduce wage even if there is an excess supply of labour in the market. This is because firms will be
afraid that the adverse effect of lower wage on productivity will outweighs the reduction in wage cost. Thus, in this model,
there will be a wage rate above the market clearing level and associated unemployment in a perfectly competitive market
set-up. In addition, the relationship between productivity and wages may differ across industries, negating the law of one
price in the labour market.
It is interesting to ask what the relationship between high wage rate and productivity that this efficiency wage theory attempts
to address. We can think of at least five different explanations for the link between wage and workers’ productivity (Stiglitz,
1986; Hidijdra, 2009):
1) the development literature shows a direct link between productivity and the level of nutrition. This offers what is
called the S-shaped wage productivity curve that is given in Figure 7.3. The figure shows, at the initial level, an
increase in income and nutrition just goes to maintain body metabolism and cannot increase work or productivity;
later, when that level saturates, productivity began to increase sharply and began diminishing eventually – hence
the S-shaped curve.
2) the second reason relates to labour turnover. The lower the level of wage, the higher the rate of labour turnover.
This will entail a higher cost of training for firms when they get a new worker. Hence, it is better to pay high wage
and ensure low turnover and higher productivity – thus the link between wages and productivity.
3) since a firm may not have perfect information about the characteristics of the worker such as the quality of labour;
it might get high quality labour by paying high wage.
4) the fourth factor relates to the condition that a firm might not have perfect information about the action of workers
and the cost of monitoring this could be very high. Paying high wage rate is another option to address such
challenges. In addition, in such situation unemployment could also be used as discipling device so that workers do
not shrink their effort. Another alternative could be developing bonding.
5) finally, the performance of workers depends on whether they believe they are being treated fairly or not. In
particular, they are also interested in their position relative to other workers. Thus, paying high wages entails
treating them high and, hence, the possibility of high productive of workers.
i) A Simple of Model of Efficiency Wages
We have developed here a simplified version of “Efficiency Wage” model that is based on Heijdra (2009). Let us assume the
“effort” level of workers in firm “i” is denoted by Ei and this Ei depends on the wage paid by firm “i” which is Wi and also
depends negatively on the wage that can be obtained elsewhere, WOT. This is given by,
, : 0; 0 [7.16]
Let Ni be the number of workers so that is the total number of efficiency units of labour employed by the firm.
Assuming away capital, this efficiency unit leads to output through a production function given by F(Li, K). The firm maximizes
its profit given by,
Π , , [7.17]
Where: “A” is the index of general productivity and “Pi ” is the price charged by the firm.
The firm choses Ni and Wi that maximize profit. The first order conditions for this are,
, , 0 [7.18]
, , , 0 [7.19]
Where: is the marginal product of labour (MPL) measured in efficiency units.

By substituting these two conditions and some algebraic manipulations, the expression that determine the efficiency wage
for firm “i” could be given by,
,
1 [7.20]
,
[Note: to get equation [7.20], insert the definition of “E” given in equation [7.16] in equation [7.18] and solve the result for
Wi/e(Wi, WOT). Then, divide both sides of equation [7.19] by Ni and solve the result for Wi/e(Wi, WOT). Divide the resulting
equations one by the other to get equation [7.20]].
Note that equation 7.20 is also an elasticity of the effort function because,
Elasticity = , , ).
Equation [7.20] says that at the optimum level the firm should find the wage for which the elasticity of the effort function
with respect to wage equals unity. This means the firm should keep increasing its wage rate as long as “effort” rises faster
than the wage rate. In Figure 7.3 this can be read by comparing the slope of the effort curve (the S-shaped, red, curve) with
the lines that are drawn as rays from the origin and crossing the effort curve. Such a line attains its maximum at “E”. This is
the only point where the unit elasticity condition, or equation [7.20], is satisfied. In any other place, say at “A” or “B”, depicted
by the dashed lines from the origin is steeper at some points such as “A” and flatter at other points such as “B”, compared
to the slope of the bold black line that originates from the origin and is tangent to the effort curve at “E”.
Figure 7.3 Work Effort and Efficiency Wage
Worker Effort, E B Effort curve

Ei=f(Wi, WOT)
E
E*
EA
A
WA W* WB Real Wage
Once the efficiency wage level and hence the optimal effort level, E*, is determined as discussed above and as shown in Figure
7.3 and equation [7.20], the corresponding number of workers can be determined using equation [7.18]. This result could be
aggregated over all firms to get aggregate demand for labour that is measured by number of workers. This can be given by,
∗
∗ ∗
, , [7.21]
The result in equations [7.20 and 7.21] also shows that productivity shock has no effect on efficiency wage, and hence, affects
only employment. The structure of the model doesn’t give the possibility of full employment either. If the effect is only on
employment for a given efficiency wage, it means it offers a partial equilibrium-based result for the existence of a horizontal
real wage-based labour supply equation – the possibility of real wage rigidity (see Heijdra, 2009, for extension of this model
and related details).
ii) Summers’ (1988) Reservation Wage
Using our model above we can show how the reservation wage, WOT, could be determined by level of unemployment and the
level of unemployment benefit. The latter is a payment that unemployed people get paid in in industrial countries until they
get a job. In Summers’ formulation the effort function using the reservation wage, the effort function is given by,
[7.21]
Where: ε measure the strength of the productivity-enhancing effect of high wage which is also termed the leap-frogging
effect and restricted as, ( 0 1); WOT is what workers would get in other firms if they were not employed by firm “i”.
We will further assume that WOT is the weighted average of the wage paid by others in the economy which is denoted by
below; the unemployment benefit is also given by” B”, while the unemployment rate is given by “U”. With this, the reservation
wage could be given by,
1 1 , [7.22]
Using equations [7.20] and [7.21] the efficiency wage could be computed as,
,
1 ⇒ ⇒ [7.23]
The result in equation [7.23] says that a firm pays a constant, of the value of the outside option, . With this
result, if all firms are treated symmetrical, in equilibrium, the average wage coincides with the optimal wage paid by firm “i”
as given by equation [7.23], that is Wi = . By substituting this condition in [7.22] and using [7.23], we can obtain the
expression for the equilibrium unemployment rate, U*,
∗
⇒ [7.23]
For the value of β between 0 and 1, 0 1, this final result of the model offers the following interesting conclusion:
(i) the higher the leap-frogging coefficient, the higher is the equilibrium level of unemployment
(ii) the lower the indexing coefficient given by β, the lower is the equilibrium level of unemployment,
7.3 Other theories of the labour market for your further readings: Union and Search Models
In addition to the models above, two other labour market theories are important in research about employment and
unemployment in industrialized countries (and perhaps also in poor countries). Thus, you may wish to know such theories if
you are working on labour market issues. The first one relates to the role of trade unions in the labour market. The second
one refers to a class of models called “search models”. These are briefly described here with the aim of guiding you to this
literature.
The Union Models: There are at least three types of trade union behaviour based partial economic models: the monopoly
union model (MUM) (Dunlop, 1944), the-right-to manage model (RtMM) (Leontief, 1946) and the efficient bargaining model
(EBM) (McDonald and Solow, 1981). The main difference among these models is on how the representative union is assumed
to be organized so as to sell the labour of its members or to negotiate wage rate, on behalf of its members, with
representative firm. Among these models, the monopoly union models depict the most powerful unions capable of dictating
terms while the other two arrived at wage and employment levels through different degree and kind of bargaining. The RtMM
works under the generalized Nash bargaining framework but the firm has the right to determine the employment level
unilaterally but bargain with the representative union over the real wage level. In the EBM both firms and unions bargain
simultaneously on wage and employment level following the same generalized Nash bargaining framework.
Despite their varieties, the idea behind the union models is to come up with a real wage level (and also employment level in
the EBM) having an organized representative union with various degrees of monopoly that has an expected utility function to
maximize for its average members. The union attempts to optimize this utility function, given the demand for labour schedule
of firms which is used by the Union as its “budget constraint”. In such optimization exercise, the optimal solution to the MUM
is a wage level choice as a markup expression involving unemployment benefit and the elasticity of the labour demand
function. The result of this model is generally consistent with the real wage rigidity models that we discussed above. Similarly,
the RtMM comes up with similar mark-up type wage which is a function of the same arguments as in the MUM. However, it
also has an additional argument which is an indicator of the relative bargaining strength of the union. The EBM offers a range
of efficient wage-employment combinations. The optimal result in this latter model is found to lead to a level of wage and
employment above the result that would have been obtained under competitive conditions. This is because the union manages
to claim its “fair” share from profit that would have been grabbed by the firm (see Heijdra, 2009 for details and advanced
and algebraic treatment of these issues).
Search Models: the labour market is generally characterized by movement of flows of labourers to jobs and from jobs to
unemployment and back to jobs in a continuous manner. This is the result of simultaneous job creation and job destruction
that occurs in most economies every day. Thus, we could have job seekers and firms looking for workers simultaneously at
any point in time. One of the tasks of the labour market is matching job seekers with available jobs. The labour market
bargaining models attempt to explain and model this matching process. Unlike the models described above, search models
do not assume that the labour market does this matching through the clearing of the market at macro level. Rather, the
search models assume that there is a search process which stochastically brings together unemployed job-seekers and
vacant jobs in a pairwise way. Since this search process takes time, and also bargaining takes place between job seekers
and employers, this process has implications for loss of output in such models.
Search modelers use a function similar to the Cobb-Douglas production function called the matching function. This function
shows the number of successful matches at particular time as a function of the unemployment rate and the vacancy rate
(vacancy as share of the labour force) for a given exogenous level of job destruction ( job destruction happening ,say, due
to unprofitability of a business or obsolesce of the technology being used by the firm). With further characterization of both
the job-seekers and firms (which is technically demanding for our level in this book), the objective of the modelers is to arrive
at a deal (wage level agreed by both parties) and the probability of job-seekers meeting firms and vice versa as a function
of the labour market tightness variables (tightness defined as ratio of vacancies to unemployed workers). The models also
offer the equilibrium unemployment rate relative to rate of job destruction, as well as workers’ job finding rate– called the
Beveridge curve. . (see Heijdra, 2009; Diamond, 1984; Pisarides, 1994; 2001 for advanced, such as PhD level, and algebraic
treatment of such models and the relevant literature).
7.4 Labour Market in Developing Countries with a Focus on Africa

We can think of three important segments of the labour market in developing countries in general and Africa in particular: (i)
the rural labour market. This employs the majority of the labour force in many countries. In Ethiopia, for instance, 80 of the
population and 86 percent of employed population (as well as economically active population) are in rural areas in 2020.
Even in most urbanized countries in Africa such as Zambia the decline in formal mining and manufacturing jobs gave rise to
the importance of the agricultural sector as a leading employer, employing about 48 percent of the total Zambian labour
force in 2014. The second (ii) important segment of the labour market is the informal urban labour market. This, for instance,
constitutes about 40 percent of the employed population in urban Ethiopia and over 80 percent in Zambia (see Box 7.3).
Though not that big, the rural labour market has also its own informal sector. Finally (iii), we have the formal labour market,
that is predominantly found in urban areas and the government sector. Not only each of these markets are important in these
countries, but also the labour market in these countries are segmented. The latter implies each of this market pays differently
for observationally identical labour. This segmentation is generally the result of geographic (rural and urban), legality (formal
and informal) or sector of engagement (agriculture, industry, etc.) difference of labour and employment conditions in these
countries. Two important theoretical approaches are forwarded to explain the labour market (and the related issue of rural-
urban migration and economic growth) in developing countries.
7.4.1 The Theories
A. The Harris-Todaro Model: this is one of the widely known labour market models that is developed by Harris and Todaro
(1970). The model attempts to explain why there is a persistent migration from rural to urban areas despite the existence of
significant unemployment in urban areas. The model hypothesizes that the decision to migrate is determined by the expected
wage in urban areas (We) compared to the average wage in agriculture in rural areas (WA). This urban wage, which is assumed
fixed, say for minimum wage reason (see Box 7.1) may not be obtained easily, hence, need to be multiplied by the probability
of getting it so as to take it as an indicator of the expected wage. This probability is expressed by the ratio of employment in
urban areas (EU) to the sum of employed (EU) and unemployed labour (LU). This is summarized in equation [7.24],
[7.24]
Obliviously, this formulation doesn’t capture all the pushing (in rural areas) and the pulling (in urban areas) factors for
migration in a typical African economy. It doesn’t capture the cost of such shift in occupation (from rural-type occupation
sch as farming to urban-type occupation such manufacturing) as well as the cost of changing geographical location (from
rural to urban areas) either. The latter is important because it is rather sensible to expect that there is a cost involved to
become an urban worker as well as in moving from rural to urban areas, getting the skill required in the new environment
etc. The migrants may also be expected to support those they left behind through social conventions and social obligation of
the extended family in African setup, which is an additional cost. In addition, as Kalecki (1976) noted, the standard of living in
urban areas is a bit higher than the rural areas and migrants may need higher than rural average earning in urban areas.
Moreover, rural laborers may move to urban areas in two stages: first perhaps to the urban informal sector and then, in the
second step, to the urban formal sector. In view of all such possible adjustment costs, it might be more reasonable to make
the expected wage larger than the average earning in agriculture in the above formulation, and hence use inequality sign
instead, (WA<We). Alemayehu and Hauzinga (2011) modelled this in the macroeconomic models they have built for Ethiopian
and Rwanda by setting the urban informal sector wage as sum of the average agriculture earning plus a margin obtained by
applying a certain mark-up rate on the average agricultural earning. The urban formal sector wage is then set as the sum of
this urban informal sector wage plus a margin obtained by applying another mark-up rate on the urban informal sector wage.
Thus, generally employing a cascading mark-up-based rate that goes increasing from agriculture to urban-informal, and then
to formal sectors.
In addition to such formulation, note also that the fixed wage assumption in urban areas used in the Harris-Todaro model
could also be developed using the real wage rigidity theories, such as efficiency wage models that we have discussed above
(See Agenor, 2006 and Agenro and Monteil 2008 for such discussion).
Box 7.1a Minimum Wage Fixing in Africa: The Case of Kenya

In the Eastern Africa region, minimum wage legislation and implementation are carried in a number of countries that includes, Kenya,
Tanzania and Uganda. Some countries such as Ethiopia do not have minim wage legislation at all. The history of minimum wage setting in
Kenya goes backs as far as over 90 years. The challenges of its implementation and effect have also attracted a number of studies. The
need for minimum wage fixing in Kenya was first given legal recognition by the Minimum Wage Ordinance of 1932 (Husband, 1955, cited
in Omolo, 2010). According to Husband (1955, cited in Omolo, 2010), the decision by the government to fix minimum wage was triggered
by the absence of effective action to improve the level of wages and protection of workers either by employers or employees’
organizations (Omolo, 2010). The objective of such policy has been to reduce poverty as well as to protect and promote the living
standards of workers (Omolo and Omitti, 2004, cited in Andalón and Pagés, 2008). The legislation empowered the Governor-in-Council
to make orders fixing minimum wages in any occupation or geographical area where they were considered to be unreasonably low
(Omolo, 2010). This law was followed by the Minimum Wage Ordinance of 1946. This provided power for a Central Minimum Wage Advisory
Board to recommend wage levels to the Governor-in-Council (Husband, 1955, cited in Omolo, 2010). In 1951, the Regulation of Wages and
Conditions of Employment Act was legislated. This Act of Parliament provided for a wider range of advisory and negotiating bodies to fix
minimum wage and other conditions of employment for workers. It provided for establishment of General Wages Advisory Board (GWAB),
Agricultural Wages Advisory Board (AWAB), Area Agricultural Wage Committees (AAWC) and Wage Councils (WCs) (Omolo, 2010). Thus, a
total of 15 sector-specific WCs were established under the Act. The councils were set to fix minimum wages and statutory terms and
conditions of employment in specific trades, industries or occupations as may be required (Omolo, 2010).
With this historical background, the modern version of Kenya's minimum wage law appeared when Kenya enacted a revised set of labour
laws in 2007 which is necessitated by the outdated nature of the existing laws and enforcement difficulties encountered. It was also
motivated by the need to embrace recent national and regional development in the economy (Republic of Kenya, 2008b, cited in Omolo,
2010). The current minimum wage fixing is, thus, empowers the Ministry of Labour (MoL) to establish general, agricultural and sectoral
wages councils (WCs). These councils are expected to advice the Ministry on appropriate levels of minimum wages and other statutory
terms and conditions of employment. The WCs which are advisory councils to the MoL have representations from the tripartite partners:
MoL, most representatives of employers and the Federation of Kenya Employers (FKE) and the Central Organization of Trade Unions
(COTU). Besides the tripartite partners, the Labour Institutions Act (2007) allows the MoL to appoint a chairperson and at most three
independent members to serve in the WCs. Though not specifically provided for in the law, the MoL normally consults with the Minister
in charge of finance on the likely implications of the proposed minimum wages before they are announced and/or gazetted (Omolo,
2010).
In the context of these laws, determination of minimum wage is based on the provisions of the Wage Guidelines (Republic of Kenya, 2005;
cited in Omolo, 2010). The Guidelines outline factors that should be considered when fixing wages with the desire to give workers “a just
minimum standard of living" (Republic of Kenya, 2005:2 cited, 2010), changes in the cost of living, firm productivity gains realized during
the period under review, and the ability of employers and the economy in general to sustain the increased labour costs as key
compensation parameters" (Omolo, 2010). This is in line with the International Labour Organization (ILO) Minimum Wage Fixing Convention.
The minimum wage fixed this way is then updated annually.
The general Wages Order, as gazetted in May 2010, contains minimum wage levels for 15 occupational categories, with different rates of
pay for cities, municipalities and all other towns (Republic of Kenya, 2009, cited in Omolo, 2010; Mwangi et al, 2017). This implies the
existence of 45 sets of minimum wages under this Wage Order. The agricultural order, on the other hand, contains minimum wages for
11 different occupations (Republic of Kenya, 2009, cited in Omolo, 2010; Mwangi et al, 2017). This order provides for national statutory
minimum rates of pay for all workers in the agricultural sector - a sector that contributes over 70 per cent to the national employment
(Mwangi, et al, 2017). However, the other WCs have largely been inactive (Omolo and Omiti, 2004, cited in Omolo, 2010). In this case, the
workers in the trades, industries or occupations under the jurisdiction of the WCs in question are covered by the general wages order
(Omolo, 2010). Observing the general picture of minimum wage in Kenya, we note the following points. First, the minimum wage varies
across time in all sectors. Second, the minimum wage varies across various occupational categories for a particular year, both for
agricultural and general workers. Third, in the agricultural sector minimum wage varies, say for the year 2017, from KSh6415 to 11,573
per month (a$ is about KS 100 in 2020). Fourth, for the same category of workers minimum wage also varies across locations, the
highest being for Nairobi city.
Box 7.1b: Effect of Minimum Wage on Emplpyment in Some African Countries

Bhorat et al’s (2015) study about minimum wage in Africa and its findings are interesting. Bhorat et al (2015), after stating the limited
research on the employment effect of minimum wages in Sub-Sahara Africa (SSA), noted the findings of these limited studies to be
consistent with the broad findings of global research where introducing and raising the minimum wage has a small negative impact or
no measurable negative impact on employment. They found, however, significant variation around this average finding – they noted, were
increases in a minimum wage are large and immediate, this can result in employment losses, but more modest increases usually have
very little observable adverse effects on employment and may have positive impacts on wages. More interestingly, however, they noted
the great variability in the findings could be related to the great variation in the details of the minimum wage regimes and schedules
across the continent and their level of compliance. Bhorat et al's (2015) study noted that although the sectors and fraction of workers
covered are small given the low rates of formality and urbanization in Africa, higher minimum wage values are found to be associated
with higher GDP per capita in African countries. Similarly, minimum wage fixing, even with little enforcement system, has led to an
increase in wages for domestic workers and had no detrimental impact on employment in South Africa (Dinkelman and Ranchhod, 2010).
World Bank’s overview of studies on the effect of fixing minimum wage in developing countries concluded that “although the range of
estimates from the literature varies considerably, the emerging trend in the literature is that the effects of minimum wages on
employment are usually small or insignificant (and in some cases positive)” (Kuddo et al, 2015). Generally, the available evidence on
Africa and beyond indicates that a simple competitive paradigm and wage ridigity is not adequate to explain the functioning of the African
labour market. The implication of this finding is to underscore on the need to work on country-focused minimum wage design,
implementation and research to see its employment and welfare effect. I hope this will motivate you to start your own research on
labour market issues in Africa. It is also interesting to relate the findings here with the theories that we have discussed in this chapter.
Extracted from Alemayehu (2018)
B. The Lewis Dual Economy Model: in his classic article “Economic Growth with Unlimited Supply of Labour “, Arthur Lewis,
the only black economist (a British citizen of a Caribbean, Saint Lucia, origin) to win the Nobel prize in 1979 has developed the
dual economy model in 1954. He did this by rejecting the neoclassical economics theory which assumes full employment and
no saving problem in the long run in its general formulation. Lewis noted this as irrelevant in poor countries context. Leaning
instead on classical economists and their theory of capital accumulation for growth, Lewis argued that developing countries
are characterized by disguised unemployment. The later refers to the deployment of two or more labour for a task that can
be handled by a single person. In fact, disguised unemployment is both an urban and rural phenomenon today. For instance,
the Ethiopian urban labour force survey of 2018 shows that about 45 percent of labourers in urban Ethiopia are
underemployed and hence the existence of disguised unemployment (See Box 7.2). Having similar disguised unemployment in
rural areas of poor countries, Lewis noted that the rural areas have a traditional subsistence economic activity while the
urban areas have a modern capitalist economy – thus developing countries are characterized by a dual economy. Since the
rural areas can provide unlimited supply of labour at subsistence wage, Lewis argued, it is possible to move this labour to
urban modern sector at a wage rate that is equivalent to average (not marginal) agricultural earning plus a margin to induce
them to go to the modern sector. This allows, according to Lewis, to attain high level of economic growth without any loss in
rural agricultural output. There will not be loss of output in agriculture because labourers moving out of the rural areas had
been underemployed there (or the rural labour market was characterized by disguised unemployment before this migration
– thus, symbolically, they are moving to urban areas with their lunch so to speak).
Box 7.2. Underemployment or Disguised unemployment: The Case of Ethiopia

The unemployment and employment figures in many African countries need to be looked at cautiously in the context of two issues: the
size of underemployment and the size of the economically inactive population. Both the 2013 and 2016 labour force survey in Ethiopia
show the existence of significant level of underemployment in the country. At national level and in the year 2013, 42 per cent of employed
population expressed their interest to work additional work at their present main job while 49.5 per cent want to work on other job in
addition to the current job. These figures were 28 and 51 per cent, respectively in urban areas; while 44.4 and 49.1 per cent, respectively,
in rural areas in 2013. The latest labour force data we have for Ethiopia is for the year 2016 and this data is for the urban areas only.
This data also shows 45.3 per cent of the 7.43 million employed persons in urban areas of the country are available and ready to work
additional hours. This is happening in the context where the mean hours worked per week in the survey (as well as for the paid employees
in general) is 41.6 hours (CSA, 2016)- this is 25 percent below the expected hours per week, assuming 8 hours per day, for seven days
as the standard ( or 13 percent below the expected hour, for 8 hours per day, 6 days per week work).
Extracted from Alemayehu (2018)
The existence of unlimited supply of labour at lower and constant level of wage rate is a key concept in Lewi’s model because
it allows the expansion of the modern sector at a constant and lower level of wage (W), which is just above the subsistence
level wage (S) in the country. This raises profit, which in turn will be re-invested continuously, leading to continuous
accumulation of capital, high economic growth and employment, depicted by the movement form N1, to N2, to N3 etc., in Lewis’s
diagram given by Figure 7.3. (Note that the area under each of the curves, Q1, Q2 & Q3 and above the wage rate line (W) shows
the total surplus generated and to be re-invested, given that the curves (NQs) depict the marginal product of labour at, N1,
N2 & N3, respectively),
Figure 7.3: Lewisian Economic Growth with Unlimited Supply of Labour
Employment (N)
N3
N2
Q3
N1 Q2
Q1
(Urban wage) W
(Subsistence wage) S
Quantity of Labour
Theoretical approaches such as the Lewis and Harris-Todaro models seem to be realistic in African set-up. Many researchers in the
African labour market argues, in line with the theoretical discussion above, that the African labour market is segmented, wage
differentials are large and in some of the markets they are rigidi (Bevan, Collier and Gunning, 1989; Teal, 1995, cited in Adenikinju and
Oyeranti, 1999). For instance, Hoddinott (1995, cited in Adenikinju and Oyeranti, 1999) reported a negative relationship between wages
and unemployment in Côte d'Ivoire, thus supporting the kind of demand for labour model that we have developed in the context of the
market clearing model above. Teal's (1995) findings support both contending theories (of market clearing and rigidity of wages) in the
Ghanaian labour markets as he found the Ghanaian labour markets to clear, although they were not competitive (Teal, 1995 cited in
Adenikinju and Oyeranti, 1999). Other African based empirical studies have also found that wages in the manufacturing sector to increase
with firm size, instead (Mazumdar, 1994; Teal, 1995; Velenchik, 1996, cited in Adenikinju and Oyeranti, 1999). Mazumdar (1994, cited in
Adenikinju and Oyeranti, 1999), in a study of wages in the manufacturing sector of four African countries - Kenya, Zambia, Zimbabwe and
Cameroon- also found wages to increase almost monotonically with firm size in all four countries. The same study noted, workers in a
very large firms, other things being equal, earn 230 per cent more than those employed in small-micro firms. Aigbokhan (2011) has also
found similar result for Nigeria. His study shows the relevance of both efficiency wage and rent-sharing models in explaining the labour
market in Nigeria’s manufacturing sector. Contrary to this finding, the study by Soderbom and Teal (2002, cited in Aigbokhan, 2011) finds
less direct evidence on rent-sharing or efficiency wages for Nigeria. In sum, it is imperative to note that empirical studies in Africa are
not conclusive about which theory is relevant in the Africa context. Thus, we need to carry more studies using theories discussed above
(and more) as possible alternative explanations that need to be examined empirically in various settings. We may also, perhaps, need to
come up with our own unique theory too. This task is left for your future research.
7.4.2 The Informal Labour Market in Africa

The two theoretical approaches about the labour market in developing countries that we have discussed above point to two
important issues. The existence of a dual (traditional and modern) economy in developing countries and the related issue of
rural-urban migration and its implications for economic growth. Second, the theories also show the segmented nature of
labour market in such economies. An important phenomenon in this context is the issue of understanding what is called the
informal sector and the informal labour market associated with it.
The informal sector is very big in Africa. Since it usually skips the official data gathering process, its actual size is usually
unknown. However, various estimates state that it might account for at least half to two third of the GDP of many countries
in Africa. This figure would be much larger than this if we include the “subsistence agriculture “sector in this category (See
Figure 7.4 and Box 7.3). AERC’s studies on African informal sector in the mid-2000s (AERC-ATF, 2006) show that the informal
sector operators in the four case-study African countries could be categorized into four sub-sectors which differ in terms
of their degree of integration with the formal sector. The first group comprises the small-scale sub-contracting sector which
produces intermediate goods for the formal sector. The second category refers to small-scale manufacturing sub-sector
which produces consumer goods for the local market, serving both low-income and medium-income households working in
both the formal and informal sectors. Some products from this segment compete with products from the formal sector. The
third group comprises retail trading, small-scale private transport operators, personal service operators such as tailors,
barbers, and repairers. There is very little competition between these latter activities and the formal sector operators. Thus,
expansion of this sub-sector is a function of what happens within both the formal and informal sectors of the economy. The
final category refers to financial sector that renders significant linkages between the formal and informal sectors of the
economy. Informal and semi-formal financial institutions such as moneylenders, rotating savings and credit associations,
known by various name in different African countries (they are referred as Iquib in Ethiopia; Susus in Southern Africa,
Tontines in Western Africa etc.). Some of these may collect, deposit and save their collection with the formal sector banks.
All these activities could be handles either by own account operators or by employed labour, and, hence, could feature as
labour market.
There are various reasons forwarded for the growth of the informal sector in Africa. The above AERC studies (AERC-ATF,
2016) noted that the informal sector has expanded significantly after the job losses due to the Structural Adjustment Program
(SAPs) that were adopted in most countries in the 1980s and 1990s as well as the economic crisis that preceded their
adoption. Rising level of poverty during this period and after has contributed for the expansion of the sector in the region.
These studies also revealed some other major factors behind the sectors growth. First, the cumbersome process of
registering businesses, over-regulation of the formal sector and high cost of business compliance that includes high tax
rates. Second, the existence of large pool of unskilled labor that cannot be accommodated in the formal sector. Third, lack of
capital, insufficient markets, poor access to raw materials, and insufficient, irregular and expensive electricity and related
infrastructure that limit the growth the formal sector. Fourth, inadequate salaries and poor conditions of service offered in
the formal sector as well as the ease at which informal sector activities can be started. Fifth, biased procurement procedures
against the informal sector by the government and big market players which create market barriers for small operators.
These constraints are compounded by the lack of a clear national policy about the informal sector. Six, conflict can also lead
to informality as the rule of law, enforcement of contracts and the like are severely undermined during conflict and open the
way for informal activity – Libya being the latest case in point (Note that the last seven countries in Figure 7.4, at the right-
hand side, are conflict-affected countries that have a very high rate of informality).
Figure 7.4: Informal Employment as a Percentage of Total Non-Agricultural Employment in Selected African Countries
Source: AERC and German Federal Ministry of Economic Cooperation and Development (2020) based on World Bank, WDI data, 2020.
Fields (2007) also emphasized the second factor above and the pervasive poverty when stating that ‘labour markets in
denveloping countries exhibit low unemployment and substantial working poor’ (ILO, 2006, cited in Fields, 2007). Since
workers in poor countries cannot afford to remain unemployed for very long time because they do not have a better option,
in order to earn cash quickly, the majority of them take up wage-employment or self-employment in the informal sector.
Fields noted, this explanation, proposed long ago in ILO (1972) and Hart (1973) (both cited in Fields, 2007), is essentially still
correct. The informal sector thus plays the role of a free-entry or fallback sector for those who cannot obtain formal sector
jobs. He also noted that, a broader notion of “informal economy” is on the ascendancy (ILO, 2002; Jhabvala et al, 2003; Chen
et al, 2005, cited in Fields, 2007). In relation to this, the ILO now defines the informal economy as comprising: informal
employment (without secure contracts, worker benefits, or social protection) of two kinds: a) self-employment in informal
enterprises (small unregistered or unincorporated enterprises) including employers, own account operators, and unpaid
family workers in informal enterprises and b) paid employment in informal jobs (for informal enterprises, for formal
enterprises, for households, or no fixed employer) including: casual or day laborers, industrial outworkers, unregistered
workers etc.”. Thus, from the discussion thus far, it is conceivable to think of the informal economy as complementing the
formal sector, and hence, filling the gap left by the formal economy, that includes incapacity to provide decent jobs. Finally,
note also that, although the informal labour market is primarily an urban phenomenon, it also exists as part of the rural
labour market in Africa. This in fact becomes significant if we include “subsistence agriculture” in our definition of the
informal category (see Box 7.1).
7.4.3 The Rural Labour Market in Africa
There is a widely held view that labour market in general and wage employment in particular is either very thin or does hardly
exist in rural areas. This view is not generally true, however. Not only rural labour markets do exist and are important but
also there are also wage employees in rural areas working for big farming enterprises, small enterprises, small local farmers
as well as those who work as domestic workers in some of the rural households. In addition, there are also rural wage and
salary workers that work for government and privately owned projects and for government ministries such as education,
health and the like ministries. In addition, there are also non-farm rural activities such weaving, pottery and the like where
the rural labourers also engaged.
Given the importance of agricultural activities in rural areas, the rural labour market is usually characterized by seasonality.
Rural labour studies also show that wage earners in such market earn an income which is unreliable that fluctuates
significantly both over time and across geographical locations. Sender et al’s (2006) characterization of rural labour market
in Mozambique is quite relevant for many countries. They noted: (a) there are both large and small farm enterprises employing
large numbers of wage workers in rural areas, (b) government offices such as ministries of education, health and agriculture
bureaus do also employ wage and salary earners, (c) domestic workers (especially female) are also common and most such
workers worked for small local farmers or neighbors, and (d) small holder agriculture is generally unlikely to generate large
numbers of regular or well-paid wage employment opportunities, and so is micro-credit provision for self-employed and
small holders in rural areas, and (e) finally, they noted that wage-earning rural households are not better-off than non-wage
earning households since so many desperately poor people depend on wage incomes . Similar characteristics is also
observed by Fink et al (2014) in their study of the rural labour market in Zambia. They noted, over 50 percent of respondents
reported working on other small farms (owners of less than 12 acres) and about one third of households also reported
occasionally hiring wage labour. Wages are also found to be seasonal, with highest wages being reported during planting
seasons of Zambia (October to early December) and at harvesting season. In the face of transportation problem in these
rural areas, wages are mostly determined locally, which either means within a village, or within a small group of villages.
Wage rates are typically negotiated on a case-by-case basis, and anecdotally are highly responsive both to demand and
supply shocks. In the difficult and drought/hunger season (when resources are most constrained), wages are likely to be
suppressed both by increased supply from credit-constrained farms and by reduced local demand for labour (inability to
hire). In sum, it is imperative to note that this characterization of rural wage employment in Mozambique and Zambia is pretty
much relevant for the majority of African countries.
With this, it is worth concluding this chapter by pointing out that we have not discussed in this chapter the creation of skilled
labour (an increase in supply of high quality labour) which is crucial in the course of development. This is an extremely
important issue that will be discussed on volume two of this textbook (Advanced Long-run Macroeconomics for Africa). The
issue will be discussed in the part that deals with the role of “human capital” in various growth models. The role of government
in supply of such labour, through provision of quality health and education services, has paramount importance in Africa and
will also form part of this discussion.
Box 7.3 The Size of Informal Labour Market in Africa: The Case of Ethiopia and Zambia
Ethiopia: As in many African countries, the informal economy is defined by the Central Statistical Agency, CSA (2016) of Ethiopia as “a
group of production units [that] form part of the household sector as household enterprises or, equivalently, unincorporated enterprises
owned by households”. It is defined irrespective of the kind of work place where the productive activities are carried out, the extent of
fixed capital used, the duration of the enterprise and its operation as main or secondary activity of the owner” (CSA, 2016).
According to the National Labour Force Survey 2013 and using this definition, out of 31.5 million employed population of the country, 18
per cent were employed in the informal economy. In the rural areas, out of 26 million employed populations, 17 per cent were employed
in the informal economy. On the other hand, the urban informal economy employed 26 per cent of the total 5.2 million people employed
in the urban areas of the country in 2013. This 26 percent remained unchanged in 2016 too. This CSA analysis is problematic, however.
This is because it is based on employment figure that excludes those employed persons who are engaged in "subsistence farming" and
those who work in "private households" sectors from the total (national/rural/urban) employed population. Given such types of
employment in Ethiopia are informal in their nature; we need to include such omitted categories in the informal economy. When this is
done, the share of the informal sector in total employment would become about 40 per cent of the total employment both in 2013 (at the
national level) and in 2016 (in urban areas).
The composition of informal sector employment by major branches of industry shows that the majority of such employment at the
national level is found in "agriculture, hunting, forestry and fishing sector" (55 per cent of the country’s informal economy employment,
68 percent of the rural informal economy). This is followed by employment in the "whole sale and retail trade" industry (19.2 per cent).
A further look at the distribution of urban informal economy employment by major occupational categories shows that, in 2016, "service
and sales workers” rank top having a share of 40.3 per cent. This is followed by "craft and related trade" workers category (25.5 per
cent). The proportion of female workers is relatively higher in all the major occupational categories of the informal economy in 2016.
The number of females is more than double that of men in the "services and sales workers" category, which is the most important urban
informal occupational category in 2016.
Zambian: In Zambia, the informal sector comprises enterprises that are not formally registered and consequently, do not pay tax nor
any statutory fees. Using this definition, the Zambian official data (the 2014 Labour Force Survey) shows that the informal economy is an
important source of employment accounting for 84 percent of total employment in the country. In addition, 92 percent of employment
in the rural areas is also found in the informal sector, compared to 72 percent in the urban areas. This high level of rural employment
reflects higher participation in agricultural activities by rural populations when compared to urban dwellers. Note also that this national
data is much higher than the data from international sources (such as the World Bank) given in Figure 7.4
Extracted from Alemayehu et al (2017) and Alemayehu (2018)

Efficiency wage Real and nominal wage rigidities
Search models The Harris-Todaro Model
Union models The Lewis model
The informal labour market The implicit contract theory
The Phillips curve Okun’s law
Segmented labour market Disguised unemployment
Frictional unemployment (the natural rate of unemployment) The augmented Phillips curve
Review Questions
[1] What do you think is the role of the informal sector in African economy. What policy would you advise the government
to pursue with regard to the informal sector?
[2] Which of the theories discussed in the chapter is relevant for Africa, Compare and Contrast your choice with those
theories that you did not chose.?
[3] Macro policy in developing countries such as those in Africa is primarily aimed at reducing poverty. What are the
transmission mechanisms from macro policy to poverty? Explain the role of the labour market in that process?
[4] Is the determination of the demand for labour in African could be different from developed countries? Explain.
[6] Is the determination of the supply of the labour in Africa could be different from developed countries? Explain.
[7] Do you think the Lewis model of growth with unlimited supply of labour realistic? If yes, explain; If not, Why not?
[8] What is the role of expectation on the labour market. Would some of the results of the theories in this chapter
change if we use adaptive and rational expectation each at a time? Explain your answer.
[9] What is the difference and relationship between the standard demand and supply based analysis of labour market
discussed at the beginning of the chapter and the search models of labour market discussed latter.
[10] What do you think are the main elements of labour market policy a developing country should follow?

Abel, Andrew B. and Ben S. Bernanke (2001). Macroeconomics, 4th edition. USA: Addison Wesley Longman, Inc.
Adenikinju, Adeola F. and Olugboyega Oyeranti (1999).' Characteristics and Behavior of African Factor Markets and Market Institutions
and Their Consequences for Economic Growth', CID Working Paper No. 31 December 1999
AERC-ATF, African Economic Research Consortium -Analytical Trust Fund (2006), ‘A Synthesis Report of the study on ‘Enhancing
Contributions of the Informal Sector to National Development: Case Studies of Ethiopia, Ghana, Uganda and Zambia”
(Unpublished background study by Alemayehu Geda for AERC-ATF project that served as an advisor for African
representatives in World Bank and IMF in Washington, D.C.).
AERC and German Federal Ministry of Economic Cooperation and Development (2020), ‘The Coid-19 Pandemic and Structural
Transformation in Africa: A Framing for a Sustainable and Cohesive Future’ (unpublished, Nairobi & Bonn)
Agénor, Pierre and P. J. Montiel (2008). Development Macroeconomics. Princeton: Princeton University Press.
Aigbokhan, Ben E (2011), ‘Efficiency Wage, Rent Sharing Theories and Wage Determination in the Manufacturing Sector in Nigeria, AERC
Research Paper 222 African Economic Research Consortium, Nairobi January 2011
Alemayehu Geda (2018). Towards a National Minimum Wage in Ethiopia An Exploratory Study for ILO Regional Office Addis Ababa (A
Background Study for ILO Regional Office in Ethiopia, Eritrean and Djibouti).
Alemayehu Geda, John Weeks and Herryman Moono (2018), ‘Impact of Macroeconomic Reform on Labour Markets and Income in
Zambia: Assessing ZAMMOD’’, A Study for the International Labour Organization and Ministry of Finance, Zambia.
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Fields, G. S. (2007), ‘Modeling labor market policy in developing countries: A selective review of the literature and needs for the
future’, IPC Working Paper Series Number 3. Ann Arbor, MI: International Policy Center.
http://digitalcommons.ilr.cornell.edu/workingpapers/103/
Fink, Gunther, B. Kelsey Jack and Felix Masiye (2014), ‘Seasonal Credit Constraints and Agriculture Labour Supply: Evidence From Zambia,
NBER Working Paper 20218 at www.nber.org/paper/
Freidman, M (1968), ‘The Role of Monetary Policy’, American Economic Review, Vol. 58, No. 1 (Mar., 1968), pp. 1-17
Hunt, Diana (1989). Economic Theories of Development: An Analysis of Competing Paradigms. New York: Harvester Wheatsheaf.
International Labour Office, ILO (1972). Employment, Incomes, and Equality: A Strategy for Increasing Productive Employment in Kenya.
(Geneva: ILO).
Lewis, W.A (1954), ‘Economic Development with Unlimited Supply of Labour’, Manchester School (May, 1954), re printed in A. Agarwal and
S. Singha, eds. (1963). The Economics of Underdevelopment. Oxford: Oxford University Press.
Mankiw, G. 2013. Macroeconomics, 8th edition. New York: Worth publishing.
Modigliani, F (1944), ‘Liquidity Preference and the theory of interest and money’, Econometrica, 12 (1): 45-88
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Pissarides, C.A. (2001), The Economics of Search’, in International Encyclopedia of the Social and Behavioral Sciences, pages 13760-
13768. Amsterdam: North Holland.
Schumpeter, Joseph A. (1954). History of Economic Analysis. London: Allen Unwin.
Sender, John, Carlos Oya and Christopher Cramer (2006), ‘Women Working for Wages: Putting Flesh on the Bones of a Rural Labour
Market Survey in Mozambique’, Journal of Southern African Studies, 32(2):313-333.
Soderbom, M. and F. Teal. 2002. “The performance of Nigerian manufacturing firms: Report on the Nigerian Enterprise Survey 2001”.
The United Nations Industrial Development Organization and Centre for the Study of African Economies, Oxford, August.
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383-388.

AFRICA I: THE SHORT RUN

Alemayehu Geda


1
Ch 8: Short-run Macroeconomic Policies Alemayehu Geda

Alemayehu Geda

© 2020
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3
Chapter 8 Macro Policy and the African Context
…..Practical men, who believe themselves to be quite exempt from any intellectual influence are
usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air,
are usually distilling their frenzy from some academic scribbler of a few years back. I am sure
that the power of vested interest is vastly exaggerated compared with the gradual
encroachment of ideas…But soon or late, it is ideas, not vested interest, which are dangerous
for good and evil. J. M. Keynes (1936), The General Theory.
Tax economists, [the richest 1%], accountants and lawyers refer [to tax as] the ‘tax burden’ -
and if you think ‘tax burden’ is a neutral label, then for the sake of consistency you should be
happy for the term ‘public spending’ to be replace with ‘public benefit’
Jonathan Aldred, 2019, Licence to be Bad: How Economics Corrupt Us.
..The illusion that economics is a ‘positive science’ without ideology .. is itself an ideological
illusion, Journal of Post Keynesian Economics, in T. Palley, 1996
As the quotation above shows macroeconomic policy is not drawn from the blue. It rather has a theoretical and ideological
basis whether policy makers know it or not. This bring us to the issue of looking at short-run macroeconomic policy in the
political-economy context of Africa. I have classified the exposition about macroeconomic policy in this chapter as having
technical and political aspects for pedagogical and practical reasons. Though I have classified it in this manner for ease of
exposition and to emphasize the unique situation of developing countries (where politics is key for policy), the two are not
unrelated, however. Up to this point, each of the chapters that we have covered so far has presented to us macroeconomic
policies that are related to the theory in that particular chapter. Thus, we begin this chapter by briefly summarizing these
policies. You are advised to refer back to each chapter to see the detailed policies that are summarized in here.
Mankiw (2005) -the author of the most famous undergraduate macroeconomics textbook - said that we economists often
pose as the ones who “… formulate theories with mathematical precision, collect huge data sets on individual and aggregate
behavior, and exploit the most sophisticated statistical techniques to reach empirical judgments that are free of bias and
ideology (or so we like to think)” – so we act as scientists. Having spent two years in Washington as an economic adviser to
the US president, he said, he learned that the subfield of macroeconomics was born not as a science but more as a type of
engineering. Elaborating this, he said, “God put macroeconomists on earth not to propose and test elegant theories but to
solve practical problems. The problems He gave us, moreover, were not modest in dimension. The problem that gave birth to
our field—the Great Depression of the 1930s— was an economic downturn of unprecedented scale, including incomes so
depressed and unemployment so widespread that it is no exaggeration to say that the viability of the capitalist system was
called into question” (see Figure 1.2 in Chapter 1). Mankiw noted, engineers are, primarily problem solvers while scientists
4
attempt to understand how the world works. The research emphasis of macroeconomists has varied over time between these
two motives since its birth in the 1936, with Keynes and his followers being closer to engineers than scientists, according to
Mankiw. On the other hand, Mankiw thinks that research in recent decades such as the works of New Classical and New
Keynesian research on business cycle models (RBC), dynamic stochastic general equilibrium models (DSGEs), monetary
policy etc., as works of scientists because they were attempts to come up with theoretical principles and analytical tools. He
also noted that such university or research centers-based works take a long time to be adopted in practical work, partly
because the practitioners don’t want to take risk by adopting new models and tools that they are not sure of. There is also
path dependence – old tools leave slowly. He stressed, he doesn’t mean one is better and the other is not. He rather meant
that, “just as the world needs both scientists and engineers, it needs macroeconomists of both mindsets”. But he stressed,
“the discipline would advance more smoothly and fruitfully if macroeconomists always kept in mind that their field has a dual
role”. Though I do not think there is such vast distinction between the two (notice the current use of DSGE models in most
central banks of advanced countries), I think this is an excellent introduction to our discussion of macro policy in this chapter,
especially when we divide it as ‘technical’ and ‘political’ aspects of macroeconomic policy. This latter division, instead, seems
to me more relevant in the context of developing countries where macroeconomic is more complicated than Mankiw’s
classification scheme owing to the primary and key role of politics in macro policy making in developing countries. Though at
times not explicit, politics is also behind major macro policies and policy making in advanced countries too.
Be that as it may, two institutions are usually responsible for macroeconomic policy. Ministries of finance and development
are usually responsible for fiscal policy while central banks (referred in some countries as “national bank” or “reserve bank”)
are generally responsible for monetary and exchange rate policies. The primary responsibility of central banks in many
countries is ensuring macroeconomic stability in general and price stability (that includes exchange rate) in particular. They
are also expected to manage and regulate the financial sector and contribute to sustainable growth of the national economy.
In Asian miracle economies macro policies were not seen separately and they were generally framed in the context of an
overall industrialization strategy of these countries as discussed in the final section of this chapter.
8.1 Technical Aspects of Short-run Macroeconomic Policy

In Chapter 2 we have developed the IS-LM and aggregate demand and aggregate supply (AD-AS) models and used them to
analyze the impact of fiscal and monetary policies on output (and, hence, employment). Since that analytical framework is
developed in the context of a closed economy, its relevance became limited when we moved to Chapters 3 and 4 where we
discussed the rational expectation hypothesis and an open economy macroeconomics, respectively. In particular, our
discussion of rational expectation and the “Lucas Critics” in Chapter 3 led us to question the policy effectiveness of macro
policies and the tools (the large scale macroeconometric models) that were in use for that purpose. The same chapter,
however, has also shown us the possibility of policy effectiveness owing to the existence of rigidities which are developed in
the research programs of New Keynesian macroeconomists.
In Chapter 4 we focused on open economy macroeconomics using the Mead-Mundell-Fleming model (the MF model) by moving
away from the closed economy assumption of the IS-LM model of Chapter 2. Two important issues have emerged that changed
the effectiveness of monetary and fiscal policy as we moved from the closed economy models of Chapter 1 to the open
economy version. These are: the role of exchange rate regime (whether fixed or floating) and the nature of capital flows
(whether perfect or imperfect). In addition, we have also examined Weeks’ critique of the MF framework, in particular in
developing countries context, where the inflationary impact of change in exchange rate is very important (see section 8.1.2
5
below too). In this regard, Weeks’ critique basically says that “in addition to revision of the standard policy rule about
monetary and fiscal policy effectiveness, …. whatever the causes of disequilibrium, automatic nominal exchange rate
adjustment to correct it is potentially destabilizing because of [its] domestic price level effects”. This policy effectiveness
issue is summarized using Figure 8.1. In Figure 8.1 column one shows the ‘exchange rate regimes’ while columns two and
three show the ‘capital flow regimes. Rows one and two (the red ones) show the fixed exchange rate regime while rows three
and four (the gray ones) show the floating exchange rate regime. The interaction of these ‘exchange rate’ and ‘capital flow’
regimes that could be given by the coordinates of the rows and columns (i.e. where a row and column meet or cross each
other) such as (Fx, P) shows the effectiveness of either monetary or fiscal policy at that combination. Weeks’ version of the
same is given in the final two columns.
Figure 8.1 Summary of the Mead-Mundell-Fleming Model Policy Matrix and Weeks’ Critique
Nature of Capital Flows Policy Effectiveness Policy Effectiveness in J. Week’s
Version
Exchange Rate (Capital Flow Regimes) (In MF Model)
Regimes [in Developing Countries Context]
Perfect (P) Imperfect (I) Monetary Fiscal Monetary Fiscal
Fixed (Fx) (Fx, P) Not effective Not effective Not effective Effective
Fixed (Fx) (Fx, I) Not effective Effective Note Effective Effective
Floating (FL) (FL, P) Effective Not effective Not effective* Effective
Floating (FL) (FL, I) Not effective Not effective Not effective Effective
Notes: * For Weeks, the effectiveness of monetary policy depends on the values of the import share and the sum of the trade elasticities. Monetary
policy will be more effective than fiscal policy if and only the sum of the trade elasticities exceeds the import share. Inspection of data from
developing countries indicates a low effectiveness of monetary policy under flexible exchange rates (J. Weeks).
A related issue in the context of the discussion about macro policy using the MF model is what is called the ‘Impossible Trinity’
or ‘Trilemma’. The idea states that a government may choose any two, but not all three of the following policies: ‘monetary
independence’, ‘a fixed exchange rate’ and ‘free capital flow’. For instance, choosing a flexible exchange rate regime would
seem to leave a government with two of the three options, monetary independence or free capital flows. If the government
choses, say, free capital flows, it won’t have monetary independence and vice versa. However, when Weeks’ critique above is
taken on board, “a more accurate statement may be that a government operating a flexible exchange rate is left with
substantially fewer than two lemmas, because exchange rate adjustment can drastically reduce ‘monetary independence’ if
the latter is defined as a full policy impact. With a fixed exchange rate, governments face the Trilemma; with a flexible
exchange rate it can become a Dilemma”.
In addition to this aggregate approach to macroeconomic policy discussion, we have seen in Chapters 5 to 7 different policies
that are related to the theoretical issues discussed in each of these chapters. These policies were also discussed in relation
to their implications and relevance in the context of developing countries in general and African countries in particular. In
the rest of this sub-section we will discuss the two standard macro policy approaches: fiscal and monetary. The discussion
about these policies will also be related to the issues of financing development, inflation and debt which are crucial in the
context of developing countries. Such macro policies are also crucial in the process of industrialization and development,
which is briefly discussed in the final sub-section of this chapter, using the example of successful developmental states of
East Asia as illustration.
6
8.1.1 Fiscal Policy, Financing Development and Government Debt

The best way to understand fiscal policy is to look at the structure of a government budget and its financing. This means
looking at how resources for the budget are raised and how they also spent. In effect, the budget of a country shows the
politics, ideology and related concrete policy directions of a government. Table 8.1 shows a typical picture of the budget of
an African country (illustrated using Ethiopian budget for the year 2017/18).
A]. Government Revenue (Public Revenue): Columns one and two of Table 8.1 show the sources of government revenue.
As we can read from columns one and two, taxes are the most important sources of government revenue (being about 80
percent in the Ethiopian example, in Table 8.1). Apart from raising revenue through such taxes, the types of taxes, levying
taxes on different sectors of the economy (direct versus indirect, domestic versus foreign, on agriculture versus industry
etc.) or types of income (personal, business etc.) have implications for incentivizing or not a particular sub-sector of the
economy. It is also an instrument for governments’ policy about distribution of income. The latter can be inferred from
examining on whom and in what proportion the government is levying taxes and raising its revenue (say whether the
government relies more on profit taxes versus wage income taxes; taxing rural versus urban dwellers, low income groups
or high-income groups etc.). In addition, the nature of taxation such as whether it is regressive or progressive (progressive
tax is a tax rate that increases with income while regressive tax is the opposite.) also shows the government’s stand on
distribution of income among different classes of people based on their income. The latter also shows its political ideology
such as whether it is left-leaning, if it is highly progressive; and right-leaning if it is highly regressive. Finally, the tax share
(share of total taxes in GDP) also shows the nature and capacity of state. The higher this tax ratio, the higher is the capacity
of the state since it is able to finance its spending by its own resource, without resorting to internal or external debt, that
includes foreign aid.
Table 8.1 Public Revenue, Expenditure and Deficit Financing of a typical African Country (Ethiopia, 2017/18, Billions of Birr)
Government Revenue Birr Government Expenditure Birr Deficit & Deficit Financing Birr
Total Revenue & Grants =[1]+[6] 287.6 Total Expenditure=1+2+3 354.2 Revenue and Grants 287.6
Total Revenue =[1]=[2]+[5]+Others 269.6 Current Expenditure [1] 210.5 Revenue 269.6
Tax Revue [2]=[3]+[4] 235.2 General Services 62.7 Grants 17.9
Income & Profit Taxes (Direct Taxes) [3] 97.6 Economic Services 26.5 Total Expenditure 354.2
Personal 34.8 Social Services 97.8 Current 210.5
Business 44.7 Interest and Charges 11.6 Capital 143.7
Others 15.3 Others 11.9 Overall Surplus/deficit
Rural land use fee 0.4 Capital Expenditure [2] 143.7 Including Grants 66.6
Urban land use fee 2.4 Economic Development 89.7 Excluding Grants 84.6
Indirect Taxes [4] 137.6 Social Development 37.5 Total Financing [Required] 66.6
Domestic Taxes 67.2 General Development 16.5 Net External Borrowing 28.1
Foreign Trade Taxes (Import taxes) 70.4 Special Programs [3] 0 Gross Borrowing 32.5
Non-Tax Revenue [5] 34.4 Amortization paid 4.3
Charges and Fees 4.2 Share in total Expenditure Net Domestic borrowing 14.9
Govt Investment income 12.2 Capital 40.6% Privatization receipts 9.3
Reimbursement & Property Sales 0.1 Current 59.4. Others & residual 14.3
Sales of Goods & Services 5.3 Share in Total revenue& Grants Share in Deficit financing
7
Others (pensions etc.) 12.6 Taxes 81.8% External borrowing 42%

Grants [6] 17.9 Non-taxies 12% Domestic borrowing 22.4%
Source: National Bank of Ethiopia, Annual Report, 2018
B]. Government Expenditure (Pubic Expenditure or Spending): Columns three and four of Table 8.1 show the composition
of public expenditure/spending. This is invariably determined by government policy and historical values of the budget (the
latter is called ‘path dependence’). A government whose policy is an expansion of education spends relatively a lot in the
education sector than, say, the health sector. Similarly, the composition of the government expenditure in terms of current
and capital also shows the nature of the government policy. For instance, a developmental state committed to expand
infrastructure and wants to engage in strategic sectors of the economy itself spends relatively larger on such budget items.
As a result, its capital expenditure could be larger. This is in particular the case in developing countries that are aspiring to
develop fast, yet have significant infrastructure deficit. In contrast, in advanced countries, where they passed this stage of
development, such large capital spending on infrastructure may not be needed.
Public spending is an important policy tool in developing countries too. In our policy discussion in Chapters 2 and 4, we
designated government expenditure by the letter “G” and “I” (assuming I=Ig+Ip) and this is given as part of the national income
identity equation, Y=C+I+G+X-M. Thus, [G+ Ig ] represents a summary of all the items given in columns 3 and 4 of Table 8.1.
Public spending is needed for two reasons. First, governments need to spend on the economic and social sectors to ensure
the smooth functioning of a country that includes spending in the justice system, national defense, education, health etc. The
bulk of such spending is included in what is called the current expenditure category of public expenditure which is invariably
dominated by wage and salaries of workers in many developing countries. In addition to current expenditure, the government
is also involved in investment which could either be social (such as building a school, police station or health center etc.) or
economic (directly engaging in construction of roads, or running public utilities and public companies). Such spending is
referred as capital expenditure in the government budget. These categories of spending are shown in the third and fourth
columns of Table 8.1.
An interesting issue in the context of public spending and fiscal policy is whether the government can fully finance its spending
through its revenue? Invariably, a developing African country hardly does that. When a government fails to cover its spending
through its revenue, it will encounter a budget deficit that needs to be financed somehow. This is shown in Table 8.1 in the
fifth and six columns. The excess of public spending over revenue is shown under the item “overall surplus/deficit”. In our
example in Table 8.1 this is a deficit of Ethiopian Birr 66.6 and 84.6 billion including and executing grants, respectively. From
Table 8.1 we can also read that total tax revenue is financing only 66 percent of the total government spending. In general,
governments invariably resort to either domestic or external borrowing or both when they fail to finance their expenditure
with their own revenue. The external borrowing leads to external debt which is discussed next. The domestic borrowing is
usually done either by directly borrowing from the central banks or by borrowing from the general public, usually through
Ministries of Finance (or central banks). These institutions sell treasury bills (i.e., government borrowing by issuing
certificates for 3, 6 or 12 months period) or bonds (i.e., similar borrowing by issuing government certificate for a period of
over one year) to raise the required money from the public. The latter type of borrowing is referred as open market
operations. This domestic debt issue is discussed in the context of what is called “monetarization of deficit”, as part of our
monetary policy discussion in sub-section 8.1.2 below. Monetization of deficit shows also the strong link that exists between
fiscal policy (excess of public spending over revenue) and monetary policy in the context of African economies.
8
C]. External Debt1 and Financing Development: Financing of government deficit through external borrowing usually has
different forms that depend on the nature and sources of the finance. One dominant form of such financing is aid. If an African
country managed to get, say, an external borrowing of 100 million dollars from OECD countries and this loan has a grant
element that is greater than $25 million (25 percent), the whole $100 million is usually referred as aid, though it is essentially
a debt-creating flow and the equivalent of the US$75 has to be repaid with interest at the maturity date. In terms of sources
of financing, such flows may come from multilateral institutions such as the World Bank and IMF or from bilateral lenders
which are individual countries such as USA, UK, Germany etc., usually accompanied by policy conditionality. Governments can
also borrow from the private sector of advanced countries such as commercial banks and suppliers of goods and services
that usually offer short-term credits. Another interesting source of such external financing which is becoming important
recently is borrowing from China and other emerging developing economies such as India, Brazil, Turkey and the like. Though
such inflows don’t comply with the above definition of aid from OECD countries, they do have also a small grant element. It
doesn’t have policy conditionality like that of the financing coming from the WB, IMF and the Western countries, however. The
dominant form of such finance to Africa, especially from China, is availing finance for investment projects of a particular
country, usually for building infrastructure. This finance usually comes being conditional on Chinese firms doing the job. Here
we need to note that this is not FDI because it is not invested by Chines firms as the standard definition of the term requires.
It is rather an investment of the recipient country but financed by China, usually through its export and import bank (called
EXIM bank). We may refer to such investment-cum-financing as quasi-FDI or vender financing.
Whatever is the source of such debt creating capital inflows, an enduring feature of them is to make African countries
indebted. This indebtedness has strong relation with its means of payment which is the dependence of most countries in the
continent on commodity exports which are vulnerable to global economic conditions. This dependence is historically formed,
especially during the colonial period. Since the year 2002 the global commodity price, upon which most African countries
strongly depend, has increased steadily and the terms of trade (ToT) of Africa become positive for the first time after its
continuous decline of about one percent per annum for the last 100 years before this time (Alemayehu, 2019). This ToT
improvement has continued until the year 2013 when these commodity prices began to collapse. What is notable is that, in
tandem with this terms-of-trade improvement since 2002, economic growth in Africa became one of the highest in the world,
being 5 to 6 percent per annum between 2002-2013. This growth collapsed by nearly 50 percent, to about 3 percent (and
even to 2 percent in 2016), following the global commodity price collapse that began in 2014. A striking feature of this
dependence is its ability to trigger the need for more external finance and, hence, indebtedness when countries face such
external shocks. Thus, the indebtedness emerges not only because of the excess of public spending over revenue, but also
because of a policy response to such commodity price shocks and their effect on the economy and government budget.
In general, the following points are worth noting about Africa’s external debt. First, one of the implications of such historically
formed pattern of trade and growth for the external finance conditions of the continent is to make the continent structurally
indebted and unable to pay the debt in a sustainable and lasting manner. By the end of 1990s most countries not only became
extremely indebted owing to such pattern, but also structurally unable to pay back their debt. By the end of the 1990s, African
debt had reached US$ 324 billion, twenty-fold the level in the mid-1970s. By 2013, compared to 1970, the total external debt
of Africa had increased twenty-eight-fold, to about US$ 482 billion. The major component of this debt are official flows

1
This section is based on Alemayehu (2019). References used here as well as more detail information about the historical origin of the
African external finance, debt and trade problems are given in the book.
9
(multilateral and bilateral flows), and about 30 percent of these flows is generally obtained on non-concessional terms. From
mid 1970s to date this debt as percentage of total exports of goods and services of Africa ranged from 320 percent (the
lowest, in 2013) to 1476 percent (the highest, in 1985-89).
Second, the continent’s economic crisis in 1980s and 1990s widened the role of multilateral and bilateral finance despite only
being available at unacceptable terms – policy conditionality. Thus, another major development in the 1980s and 1990s was
the growth of bilateral and multilateral debts, especially those owed to the World Bank, IMF and OECD countries. The main
reasons for this were: (a) the stepping-in of these multilateral banks to finance the partial bail-out of commercial banks and
countries in distress in the 1980s and 1990s (Alemayehu, 2003); (b) the fact that these debts were denominated in SDR and
ECU when most African countries earned their currency in US dollars, which had depreciated against both the SDR and ECU
for the 30 years before this time, thus aggravating the indebtedness (see Mistry, 1994; 1996); and (c) since the 1980s IFIs
were convinced that the African economic crisis was a policy problem, as noted in Chapter 1. The latter entailed a rise in
multilateral and bilateral flows following the acceptance of the conditionality-based policy packages aimed at correcting
these ‘policy problems’ - the SAPs initially and the PRSPs latter.
Third, the SAPs not only aggravated the crisis in the 1980s and 1990s but also were accompanied by a significant outflow of
capital from the continent. Although the share of African debt as a proportion of the total debt of all developing countries is
low, the relative debt burden born by African countries compared to their debt servicing capacity was extremely heavy (the
debt to export share was 1470% in 1985-90, over 800% in 1995-99 and remains over 300% today, 2018). Moreover, in the
1990s, nearly 35% of grants to Africa, in fact, went back to ‘technical experts’ that usually come from donor countries
(Alemayehu, 2003). This is in addition to unrecorded capital outflow in the form of capital flight, which Ndikumana et al (2015)
estimated – for 39 African countries during the period 1970-2010 – at US$ 1,273.8 billion (at constant 2010 US$). The latter
is more than three times the total stock of debt owed by the continent, thus making Africa a net lender to the rest of the
world. Primary commodity trade and debt creating flows noted above are both the vehicles and the sources of such capital
flight (see Alemayehu and Addis, 2016).
Fourth, the indebtedness and foreign exchange constrained nature of growth in the continent led to fiscal and foreign
exchange stress (that includes servicing the debt). The accumulation of debt had also resulted in a ‘debt overhang’ problem,
which, together with a shortage of foreign exchange, tends to undermine the confidence of private investors. A decline in
levels of private investment as a share of GDP from the late 1970s onwards as well as the high level of fiscal deficit in many
countries in the continent during this time could partly be attributed to this factor (Elbadawi et al, 1997; Alemayehu, 2003).
The combined effect of this with the policy of the ‘Washington Consensus’ implemented during this period was to depress
growth in the 1980s and 1990s. The fiscal deficit also led to the dependence of financing the deficit through borrowing/aid
and monetization. Thus, from the mid-1970s onwards, aid as a share of government expenditure ranged from 21 to 33% for
the continent during 1970-2005 (and from 55 to 89% for 17 SSA countries during the period 2005-2013). As share of GDP
this is about 12% of GDP for SSA for 1970-2012.
In sum, the historical legacy of the dependence on primary commodities for exports has made Africa and its growth
disproportionally dependent on the external sector (external trade and finance). This has taken shape through three
interrelated phenomena. First, the cyclical nature of commodity prices led to the indebtedness of the continent. It also
encouraged the importance of the commodity trade both to service this debt and to secure new debt creating flows. This
further strengthened the dependence of Africa on the primary commodity trade in the post-independence period. Second,
10
growth has also accelerated and decelerated in tandem with these commodity price cycles. Such growth performance,
coupled with the mounting debt burden, indicates that African countries were incapable of simultaneously servicing their
debt and attaining a reasonable level of economic growth and poverty reduction by the end of the twentieth century and the
first two decades in the 21st century. Thus, we note that one of the legacies of the colonial structure is that the external
finance problem of the continent may not be solved by mere debt cancellation (which has been attempted in the past)2
because the African external finance problem is essentially a manifestation of its trade problem (Alemayehu, 2002; 2003,
2019).
Finally, an issue that we have not discussed here but important in the context of Africa’s external debt creating flows and
other capital flows such FDI and remittance is their effect on the fiscal posture of the government as well as their effect on
real exchange rate appreciation which discourages exports. These are referred as the macroeconomic effect of external
finance and are usually discussed under two broad topics: the “fiscal response to external finance” and “the Dutch disease
problem”. You may consult theses literature as part of your further reading (see, for instance, Alemayehu, 2002 for these
theories and their empirical evidence in Africa).
8.1.2 Monetary Policy, Financing Development and Inflation
We have noted in Chapters 2 and 4 that the “demand for money” function is one of the key equations in the IS-LM/ AD-AS
model-based analysis of monetary and fiscal policies. In those chapters, the demand for money was specified as a function
of interest rate and income following the Hicks-Modigliani formulation of the IS-LM model (i.e.; Md=f (Y, i)). In addition, the
supply of money is assumed exogenous in the IS-LM model we have discussed in Chapters 2 and 4. In this sub-section we will
briefly discuss the demand for and supply of money in relation to monetary policy in more detail.
i) The Demand for and Supply of Money
A]. The Demand for Money: Money is demanded for various reasons. It is needed for (a) transaction purpose, (b) for
precautionary motive as well as (c) for speculative purposes. The transaction demand is basically a demand for money to
effect payments for one’s expenditure. It usually emerges due to lack of synchronization between expenditure and income (if
the two were perfectly synchronized there is no need for money for transaction purpose). Thus, such demand depends on
income. The higher the income (and the greater the lack of synchronization between expenditure and income), the larger will
be the transaction demand for money. In addition, since, alternatively, we could have put such money on interest bearing
financial assets, such as bonds, the higher the interest rate on such assets, the lower will be the demand for money for
transaction purpose.
The second motive for holding money is related to the demand for unexpected or sudden purchase – called the ‘precautionary’
motive. It might be costly not to get hold of liquid money when a sudden demand for unexpected transaction occurs. This is
because it means we need to convert assets back to liquid money to conduct such transaction, which is a costly process. In
addition, the probability of the occurrence of such transaction could also be rising for many reasons. To avoid such cost and
spend on contingencies as they happen, holding money for such purpose could be worth it. Since such expenditure also relates

2 The Highly Indebted Poor Countries (HIPC) Initiative that has been on the table since 1996 was partly triggered by the recognition of the
severity of this debt problem. However, it was not only besieged by much policy conditionality but also did not offer a lasting solution to Africa’s
external finance problem, which is intricately related with trading in primary commodities. Thus, no sooner had countries found themselves as indebted
as before after receiving such debt cancellation.
11
to income, the precautionary demand for money is a positive function of income. Given the opportunity cost of holding such
money in terms of interest-bearing assets instead, the precautionary demand for money is also negatively related to interest
rate which is an indicator of the forgone interest income.
Finally, the third type of demand for money is the speculative demand for money. This is the most important type of demand
from the Keynesian macroeconomics perspective. Keynes himself noted that this type of demand is important not only
because it is less known by many but also, and more importantly, because it is “particularly important in transmitting the
effects of a change in the quantity of money” to the rest of the economy (Keynes, 1936). This type of demand basically means
that we would compare holding of liquid money vis-à-vis holding other interest-bearing assets and could prefer to hold money
or not depending on our demand for liquidity (liquidity preference) vis-à-vis the expected interest earning by holding interest-
bearing financial assets, instead. It is, thus, defined as a function of the interest income forgone on holding of such assets.
Though we can divided the demand for money as “the transaction and precautionary motives” (M1) which are primarily
dependent on income (Y) and “speculative demand” (M2) which depends on “the relation between the current rate of interest
and the state of expectation”, for analytical purpose, the two liquidity functions (L1 and L2,) and the decision to hold money
for one (M1) or the other (M2) motive is not independent of each other for Keynes. These two types of demand for money can
be summarized using Keynes’ original formulation as, (Note: don’t confuse this denotation of demand for money here as M1 &
M2 with the narrow and broad money supply definition which is also given in modern writings by M1 & M2. I used it here to
present Keynes’ original formulation).
[8.1]
As the link between change in money supply with M2 above (L2) is the key relation for Keynes, he wants us to imagine
hypothetically money is a gold coin and more money is generated through more mining. As the mining activity raises the
income of the miners, so does government spending by printing money for those who earned this money as income. This
change in income (Y) due to the government spending may not be fully absorbed by M1 and some portion of the money will
seek an outlet in buying securities or related assets until “r” has fallen so as to bring about an increase in the magnitude
of M2 (i.e., an increase in demand for liquidity, instead) and at the same time to stimulate a rise in Y to such an extent that
the new money is absorbed either in M2 or M1 which corresponds to the rise in “Y” that is caused by the fall in “r” (Keynes,
1936). According to Keynes, the division of the increase in M (money supply) between M1 and M2 in the new equilibrium will
depend on the responses of investment to the fall in interest rate and that of income to an increase in investment. Thus,
Keynes concluded, “since ‘Y’ partly depends on ‘r’, it follows that a given change in M has to cause a sufficient change in ‘r’
for the resultant change in M1 and M2, respectively, to add up to the given change in M”.
Having this formulation, Keynes stressed the importance of the income velocity of money in this process. Keynes noted, the
income velocity of money could be defined as ratio of Y to M or M1. However, he preferred the latter. He also noted that the
income velocity is not necessary constant and depends on: (i) the character of the banking and (ii) industrial organization;
(iii) on social habits, (iv) on the distribution of income between different classes and (v) the effect of cost of holding idle cash.
This income velocity is given by equation 8.2 (Note that in its modern version the money velocity is defined as Y/M, and now
days it also depends on financial innovation such as mobile money in Africa – the prominent example being M-Pesa in Kenya).
In Keynes’ original formulation this income velocity was given by,
, in its modern version [8.2]

12
Given the discussion so far, the Keynesian demand for money function could be, thus, given by,
, , or in a linear form as [8.3]
This characterization of the income velocity of money by Keynes takes us to another famous demand for money function that
informed neoclassical economists that includes the famous American economist and Nobel Laurate, Milton Friedman.
Friedman is known, among other things, for his famous statement relevant in the context of this sub-section which says
‘inflation is always and everywhere a monetary phenomenon.’3 The theoretical basis for such statement could be traced back
to the “quantity theory of money” that is given by,
[8.4]
Where: V stands for velocity (which is similar to Keynes’s definition given in Eqn [8.2]), Q for real output, P, for general
price level and M for money.
The quantity theory of money traces its origin to more than 550 years ago to the work of Bodin in 1568 who is widely
considered as the discoverer of the theory. Davanzati (1588) is also credited for refining it with superior formulation than
that of Bodin. Biscoer (1694) is credited for writing it in an equation form for the first time, though he wrote the equation as
money equals price times real income -which implicitly assumes a velocity of 1 in the light of equation [8.4]. This is further
reasserted in the 18th century by people like the famous Scottish philosopher David Hume in 1752 (see Schumpeter, 1954). In
all its ancient formulation the quantity theory was a theory of general prices. Freidman (1956) is credited for presenting this
ancient quantity theory afresh by reincarnating and then transforming it from its historical understanding as the theory of
a general price level to a theory of demand for money. In a simplified form, Friedman’s innovation on quantity theory is to
include expected rate of inflation (Pe) and individual’s test and preference (Test) as part of the explanatory variables. He also
used his permanent income (Yp), instead of the Keynesian current income (Y). This, Freidman’s version of the demand for real
money, is given by,
, , , [8.5]
As noted by Patinkin (1969; cited in Snowdon and Vane, 2005), this Friedman’s formulation of the demand for money is
basically an extension of the Keynesian analysis we discussed above though he used his idea of permanent income (Yp) and
expected rate of inflation. The latter could also be taken as part of Keynes’ presentation of taking “r” in relation to expectation
as we discussed it above. Friedman also took this demand formulation as a stable function of the variables given in the right-
hand side of Eqn [8.5], including stable velocity. The latter is not necessarily true in the Keynesian formulation as it is a
function of about five factors as outlined by Keynes and discussed above. Notwithstanding its affinity with Keynes’ analysis,
the stable velocity and full employment assumption of neoclassical economics has led Freidman to come up with the
conclusion that changes in money supply are generally the causes of changes in price and hence such changes in money

3
See Weeks (2014) who argues that this statement is not true. On top of showing the difficulty of defining money and the difficulty of showing
who actually increases money in theory (i.e. is it government or banks?), using data for US from 1992-2010, he shows that price of fuel (fuel inflation)
explains over half of the change in the US consumer price index (the US inflation. During 1960-69, when the international petroleum price was constant,
the USA manufactured price rose only by 1% per annum. During the next 10 years petroleum price rose by 115% in US and worldwide. Every country,
including US, experienced a fuel inflation as fuel is important in household consumption. Then, he asks, is this ‘a monetary phenomenon?’; and noted,
“training people to answer ‘yes’ to this question when the truth is obviously ‘no’ represents one of the greatest ideological scam” … and this is
achieved, he noted, using what is called ‘the quantity theory of money’.
13
affect only nominal, not real, variables (he also referred this as an empirical generalization of his studies). Later in his 1968
influential article (a paper presented to American Economic Association a year before) he offered a theoretical foundation
for this conclusion that is formulated as part of his critique of the Keynesian Phillips curve. The Phillips curve was using
money wage instead of expected real wage, in the inflation-employment tradeoff it was attempting to depict (see Chapter 7
for Phillips Curve). By introducing this ‘expected real wage’ in the traditional Phillips curve model, he came up with what is
now called the expectation-augmented Phillips curve – a crucial equation in modern macroeconomic models (see Chapters
2 and 7). With this formulation, Freidman said, although monetary policy could have real effect in the short-run as in the
original Phillip curve, it will not have real effect in the long run as was the case in the classical quantity theory of money. This
is because the expectation-augmented Phillips curve becomes vertical at the natural rate of unemployment in the inflation
(Y-axis)-unemployment (X-axis) plane (see Snowdon and Vane, 2005). From this analysis, Friedman concluded that swings in
monetary aggregates are causes of swings in the economy in the past, and hence, he advised monetary authorities “to set
to themselves a steady course and keeping to it”. By doing so, he said, monetary authorities “could make a major contribution
to promoting economic stability. By making that course one of steady but moderate growth in the quantity of money, [they]
would make a major contribution to avoidance of either inflation or deflation of prices” (Freidman, 1968). It is worth noting
that in this latter conclusion the assumption of a stable demand for money, that includes stable velocity, is very important.
Empirical evidences hardly find stable velocity, especially in developing countries and this is becoming truer each day with
the current surge in financial innovation such as the M-Pesa (mobile money) in Kenya. In addition, Keynes’ theoretical
characterization of it that we saw above and the unrealistic nature the full-employment assumption both stand against
Friedman’s conclusion.
B]. The Money Supply: As we have seen in Chapter 4, the narrow money (M1) is defined as the sum of currency outside banks
and demand deposit. When we add all other types of deposits, such as saving deposits, to the M1, we will get what we call the
broad money (the M2). In the AD-AS models of Chapters 2 and 4, we have assumed the money supply to be exogenous. On the
other hand, from the balance sheet of the central bank that we saw in Chapter 4, the money supply could also be derived as
a multiple of what is called the “high-powered money” or “monetary base” or “reserve money”. The latter is defined in Chapter
4 as sum of total credit and net foreign assets. Thus, foreign exchange sales (purchases) that arise from the balance of
payment surplus (deficit) could automatically reduce (increase) the stock of high-powered money, which in turn increases
(decreases) the money supply. The monetary authorities can temporarily could put a break in this automatic link through
what is called “monetary policy sterilization”: that is, manipulating domestic credit to offset the effect of the net change in
foreign assets as discussed it in Chapter 4. It is imperative to note, however, that it is only under the fixed exchange rate
system such accumulation or de-accumulation of foreign exchange reserves of this type (which allows to change the money
supply, Ms) is possible. Thus, it is in such system that the money supply could be taken as exogenous. In a flexible exchange
rate system, the money supply becomes endogenous and, hence, it is not under the full control of central banks.
In addition, as argued strongly by Post-Keynesians, money supply could also be endogenous. This means financial institutions
such as banks can create their own money since they put only a small fraction of their deposit as statutory reserve
requirement set by central banks. This basically means one Shilling or Birr deposited by one person in Kenya or Ethiopia could
be given as loan to two or more persons by the banks receiving this deposit. Since domestic credit is one of the components
of the high-powered money as we noted above, when it increases due to such actions the money supply also increases
endogenously. In this way, banks can endogenously increase the money supply. Central banks do control this, to some degree,
by increasing or decreasing the reserve requirement as well as using other regulatory rules such as a limit on deposit to
14
lending ratios that could set a restriction on the activities of commercial banks. Such requirements are obligations that
central banks impose on commercial banks to control the supply of money.
Given our exposition of the demand for and supply of money thus far, monetary policy is expected to work through
manipulation of the money market that influence the economy thorough two channels: (i) by influencing the creation of private
credit using the so-called open market operations and or (ii) through influencing the borrowing rates for the private sector
by manipulating the interest rate at which commercial banks can borrow from the central bank. The open market operation
is expected to work through the money market in general and the demand for money function in particular that we discussed
above. Thus, for instance, an increase in money supply, relative to demand as given by the demand for money equation, leads
to a decline in interest rate which stimulates the economy through an increase in credit and private investment and, hence,
Y. Alternatively, it could cool down the economy when the money supply is reduced, leading to a rise in the interest rate (and,
hence, lower investment and income, Y).
If the country has a well-developed money market (securities market), this increase and decrease in money supply is done
through “open market operation” in the securities market. An open market operation here is defined as an activity of a central
bank or a government by issuing (selling) securities (certificates) to reduce the money supply, and purchase back such
securities when the government wants to increase the money supply. However, as Weeks (2010) argued, only 11 out of the 53
African countries have a narrow bond market which is dominated by few expatriate banks, 17 countries in West Africa are
under common currency and hence do not have central bank, and 16 countries do not have such market at all. Thus, monetary
policy is ineffective in Africa since the market itself is not there. The only exception to this is the existence of such market in
South Africa and North African countries such as Algeria, Egypt and Tunisian. Thus, the International Financial Institution’s
(IFIs) policy advice in Africa that emphasizes monetary policy to control inflation and ensure exchange rate stability is the
wrong approach as most countries simply do not have the market (security market) to use such indirect monetary policy,
In general, because such markets are not available in many African countries and the financial sector is not well developed
either, monetary policy generally plays an accommodative role to the fiscal policy (called fiscal dominance), through
monetization of government deficit. The latter takes the form of government direct borrowing from the central banks. Since
central banks do not have their own resources, this is tantamount to printing money and provide it to the government (an
increase in money supply directly). When a government finances its deficit in such manner, it is referred as the monetization
of deficit. The latter is an important monetary policy issue discussed latter.
ii) Financing Development: Monetization of Deficit, Domestic Debt and Inflation4
We have noted above that the government budget deficit could be financed either by external or domestic borrowing. We have
also noted that the internal debt is related to what is called the ‘monetization of deficit’. From a theoretical perspective and
the African experience, this policy issue is very important and its implication for the “growth-inflation trade-off” can be easily
demonstrated using the Kaleckian framework summarized in Figure 8.1 (Kalecki, 1976 and Alemayehu and Kibrom, 2020).
In one of his classic work about the problem of financing development in developing countries, Kalecki (1954, 1976) noted that
in poor countries’ ambition for rapid growth, that requires high investment, “there is no financial limit, in the formal sense,

4
This section is based on Alemayehu and Kibrom (2020) ‘The Challenge of Inflation and Financing Development in Ethiopia: A Kaleckian
Approach with Empirical Result’, Department of Economics, AAU. You may refer the article for details of inflation studies in Africa and econometric
application in modelling inflation. All references mentioned here are, thus, given in this article.
15
to the volume of investment [required for growth]. The real problem is whether the financing of such investment does, or
does not, create inflationary pressure” – this is “the gist of the problem”. For Kalecki, one of the crucial issues for having
non-inflationary financing of such investment for high growth is whether there is enough expansion of supply of consumer
goods in general and food supply in particular in response to the demand that comes with such investment (Kalecki, 1954,
1976). Thus, for Kalecki, the condition of food supply elasticities in these countries are key issues to understand the challenge
of financing development – inelastic food supply leading to inflationary situation. This issue and the Kaleckian macroeconomic
framework (that includes the issue of income distribution) in the context of which this idea is developed, as well as its
relevance for many African countries would make it an overarching analytical framework to study the inflation-growth trade
off and its relation to monetary and fiscal policies in these countries (Kalecki, 1954, 1976; Sawyer, 1985; FitzGerald, 1993). In
short, in this framework inflation in developing countries is related to their desire for high growth, the nature of financing
this growth (that includes both fiscal and monetary policies) and the condition of food supply in these countries. These issues
are discussed here by focusing on inflation.
On empirical front, several cross-country and country specific studies about determinants of inflation in developing countries
have found mixed results. External factors such as openness and exchange rate liberalization are found to be important in
some of these studies (Romer,1993; Terra, 1998; Chhibber, 1991 and Isakova, 2007). Monetary developments also appear to
be among the key determinants of the inflationary in Africa (Edwards and Tabellini, 1990; Chhibber, 1991; Barnichon and Peiris,
2007; Alemayehu and Kibrom, 2011). These studies generally show the existence of huge fiscal deficits that led to inflationary
pressures in many African countries primarily through monetization of these deficits, as well as devaluation or depreciation
of domestic currencies. Isakova (2007) indicated that such money supply played a role in inflationary process in other
developing countries such as central Asia too. Other key determinants of inflation in such economies include output gap
(Isakova, 2007; Barnichon and Peiris, 2007), international price and nominal exchange rate movements (Isakova, 2007) and
political instability (Edwards and Tabellini, 1990). Most of these studies are based on cross-country data. In addition to such
cross-country studies, most country specific inflation studies in Africa also found that money supply, followed by exchanger
rate and food supply conditions, as the prime sources of inflation in Tanzania (Laryea and Sumaila, 2001), South Africa
(Akinboadeet al, 2002), Ghana (Chhibber and Shafik,1990; Ocran,2007), Malawi (Simwaka, 2004), Mozambique (Ubide, 1997),
Swaziland (Dlamani and Nxumalo, 2001) and Ethiopia (Alemayehu and Kibrom, 2011; 2020), among others.
A common missing element in both types of the above studies is lack of comprehensive macro-analytical framework and a
model specified from that so as to analyse inflation in the course of growth and its financing. The Kaleckian theoretical
framework (Kalecki, 1954, 1976, 2006) can bridge this analytical gap, as noted. More specifically and in a nut shell, the
Kaleckian macroeconomic framework about financing development and the challenge of inflation notes three important issues
that are relevant to take on board. First, sectoral growth imbalances are key conditions to watch for non-inflation financing
of investment for growth. Second, the limit to investment financing is not finance as such but the possibility of inflation that
is related to backward agriculture and the resulting challenge of food supply in these countries. A foreign exchange constraint
could be added to this. Third, inflation is not a simple monetary phenomenon but a key macro variable that has a strong
bearing on distribution of income, macroeconomic instability and the related issues of sustainable growth and the welfare of
the majority (Kalecki 1954, 1976, 2006).
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Based on such Kaleckian framework and the above empirical studies we can think of (and later model) three major factors
that determine inflation in African countries: monetary factors that includes monetization of deficit, cost push factors and
supply bottlenecks (especially of food supply). The three factors are not independent of one another either. A rise in the price
level due to (say) a rise in raw materials cost or exchange rate depreciation may have budgetary implications. High budget
deficits may, in turn, lead governments to get indebted and to monetize such deficits which could result on significant growth
of money supply. This may lead to high growth; but also, can lead to another round of price hike. Associated with such price
rises is the possibility of cost-price spirals (conflict-inflation) as workers demand higher nominal wage rates to mitigate the
effect of the rise in price while firms in turn pas such rise in their labour cost on to consumers. The latter is invariably done
by those firms with market power and, hence, have the ability to pass the rise in their cost of operation onto consumers. On
the other hand, contractionary monetary policies may lead to contraction of investment which may have adverse
consequences for growth – showing the “inflation versus fast growth” trade-off which a dilemma for policy makers. This
situation is summarized in Figure 8.1.
Figure 8.1 shows that an increase in money supply due to monetization of public deficit that is triggered by high investment
for high growth, which is depicted in quadrant II (with M’>M), triggers inflation which is depicted in quadrants II & I (thus,
price will increase from P to P’, where P’>P). On the other hand, through quadrants III and IV, the increase in money supply
does also result in an increase in economic growth from g to g’, where g’>g. The latter is depicted in quadrants IV and I.
Quadrant I explicitly shows this trade-off between growth and inflation which is the policy challenge. Quadrant I also shows
the possibility of non-inflationary high growth that could be attained by investing the increase in money supply on raising
food supply that shifts the inflation-growth schedule to the right (the dashed, red, line). The latter could also be attained by
importation of necessities, if the country has enough foreign reserves.
An inflation model that could be developed using such analytical framework could be estimated using various econometrics
approaches (see Alemayehu and Kibrom, 2020 for instance). The estimation of such model could be done both at general
inflation level as well as by splitting the general price level into two: food and non-food inflation. Such categorization is
important in a Kaleckian framework because it assumes that the price setting processes may differ by sector (in the two
markets). The food sector, being dominated mainly by small holder agriculturalists, is usually assumed to be competitive (i.e.,
firms here are operating in flexi-price market). The non-food sector firms (usually characterized by few suppliers), on the
other hand, could be assumed to be monopolistically competitive that operate in fix-price market with a mark-up pricing rule
(Weeks, 2007; Kalecki, 1954; 1976, 2006; cited in Alemayehu and Kibrom, 2020).
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Figure 8.1: Monetary Policy and the Inflation-Growth Trade-off
Inflation
P’ Impact of an increase
E
in food supply
P
M’ M g g’

Money Supply 450 Growth
M
M’
Money Supply
Source: Alemayehu and Kibrom (2020)
Finally, we may conclude this section by noting that exchange rate policy could also be taken as part of monetary policy with
possible effect on inflation. Not only it is generally managed by central banks; but also, it is strongly associated with inflation
as shown above. In addition, depreciation of currency could lead to inflation as shown in Weeks’ critique of the Mundell-
Fleming model (see Chapter 4 for the theory behind exchange rate determination as well as its inflationary impact in the
context of the MF model). Thus, the policy towards exchange rate needs to be looked at in the context of the challenge of
inflationary too. It also needs to be looked at as part of the trade and industrialization policy of such developing countries as
discussed in sub-section 8.2.3 below (see also Alemayehu 2002 for the relationship between exchange rate, external finance
and the ‘Dutch Disease’ theory in African context).
8.2 Political Aspect of Macroeconomic Policy in Africa

8.2.1 The Washington Consensus and the Structuralist Critique of Macro Policies in Africa
In Chapter 1, we have discussed in detail the evolution of macroeconomic policy in Africa since the 1980s (so you may have
some repetition here in the attempt to summarize it for your convenience and making the explicit link between macro policy
and politics). From Chapter 1, we have noted that two schools of thought had quite contrasting views about the African
economic crisis (the challenges of growth and poverty reduction) and the policy direction required to address them. The
neoclassical (mainstream) view which is based on the market clearing free market theory considers these challenges as
policy problems -this is what Acemoglu and Robinson (2013, 2001) called it the ‘our ignorance’ argument (see below). This
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has led to the policy prescription called the Washington Consensus that came in the explicit name of ‘structural adjustment
policies’ (SAPs) in 1980’s and 1990s and ‘poverty reduction strategy programs’ (PRPs) in the 2000’s (Table 8.2). These are
policies imposed by IMF/WB (the IFIs), on behalf of the Western economies on Africa, being conditional on the aid they offer
to countries in the continent. These policies have largely failed to address the challenges (see Alemayehu, 2019). The model
used by IFIs when they negotiate with African governments and impose this policy conditionality is termed as ‘the revised
minimum standard model’ (RMSM). The RMSM model is specified in detail in Chapter 4, and you may need to revise it. Chapter
4 also offers an alternative model which is based on the Kaleckian theory of financing development in developing countries.
In terms of macro policy direction, the IFIs’ policy stance has not changed much from the SAPs and PRPs even today (this
can be read from the latest agreement between these IFIs and the Ethiopian government agreement (2018-2021) for instance,
see Chapter 9). These policy directions could be labeled generally as “liberalization” which is summarized in Table 8.2,
reproduced here from Chapter 1 for your convenience.
As we noted in detail in Chapter 1, the African Economic Research Consortium (AERC), the prime intellectual economic think-
tank in the continent, conducted a comprehensive study about the political economy of growth in Africa since independence.
The result of these studies is published by Cambridge University Press in two volumes (Ndulu et al. 2008a; 2008b). AERC
researchers noted that there were about four political regimes that characterised the political and policy landscape of post-
independence Africa. These are countries characterised by: State Controls (SC), Adverse Redistribution (AR), Inter-
temporally Unsustainable Spending (IUS), and State Breakdown (SB); also presented is the complementary Syndrome-free
(SF)5 category (Fosu 2008a). The study noted that the quality of economic policy pursued by each of these regimes has a
powerful effect on whether countries seize the growth opportunities implied by global technologies and markets and by their
own initial conditions (Fosu in Ndulu et al. 2008a).
Table 8.2: The Washington and Augmented Washington Consensus: The Orthodox Policies Advocated by IFIs in Africa
Source: Dani Rodrik (2006), Journal of Economic Literature, Vol, XLIV (December)

5
The prominent African economist who passed away this year (2020), Thandika Mkandawire, told me a couple of years ago in Dakar, Senegal,
that he doesn’t agree with this “Syndrome based explanation” of African growth of the AERC – see below for his view.
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This is an excellent and comprehensive study. However, one of its main weaknesses lies in its failure to look at the deeper
historical reasons for having a structure that is vulnerable to syndromes. The second weakness is to delink the policy regime
analysis from the internal and external political-economy context of African countries (see, inter alia, Hyden, 1983; Sender
and Smith, 1986; Mkandawire 2001, 2010; Routely, 2012; Mamdani, 2018).
Notwithstanding the overall impact of the nature of political regimes as noted, the politics of policy making, the capacity of
the state and its bureaucracy as well as the quality of policies are generally considered as necessary factors for creating a
conducive environment for development (Wali 2000; Eifert and Ramachandran 2004; World Economic Forum 2007; Alemayehu
2019). The successful experience of African developmental states such as Botswana and Mauritius that followed pragmatic
and structuralist/heterodox policies with strong state-intervention, which is the antithesis of liberalization policies, adds to
the importance of good policies, good institutions, strong role of the state and alternative heterodox policy approaches for
successful development in Africa (Alemayehu, 2019).
We may conclude this brief summary of the debate, which is still alive by re-writing the quote from the great late Thandika
Mkandawire who made a theoretically penetrating and explicit link between the theory behind the policies outlined in Table
8.2 and their critics. Mkandawire (1989, cited in Elbadawi et al, 1992) summarized the two contending views about the causes
of the African economic crisis as structuralist and neoclassical (as noted in Chapter 1 and reproduced here for your
convenience). He noted,
The structuralist view is one which highlights a number of features and ‘stylized facts’ that almost every point
contradicts the neoclassical view...class based distribution of income rather than marginal productivity based
distribution of income; oligopolistic rather than the laissez-faire capitalist market; increasing returns or fixed
proportion production functions rather than ‘well-behaved’ production functions with decreasing returns and high
rates of substitution; non-equivalent or ‘unequal exchange’ in the world rather than competitive, comparative
advantage based world system; low supply elasticities rather than instantaneous response to price incentives.
Note also that, not only the theoretical approach such as the neoclassical market clearing model, but also the approach to
economic policy research (the methodology or philosophy of science) has also a strong bearing on policies (see Alemayehu
2018b for the methodological difference between the two schools and its implications in African context).
8.2.2 History, Politics and Institutions in Policy Making: Why Nations Fail?
Generally, macro policies are not made in a political vacuum. The political economy context, both internal and external, in
which macro policy is formulated has a strong bearing on the resultant macro policy and hence the macroeconomic
environment for growth and poverty reduction. Since politics is extremely important and perhaps is the main factor behind
good or bad policies, we will briefly discus this issue in this sub-section.
Acemoglu and Robinson (2013, 2001) both in their popular book ‘Why nations fail’ and their 2001 journal article that is focused
on ‘the colonial origin of Africa development’ begun their argument by challenging the three popular reasons given in the
European and North American literature about ‘why nations fail’ and/or ‘why there is an enormous income gap between poor
and rich nations’. These popular reasons are geography (tropical climate with many diseases, poor soil, and making people
lazy is bad for growth and development), culture (developing countries such as those in Africa have poor work ethics,
traditional beliefs, poor trust and do not like to accept new Western technologies) and ignorance (we or our rulers do not
know how to make countries rich, that includes economic policy – this idea is usually held mainly by economists, they noted).
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The authors have shown how wrong all these popular explanations are by providing counter examples (such as tropical
countries that managed to develop such as Singapore; countries with the same culture but with divergent development
experience such North and South Korea and border towns between US and Mexico with striking developmental differences
etc..). They also argued that both ‘culture’ and ‘ignorance’ could be the result of lack of institutions and, hence, by themselves
cannot be reasons for why nations are poor. Institutional difference seems the key word in their explanation about why some
nations are poor while few others are rich. The important question then is, what do they mean when they say “institutions”?
Being more specific, Acemoglu and Robinson (2013) noted that the main reason behind the significant gap between poor and
rich countries is lack of inclusive political and economic institutions or the prevalence of ‘extractive’ as opposed to
‘developmental’ institutions in poor countries. Inclusive institutions are defined as institutions that allow and encourage the
great mass to participate and benefit from the economy freely by providing appropriate incentives. To have inclusive
institutions, according to these authors, security of private property, unbiased system of law, provision of public services
(such as education and health) that provide and enable level playing field for all, not for few elites, is required. On the other
hand, extractive institutions are defined as those institutions designed to extract income and wealth from a society to benefit
a few elites at the expense of the majority. Inclusive institutions in turn are found to depend primarily on inclusive politics –
defined as institutions which are sufficiently centralized, yet pluralistic or democratic. When either of these latter two
features are missing, we will have extractive political institutions.
Having such broad understanding of institutions, Acemoglu and Robinson (2013) argued, it is lack of inclusive political and
economic institutions that causes poverty of nations. Then, they also asked why nations chose extractive, as opposed to
inclusive institutions (because even a dictator and corrupt leader seems to be better-off if he is a president of a wealthy
than a poor nation). They reasoned; this is because extractive institutions suit the few elites. Thus, inclusive institutions, even
if they are developmental and benefit the majority, they will be thwarted by such elites since they distribute power and income
for the majority and, hence, are a threat to these few elites which are beneficiaries of the system with extractive institutions.
In addition, since progress in capitalism, as Schumpeter noted, is characterized by ‘creative destruction’ (new innovation
destroying past innovations – e.g. smart-phones destroying desktop computers or the camera industry), there could be a
fear of such change and such elites’ fear of becoming a possible victim of this destruction could force them to stick to the
status que. These authors also noted that such choice is also ‘path dependent’, in the sense that history and critical junctures
in history could shape the choice of the type of institutions a country has.
Though the above arguments are generally valid, it is imperative to note that historically, when today’s developed countries
(as well as the East Asian economies recently, see below) were developing, the role the state and public property were central
for their economic development. Thus, their definition of the term ‘developmental institution’, inter alia, as institution of
private property with the state relegated to the minimum role of regulation is not only illogical but also ahistorical – it rather
looks ideological (see for instance Mazzucato, 2019, for the strong role of state in developing the high-tech industry in US
even today). Globally, there are also efficient publicly owned firms since ownership and management usually becomes distinct
and separate as firm grows – leaving the prosperity or demise of the firm to the managerial class and its board with owners,
especially public shareholders, having little power (see Aldred, 2019). Autonomous and professional management, competition
and proper regulatory body are key factors for efficiency, not ownership as such – an excellent example of this in Africa is
the Ethiopian Airline which is fully state-owned and yet the top airline in the continent, the 4th Airline in the world in terms of
the number of countries served and the 6th best airline in the world. In addition, the authors’ perception of the US type
21
(capitalist) economic system as unbiased with opportunity available for all is questioned by recent studies on inequality.
These studies revealed the limited social mobility in US (and also other developed countries) which is characterized by the
continuous reproduction of the top 1 % high income earners that is perpetuated through inheritance, admission to ivy-league
universities and working in the financial and fintech sectors (Weeks, 2012; Piketty, 2014; The Economist, Feb 2, 2017; Aldred,
2019). In his excellent book and a provocative title of a diagram in the book, ‘Anyone can be rich in the US, if you are already
in the top 1%’ , Weeks showed that in the 28 years between 1979-2007, the average income of the richest 1% in US has
increased by 278% (3.5 % per annum) while that of the poorest 20% has increased just by 18% (0.6% a year). In addition,
Weeks (2014) also showed that in mid-2000’s parental income explains about 60% of secondary school performance of
students in the US, showing the importance of being born rich for being rich (Weeks, 2014). Similar data is also appearing
about admission to ivy-league US universities, a significant factor in getting a highly remunerative job. Unfortunately, most
of the Ivy-league students come from high income earning parents – reproducing that class (The Economist, 2017). Similar
glaring inequality pictures, data and analysis are also found in Pikietty (2014) and Aldred (2019) which are worth exploring in
your further reading.
In their 2001 article that has similar argument but focused on Africa (Acemoglu et al, 2001), Acemoglu and his colleagues
argued that African colonizers left developmental institutions in their former colonies that were safer for their settlement
during colonialism. The latter are colonies with low mortality rate for the white soldiers from diseases such as Malaria at the
initial state of colonization. From the latter it is inferred that the region was conducive for white settlers. On the other hand,
the colonizers set-up extractive institutions when the African colonies in question were not conducive for their early
settlement. Acemoglu et al (2001) argued that the post-independence African governments have inherited these institutions
with contrasting effect for development. Thus, those who inherited colonies that were conducive for white settlement,
inherited ‘developmental’ institutions while those black elites that inherited colonies that were not conducive for white
settlers inherited ‘extractive’ institutions. Though this argument has some merits, it is not entirely an accurate reading of
that economic history. This has been shown by earlier studies before this article by Amin (1972), Nzula et al, (1930/1979),
Mamdani (1996/2018), Alemayehu (1998/2002) and Mkandawire (2001; 2010), incidentally all African researchers.
It is true that an interface between the nature of the African state today and the legacy of colonial structure (‘institutions’ in
the Acemoglu et al’s, 2001, reading) that shaped the post-independence states in Africa shows an interesting pattern. This
has been recognized by African researchers before as noted above. However, for these African researchers, although
colonialism shaped economic structure in a similar way across Africa, one may nevertheless observe certain variations in
this general pattern between different macro regions in Africa. Leaving aside North Africa, Nzula et al (1979/1930) and Amin
(1972) categorized the rest of the continent into three distinct regions, which is based on their colonial structure. First, ‘Africa
of the labour reserves’ (LRE), which Nzula et al (1979) labeled it as ‘East and Southern Africa’. Second, ‘Africa of the colonial
economy’. Nzula et al (1979) labeled this region ‘British and French West Africa’ (WCA). Third, ‘Africa of the concession owning
companies’ -the concession companies’ economies (CCE). Nzula et al (1979) labeled this ‘Belgian Congo and French Equatorial
Africa’. The fundamental distinction between these regions is derived from the manner in which the colonial powers settled
the ‘land question’ and organized the colony on how to extract resources – in all case the motive of colonialists were
extractive. This had (and still has) implications for the state structure and capacity that stretched to date (Nzula et al, 1979:
36; Alemayehu,2002; 2019; Mkandawire, 2010; Mamdani, 2018). This classification scheme also shows, inter alia, the historical
fiscal needs of the colonial administration which has a bearing on state capacity and related macroeconomic outcomes, that
22
includes, for instance, tax levels and structure today which are important indicators of state capacity (Mkandawire, 2010;
Alemayehu, 2020).
Looking at these macro regions, the LRE region is often associated with racial segregation, and migrant labour that includes
the infamous townships. The region’s ‘white economy’ drew from these labour reserves for its labour requirements
(Alemayehu, 2002; Mamdani, 2018). In some of such white-settler economies, where minorities dominated majorities, there
was strong interest in security which induced strong state apparatus for both administration and ensuring security
(Mkandawire, 2010; Mamdani, 2018). These characteristics produced a number of political economic features that includes,
inter alia, larger bureaucracies and, hence, high state capacity as well as high level of inequality. Thus, looking at these
rationale and factors for the evolved state structure and coining it as ‘developmental’ institutions as in Acemoglu et al (2001)
is problematic.
In WCA region, production was left to peasants while marketing was dominated by monopolist mercantile houses and, later,
after independence, by state marketing boards (Alemayehu, 2002; 2019; Mkandawire, 2010). Here, taxation took place largely
through the marketing channels and poll taxes, as well as through their use of exploitative pricing (Bauer, 1954; cited in
Mkandawire, 2010; Alemayehu, 2019). In CCE region, the colonial powers gave private companies concessions on large land
for crop production or for mineral extraction. Forced labour, taxation and plunder than production and developmental
investment was its main features (Alemayehu, 2002; Mkandawire, 2010).
The above historical phenomena and its legacy have a long-lasting impact on the nature of state and state capacity as can
be inferred from the levels and structures of taxation (Mkandawire, 2010; Alemayehu, 2020). It has also made the continent
and its growth dependent on the external sector through primary commodity trade (Alemayehu, 2002, 2019). In terms of the
nature of state, as a consequence of the colonial legacy, at independence, the LRE’s had more elaborate state structures and
formidable repressive state that resulted in fairly elaborate tax collection mechanisms and hence much higher tax share (of
GDP) than CCE and WCA regions (see Mkandawire; 2010 and Alemayehu, 2020 for latest data). In addition, there were (and
still are) significant diﬀerence in the level and structure of taxation among these macro regions. The LRE had and still has
high domestic taxes and depend more on direct taxes. The latter are more difficult to collect and, hence, shows the existence
of high state capacity than the WCA and CCE counterparts. Similarly, the WCA region relies much more on trade taxes, which
are relatively easier, than the LRE region. In addition, this colonial legacy has implications for two additional political economy
features: the LRE region exhibits high level of inequality and high formalization of the economy than the cash crop economies
of the WCA region (Mkandawire, 2010). Note here how macro policy issues such as taxes and tax structure – a fiscal policy
issue -are shaped by history and politics.
Thus, the nature of state today is not an accident and has to do with political and economic structure that is inherited from
the continent’s colonial history and shaped (downsized & liberalized) lately by IFIs through their policy of liberalization and
aid conditionality. Such legacy, its politics and related policy could be either developmental or extractive with consequences
for sustainable and inclusive development. This in particular shapes the state-private sector interaction with implications for
positive or negative development of a country. As Emery (2003) noted, the African political system is stifling, for instance,
for private economic agents which are crucial for development, not only for the simple extraction of financial gain by the
state but most importantly and primarily because the political elite wants to control the private sector for its potential
political imperative. This is a legacy of the colonial system where the colonial masters were imposing similar institutional
set-up of regulation and control and structured the economy for extraction of resource and stifle potential political threat
23
(see Alemayehu, 1998, 2002; Acemoglu, 2001, Mkandawire, 2001, Emery 2003 for detail). The post-independence political elite
basically inherited this system and using it to date to further its interest. Relating this to current reality, Emery noted " a
successful businessman who is not somehow beholden to the political establishment for his success is a potential political
threat. If he is an active member of the opposition or developing his own power base by virtue of his economic clout, then he
is perhaps a real political threat". This is not a major problem for foreign based private sector operators which are usually
protected by IFIs, however – thus showing the challenge of inclusive political and economic environment with a level playing
field for all. Thus, such factors may shape macro policies more than their simple, and perhaps technical, use for growth and
development of the whole country.
Notwithstanding this general picture, and unlike Acemoglu et al (2001) for whom the nature of the state is simply a
confirmation that white settler economies had better (developmental) institutions while the other places had extractive
institutions (which latter are inherited by the post-colonial states of Africa), Mamdani (2018), Mkandawire (2010) and
Alemayehu (2002/1998, 2019) argued that this is the result of a repressive, security-seeking minority colonial state
structure, instead. Thus, its effect after independence is also similar as was historically the case, repressive, security-
seeking minority African elite that replaced the Europeans, and not necessarily developmental. In addition, an excellent
complimentary argument to this view could be learned from Ethiopia’s economic history which could serve as counterfactual
to this “developmental” argument since it represents a strong, yet repressive, state structure which was not colonized at all
(see Alemayehu, 2008 and Box 8.1). The importance of this historical view and its implications is not to place a blame on
either colonizers or Africans as such (which is legitimate but not that important today), but rather to take the enduring
impact of such historically formed structural legacy and associated political-economy context of countries in the continent,
first, in their proper historical perspective; and second, in any macroeconomic policy analysis or design.
In sum, we may conclude the following from the discussion in this sub-section thus far. First, any macro policy analysis in
Africa needs to take the history as well as the political economy context of policy making and its implications on board. This
will contribute towards having an informed policy making process, a democratic-developmental state and an intelligent and
pragmatic engagement of the state with the private sector through innovative institutions. Second, it seems that different
regimes in the continent (those with competitive democracy, fragile states as well as those in the middle) have problems in
getting development friendly economic policy as the latter could be overridden by the elites’ interest for power and control
of resources. Although a prescription across the board is not possible, macro policy making in each country needs to be
informed by a country's specific political economy context as well as the power of interest groups and their management.
Notwithstanding such political-economy conditions, the overall focus of a developmental government needs to be to
encourage the setting up of functional inclusive institutions conducive for inclusive growth. Continental or regional
organization could be important in realizing this by acting as agents of restraint in this process. Finally, it is imperative to
understand the amalgamation of the internal and external political factors in seeking to understand the implication of the
political economy of macroeconomic policy making for growth and poverty reduction in the continent. This amalgamation has
made the macro policy environment of countries in the continent to be quite complex. Thus, it is instructive to ask what the
implication of such complexity is for growth and poverty reduction policy in the continent. To shed light on this and by way of
conclusion, we have briefly discussed the experience of successful East Asian developmental states in this regard next. This
will highlight the importance of the political economy of policy making in their success story.
24
Box 8.1 Ethiopia: Power gripping by the elite, conflict, institutions, and economic growth policies
With a population of about 110 million in 2020, Ethiopia is the second most populous country in Africa. Its history as a political entity
stretches back to antiquity, and almost uniquely within Sub-Saharan Africa, it has never been colonized. Yet Ethiopia is one of the poorest
countries in the world. Ethiopia’s modern history reflects the institutional legacy of centuries of internal conflict and external threat.
Internally, religion, regional location, ethno-linguistic groupings have each, at various times and in varying combinations, served as focal
points in the contest for power and control over economic resources by the elites. Land remains an economically critical and politically
contested resource in the country’s history and remains so until today, reflecting the age-old antagonism between a landed aristocracy
(including the church, a major presence since the 4th century) and the peasantry (Addis 1975; Gebru 1995). Externally, although the
country was never colonized, hostile and powerful colonial forces encircled it from the last quarter of the 19th century and rendered its
independence a besieged one. The country fought three times with the Egyptians, four times with the Dervishes, five times with the
Italians and once with the British in the period from 1868 to 1896 and in 1933 (Bahru 2001; Pankhurst 1963b). As a result, Ethiopia
developed as a militaristic state with an economy dependent on the export of primary commodities and the import of manufactures,
especially weapons. The acquisition of firearms from nearby European powers by Ethiopia’s regional lords (kings) also shaped the pattern
of internal conflict and the regional balance of power. The institutional legacies of conflict and militarization could generally be identified
as the major internal constraints on growth and development in Ethiopia. Most importantly these internal and external conflicts have
created a militaristic state with accompanying institutional set-up that is detrimental for development and might perhaps informed the
current socio-political set-up of the country (Alemayehu 2002a and 2004; Gebre-Hiwot 1924; Pankhurst 1963a and 1963b).
Economic performance in Ethiopia is therefore highly correlated with conflict and the political processes that accompany it. With such
political-economy context, the period from 1960 to 2020 breaks down readily, ex post, into the Imperial, Derg and EPRDF sub-periods,
reflecting the divergent policy regimes implemented by a succession of ruling cliques. The political process that brought first the Derg
(a military regime) and then the EPRDF (Gruella fighters turned state) to power in 1974 and 1991, respectively, was both unpredictable
and violent. Economic insecurity pervades Ethiopia’s modern history, with the rule of law, the enforcement of contracts and the security
of property each configured on a shaky political base. So was the state-peasant and state-private sector relation (Desalegn, 2008).
Thus, I argue that growth in Ethiopia is largely determined by political economy factors, climatic risks (such as drought), the strength
and efficiency of institutions, the quality of public policies, and risks related to war and property rights. Product and input markets are
found to be not only thin but inflexible. Combined with the unstable political environment, this has greatly limited both the potential for
long-run growth and the sustainability of individual growth episodes. At the same time, my analysis also suggests a potentially powerful
role for Ethiopia’s long and unique history, operating through the continuity provided by a few key public sector institutions. In the
absence of such continuity – and notwithstanding the manifest inefficiencies of these institutions in other respects – the growth record
of the last six decades reign by these three regimes may well have been worse than observed. In identifying the political process that
shapes policy choice in Ethiopia, it is worth emphasizing the cycles of revolt and conflict for power. These conflicts, though apparently
look ethnic, were essentially class-based and regional. The evidence for this is that they were structured by:
a) The ‘king of kings’ system (from antiquity to 1974, for 3000 years recorded history) where the strongest regional-based king
became the king of all regional kings and occupied the central position of power historically. The king of kings normally comes
from one region (which is not necessarily ethnic based) and maintained his power by drawing officials from different regions and
ethnic groups (usually tying regional lords through marriage to his off-springs) – looks strikingly similar to the famous America
TV drama series “Game of Throne” – I always wonder whether the author ever read Ethiopian History or not.
b) The subjugation of all peasants (the majority, being over 80 % even in 2020) from all ethnic groups by the ruling elites; and
c) Civil conflict among the intelligentsia (the political elite) since the 1974 that led to underdevelopment of the country. This elites
and their political parties drew their members initially from different ethno-linguistic groups and subscribed to the same leftist
25
(Marxist-Leninist) ideology, yet fought among themselves bitterly. This is increasingly taking an ethnic form in the last three
decades, however.
Each regime that appeared as winner in this fight for power and resource created institutions to help it to sustain its grip on power. At
the core of the Imperial regime lay the church and the military & the security apparatus; at the core of the Derg, mass organizations
such as peasant associations, as well as marketing boards and the military & the security apparatus; and at the core of the EPRDF,
ethno-linguistic parties, party-affiliated companies and the military & the security apparatus. In their quest for controlling power through
these institution, economic development always took the second position. Thus, developing inclusive and democratic institutions were
relegate to the second position. Thus, most economic institutions are archaic, yet have been riven with conflict, as one group or the
other seeks to control them to advance its interests. This, in turn, has led to cycles of violence and created levels of risk sufficient to
thwart the growth of the economy most of the times.
Analysis of determinants of growth performance shows that the major factors behind the poor growth performance in the last 5 decades
were vagaries of nature (such as drought), the condition of international commodity prices, bad policies and risk related to war and
insecurity. Most of these factors are in turn mediated through institutions, which are used to effect policies that, by and large, reflect
the extractive and power grapping motive of the ruling elite in each regime. Competition for power and resources among such interest
groups has led to conflict, which is invariably resolved in a violent way. In this score, the latest regime, the EPRDF regime, is found to be
characterized by having policies aimed at regional-cum-ethnic distribution of income. The latter saw the seed for another conflict and
eventually its demise by the other ethno-linguistic groups in 2017.
The fundamental factor behind all these growth stifling effects is lack of political stability and a functioning democratic system across
the three regimes – lack of inclusive political and economic institutions. Existing institutions were, and still are, being used to empower
the ruling elite’s grip on power (and resource) across the three regimes. This abuse of institutions by using them to serve the interest
of the ruling elite dashed the hope of instituting a peaceful power sharing mechanism for power protagonists in the country. This in turn
has led to cycles of violence and risk which thwarted the potential growth of the economy. Much should not be expected in realizing the
potential growth of the country if such political economy problems and the structural constraints of growth are not addressed properly.
In sum, analysis of Ethiopia’s growth history underscores the significance of the political economy approach about conflict and
democratization to offer adequate explanation for the country’s backwardness. The major cause of conflict in Ethiopia is grounded in the
political economy of the country, underscored by competition for power and resources. History, institutions, the path-dependent nature
of state formation and external intervention are important in this process. Ethiopian governments have never been accountable to the
people. This created a fertile ground for insurrection and offered opportunities for people to express their grievances or greed only
through violence, often at negligible opportunity cost to the opposition but relatively high opportunity cost to the incumbents. Inevitably,
the incumbent’s attempt to defend and maintain its position led to increased militarism & control of the security apparatus for the benefit
of few elites: just as good institutions enhance growth so are bad institutions such as this in stifling potential growth, long-term
development and durable peace. This seems to be the case in Ethiopia. I hope this will give you a context on how to think about the
formation and implementation of macroeconomic policy in Africa.
Extracted form: Alemayehu Geda (2008), ‘The Political Economy of Growth in Ethiopia’, AERC Research in Ndulu et al (2008)
Alemayehu Geda and Befekadu Degefe (2005) ‘Conflict, Post-Conflict and Economic Performance in Ethiopia, AERC Research’
26
8.2.3 Macro Policy as Part of Industrialization Policy: The East Asian Success Story6
It is worth briefly discussing the political economy of policy making process in successful East Asian countries (in particular
in Taiwan and South Korea) which have confronted similar problems to that of Africa after their independence from Japan
but managed to carryout success full macro and industrial policy and develop successfully. Without such policies and active
role of the state, the registered success in those countries was unthinkable. One distinguishing feature of this process in
Taiwan and Korea, for instance, was the tradition of policy research, planning, implementation and monitoring of proposed
policies based on an in-depth study and accurate information. This is also done by the best and the brightest brains in each
of these countries. We will also briefly look at this.
A. The Developmental State and Its Role in the East Asian Success Story
Nearly half the African population (47%) today are below the poverty line of US$ 1.25 PPP; and this becomes a staggering
70% at US$ 2.00 PPP. The latest data from the World Bank shows that the number of extremely poor in Sub-Saharan Africa
has increased, from 278 million in 1990 to 413 million in 2018. Many countries, especially those in East Asia, extracted
themselves from such massive poverty, among other things, by designing and implementing appropriate macro, industrial
and trade policies and strategies. As a result, between 1981 and 2008, East Asia saw dramatic drops in poverty; from 77% of
the population in 1981 to 14% in 2008 (63 percentage points!) and they have eliminated poverty today (by 2019), even at $3.20
PPP poverty line. Through a developmental state model, most of them, thus, transformed themselves from primary commodity
exporters (that used to constitute over 90 % of their exports) to manufactured good exporters (that is now about 90% of
their exports) in one generation.
It is useful to briefly discuss the idea of the developmental state before discussing the role of that state and the political
economy of macro, trade and industrial policy making in East Asia’s miraculous growth and development. This is important
because it is precisely this form of state and its strategic and unorthodox interventionist policy that led to the industrialization
(development) success story of East Asia. Defining ‘the developmental state’ is becoming a difficult task. However, it is
generally related to the role of the state in East Asian development that includes that of Taiwan, Korea, China and the early
Japanese development experience. A general understanding of the term could be gleaned from Routley's (2012) survey and
related studies (Taylor, 2002; Mkandawire, 2001). Routely (2012) and Taylor (2002) noted that a state is a developmental
state if: (i) it has a capable and autonomous (but embedded) bureaucracy (Evans, 1995); (ii) it has a political leadership
oriented towards the dominant ideology of development, i.e. a determined developmental elite and a weak and subordinate
civil society (Musamba, 2010; Fritz and Menocal, 2007; Leftwich, 1995, cited in Taylor, 2002; Mkandawire, 2001); (iii) there is
a close, often mutually beneficial symbiotic relationship between some state agencies (often referred to as pilot agencies)
and key industrial capitalists (Johnson, 1982; 1987), which requires the effective management of non-state economic
interests, legitimacy and performance (Leftwich, 1995, cited in Taylor, 2002); and (iv) it makes successful policy interventions
which promote growth (Wade, 1990; Beeson, 2004) with equity (all cited in Routely, 2012 and Taylor, 2002).
Mkandawire (2001) divides these various characterizations of the developmental state into two major components: ideological
and structural. In terms of ideology, a developmental state is essentially one whose ideological underpinning or mission is
‘developmentalist’ (high rates of accumulation (growth) and industrialization). This ideology is also the state's principle of
legitimacy and the élite in charge must be able to establish an ‘ideological hegemony' in Gramsci’s (1971) sense of the word

6
This section is based on Alemayehu (2019) and the reference cited here are given in this book.
27
to which key actors in the nation adhere voluntarily (Mkandawire, 2001). The state-structure side of the definition emphasizes
the capacity (institutional, technical, administrative and political) to design and implement economic policies effectively. This is
said to need, according to Mkandawire (2001), a strong, both in an administrative and political sense, state and an autonomy
of the state from social forces so that it can use these capacities to devise long-term economic policies that do not fall prey
to myopic private interests. Finally, Mkandawire noted, the state must also "have some social anchoring that prevents it from
using its autonomy in a predatory manner and enables it to gain adhesion of key social actors" (Mkandawire 2001).
Based on Amsden's (2001) study of the region, the Asian developmental state as characterized above was crucial for its
industrialization and manufactured goods export success. The state did this by designing and implementing successful macro,
trade and industrialization policies as well as, at times, engaging itself in the actual production and trading processes. For
this to happen, the state set four functions for itself: (i) support through development banking (note, monetary policy); (ii)
focus on local content management; (iii) selective seclusion (i.e., opening some markets to foreign transactions and closing
others; note fiscal policy and informed liberalization and protection policy here); and (iv) national firm creation (Amsden,
2001: 125). Two principles guided this effort: (a) to make manufacturing profitable enough to attract private entrepreneurs,
and (b) to induce enterprises to be result-oriented and to redistribute their monopoly profits to the population at large. You
will note in passing here that these policies are quite contrary to a free market (market clearing models) policy subscribed
to Africa by IFIs in the form of SAPs/the “Washington Consensus” given in Table 8.2 above.
In undertaking these functions, the state's autonomy was important. As noted by Evans (2010) and Grabowski (1994), owing
to their history of land reform and the existence of a weak entrepreneur class (capitalist class) in these countries at their
early stage of development, "not having to deal with a powerful landlord class and starting from a position of strength vis à
vis local capitalists put the state apparatus in a position to orchestrate a concrete national project of development, built on
a dense set of concrete interpersonal ties". This ‘embeddedness’, Evans (2010) noted, was as central to the success of the
twentieth century developmental state as bureaucratic capacity was, since "avoiding capture and being able to discipline the
entrepreneurial elites is a defining feature of the ‘embedded autonomy’ of East Asian developmental states, distinguishing
them from less successful states in Asia and Africa" (Amsden 1989; Kohli 2004, cited in Evans, 2010). Stressing the
importance of such capable bureaucracy for the twenty-first century developmental state, Evans noted,
...Without competent, coherent public bureaucracies, capability-expanding public services [such as education and
health] will not be delivered. Building organisational capacities comparable to those of 20th century developmental
states is, therefore, crucial to the success of a 21st century version. A 21st century developmental state requires new
kinds of capacity as well. Most crucially it requires the ability to promote a more encompassing form of
embeddedness. (Evans, 2010).
B. The Success Stories of the Developmental States of Korea and Taiwan & the Lesson for Africa
The significant role of the developmental state in East Asian development as noted above means there was clearly a politico-
economic dimension to the success stories of both Taiwan and Korea. For instance, the private firms in Korea (the Chaebols)
were led by Koreans who had close ties to the government and over time came to be major supporters and financiers of the
governing party and its president. In both Taiwan and Korea, the role of the state in the industrialization and promotion of
exports was very significant - this is the antithesis of neoclassical economics and the IFI's ‘free market-based liberalization’
and ‘downsizing the state’ policies in Africa. This role included not only export promotion but also the protection of the
28
domestic market for import substituting industries. Government policy played a critical role in helping these firms attain the
boom in exporting manufactured goods. In Korea, in the absence of an elaborate market mechanism, the banking system was
used to channel resources to these large firms. The government was even drawn into the business decisions of some firms
and saw to it that these large firms became successful exporters, and consequently expanded into industrial groups that
dominated the manufacturing industry later. Park (1990) labelled this 'interweave' of the government and industrial
conglomerates that continued to develop past the 1980s as a 'development mercantilism'. Contrastingly, according to Park
(1990), the Taiwanese economy exhibited a high rate of savings, trade surpluses, a conservative stance on fiscal and
monetary policy, an egalitarian development philosophy and, most importantly, an industrial structure characterized by a
large number of medium and small-sized firms in manufacturing. The political leadership was also determined to avoid the
concentration of domestic productive resources in the hands of a few private businessmen, and thus they focused on the
publicly owned firms. Thus, the public sector accounted for half of the manufacturing value added during the 1950s. Park
(1990) and Kim (1995) also concede that Taiwan took up export-promotion of labour-intensive manufacturing products, just
as Korea did, but the choice of technologies for Taiwan was not similar to Korea’s increasing returns, since they had at their
disposal a large pool of experienced entrepreneurs and a large number of small firms. Park’s study shows that the Taiwanese
industries, with their small size of an average of 300 employees, accounted for about 60% of the manufacturing value added,
while such share was around 6% in Korea. This meant that the Korean experience of direct intervention could not be adopted
in Taiwan. Thus, it is logical that Taiwan’s policy makers took measures to provide uniform incentives on the basis of export
performance and also focused on public firms. What is interesting to note here is that, despite having similar objectives, the
nature of state intervention has been context specific - there is no ‘one-size-fits-all’ formula of state intervention.
In addition to export promotion through industrialization, these countries have also followed import substitution (IS) at the
same time. For instance, the so-called 'referral' system (where an importer is referred to domestic suppliers when he/she
asks for a license to import a particular good) shows that they were engaged in IS industrialization but made sure that it was
strictly linked to the export promotion strategy (Stein, 1995; Kim, 1995; Hsueh, 2001). Thus, the East Asian trade and industrial
policy success is also related to the fact that import substitution (IS) and export promotion (EP) policies were taken as
complementary and not as competitive. According to Grabowski (1994), the IS strategy, combined with the prior development
of agriculture in these countries, was not only crucial for their exporting success but also was instrumental in making the
East Asian developmental state strong and effective. Grabowski (1994) argues that these states were effective because they
were able to discipline firms, which in turn was dependent on the credibility of the government to do that. Although this
effectiveness and credibility was a function of a number of factors, having a large domestic market for an IS was one of
them. This strategy allowed firms to grow and learn in a protected market and at the same time allows the state to reward
some and penalize others among a multitude of firms – i.e. it has a choice – was crucial. Grabowski (1994) noted that since
the IS strategy needs a big domestic market, the rapid and successful development of the agricultural sector with widespread
(equitable) benefits for the farming communities was crucial for the growth of domestic demand for industrial goods (see
also Kalecki, 1976). The land reforms that were undertaken in both Taiwan and Korea, following their independence from
Japan, and the technology transfer from Japan to the agriculture sectors of its colonies (Taiwan and Korea) so that they
could supply Japan with agricultural products (in particular rice) in the pre-independence period were also crucial in this
process. The US assistance to Korea owing to cold war politics, inter alia, by financing over 70% of its imports in the initial
years was also crucial.
29
The important lesson to draw is that state intervention is crucial but there is no ideal model for the role of the government
in the development process. The differences in the technologies adopted and the focus on the private versus the public sector
at the initial stage of industrialization by the two countries bears testament to the fact that structural, political and
institutional forces in the two economies have shaped the form of government policy intervention. As noted by Amsden (2001),
the developmental state in the Asian countries was crucial for their industrialization and export expansion success. It did so
through designing and implementing appropriate macroeconomic, industrial and trade policy, supporting the private sector
as well as engaging itself in the actual production and trading process.
Another interesting politico-economic phenomenon that was crucial in most of the newly industrialized countries of Asia was
the success in attaining growth with the equity that accompanied their industrialization and openness, which was not common
during the industrial history of Western countries. The agriculture sector’s development and land reforms before
industrialization in both Taiwan and Korea were crucial for this (see Athukorala and Menon, 2000)
C. The Role of Experts and Technocrats in the Bureaucracy
As part of the role of the state in policy research, policy making and implementation in these economies, the state
bureaucracy in general and capable experts – and policy research institutions under such bureaucracy - in particular were
crucial for this success. These were responsible for the design, implementation and monitoring of the successful
industrialization and trade-cum macro policies of these countries. Evans (2010) contends that the East Asian public
bureaucracies were more closely approximate to the ideal-typical Weberian (Max Weber) bureaucracy. He further noted that,
in these countries, meritocratic recruitment and careers offering long-term rewards commensurate with rewards from the
private sector were institutional cornerstones of their success. According to Evans, career reward that is based on
performance and "meritocratic recruitment was important, not only to promote competence but also to give state employees
a sense of esprit de corps and belief in the worthiness of their profession". This has also helped to avoid individuals from
deserting the public sector (Evans, 2010).
Policy research institutions staffed by qualified experts that worked with capable bureaucrats were important in both Taiwan
and Korea too. Thus, one distinguishing feature of these countries was the tradition of research, planning, implementation
and monitoring of proposed policies based on an in-depth study and accurate information by the best and the brightest brains
in each of these countries. This is generally missing in many African countries. The Council for Economic Planning and
Development (CEPD) of Taiwan is a case in point (the Koreans had also similar institutions such as the Korea Institute for
Economics and Technology and the Economic Planning Board). The CEPD had over 300 professional and non-professional
staff.7 Of these, 250 had a university qualification, of which engineers made up about 20 percent, economists about 40
percent, while the rest were accounting, finance and statistics graduates. The staff was divided into nine departments: overall
planning, sectoral planning, economic research, urban development, performance evaluation, financial administration, manpower
planning, personnel and financial administration. The economic research department had 50 professionals, each of whom
monitored one sector in addition to other duties. As an advisory body of the cabinet, the CEPD is outside the ordinary

7 Even if such institutions do not have the required staff, they were able to get the best experts in the country to do the research for a policy
question and come up with a policy recommendation. A case in point is Yu Kuo-hua's plan of 'economic liberalization, internationalization and
institutionalization’ when he became the Premier in 1984. For this purpose, four economists were asked by the CEPD to research how to liberalize the
economy. The research result and the resulting discussion of the research result in a conference was the basis for the subsequent liberalization
policy of the country (Hsueh et al, 2001).
30
machinery of the government, allowing it to pay a higher than normal civil service salary to its staff, and it can recruit high
quality talent by offering relatively better terms. Not only was the CEPD staffed by the best and the brightest in the country
and from the diaspora, it was also chaired by powerful political figures such as the premier/president himself. The story was
similar in South Korea as the president used to chair such policy forums including the public-private sector forum almost
every month (Wade, 1990; Hsuesh et al, 2001).
Such research-based policy making was also characterized by adhering to a dynamic process. For instance, in the 1980s, the
emphasis in industrial policy in Taiwan shifted from heavy to technology-intensive industries, and the issue became how to
upgrade Taiwan’s industries so that they remain internationally competitive. Scientific research was, thus, geared from basic
academic research towards applied scientific research. The latter included the establishment of Taiwan’s science-based
industrial park, the reversal of brain drain by introducing appropriate incentive schemes, and a science and technology
research plan, including the required budget that the government demanded from each relevant ministry (Hsueh et al, 2001).
This approach was similar in Korea.
In both countries, development planning was very important and was generally indicative of the direction in which the
economy should go (leaving most firms to make their own specific decisions). In Korea, for example, the Economic Planning
Board (EPB) – considered the “brain and engine of the Korean economic miracle” (Castells, 2000; cited in UNECA, 2001) –
was in charge of the five-year economic plans. It had a substantial budget with talented and technically trained bureaucrats
(young Koreans trained in economics and planning) and access and support from other ministries and academic institutions.
The director of the board was also the deputy prime minister of the cabinet. It was also highly supported by the president of
the country. It had a special planning unit for designing and implementing plans at the ministerial and lower levels of the
government. These plans were in turn connected with the budget of the country (Kim, 1995). Similarly, Taiwan had medium-
term economic plans, which were instrumental for the coordination and implementation of economic development policies
(UNECA, 2011). In general, in the East Asian experience, such institutions and the bureaucracy were responsible for the “actual
planning, intervening and guiding of the economy” (Johnson, 1987, cited in UNECA, 2011). Kim (1995) also noted "plans do exist
elsewhere too, but what is unique in Korea was the ability to get the plans and strategies put into practice". As Evans (1997)
noted, although these countries were able to build strong bureaucracies, these "were neither gifts from the past nor easy
outgrowths of surrounding social organization, but hard-won edifices constantly under construction" (Evans, 1997; cited in
UNECA, 2011). Moreover, the bureaucratic elites were not the only players in the economy. There were other relevant
institutions of the developmental state that included the central bank, other financial and regulatory authorities, and the
judiciary. In sum, the experience of these countries shows the capacity of such institutions is directly related to the capacity
and performance of the state (UNECA, 2011) and the realization of its policies.
It is imperative to note that the experts in the policy research centers and the bureaucracy, in particular the economists,
who were responsible for this success practiced what can be called heterodox economics, especially at the early stages of
the industrialization drive. This was the opposite of what occurred in Africa where IFIs' SAPs policies were based on
neoclassical 'laissez-faire' economics (see Alemayehu, 2019; Mkandawire, 2010). In East Asia, not only was the focus on
learning from late industrializers such as Japan8, but also, they gave a marginal role to neoclassical economists, especially

8
Ethiopian development economists in the 1920s such as Gebre-Hiwot Baykedagn and Deresa Amente as well as other writers of the latter
time in 1940/50s such Kebede MIikael were advocators of the Japanese model of development for Ethiopia. These earlier writers characterized
Japan’s development as ‘safe modernization’, nearly 100 years ago – these writers are referred as “the Japanizers” in Ethiopian intellectual history.
31
of the Anglo-Saxon variety. Opposition to neoclassical economics came early in the 1950s, when these neoclassical economists
objected to the developmentalist thrust of economic policies in the region largely on the basis of static comparative advantage
arguments (Wade, 1990, cited in Mkandawire, 2010). Similar neoclassical arguments also appeared from neoclassical
economists in Taiwan, South Korea and, at an early stage, in Japan, to which the policy makers of these countries were
adamantly opposed. This was because, according to these policy makers, the neoclassical based policies were not based on
their economies' stylized facts and their idea of the role of the state in economic development (see Wade, 1991; Amsden, 1994;
Gao, 1997, all cited in Mkandawire, 2010). With the benefit of hindsight, we now know that by not adhering to the neoclassical
economics-based policy advice of a free market economy and static comparative advantage, these countries have managed
to create a comparative advantage in exporting manufactured goods which was not there before.
We may conclude this sub-section with Evans' (2010) view that this aspect of the East Asian experience is fairly transferable
and makes governments very effective. It has been found for example (Evans and Rauch, 1999; Rauch and Evans, 2000, cited
in Evans, 2010) that for a sample of developing countries, an increase of half a standard deviation in the ‘Weberian score’ (an
indicator of bureaucratic capacity) was worth a 26 per cent increase in GDP from 1970–90 (controlling for human capital
and initial GDP per capita). Likewise, an increase of one standard deviation in the Weberian score was roughly equivalent in
1965 to a shift of three to six years in terms of average years of education. Evan also found similar results in his earlier
study with Rauch in 1999 (see Table 8.3). Thus, since such capacity is generally transferable, it is important to build a capable
bureaucracy, which is crucial to give the state its autonomy and allows it to pursue a coherent national project that is
contextualized in the socio-political realm of African countries. Without such capable, motivated and professional
bureaucracy as well as capable policy experts of integrity, a state cannot become a developmental state (Evans, 2010). It is
for this reason that the most enduring lesson from East Asia is said to be investing in high quality human capital, which is
central to get the above-mentioned capable experts, bureaucracy and high-quality labour force (Kim, 1995). East Asian policy
makers, including their early role model Japan, were the view that “the market mechanism cannot be entirely trusted to
increase competitive advantage by industries” and thus conscious government intervention is crucial (Taylor, 2004). As well
summarized by Taylor (2004), “Dialogue between the bureaucracy and enterprise permitted that East Asian nations to
practice economic planning effectively in a capitalist environment. Short-term allocative efficiency (“getting prices right”)
was often sacrificed to long-term productive efficiency or rapid productivity growth”. For this purpose, Chaeblos (the big
Korean firms, the likes of SAMSUNG), trading companies, planning bureaucracy and the macroeconomic policy mix all emerged
in the early 1960 and were effective in the industrialization success story of these countries. This, Taylor (2004) noted, with
appropriate modification and adoption by other countries “would be a proper domain for realistic theories of economic
growth”.

In fact, Kebede Mikael wrote a whole book on Japan’s development entitled “How Japan Developed/Modernized” (see Bahru, 2002 and Alemayehu,
2005).
32
Table 8.3: Economic Growth and the Weberian State Bureaucracy*
Source: Peter Evans and James E. Rauch (1999), American Sociological Review, 64(5):748-765.
*Note: The Weberiannes Scale is constructed from 10 basic question to three top experts of a country in 35 countries.
To conclude, you may consult Alemayehu (2019) and Mkandawire (2001) for the existence of similar successful developmental
states in Africa (such as Botswana and Mauritius) and on how to draw lesson for the rest of Africa from the experience of
these East Asian and African developmental states by investigating the variation in initial conditions between these Asian
economies and African countries. From this chapter’s perspective, note that macro policy (fiscal, monetary, exchange rate,
growth etc.) needs to be designed in the context of a nationwide strategic industrialization (development) framework and
having capable experts and bureaucracy.
33

Fiscal Policy The Washington consensus & policy conditionality
Monetary Policy Structural Adjustment (& Poverty Reduction) Programs
Monetization of deficit and inflation The policy trilemma
Capital and current expenditure Open market operation
Endogenous and exogenous money Political-economy of policy making
The demand for money The supply of money
Inclusive economic institutions Inclusive political institutions
Extractive economic institutions Extractive political institutions
Developmental state Monetary policy of sterilization
Weberian bureaucracy
Review Questions
[1] Are fiscal and monetary policies separate and distinguishable in Africa? Which one dominates?
[2] What is the role of politics in macroeconomic policy making in Africa? Is it possible to design a macro policy that
benefits the majority in such political context? If not, what should be done?
[3] What kind of macroeconomic policies would you follow if a country is hit by external shocks such as the 2008/09
global economic crisis or the 2020 COVID-19 virus?
[4] What is the main distinction between liberalization policy of the ‘Washington Consensus’ type and structuralist
macroeconomic policies in the context of developing countries/Africa?
[5] What policy lesson can we draw from East Asian countries for Africa? Can we directly apply them or do we need to
adopt it? If to be adopted, how?
[6] Is demand stimulation an important macroeconomic policy issue in the context of Africa as that of developed
countries? Explain your answer.
[7] How do you tackle the possibility of “inflation-high growth” trade-off in the course of growth and financing
development in Africa?
[8] Explain what is called the ‘policy trilemma’ and its relevance in the context of Africa?
[9] What is the transmission mechanism when a macroeconomic policy has the objective of poverty reduction? Explain.
34
[10] Given the impact of COVID-19 in the economy of the advanced countries, macro policy is shifting from the dominance
of monetary policy to the neglected realm of fiscal policy? Is this a good shift? What is the implication of this for
the future of macroeconomics and macroeconomic policy both in advanced and African countries?

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Advanced Macroeconomics for Africa I: Short-run Macroeconomics (MSc Level,

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Advanced Macroeconomics for Africa I: Short-run

ADDIS ABABA UNIVERSITY

Prof. Jon Weeks (1941-2020)

Right top: John’s books which shaped my

Right bottom: Appearing with John in his

Brief Table of Content

Advanced Macroeconomic for Africa II: Long-run Macroeconomics

Detailed Table of Content

Chapter 3 Rational Expectation in Macroeconomics

Chapter 6 Investment and Investment Theories

Chapter 7 The Labour Market & Labour Market Theories

Chapter 8 Macroeconomic Policies and the African Context

(Back Cover, next)

Advanced Macroeconomic for Africa I: Short-run Macroeconomics

ADVANCED MACROECONOMICS FOR AFRICA I: THE SHORT-RUN

ADDIS ABABA UNIVERSITY

Brief Table of Content

Advanced Macroeconomic for Africa II: Long-run Macroeconomics

Chapter 1: Historical Excursion in Macroeconomics & The

Source: Marc Lavoie (2006). Introduction to Post-Keynesian Economics

2.1 Schools of Thought in Macroeconomics

John Maynard Keynes Michal Kalecki

John Hicks James Tobin Paul Samuelson Franco Modigliani

2.1.3 The New Classical Macroeconomics [NCM]

J. R. Lucas Milton Friedman Edward C. Prescott Thomas J. Sargent

2.1.4 The New Keynesian Macroeconomics [NKM]

G. Mankiw John B. Taylor Joseph Stiglitz Allan Blinder

2.1.5 The Post-Keynesian Macroeconomics [PKM]

Joan Robinson Paul Davidson Nicholas Kaldor John Weeks

2.1.6 Structuralist Macroeconomics: The Kaleckian wing of the Post-Keynesian Macroeconomics3

Lance Taylor Krishna Dutt E.V. K. FitzGerald Raul Prebisch

Claude Ake Samir Amin Walter Rodeny Gébré-Hiwot Baykédagn Déressa Amente

Thandika Mkandawire Mahamood Mamdani

Extracts from Alemayehu (2005)

Important Concepts for Review

References for Further Reading

ADVANCED MACROECONOMICS FOR AFRICA I: THE SHORT-RUN

ADDIS ABABA UNIVERSITY

Brief Table of Content

Advanced Macroeconomic for Africa II: Long-run Macroeconomics

Chapter 2 Review of the IS-LM and Aggregate Demand

Figure 2.1 Graphical re-presentation of three equations

, Where: 0 & 0 [13]

Y and actual and potential (full-employment) output, respectively.

A. Short-term Policy Analysis using the AD-AS Model

Matrix A Endogenous variables Matrix B Exogenous variables

, using the long-run condition of dP=0 [21a]

Figure 2.2 The Stability Requirement of the Model

Source: Sbordone et al (2010).

Important Concepts for Review

References for Further Reading

ADVANCED MACROECONOMICS FOR AFRICA I: THE SHORT-RUN

ADDIS ABABA UNIVERSITY

Brief Table of Content

Advanced Macroeconomic for Africa II: Long-run Macroeconomics

Chapter 7 The Labour Market & Labour Market Theories

7.1 The Aggregate Labour Market

In sum, the demand for labour could be given as,

7.1.2 The Supply of Labour

0 if the substation effect is the income effect. [7.9a]