1macroeconomics Under Graduate Course Chapters 123

Macroeconomics
by
Worku Gebeyehu (PhD)
Department of Economics, College of

Business and Economics, Addis Ababa
University
1
Macroeconomics: Econ 1031
Course Information:
Mode of Course Delivery: Semester Based
Interactive Teaching
Course Number:
Course Load: 3 Credit Hours, 5 ECTS
Number of Contact Hours: 3 Hours a Week
Competency at the End of the Course:
Able to Analyze and Evaluate Macroeonomy
2
Macroeconomics –
How can an economy

How does an moves into a higher
Economy behave? growth trajectory?
Discusses (At Determinants of growth
the views Equilibrium/Out
and of equilibrium in
Growth
approaches the SR)
of different fundamentals
schools of
The role of
thoughts on
market and Growth models
government to
achieve Role of markets
equilibrium and government
3
Macroeconomics –Econ 1031
Module Objectives: To show students
How to present and analyze the interrelationship

among macroeconomic variables; situation and
growth trend of the economy;
How government uses macroeconomic policy

instruments & the transition mechanisms to
influence aggregate economic variables;
How can academic learning and professional practice

are linked to analyze economic situations.
4
Macroeconomics – Econ 1031
What is it?
Concepts & methods of
Ch.1: The state of analysis
macroeconomics –
Course outline (Six
Evolution & Recent

developments
Chapters)
GDP, GNP, NI, NNP, PCI, DI,

Ch.2: National RGDP, Deflator, GDP & Welfare,
Income Accounting Business Cycle
Unemployment
Theory of AD
Goods Market & Is
Ch.3: AD in a Money Market & LM
Closed Economy SR Equilibrium
AD curve from IS & LM
5
Macroeconomics –
Flow of Capital Goods from
abroad
S&I in Small Open
Economy
Ch.4: AD in
Course outline (Six
Exchange Rate
Open Economy Mundell-Fleming Model
FP and MP in Open
Chapters)
Economy
Ch.5:
Classical Approach
Aggregate Keynesian Approach
Supply
6
Macroeconomics: Econ-1031
References: In addition to handouts, refer at least
the following basic references.
• Mankiw, N. Gregory (2007): Macroeconomics,
4th ed. Worth Publishers;
• Branson, William H(1989): Macroeconomic
Theory and Policy, 3rd ed., Harper & Row
Publishers;
• Dornbush, R., S.Fisher & R. Startz (2008),
Macroeconomics, 10th ed. McGraw-Hill Irwin.
7
Macroeconomics: Econ1031
Basic Requirements to Pass the
Course
 Continuous Assessment (test &
assignment) 50%
 Final Examination: 50%
8
Macroeconomics: Econ1031
Disciplinary Issues:
• Come on time and attend all classes.
• Switch-off mobile phones.
• Duplication of assignments, cheating on
exams & tests lead to serious academic
penalty.
• Missing test or quiz without convincing
evidence leads to zero marks.
9
Ch.1: The State of Macroeconomics
1. Definition and Scope of Macroeconomics
 Describes and explains the aggregate behavior and processes of

an economy.
 Measures and explains overall consequences of the decisions

and operations of economic agents [households, firms,
government, and foreigners/countries] on the economy using
macroeconomic variables/parameters.
 Deals with structure, behavior, performance and growth of the

overall economy.
 Analyzes the underlying determinants of the aggregate trends in

the economy with respect to GDP, unemployment and inflation.
10
Major macroeconomic issues
• Output (GDP/GNP) and its growth

• Cost of living, inflation
• Unemployment
• Budget deficit,
• Trade deficit, current account and balance of payment
deficit
• Why countries become poor or rich? How could
countries grow
11
Why do we learn macroeconomics?
 Macroeconomics deals with issues that affect society’s well-being such

as unemployment, budget deficit, etc. Why?
 Unemployment - dissatisfaction, helplessness, mental problems,
homelessness, violence and suicide, political unrest.
 Inflation: High cost of living, low saving, low investment and political
unrest;
 Budget deficit: Government revenue fails to expenditure; leading to
high inflation, crowding out effect on (replacing) private investment and
lowering investors confidence;
 Trade deficit: Imports>exports and imply leading high foreign debt and
dependence
 Macroeconomic issues attract media attention, central issues for
political debate.
 Successful economy: Low unemployment, low inflation, and steady and
sustained economic growth. 12
1.2. Methods of Macroeconomics Analysis
 Macroeconomics research aims to understand how the

economy functions or how the economy reacts to policies
and shocks that cause instability.
 Research requires a theory to test against the perception
about the reality.
 Theories are simplifications of complex realities.
 Macroeconomics cannot conduct controlled scientific
experiments.
 Macroeconomic theory consists of a set of views about
the way the economy operates. It is organized in a logical
framework & become a basis for economic policy design.
 Unlike pure science, historical economic episodes allow
diverse interpretations and many conclusions. 13
1.2. Methods of Macroeconomics Analysis …
 Macroeconomics uses models to display the interaction of
macroeconomic variables to understand the complex world.
 Theories and models help to identify important factors that need to be
analyzed as causes and consequences of various economic phenomena.
 Successful theories enable to
 Understand the relationship among macroeconomic variables;
 Make better predictions about the consequences of alternative
courses of action and
 Indicate the policies most likely to achieve society’s chosen
objectives.
 Successful economic policy design depends on theoretical models:
(a) internally consistent
(b) explain satisfactorily the behavior of macroeconomic variables and
(c)are not rejected by the available empirical evidence.
14
1.2. Methods of Macroeconomics Analysis …
 No consensus among economists about the best theories or models or
policies relevant to any country at any given time.
 Uninterrupted controversies among economists lead to alternative

theories and models what constitute macroeconomic thought.
 As Blanchard (1997a) points out macroeconomics:
 Is not an exact science but an applied one where ideas, theories, and
models are constantly evaluated against the facts, and often
modified or rejected …
 Is thus the result of a sustained process of construction.
 Is built on theories by eliminating those ideas that failed and keep
those that appear to explain reality well.
15
1.3. Macroeconomic Goals and Instruments
 Economists may disagree on theories, empirical evidence and policy

instruments.
 However, there is almost a consensus on major goals of economic
policy high/full employment, stability and rapid growth.
 Full employment: Full use of all available resources (labor, capital,
land, and entrepreneurship) in the economy. Unemployment/under
employment is sub-optimal/below capacity operation; affecting income
and wellbeing of individuals and society.
 Economic Stability: Smooth movement of production, employment,
and prices on socially desirable growth path.
 Instability: High - inflation, unemployment, fiscal deficit, trade and
balance of payment deficit and erratic movement of GDP. Instability
affects (i) the welfare of society, (ii) the planning and functioning of
firms and also (iii) causes potential political unrest.
 Economic growth is simply an increase in the production of goods and
16
services over time, shown as: g = (GDPt-GDPt-1)/GDPt-1; g>0.
 Economic growth arises from increased labour productivity, TFP, R&D,
etc.
 Gains from economic growth (income/wealth) needs to be fairly
/equitably distributed among members of society.
 Is there a broad spectrum medicine that addresses these problems in
one spot? No!
 Does policy prescribed for one problem/imbalance cause
positive/negative effect on other variables on an economy? Yes!
1. Trade-offs: These goals may not be mutually compatible.

For instance:
 Increased money supply enhances employment but possibly leads to
inflation.
 Use of modern technologies may enhance economic growth but
possibly leads to workers-lay off. 17
 Economic growth arises from increased labour productivity, TFP, R&D,
etc.
 Gains from economic growth (income/wealth) needs to be fairly
/equitably distributed among members of society.
 Is there a broad spectrum medicine that addresses these problems in
one spot? No!
 Does policy prescribed for one problem/imbalance cause
positive/negative effect on other variables on an economy? Yes!
1. Trade-offs: Goals may not be mutually compatible. For instance:

 Increased money supply enhances employment but possibly leads
to inflation.
 Use of modern technologies may enhance economic growth but
possibly leads to workers-lay off.
18
1.3. Macroeconomic Goals and Instruments…
2. Disagreement on mechanisms of achieving macroeconomic
goals:
 Classical school: Market forces solve macroeconomic instability.
 Keynesian school: Because of market failure government should
intervene to address imbalances or economic disequilibrium.
Macroeconomists use different policies such as monetary and fiscal

policies.
 MP uses policy instruments (interest rate, reserve requirements,

domestic credit, treasury bills, etc.) managed by monetary
authorities or Central Banks.
 FP uses policy instruments (taxes, government expenditure, social
security, etc.) are used by the government bodies that manage the
country’s budgetary revenue and expenditure. 19
1.3. Macroeconomic Goals and Instruments…
 Expansionary Policy: Increased money supply (MP) and increased
government expenditure or declining tax rate (FP).
 Contractionary Policy: Reduced money supply (MP) and declined

government spending and increased tax (FP).
 Example: If tax increases (contractionary measure) government

revenue may increase and budget deficit may be eliminated; but
disposable income and consumption and AD may decline; profit of
firms may also be affected; thus affect economy.
20
1.4. State of Macroeconomics: Evolution & Recent
Developments
1. Mercantilists
 Wealth and power of a nation is determined by its stock of
precious metals (stock of foreign currency assets). Implication
for policy: A need to use export subsidies and import duties to
maximize the stock of precious metals/foreign currency.
2. Classical School
 Main contributors: Adam Smith, (Wealth of Nationsin 1776),
Recardo, etc.
 Ups and downs of economic activities are reflected in up and
down movements of prices. Imbalances are short-lived.
 Prices are flexible. Economic agents react to price changes as
immdediate as possible so that market clears; equilibrium is
ensured. Just leave the economy for the market (laissez faire).
 The theory was dominant up to the 1930 incidence. 21
1.4. State of Macroeconomics
3. Keynesian school
 Between 1929 and 1932, Western economies faced a tragic
performance. Unemployment increased (USA 25%), price fell
(40% in Germany and USA) and output declined (USA 50%,
40% in Germany and 30% in France).
 The Great Depression of the 1930 in USA and other western
economies challenged the role of markets and gave rise to
aggregate economics or macroeconomics.
 Keynes, Hicks (1937), Modigliani (1944) and Tobin (1958)
are main contributors for Keynesian school.
 Keynes argued that the classical economic thinking failed to
explain the causes of depression.
22
 The assumption of flexible prices is wrong.
 Prices (including wages) are upward sticky.
 Workers engage in long-term contracts. Workers are not
usually willing to see their wage fall even if prices fall. There
is money illusion; no focus on real wage. Thus, markets are
not always self-regulating.
 Output fluctuations are partly caused by private sector
behaviour (animal sprit). Investors pessimism reduces
investment and output and causes for unemployment.
 Market failure leads to involuntary unemployment.
 Example: Assume initial labour market equilibrium at:
w0 =W 0/P0
 If price declines from P0 to P1: will it cause unemployment?
23
w1=W0/P1 s
s
w0=W0/P0
LD s
s
24
 Classical school: Firms will not be profitable as P declines; real
wage increases to (w1); labour becomes expensive
w1 = W 0/P1
 Demand for labour declines; firms lay off workers,
 Thus, workers voluntarily reduce their nominal wage from W 0 to
W1 so that the real wage remains the same at:
w0=W 1/P1=W0/P0
 Thus, no unemployment, initial equilibrium is restored.
 Keynesian School:
• Workers do not reduce wages. Thus, real wage increases to w1;
demand for labour declines and labour supply increases.
Unemployment arises by LS – LD.
• A need for government intervention, AD management.
• If money supply increases, aggregate demand increases, price
25
increases and thus real wage goes back to w0.
W
w1=W0/P1 s
s
w0=W0/P0
LD s
s
As money supply increases; unemployment decreases and

inflation rises; which leads to Philips curve or an inverse 26
relationship between inflation and unemployment
P* MP is used to make advantage of money

illusion of workers to increase
employment. Government policies can
improve macroeconomic performance
and stabilize the economy
U
NU
This theory was dominant until 1960’s but
after that it was found that inflation could only
Friedman: Avoid arbitrary temporary unemployment.
money supply measures. Monetarists
Because it aggravate There is natural unemployment level that
inflation and does not could not be addressed by increased money
eliminate unemployment in supply. Otherwise, it leads to staginflation:
the long-run. both unemployment and inflation. 27
E. New Classicalists
 No need for use of demand management policies by government
(Lucas, 1981a).
 Economic agents (HHs and firms):
 Make rational expectations about the future.
 Make optimal decisions or maximize their benefits/profits.
 Their forecasts are on average accurate; deviations or errors in
forecasts are random.
 Economy operates at the natural rate of unemployment level;
 Market forces remove disturbances quickly by equilibrating demand
and supply through wages and prices adjustments, and return to
natural level of output and employment.
 Economy is inherently stable; but disturbed by instable monetary growth
(as also argued by monetarists) and other government interventions;
For instance, rate of increase in money wages equals expected rate of
28
inflation, no change in real wage.
 Stabile money supply and minimal government role help to
correct the macroeconomic imbalances;
3 Main arguments by the new classical school

(a) Policy ineffectiveness proposition: Random or arbitrary MP
bring short-run real effects because they are not anticipated by
rational economic agents; (Sargent and Wallace, 1975, 1976).
In the long-run, they do not have no effect.
(b). Keynesian-style macro-econometric models do not accurately

predict the consequences of various policy changes on key
macroeconomic variables (Lucas 1976).
(c).Remove discretionary government powers to improve

29
eeconomic performance.
E.The New Keynesian School
 The school considered:
 Rational expectations hypothesis, wage and price stickiness and
Friedman’s natural rate of unemployment hypothesis (No long-run
trade-off between unemployment and inflation).
 The school argues:

 Demand and supply shocks cause output and employment
fluctuations.
 Stagflation could result due to supply shocks (cost-pushed
inflation).
 Markets may not clear even if agents are rational and optimizing
because of information problems, transaction costs and thus
price rigidity in the economy.
 Government policies can improve macroeconomic performance
and stabilize the economy. 30
2. National Income Accounting
2.1. Introduction
National Income Accounting is a formal record of aggregate transactions of
economic agents (households, firms, government and foreign nationals).
2.2. GDP: Definition and Measurement

 GDP: Total income earned by domestically-located factors of production
regardless of nationality of owners or monetary value of current final
goods and services produced within a country in a given period.
 In an economy: Sum of all (buyers) expenditures = Sum of all income
(suppliers) for factors of production= Sum of value of goods and services
produced.
31
2.2. GDP and GNP: Definition and Measurement
 Thus, there are 3 approaches of measuring GDP: Product

Approach; Expenditure Approach and Income Approach. In
the calculations, consider the following important tips:
 Do not include used goods in the calculation of GDP;
 Do not include spoiled inventories;
 Do not count intermediate goods as part of value added;
 Include change in inventories, if goods are in store;
 Use imputed value as an estimate of market value of goods,
for those which do not have market place; example
government services such as education, free health,
domestic (household activities)).
32
 Product Approach: GDP is the value of final goods produced= sum of
value added at all stages of production.
 Important concept: Value-added = Value of production at the end of
each stage – intermediate input/goods. [Careful not commit double
counting!]. Consider a simple economy :
Service
Agriculture Industry
Farmer sells a quintal of
A trader sells a
quintal of wheat A miller sells a quintal of flour to
GDP:
wheat to a trader with to a miller bakery and bakery produced bread VA1+
and distributed Birr
Birr 1000 Birr1500
2500
VA2+
VA2=1500-1000
VA1=Birr1000
Birr=500 VA3=2500-1500 VA3
Birr 1000
33
B. Expenditure Approach (EA): Total expenditure on domestically –

produced final goods and services.
GDP= C+I+G+(X-M)
Where C = Household consumption; I = (Private) investment ;
G= Government expenditure, (X-M) = Net exports, where X
= value of exports and M = Expenditures on imports.
 Consumption Expenditure (C): Values of all goods and services
bought by households for consumption:
o Durables (lasting for a longer period – cars, residence, etc.,);
o Non-durables – last a short time (food, clothing, etc.)
o Services – Work done for consumers such as dry cleaning,
transport, beauty salon;
34
 Investment (I): Includes

 Business fixed investment (spending on plant & equipment),
 Residential fixed investment (housing units of all parties) and
 Inventory investment (changes in the value of firms’
inventories).
 Government Spending/Expenditure (G):
 Government spending on goods and services; (Federal &
Local).
 G-excludes transfers payments because they are not
spending on goods and services for government use and also
the payments are used by households for consumption, for
instance, thus leads double counting (Transfer payments are
unemployment insurance payments, pensions).
35
Income Approach (IA): Total income earned by domestically –

located factors of production.
The incomes are earned in the form of:
(i) Wages and salaries (return to labor = w),
(ii) Interest (return to capital = i),
(iii) Rent (return to land =r) and
(iv) Profit (return to entrepreneurial ability = ).
Be cautious: Calculation is not street forward.
 Calculate National Income First: NI = w + i+ r + 
 NI excludes depreciation (D) while GDP includes (D) within gross
investment (I).
 NI includes factor income from abroad (FIFA) but it excludes
factor income paid to abroad (FIPA); whereas GDP calculated by
product approach excludes income from abroad (FIFA) and
includes factor income paid to abroad. 36
With certain adjustments GDP is calculated as follows:
 GDP at current market prices:

= NI + D + (FIPA – FIFA) +(IT – Subsidies)
 GDP at factor cost = GDP Market Prices + (Subsidies – IT)
The Relationship between GNP and GDP
 GNP: Total income earned by a nation’s factors of production,
regardless of where they are located.
 GNP-GDP = (Factor payments from abroad (FIFA)-(factor payments to
abroad (FIPA)) or
 GNP = GDP+ NFIFA,
where (Factor payments from abroad (FIFA)-(factor payments to
abroad (FIPA). 37
2.3. NNP, NNI, Per capita Income (PI) and Disposable Income
 GNP Less Depreciation (D)
• Net National Product (NNP)
Less: Indirect Business Taxes
Plus: Subsidies
 National Income (NI)
Less: Retained Earnings (Corporate profits-Dividends)
Less: Social Insurance Contributions
Less: Net Interest
Plus: Government Transfers to Individuals
Plus: Personal Interest Income
 Personal Income
Less: Personal Tax
 Disposable Income
Less: Consumer Expenditure
Less: Transfer to foreigners
Less: Interest paied to business
 Personal Savings 38
 Per capita income (PI) = GDP/Population
2.4. Nominal versus Real GDP
 Nominal GDP is monetary value of goods and services calculated
at current prices.
 Consider the following simple economy with two
products:
2020 2021
Qua Price Total (Birr) Quant Price Value
ntity Birr ity Birr (Birr)
Apple 40 150 6000 42 170 7140

Orange 25 200 5000 22 230 5060
NGDP 11000 12200
Growth 11%
39
 A change in nominal GDP arises either from change in
quantity of goods and services or changes in prices.
 Even if quantity of goods and service remain the same, if
prices rise between two years, then nominal GDP grows,
which is misleading in real terms.
 To control the effect of price variations on GDP growth, we
use similar prices across years, often referred as constant
prices or prices of goods and services at a chosen base
year.
 Have a look at the difference between real (constant price)
GDP and nominal (current price) GDP below!
40
2020 2021
Quant Price Total Quan Price Value(Bi

ity (Birr) (Birr) tity (Birr) rr)
Apple 40 150 6000 42 150 6300
Orange 25 200 5000 22 200 4400
RGDP 11000 10700
Growth -2.7%
 Apparently, instead of a growth in GDP by 11%, we have

witnessed a decline in GDP by 2.7% because of use of constant
prices.
 Using nominal GDP figures give misleading figures. It
exaggerate GDP and growth rate figures by the rate of
41
inflation.
2.5. The GDP Deflator and the Consumer Price Index
 Inflation is a certain percentage increase in the overall level of

prices or (∆P/P)*100.
 There two types of inflation measures: GDP deflator and CPI.
 GDP (implicit price) Deflator = Nominal GDP/Real GDP
 To gaugae the true performance of an economy in terms of
growth, one has to first deflate the Nominal GDP using GDP
deflator and get Real GDP. Real GDP measures output valued at
constant prices.
 In the above example: NGDP2020/RGDP2020 = 1
NGDP2021/RGDP2021 = 1.14
 GDP deflator measures the change in overall prices of outputs or
services of a given country vis-à-vis their prices in the base year.
 Real GDP = Nominal GDP/GDP Deflator. 42
The Consumer Price Index (CPI):

 It is a single index capturing the prices of all goods and
services so as to indicate overall price level in the economy.
• Goods and services of a sample of households are given
weights according to past patterns of consumption
expenditures.
• Individual prices per given period are multiplied by weights
of individual goods and services and added up together to
come-up with CPI.
• CPI is calculated by the Central Statistical Agency (CSA).
43
 In calculating CPI, CSA selects one normal year (with low
level of unemployment, low inflation and low fluctuations
in the economy as economy as a whole) is selected.
 Survey is conducted on representative sample households
to determine composition of the typical consumer’s
“basket” of goods in terms of the type, quantity and
money allocated.
 Based on the share of expenditure of each group of goods
and services, weights (wi) are given out of 100%. CPI is
calculated in every month.
44
 Goods and services are given weights when deflators are

calculated to serve for a long period.
 In practice,
(a) Composition of goods and services change.
(b) Consumers may substitute goods, whose relative prices have fallen.
(c) Quality of goods and services also change; which leads to price change.
(d) Thus, base-year prices and relative prices should be up-dated
periodically.
• GDP Deflator is calculated by National Planning Commission

based on CSA data.
 Chain weighted average prices could be used to update base
year prices. For instance average prices of 2000 and 2001 could
be used to compare GDP changes between 2000 and 2001; 45
often constant prices are used because of simplicity.
2.6 Problems Associated with GDP/GNP Calculations
 Growth in real GDP may not correctly measure people’s

welfare. It fails to consider income distribution
 Some underreporting activities could exist such as
 Non-traded goods: government services; volunteer work,
household activities;
 Quality improvements of goods;
 Effect of the use of resources to avoid or contain crime or risks
to national security;
 Underground economy: working at a second job for cash,
illegal gambling, works of illegal migrants, tips, drug dealing,
selling home produced goods; Reasons: (1) to hide taxes (2) to
avoid immigration laws (3) to conceal transactions which are
illegal.
46
2.6 Problems Associated with GDP/GNP Calculations
 Not all production data are available even for formal activities;
thus errors arise in the accuracy of estimations and revisions.
 Environmental pollution and degradation are usually taken into
account (negative effect on sustainability and of the welfare of
the future).
 A need to do environmentally adjusted domestic product (EDP);
give allowance to the use of environmental goods. Add
discoveries of new resources and subtracts the cost of pollution
and degradation.
47
2.7. GDP and Welfare
 GDP and GDP growth rates are crude indicators of change in

welfare of the population.
 If there are two countries have similar population, a country with a
larger size of GDP is richer than a country with a lower size of GDP.
However, if two countries have similar GDP but different size of
population, then unless population is taken into acocunt it gives
misleading picture.
 Thus, per capita income may be a better indicator of welfare than
GDP.
 In this case, welfare of the people grows on average if GDP growth
rate is higher than population growth rate.
 Per capita GDP has also its own shortcoming;, it assumes every
individual earns the same amount of income and fails to account of
income distribution issues.
 Thus, there is a need to consider what is called Gini coefficient
besides the size of per capita income, whether or not there is high
and equitable distribution of income. 48
2.8. Unemployment and inflation
 Inflation (πt): A sustained rise in the general price level; not
prices of some items.
where Pt is general price index (either CPI or

GDP deflator) for time t.
Causes of Inflation
 Inflation arises when AD > AS.
 Often causes of inflation are divided into two: Demand Pull
Inflation or Cost Push Inflation.
 Demand Pull Inflation: Arises when AD grows faster than AS.
 Different schools of thoughts view inflation differently.
49
 Classical School: AS is constant in the SR; change in AD
usually arises because of government intervention.
 If money supply increases AD for goods and services
increases and shifts the AD curve from AD1 to AD2.
50
 AS is at full employment level (P-bar ), excess demand is created:
at the original price (P0); it raises the general price level (inflation).
Thus, increased money supply is fully translated into inflation,
without an output effect.
 Output or economic growth depends on the real economic
aggregates such as stock of capital, labor, land, and technology;
not by money supply.
Keynesian School
 Increased Money supply increases in A (increase C, I , G, or X);
AS is upward sloping or horizontal.
 A shift in AD from AD1 to AD2; creating excess demand = Y2-Y1 at
P1. This will cause to an increase in price from P1 to P2. Firms
will positively react to the increase in price and boost their
supply from Y1 to Y3. New equilibrium price and output are P3
and Y3. Inflation but with real economic growth!
 AD changes by fiscal policy measures as well. 51
Keynesian Case
52
Cost Push (supply side) factors
 Because of increase in the cost of production and other structural
bottlenecks.
 Negative technological shock;
 Decline in quantity of raw materials & intermediate input supply
and increased price of input
 Downward shifts in labour supply because of, example:
 Increased migration because of new opportunities outside the
country;
 Strong labour union pushing the firms for higher wage rate; or
 High food price causing wage rise or minimum wage legislation
causing price rise).
53
Y
 Because of cost push inflation or technological shock, AS shifts from
AS1 to AS2; creating AS shortage of Y1 to Y2; price rises and AD
declines; New equilibrium: at P2 and Y3, but causes inflation.
 Given the normal case of Keynesian AS curve, inflation arises either
because of increased AD (shifting to the right) and a decline in AS
(shifting upwards to the left). 54
Structural School of Thought on Inflation
 Developing countries have specific economic situations.
 Structural problems (mostly primary activities); highly
fragmented economic activities due to market imperfections
and structural rigidities of various types.
 Structural imbalances and rigidities cause supply shortage in
some sectors and lack of demand in others despite under-
utilization of resources and excess capacity may exist.
 Thus, the causes of inflation in developing countries may
need to be analyzed in a different context than the
developed economies.
 More specific explanations can be given as follows.
55
Agricultural Sector Bottlenecks
 Bottlenecks preventing the supply of food grains to increase adequately:
 Disparities in the size of land ownership, recurrent drought, backward
technology &, subsistent farming, low skill in the labour force; etc,
 Addressing bottlenecks boost agricultural output, reduce food price and
increased real wage rate but without causing other sectors reducing
prices of other goods, and reduce inflation;
Resources Gap or Government’s Budget Constraint
 Government in developing countries spends on infrastructure, etc.
 However, it may not raise enough resources through taxation due to
low tax base, large scale tax evasion, inefficient and corrupt tax
administration, weak private sector, inadequate capacity, limited
voluntary savings and under-developed capital market.
 Thus, it resorts to increase money supply (indirect taxation); which leads
56
to inflation.
Foreign Exchange Bottleneck
 High demand for imports of capital goods, raw materials or
intermediate inputs and oil requires high foreign exchange.
 Exports are inadequate; (income and price inelastic supply natural
resource or agricultural products).
 This leads to trade and balance of payments deficit.
 To solve this problem, devaluation is often suggested; but this
raises prices of imported goods (including inputs) raises prices of
other goods and leads to cost-push inflation in their economies.
Infrastructural Bottlenecks
 Infrastructural facilities (road networks, railways,
telecommunication, air transport, water and electricity supplies)
are very weak or inadequate; makes cost of production to be very
high; limiting the production capacity of the economy and output
growth;
 Excessive growth of money supply given limited employment,
cause stagflation (high inflation with slow economic growth. 57
Two types of inflation
 Anticipated Inflation: Inflation that is built into the
expectations and the behaviour of the public before it occurs.
If anticipated and actual inflation are the same, the risk would
be relatively lower.
 Unanticipated Inflation: Inflation that comes as a surprise to
the public or at least comes before people have had time to
adjust fully to its presence; thus actual inflation deviates from
expected or anticipated inflation.
Effect of expected inflation on prices
 If Central Bank announces that it will increase money supply
next year, people will expect P to be higher next year and
increase expected inflation (πe). This will affect P even though
money supply has not changed yet. 58
1. Loss of Purchasing Power of Money: Money looses its purchasing
power because nominal cost of goods and services increases. How?
 Nominal money balance of M; real money balances is M/P.
 The rise in prices or inflation reduces the purchasing power of the real
money balances M/P;
 If M increases by 5% and P grows by 15 percent; M/P decline by 10
percent; how?
∆(M/P)/(M/P) = (∆M/M)-(∆P/P)= 5-15%=10%.
2. Shoe Leather Cost: If households hold more money to avoid iinterest
rate forgone. However, HHs rush bank repetitively to make purchases
ahead of price increase. This cost of inconveniences to avoid the
inflation tax is called shoe leather cost.
3. Menu costs: Firms change price lists as prices of the goods change.
The preparation of menus each time causes menu costs.
59
4. Relative price distortions: If prices change at different times, they lead

to relative price distortions; cause inefficiencies in the allocation of
resources. For instance, firms may have a certain proportion of the
composition of inputs (labour, capital and raw materials) to be
maintained; changes in the prices of different inputs at different rates
affect the cost proportion.
5. Unfair tax treatment: Taxes are not often adjusted to account for
inflation. For instance, if income tax brackets are categorized in nominal
terms, as nominal income of a person increases, she/he will be pushed
to a higher income bracket and pay a tax using higher marginal tax rate.
6. Distorted real depreciation expenses: If fixed assets are not re-valued

in accordance to increased inflation, the value of depreciation 60
allowance could be wiped out by the rate of inflation.
7. Olivera – Tanzi Effect: Inflation affects real value of the tax
burden when there are significant lags in tax collection.
 If the tax obligation are accrued at a certain period and payment
is made a later stage within which inflation occurs, the rate of
inflation reduces the tax burden. This phenomenon is called
Olivera – Tanzi Effect.
 Olivera – Tanzi Effect leads to a vicious circle: An increase in
inflation reduces government revenue and thus increases fiscal
deficit and this leads to higher inflation.
8. Inconvenience in Planning: Inflation makes it harder to compare
nominal values of different time periods. This complicates long-
range financial planning.
61
9. Affecting Asset/Wealth Portfolio:
 If financial institutions adjust interest according to the Fisher
Equation, i = r+π, then the demand for money (cash holding) will
reduce because of its high opportunity cost (forgone interest rate) if
banks adjust upward the nominal interest rate every time with changes
in prices.
 As prices rise, HHs try to reduce their money balances and purchases
consumer durables assuming durables will not at least lose their values
because of inflation.
 This will affect saving, investment and economic growth.
 If the change in portfolio is towards the purchase of capital goods, it
builds production capacity of the economy and thus boost economic
growth.
62
10. Effecting AD and AS and thus Overall Economic Growth
If financial institution adjust nominal interest rate based on
price fluctuations [S(i) =S(r+π), investment may decline as a
result of increasing nominal interest rate [I(i)= I(r+ π)].
A rise in prices reduces purchasing power of nominal income
or nominal money and negatively affect consumption
demand.
 Inflation reduces exports by making exportable domestic
goods to be more expensive in the domestic market and thus
in the international market as well and affect the trade
balance.
Reduction of investment, consumer demand and net export
reduce AD.
Decline in investment would affect the production capacity
and therefore the supply side of the economy.
The whole effect may be reflected in the slow down or
stagnation of economic growth. 63
Effects of Unanticipated Inflation
 Main effect is on redistribution of the purchasing power among
different parties. Many long-term contracts may not be adjusted
with actual inflation. Contracts are made based on expected
inflation (πe).
 If π turns out to be different from πe, then some gain at others’
expense.
 Distinguish the two types of interest rates: Nominal interest rate (i)
and real interest rate (r).
I =r+ π - Fisher’s equation
Case 1: Lender and Borrower
 Assume some HHs borrow and some other HHs lend money with
interest.
 Lending interest rate is real interest rate plus expected inflation: r+
πe=i;
 If actual inflation (π ) > expected inflation (πe), then (I-π) < (I-πe).64
 Actual real interest rate becomes lower than anticipated real
interest rate, leading to the transfer of purchasing power from
lenders to borrowers.
 If π < πe, then the actual real interest rate is higher than the
expected real interest rate and this leads to the transfer of
purchasing power from borrowers to lenders.
Case 2: Wage Contract between Employer and Worker
 Assume a wage and labour service contract is made by taking
into account expected inflation (πe).
 If actual inflation (π) exceeds anticipated inflation (πe), real
wages of workers will tend to be lower than its expected
amount.
65
Unanticipated inflation hurts more individuals with fixed income
(pension).
 Pensions are not often adjusted for inflation; thus given constant nominal
income, real income declines as a result of an increase in inflation.
 When inflation is high, variable and unpredictable, arbitrary redistributions
of wealth become more likely and cause higher uncertainty, makes risk
averse people worse off.
 This will cause a decline in real money holdings and affect the wellbeing of
the people.
Inflation is considered as a proxy indicator for the ability of government to
manage the stability of the economy.
 High inflation may signal the inability of the government to properly
manage the economy and adversely affects the decision of the public
(both firms and households alike).
 Government may strive to control inflation using pricing policies such as
tax and trade policies such as fixing prices of goods at whole and retail
levels. 66
 This may in turn create uncertainties to private investors and the

general public to make investment decisions; and this has likely to
have a negative consequence on economic growth.
Benefits of Inflation:
 Unanticipated inflation reduces real wages, increases the demand for
labour by firms and thereby enable to expand the level of
employment and output in the economy.
 Why? it is because of information constraint; workers slowly adjust
their perception about the negative consequence of prices on their
real wage.
 Given that nominal wages are rarely reduced, equilibrium will be
insured at higher level of employment even if equilibrium real wage
falls.
67
Measures to Control Inflation
 Inflation is a common phenomenon in every country. However, if
it is beyond a certain level, its negative consequence becomes
significant; a need to control it.
 However, there is no a straight forward policy prescription
because of controversies on what might have caused it.
 Some policy prescriptions:
Monetary measures
 Monetarists argue that inflation is monetary phenomena;
excess money supply beyond the optimal level; use
contractionary measures including interest rate, reserve
requirement ratios of commercial banks and undertake open
market operation.
Fiscal measures
 Keynesians argue that inflation could originate from the real
(product) side of the economy because of an increase in AD in
excess of AS; most often because of excessive government 68
expenditure.
 Fiscal policy such as cutting government spending may become
effective. If the excess demand is caused by the private
investment or consumption expenditure, increasing taxes reduces
AD; and thus reduce inflation.
Price and wage control measures
 If monetary and fiscal policies are ineffective and if the inflation is
primarily caused by supply side factors or an increase in costs of
production (cost push inflation), price of inputs and output and
wage regulation may be sought.
 Structuralists, a broad – based strategy of development or
economic, social, institutional and structural changes are needed
to enhance rate growth of the economy without or with low
inflation. Supply side structural constraints need to be addressed
for inflation to be curved.
69
CHAPTER 3: AGGREGATE DEMAND IN CLOSED
ECONOMY
3.1. Introduction
• Using expenditure approach, GDP is given by:
(1) Y = C+I+G+NX
In a closed economy, we do not have international trade:
(2) Y = C+I+G
• Consumption function: Assuming its other components being zero, disposable
income is given by Y-T. It is composed of C and S;
(3) Y-T = C+S

• The (Keynesian) consumption function is given by:
(4) C=C0+c1(Y-T)
where C0 = autonomous consumption, part of C, not related to current
income and it is the intercept of consumption function (CF); c1 =dc/dY, or the
slope of CF, or MPC;. It is assumed to be constant with (0<c1<1).
70
3.1. Introduction
Average Propensity to Consume (APC):
• Given constant C0, c1 and T, C0/(Y-T) declines as Y increases.

APC is the slope of a line that joins the origin and the CF line in
each (C,Y) coordinate.
71
3.1 Introduction
(2) Investment: Investments are made for profit; thus it has its own opportunity
cost. Interest rate is an opportunity cost to make investment decisions. Those
with money contemplate either to put it in the bank or invest it for a better
return. Those with no money, compare lending interest rate with its return.
(7) I=I(r), r = (i-π)
where r = is real interest rate, i = nominal interest rate and π = inflation rate.
(3) Government expenditure (G): (a) Goods and services for capital
investment or recurrent consumption by the federal and local government
agencies and (b) TR to HHs (social security payments, including pension.
Government will have a balanced budget if:
(8) G=(T-TR)
 If G>TR, there is budget deficit and if G<(T-TR), there is a budget surplus.
TR increases disposable income and consumption. For simplicity, we set T to
stand for taxes less government transfer payments.
72
3.1 Introduction
 Assume government spending (G  G ), private investment ( I  I ) and taxes
(T  T ); AD or E is given by:
(9) E  C0  c1 (Y  T )  I  G
 Aggregate Demand, total demand for goods and services in the economy, is
determined by the interaction between product (goods) and money markets.
 This interaction of the two markets is represented by IS-LM curves.
 The product market equilibrium is designated by the IS curve; where I and S

stand for investment and saving respectively.
 Money market equilibrium is captured by the LM curve. L and M stand for

liquidity and money respectively. We will discuss the two markets separately.
73
3.2. The Product/Goods Market Equilibrium
 First step use the Keynesian cross to assess the possible actions of firms
when there is disequilibrium in the product market.
 Disequilibrium occurs when planned expenditure and actual expenditure are

not equal.
 Actual expenditure (AE) is the amount that households, firms and

government actually spend on goods and services.
 Planned expenditure (PE) is the amount that households, firms and

government would like to spend on goods and services.
 PE is given by Equation (9) or displayed by Figure 3.2. PE increases less

proportionately with an increase in income.
74
Figure 3.2: Planned Expenditure as a Function of Income
75
Fig 3.3: The Keynesian Cross
The 450 line divides the quadrant into equal parts along which output equals AE. Product
market equilibrium is at point A; where AE = PE. No excess demand; no excess supply.76
 If the economy is in disequilibrium, how could it get back to the equilibrium?
Fig 3.4: Disequilibrium in the Product Market
77
• If the economy operates below point A towards the origin, PE (E1 ) exceeds
output (Y1 ); firms draw down their inventories to satisfy the excess demand
(E1-Y1).
• They also employ more workers and expand output; a movement towards A
(high output and AD).
• If the economy operates above point A, output exceeds PE; firms pile-up
inventories by the amount to reduce their sales to the level of AD, a
movement towards A.
where 1/(1-c1) =G-expenditure multiplier
• Government fiscal policies (G & T, for instance) may affect the equilibrium
78
condition in the economy.
• The (1/1-c1) is called government multiplier; because it multiplies changes

in exogenous variables such I or G to give resulting change in output .
• Income of HHs is allocated for (a) consumption, (b) saving and (c) taxes.
• On the expenditure side, AD equals
• At equilibrium, we have
 From Equation (13),

(14) S  I  (G  T )
79
• We have seen that an increase in “I”, “C” and “G” increases AD.
• What is the effect of saving on income or Y? In the short-run, an increase
in saving has contractionary or negative effect on output.
• An increase in saving requires C0 or c1 to decline or (1-c1)) to increase.
• Lowering C0 decreases PE by the same amount Y by C0/ (1-c1).

• A decrease in c1 reduces the multiplier and also has a stronger negative
effect on income. This is called the saving paradox or the Paradox of
Thrift.
• In the short-run, there is an inverse relationship between Y and saving,

because an increase in S given Y and T, become possible by reducing C.
• In the long-run, as S increases, supply for loan-able funds increases; and
interest rate falls and boost I and PE . 80
• If government has a balanced budget, then,
• Equation (15) is called Saving-Investment Identity.

• If government runs a budget deficit G>T; then
(16) S>I
• Equation (16) shows that part of the saving is siphoned off to finance
government budget deficit. It is called crowding out of private investment.
Because of excess government spending, private investment is constrained.
• If government has a budget surplus, private investment exceeds saving.

(17) S<I
• Thus, private investment is finance by household saving (SH) and government
saving (SG) , which is equal to government budget surplus.
81
• The Effect of Fiscal Policy on AD: If government increases its spending G,

∆G>0 ,
•
where
• A move from A to B
raises
• income on Fig 3.5.
82
• If tax is reduced by ∆T, disposable income increases by -∆T and consumption

increases by –c1 ∆T and planned expenditure increases by:
• Let I be endogenously determined in the model as:

where
where I is autonomous investment, independent of income and interest rate;

• b is the slope, measuring the responsiveness of investment to changes in
interest rate. Investment is inversely related with real interest rate (r).
• Fig 3.6a, Fig 3.6b and Fig 3.6c capture (a) the relationship between r & I, (b)
between r & E and (c) between r& Y respectively. 83
84
• The Effects of Fiscal Policy Change on Interest Rate and Income: If,
for instance, government spending increases (∆G>0),
• AD or planned expenditure line shifts upwards in the Keynesian cross.
Equilibrium output increases by ∆Y=[1/(1-c1)]*∆G); IS curve shifts upwards.
• IS curve below is negatively slopped because a higher interest rate reduces
investment and AD and equilibrium income. The slope of IS curve depends on
sensitivity of investment to changes in r and also the multiplier.
85
Fig 3.7a: Keynesian Cross
Fig 3.7B: The IS Curve
86
• ,
Relaxing the assumptions imposed on the multiplier: Normally
where
• Incorporate new C and I functions in (21) to AD gives:
where and
87
• Both equations (23) and (24) are called the IS Equations. The change in
income due to a one unit change in interest rate is given us:
• The IS equation as normally depicted in mathematics is given by:
• IS represents a combination of interest rates and income levels at which the

goods market clears or becomes in equilibrium. IS curve shows the negative
association between AD and interest rate through investment function.
• The slope of IS curve is
88
• The larger the government expenditure multiplier (αg ), the smaller or flatter
the slope of the IS curve becomes and the larger the effect of fiscal policy on
income.
• Changes in the IS curve: An increase in autonomous spending (TR, I, G,

C0), shift both planned aggregate spending and the IS curve. If government
increases spending by ∆G and given multiplier as
• or
• Government spending change on output across the Keynesian cross or IS

curve becomes:
• The effect of autonomous investment on income is similar to change in

government spending. 89
• Introduction of tax rate (t) reduced the multiplier and the effect
of government spending on income.
• Effect of autonomous investment change on income is similar to

change in government spending.
 The effect of change in government transfer on aggregate

output:
90
(30) The direct effect on consumption spending
(31) Induced effect because of income change through

multiplier
(32) Total effect
(33) The change in output per unit tax rate cut

Y  c1Y
 91
t [1  c1 (1  t )]
• Change in tax rate affects the slope of the IS curve through the
multiplier. If t increases, total tax collection increases and
disposable income decreases.
• Increases in t, reduces the multiplier and makes IS curve steeper
(through the government multiplier) and the change in
autonomous spending bring a lower amount of income change.
• Expansionary fiscal policy instruments such as increased
government spending and tax cut become more effective if the
economy is in recession or below full employment; to let
economy recover.
• When the economy is overheating, government either increase
tax rates and cuts its spending to get back to equilibrium.
92
• What will be the effect of change in government spending on

government budget balance?
• The effect of change in G on income
(1) The effect of change in G on tax revenue T  tY  t g G
• The effect of change in G on government budget balance
93
3.3. The Money Market and the LM Curve
Assets of an economy are divided into two categories:

(a)Real assets or tangible assets:
(i) properties owned by firms or corporations (machines, land, and
structures or buildings
(ii) consumer durables (such as cars, washing machines, stereos, etc.) and
(iii) residences owned by HHs. These assets carry a return.
Owner-occupied residences provide a return in terms of housing service with

no rent, but have opportunity costs. Machines and equipment are used to
produce output for profits.
(b) Financial assets: Money and other interest-bearing assets bonds, stocks,
equities or credit market instruments.
94
3.3. The Money Market and the LM Curve
• Bonds: Borrower’s promissory note to pay the lender the principal at the
maturity date of the bond and interest per a given period in the meantime.
Bonds are issued governments, municipalities, corporations and other
borrowers. The interest rates on bonds reflect the different magnitude of
risks of default. Default occurs when a borrower is unable to meet the
commitment to pay interest or principal.
• Perpetuity: It is a type of bond which promises to pay interest forever,
but not to repay the principal on the bond.
• Treasury Bills: Promissory notes by a borrower/central bank to pay the
lender the principal at a specified maturity date (often within 90 days) and
interest.
• Equities or Stocks: Equities or stocks are claims to a share of the
profits of an enterprise or organization. For example, a share in the
Abyssinia Bank or Raya Brewery entitles the owner to a share of the
profits of the bank or the factory. 95
3.3. Money Market and the LM Curve
Shareholders or stockholders receive return on equity in two forms:
(a)Dividends: Profit paid to shareholders as per the number of shares

at end of the FY.
(b) Capital gains: When a business becomes profitable, people want to

hold higher number of shares from the enterprise and shares become
more valuable. The price of the stock in the market rises;
stockholders make capital gains. A capital gain is an increase in the
price of assets per period of time.
Return to stock = dividend +capital gain
(c) Retained earnings: All or part of the profit retained by firms for
investment or adding the stocks of machines or structures.
96
• Money: Money is the stock of assets that can be readily used to make
transactions and can be immediately used for payments.
Money Functions:
• Medium of exchange, most convenient way of making transaction of goods
and services;
• Store of value: transfers purchasing power from the present to the future
and
• Unit of account: the common unit of measuring prices and values by
everyone.
Types of Money
a) Fiat money: Money with no intrinsic value such as paper currency or cheque
we use.
b) Commodity Money: Money with intrinsic value; for instance, silver, gold
coins, etc.
97
What does money stock constitute?
Money can take different forms:

• Currency in Circulation: Fiat money and commodity money that we see
circulating in the market.
• Demand Deposit: It is non-interest bearing deposit; it can be transferred
easily to bearer of the check.
• Saving Deposit: The common kind of deposits that we know, a deposit that
bears interest but can be drawn at any time (depending sometimes on the
amount).
• Time Deposit: An interest bearing deposit, which cannot be withdrawn
from banks before the agreement set between the bank and the client.
Three types of money based on composition
1. Narrow money (M1) : (36) M1 = C + DD, where C =currency in
Circulation, DD = demand deposit.
2. Quasi Money: (37) SD +TD , SD = Saving deposits and DT = Time deposit
98
3. Broad money (M2): (38) M2 = M1 + SD + TD
The Demand for Money: Three motives for holding money.

Precautionary Demand for Money: Money kept aside for
precautionary (for fear of risks). It is affected by transaction and
speculative demand for money. For simplicity, we assume
precautionary demand for money is zero for the time being.
Speculative Demand for Money: A person can put his liquid assets into
either bonds (investment) or money. An increase in interest rate,
which is a return on bonds, induces to hold assets in the form of bond
and hold less in the form of money. Such demand for money depends,
therefore, on the cost of holding money – interest and it is called
speculative demand for money.
99
Speculative demand for money is negatively related to interest rate.
Fig 3.7: Speculative Demand for Money

r
L(r, Y1)
M/P
• The each curve is drawn for fixed level of income.
• As Y increases, LS increases for any given level of interest rate, a
shift in the curve towards the right. A change in r leads to a
movement along Ls curve.
100
Transaction Demand for Money: It is the motive for holding money to

bridge the time gap between receipt of income and payments to be made
for transaction purposes.
• Transaction demand for money (LT) increases as income increases in
income; for given interest rate.
Fig 3.8: Transaction Demand for Money

Y
M/P 101
• The demand for money (also called the demand for real balances):
(41)
• Specifically: real money balances is a decreasing function of interest rate.
(42)
• Real money balances are the quantity of nominal money divided by the
price level. It is money expressed in terms of the number of units of goods
that the money will buy.
Money Supply (M): It is exogenously determined by the central bank. M/P is
real money supply divided by P.
• At equilibrium, real money supply equals the demand for money (real
balances). From this, we derive the LM curve:
or or
102
• The LM curve represents the pairs of interest and income that keep the
money market in equilibrium with the given level of money supply M, and a
price P. Fig 3.9: Derivation of LM Curve
LM
L2
L1 Y
• Start at Ls curve L1; an increases in Y increases LT and total money demand and
shifts Ls curve to L2.
• Given constant money supply, excess demand for money increases r from
r= r1 to r=r2; thus reduces Ls and ensure money market equilibrium.
103
• Thus, Y and r are positively associated.
Fig 3.10: The Speculative and Transaction Demand and LM Curve
r
LM
The slope of the LM – curve is:
Y
Ls
LT
104
• Note: LM curve is drawn by changing the income level for a given M/P.
If National Bank (NB) reduces nominal money supply from M1 to M2
and real income remain constant.
• This leads to a fall in real money balances from M1/P to M2/P , shifts the
real money supply curve towards the left, creates scarcity in money
circulation; people will have no option but reduce LS.
• Interest rate raises; new equilibrium occurs in the money market [See
Fig 3.11 a]. This shifts the LM curve upwards in Figure 3.11 b. An
increase in real money balances leads a right or downward shift in the
LM curve.
105
Fig 3.11a: Money Market Equilibrium Fig 3.11b: Shift in LM Curve in Response to Money Policy Changes
Interest rate, r Interest rate, r

LM1
r2
r1 L = (r, )
Income, Y
M2/P M1/P
106
What determines the slope of the LM curve? It is determined by

the slope of transaction demand for money (k) and the slope of
speculative demand for money (h).
• High (k) or high responsiveness of LT to Y and/or low h or low
responsiveness of LS to r; make LM curve steeper. If Ls is relatively
insensitive to the interest rate or h is close to zero, the LM curve
is nearly vertical.
• If LT is vey sensitive to the interest rate, large h mean LM curve
closes to a horizontal line.
• In low LM slope case, a small change in r is accompanied by a large
change in Y to maintain money market equilibrium.
What causes the LM curve to shift? A change in the M/P shifts the LM
curve. If M/P increases, a rightward shift of M/P schedule, r declines to
restore money market equilibrium and shifts LM curve to the right. 107
Points not on the LM curve?
Figure 3.12: Points on the LM Curve

i i
LM
E2
r2 E3
r1 E1
E4
LT (Y2)
LT(Y1)
Income Y
• Money market is in equilibrium at point E1. Assume Y increases to Y2. The

demand for real balances increases; LT shifts to the right.
• At the initial i1, the demand for real balances increases, r has to increases, a
movement to LM curve.
• All points below and the right of the LM curve, example E4, there is excess
demand for real balances. Points above and to the left of the LM curve,
there is excess supply of M/P. When excess demand i increases and 108 when
excess supply i declines to ensure equilibrium.
3.4. Short-Run Equilibrium in the Economy
• Note: Keynesian cross in the product market is the basis of IS curve.

Theory of liquidity preference in the money market is the basis for LM
curve.
• Goods Market: IS (46)
• Money Market:: LM
Fig 3.13: Equilibrium in the IS-Model
i
LM
Equilibrium A
IS
Y
109
Equilibrium
At A, with r-bar and Y-bar,

(a) IS curve: Planned spending equals output or the demand for
goods equals output.
(b) LM curve: money demand equals money.
(c) Simultaneous (money and product market) equilibrium is
maintained at A, given G, taxes, R, I-bar, M, & P.
(d) If there is a change in G, T, I-bar & R, IS curve shifts.
(e) If M or P, LM curve shifts.
(f) If IS, LM or both shift, equilibrium Y (output) and r change.
110
Fiscal Policy Changes
•Changes in fiscal policy (G, R-bar, T-bar) shift the IS Curve. Change in t
affects the slope of IS-curve. These changes alter equilibrium in the two
markets.
Changes in Government Spending:
•If government increases its purchases of goods and services by (ΔG), PE
increases; PE line shifts upwards on the Keynesian cross.
•Firms are stimulated to increase supply of goods and services and thus
income (Y).
•The change in income:
1
(a) If T  T , Y  .G (48)
(1  c1 )
1
(b) If T  tY , Y  .G (49) 111
1  c1 (1  t )
3.4.1. MP and FP Analysis Using the IS-LM Framework
Figure 3.14: Effect of Change Government Spending in the IS-LM Model
r
LM
A
iii B
i
IS2
IS1
ii
Y
112
• Transmission: If G PE  Y; IS1 to IS2. At r1, B, money market

not in equilibrium.
• If Y LT (given constant M/P) rLs in the money market & I
in the product market  new equilibrium at C (higher Y and r). I
partially offsets the expansionary effect of G.
• Note: > , represent equilibrium at B.
• Both changes do not consider product and money market interactions.

But point C shows the overall product & money market interactions and
equilibrium in both markets; thus the effect of change in G:
• (a) With no LM and no tax rate, brings the highest change in Y.
• (b) With no LM, with tax rate, brings the second largest change in Y,
• (c) With LM and with tax rate, brings the smallest change in Y because
113
of crowding –out effect. .

Figure 3.15: The Effect of Change in Tax
r LM
Tax cut shifts IS1 to IS2:

C at ,at B
A
B
iii
IS2
IS1
ii
Y
Changes in Taxes
If tax is not function of Y, if tax declines from T1 to T2 by ∆T,  (Y-T), PE shifts on the
Keynesian cross; IS1 shifts IS2 in Figure 3.14, move from A to B. (Y-T) LT (given
constant M/P) rLs in the money market & I in the product market 114  new
equilibrium at C (higher Y & r compared to A but lower Y & higher r compared to C).
Figure 3.16: The Effect of Real Money Supply

Monetary Policy Effects
r LM1
LM2
A
B
IS
• Assume fixed P in the SR, M  M/P; (given Y) r until excess money
vanishes. Money demand (Ls) . LM shifts from LM1 to LM2. As rPE
Y; a movement from B to C. This process is called the monetary
transmission mechanism.
115
The interaction between fiscal and monetary policies

• The effect of a change in one government policy (either fiscal or
monetary) depends on whether or not other accompanied policies are
changed.
• If government increases tax, the economic impact depends on Central

Bank’s response for fiscal policy. CB could (a) hold M/P constant, (b)
hold r constant or (c) Y constant.
• Assume government increases a lump-sum tax.
116
Fig 3.17a: Effect of Tax Increase (Holding M Constant)
Suppose the CB holds M/P constant.

• Initial point A. Tax increase shifts the IS from IS1 to IS2 because of PE
(through (Y-T) & C) a move from A to B.
• As  Y-T Money demandrI=a move from B to C.
Equilibrium at C, low interest rate and low Y compared to A.
117
Fig 3.17b: Effect of Tax Increase Holding r Constant)
r
LM2
LM1
C A
B
IS1
IS2
Y
Suppose CB decides to maintain (r=r1). As T IS shifts from IS1 to IS2: Y &r

to Y2, r2. To maintain r =r1, CB decreases M. M LM curve shifts from LM1 to
LM2; r I  further Y and causes r to pick up to its original level;
(r=r1).
Y because of the tax cut; as M varies to hold r constant, is larger than
118
Y
when M constant
Fig 3.17c: Effect of Tax Increase Holding Y Constant (a) Suppose CB wants to
Interest Rate, r prevent the tax increase
from lowering Y: M
LM1 HHs hold excess money
LM2 than demand; LM curve
A
shifts to LM2; r, I; IS
shifts from IS1 to IS2.
B Income remains
C IS1
constant; tax increase
IS2 does not cause a
recession, but it causes a
Income, Y
fall in r.
A combination of FP (T) and MP (M) maintain Y constant but change the

allocation of resources or the composition of planned expenditure. Lower C &
high I. 119
3.5. Aggregate Demand
• To derive AD curve relax fixed price assumption. Equilibrium was at

point A on Figure 3.18a, when P=P1. P increases to P2, real money
balances declined from M/P1 to M/P2; a shift from LM1 to LM2; r increases
from r1 to r2 & Y declines from Y1to Y2. AD curve shows a negative
relationship between income (AD) and price on Figure 3.18b.
• AD curve shows the set of equilibrium points of income on the IS–LM
model as the price level varies.
Figure 3.18: Derivation of AD Curve
(a) P
r (b)
LM2
B LM1 B
A
A
AD
IS Y
Y
120
Figure 3.19: Effects of Expansionary Monetary and Fiscal Policy
121
Fig 3.19: Effects of FP & MP Changes on IS-LM & AD
Curves in SR & LR
122
3.6 AD curve and Effect of FP &MP Changes
• The IS–LM model explains the economy in the SR when P is fixed. SR

equilibrium of the economy is at point K in panel a; income is less
than its natural rate at C.
• Fig. 3.19, panel (b) SR equilibrium at Point K where P=P1: insufficient
demand for goods and services to operate at the natural level of
output. Low AD leads to fall in P to P2, movement to point C, AS and
AD curves intersect; LR equilibrium. In panel (a), a fall in price raises
real money balances and shifts the LM curve to the right by a shift in
the LM curve.
123
3.7. Conclusion
• The IS curve:
• The LM curve:
• Substitute r in the LM equation into IS equation:
• Solve for Y:
A  G  I  C0  R
where
• Change in Y as a result of change in A-bar, for instance, G, will
be given by: 124
3.7. Conclusion
• New multiplier captures the effect of crowding-out effect of
expansionary FP on private investment; thus it is lower than
the previous multipliers and the associated change in Y.
• IS-LM is a good guide for policy analysis but has its own
limitations. [The discussion of IS-LM model limitations is
beyond the scope of the chapter].
• Thus, one should not necessarily assume that the

predictions of the IS-LM would exactly happen in reality.
125
Chapter 4: Open Market Macro Economy
4.1. Introduction
• In the real world, countries are not self sufficient in
everything. They have economic interactions to each
other through their economic agents as indicated in
Chapter 2.
• Open macroeconomics captures not only domestic
macroeconomic variables but also the economic
interactions of economic agents with the rest of the
world.
• In open economy model, the global trade in goods and
services (exports and imports) and also capital and
labour markets are considered.
126
4.1. Introduction
• Markets for Goods and Services: Goods and services are

imported and exported. The movements of goods and services
are registered in every country.
• Financial Market (Capital Mobility): Non-residents or
foreigners buy bonds, shares and other securities to get interest
and dividends. Such transactions are also registered.
• Labour Market: In an open economy model, there mobility of
labour across countries. International wage differentials cause
both inward and outward migration. Such effects are also
reported.
• Countries have different currencies. Small economies often face
difficulties to use their currencies in international trade. There
must be a market to convert a currency of one country to the
other to facilitate trade. This is called foreign (currency)
exchange market. 127
4.2. Exchange Rate
• Nominal Exchange Rate (E) is the price of local currency in
terms of foreign currency. In Ethiopian context, it can be the
price of US Dollars in terms of a local currency (Birr). It is
given as:
NER = xBirr/USD (1)
where is the amount of Birr and USD is the US (foreign)
currency. If NER declines, the domestic currency Birr becomes
stronger or expensive relative to dollar.
• Real Exchange Rate: It is a more realistic measure and
helps to gauge the competitiveness of a country in the
international market. It is given by:
eP W ….(2)
RER 
PD
• where Pw is foreign (world) market price, Pd is domestic
market price and e is NER). 128
4.2. Exchange Rate
• Both prices are expressed in domestic currency.
• To know whether local goods are cheaper or more
expensive than foreign goods, one needs to compare the
price of local goods vis-à-vis the price of other countries
goods in local currency.
• A change in RER occurs if e, PW or Pd or two or three of
the variables change. In other words, it is given as:
RER  e  PW  P D
• RER increases if e, or Pw increase or PD declines,
implying similar goods are more expensive
elsewhere than in the domestic market; the local
economy is more competitive in the international
market. The reverse happens if RER declines. 129
4.2. Exchange Rate
• Fixed Exchange Rate (FER): It is a system of
determining nominal exchange rate by the government
(or central bank-CB).
• The policy of CB to buy a unit of foreign currency with
higher amount of local currency is called devaluation.
• CB devalues local currency by increasing (e) and thus
(RER) with the aim of making exports cheaper and
imports more expensive and thereby improve trade
balance or balance of payments.
• The policy of making local currency more expensive than
before by CB is called revaluation.
• Thus, FER is used as a trade policy instrument. CB needs
to accumulate foreign exchange reserves to maintain its
130
exchange rate constant or fixed.
4.2. Exchange Rate
• Whenever the demand for foreign currencies increases,

central bank supply foreign currencies to maintain the
exchange rate fixed.
• If a country persistently runs balance of payments deficits
and runs out of its foreign exchange reserves, CB has no
option but devalue the currency.
• Flexible or floating exchange rate is a system,

whereby the relative price of currencies or a value a
currency in terms of another currency is determined by
the market or the supply and the demand for foreign
currencies vis-à-vis the local currency. CB imposes no
intervention.
131
4.2. Exchange Rate
• The situation of local currency losing its value in terms of

foreign currency (or an increase in e) is called depreciation.
• RER depreciates if e depreciates (or increases), PW increases
or PD declines. RER appreciates if the reverse happens to e,
PW or PD.
• The process of swelling the value of local currency in terms
of foreign currency in a floating exchange rate system is
called appreciation.
• If there is BoP surplus or foreign currency accumulates, it will
be eliminated by e appreciation.
• If BOP is in deficit, e depreciates, net export improves and
eliminate the deficit.
• Thus, disequilibrium or deficit or surplus in ) is self
correcting, through flexible exchange rate. 132
4.2. Exchange Rate
• If exchange rates are freely exchanged without any type

of CB intervention, the exchange market is called clean
floating exchange rate. In this system, the official
foreign exchange reserve is zero and the BOP is also
zero.
• The market adjusts the sum of the Current Account
Balance (CAB) and Capital Account Balance (CapAB) to
be zero. CAB & CapAB could be non-zero.
• Often there is no clean floating exchange rate, CB
intervenes. The presence of CB intervention within
the floating exchange rate market is called
managed or dirty floating exchange rate.
Example: the Ethiopian foreign exchange system.133
4.2. Exchange Rate
• Purchasing power parity: If domestic and foreign markets are

closely integrated & commodities are traded freely, then the same
good may not be sold for different prices in different countries.
• The law if one price requires that the price of a good (expressed in
a common currency) to be the same across countries if no-trade
barriers. This law is called Purchasing Power Parity (PPP).
• PPP states that if international arbitrage is possible, then a currency

must have the same purchasing power in every country.
• Arbitrage is the process of a simultaneous purchase and sale of the

same asset or good in different markets that ensures the law of
134
one price to hold.
4.3. Current Account and Capital Account
• Overall records of different transactions of a country with the rest of

the world by authorized government agencies (CB) is called balance of
payments.
• BoP has two main accounts: the capital account and the current account.
• Capital Account is a record of purchases and sales of assets, such as
stocks, bonds, and land and bank deposits.
• Paying foreign currencies to acquire local financial assets leads to
capital inflows.
• Investments of locals on financial assets in other countries in foreign
currencies leads to capital outflows.
• If a country’s receipts from the sale of different capital assets exceed
its payments to own foreign assets, the country will have a CaPAB
surplus or positive net capital inflow; otherwise the country will face
CapAB deficit. 135
4.3. Current Account and Capital Account
• Movement of funds into and outside the country is motivated by

asset market.
• Capital inflows if holding domestic money and financial assets

pays a higher return than foreign financial assets or if local interest
rate is higher than foreign interest rate.
• Current Account is a record of trade in goods, services and

transfer payments.
• CAB is in surplus if receipts from trade or value of exports plus

net transfers to foreigners exceed payments made on imports.
Otherwise, it is said to be CAB deficit.
136
4.4. Extension of the Basic IS-LM Model
• GDP in the open economy differs from the closed economy. Exports
(which are injections into the economy, boost PE) and imports
(which are leakages, reduce PE) are added on PE or AD.
• Thus, we have
• Net export (external balance)=GDP-Domestic Absorption (Domestic

Balance)
• The balance between external balance and domestic balance can be

given Fig 4.1.
137
Fig 4.1: The Equilibrium Condition of an Open Economy
Y-(C+I+G), NX(Y) Net domestic spending

curve is positively slopped.
Y-(C+I+G) Net export curve is
negatively sloped. Why? Next
page.
Points to the right of the intersection shows income exceeding

expenditure on domestic goods; the country is net exporter; or trade
account surplus or NX>0. 138
• Recall in Chapter 3: Income side:

Y= C+S+T
• Expenditure side:Y = C+I+G+X-M
• Equilibrium:Y = C+S+T = C+I+G+X-M or

S+T= I+G+X-M
• Private saving and tax revenue finances private investment spending

and government expenditure respectively to have a balanced current
account or NX=0.
139
• Net export = Net Private Saving +Net Government Saving

(X-M) =(S-I) + (T-G)
• Current account deficit implies:
 Because of excess payments (over export receipts) made on
imports, S falls short of financing I and/or T becomes
inadequate to finance G.
 Inability of S to finance I and/or inability of T to finance G
exposes the country into current account deficit.
(X-M) = S+ (T-G)-I or GDS –I, where GDS=S+(T-G)
• If the country is unable to finance investment from its own
sources (GDS-I)<0, it relies on the rest of the world; (X-M)<
or M>X. 140
• I=S+(T-G)-(X-M)
• Private investment is determined by HH saving,
government saving and external balance.
• (a) If (T-G)=0, (X-M), then I is financed by S.
• (b) If (T-G)=0, if I>S, then (X-M)<0, I is partly financed
by borrowing (imports through borrowing).
• (c) If (T-G) =0, if I<S, then (X-M) >0, the country is net
lender.
• (d) If and , the effect on I depends on the
size and direction of government & external balance.
141
If (T-G)<0 and (X-M)<0,

(i) I=S, then government deficit is partly financed by
foreign borrowing.
(ii)(ii) If I<S, then government deficit is partly financed
by HH saving by crowding out private investment.
assume that prices and nominal exchange rate are assumed
constant.
Autonomous imports or expenditure on imports even if Y=0, m is MPI

or dM/dY
142
• Equilibrium level of income:
• Solve for Y: The New IS -Curve
One unit change in r brings the following change in Y or output.
The slope of the IS curve as it appears on the graph:
143
Government spending multiplier:
• The open market government expenditure multiplier is lower than

the closed market government expenditure multipliers or
1/[1-(c1(1-t)+m]<1/[1-c1(1-t)]<1/(1-c1)
• Reason: If G increases, Y increases and part of goes to M; imports are
leakages just like saving; they reduce PE and increases foreign income.
In the long-run, it may increase the demand for our exports and
GDP. In SR, increased import has a contractionary effect on income.
• Note: The multiplier for private investment, exports and autonomous
consumption are the same as government multiplier. 144
• The multiplier for government transfer & Imports:
• Assess the effect of high/low c1, t and m on the multipliers and also the
effect on the change on X, M, G, C0, G, I-bar or R on income.
• Current Account Balance:
• Total change in CAB:
145
• The multiplier for government spending on current account balance:

d[CAB ] m
 <0
dG 1  c1 (1  t )  m
• Why increased government spending deteriorates CAB?
• Increased in G, increases Y and thus M (through mY), given X, then
CAB deteriorates by:
d[CAB ]  
m
dG 
1  c1 (1  t )  m
146
• The multiplier for export on CAB:
• As export increases, income increases by ∆X times x

multiplier; but as income increases; ∆M=m∆Y; thus,
• ∆CAB = ∆X-m∆Y>0, but not as much as ∆X because:
147
4.5. The Mundell-Fleming Model
• Mundell-Fleming Model introduces the Balance of Payment curve in

the IS-LM framework. It assumes that three different scenarios about
capital movement (inflow or outflow) among countries. (a) Capital in
and outflow, (b) imperfect capital inflow and (c) no capital inflow.
• As part of the model: CAB = .
• Capital account balance (CapAB) is a function of interest rate
differential between domestic and foreign interest rates.
• And Balance of payment:
148
• Assume BP =0, interest rate differential equation is given by:
• The slope of BP schedule or curve:
•
• The slope of BP depends on the sensitivity of imports on change
in income (m) and the sensitivity of capital to the change in local
interest rate.
149
• r -vertical axis and Y-horizontal axis, four possibilities for BP

curve:
a. ß=0 capital inflow does not respond to interest rate, slope
of BP goes to infinity, BP is vertical. (4.2a)
b. If ß is small; the BP curve is steep and there is less capital
mobility (4.2b).
c. If ß is large; capital mobility is very sensitive to interest rate
differential; BP slope is low;(4.2c) .
d. ß infinity, perfect capital mobility, BP is horizontal, (4.2d).
150
The system of equations for IS-LM-BP:
151
4.5.2. The Mundell-Fleming Model: Perfect Capital Mobility
Assumptions:
(i) Similar taxes across countries;
(ii) Foreign asset holders never face political risks such as
nationalization, restrictions on transfer of assets, default risk by
foreign governments, etc).
(iii) Capital flows without restrictions and perfectly.
(iv) Low or no transaction costs;
(v) Quick decisions without delays with unlimited amount.
• The model gives different equilibrium outcomes for any FP or MP

action depending on the nature of the exchange rate regime:
fixed exchange rate and floating exchange rate.
152
4.5.2. The Mundell-Fleming Model: Perfect Capital
Mobility – Fixed Exchange Rate Regime-MP
• MP Action: A slight difference in interest rate between local and

other countries provokes infinite capital inflows.
• MP has no effect under fixed exchange rate.
• Example: consider a country that wants to raise interest rate by
tightening MP or reduces money supply; a shift from LM1 to LM2 and
r increases [Fig. 4.3].
• Asset holders worldwide shift their wealth to the domestic
economy.
• Infinity capital inflow leads to CaPAB and BP surplus.
• As foreigners try to buy domestic assets, exchange rate tends to
appreciate. CB intervenes or purchases foreign currencies in terms
of domestic money by pumping money supply. LM shifts towards
LM3 and r declines. 153
• A monetary expansion at point E’ tends to causes the local

currency to lose its value or devalued.
• But, as r declines, capital outflows; foreign reserves and BP
surplus depletes;
• Demand for foreign currency increases as against local currency,
to make the exchange rate fixed, CB sells foreign currencies and
buy domestic currencies until the LM curve goes back to the
initial position.
• One can try the effect of expansionary MP.
154
Figure 4.3: The Effect of MP tightening under Fixed Exchange Rate

and Perfect Capital Mobility
LM2
r LM1
LM3
E
BP = 0
E’
IS
Y
155
Mobility – Fixed Exchange Rate Regime-FP
FP Action: FP under fixed exchange rates is effective.

• Assume expansionary FP, IS curve shifts right (IS1 to IS2: Fig 4.4.).
• r & Y increases.
• Capital inflow increases; CaPAB and BP will be in surplus;
• A tendency for currency appreciation.
• CB expands money supply to buy foreign currency & maintain
exchange rate fixed.
• LM curve shifts from LM1 to LM2.
• A new equilibrium: original rd = rf as sufficient money stock is
pumped into the economy.
• Higher Y but r remains as it is; no private investment crowding out;
• Output changes with as for instance G changes times the simple
Kenyesian multiplier of the type we had before with no role for r to
156
affect.
Mobility – Fixed Exchange Rate Regime-FP
Figure 4.4: The Effect of Fiscal Policy Expansion
r LM1 LM2
rd  r f LM
IS2
IS1
Y
157
Mobility under Flexible Exchange Rates
• Assume that domestic prices are fixed. CB does not intervene in the
foreign exchange market.
• Demand and the supply of foreign exchange balance by flexibility of
exchange rate.
• If there is CAB deficit, it will be financed by private capital inflows.
CAB is counter balanced by capital outflows.
• Market forces adjust exchange rates to ensure the sum of CAB &
CapAB or BP to be zero.
• In perfect capital mobility assumption, BP is always zero at id = if. In any
other interest rate, BP is not zero, short-lived & adjusts automatically.
• Under flexible exchange rate, there is a link between BP and the
money supply.
158
Mobility under Flexible Exchange Rates
Figure 4.5: The Effect of Exchange Rates on AD
• If rd < rf, capital outflows & leads to exchange rate depreciation;

increases competiveness in the global market; increases net export &
shifts IS to the right.
• If id >if, capital inflows; leads to currency appreciation, loss of global
competitiveness & decline in exports & a shift in IS to the left. 159

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Macroeconomics

Department of Economics, College of

How can an economy

Module Objectives: To show students

How to present and analyze the interrelationship

How government uses macroeconomic policy

How can academic learning and professional practice

Evolution & Recent

GDP, GNP, NI, NNP, PCI, DI,

 Final Examination: 50%

 Describes and explains the aggregate behavior and processes of

 Measures and explains overall consequences of the decisions

 Deals with structure, behavior, performance and growth of the

 Analyzes the underlying determinants of the aggregate trends in

• Output (GDP/GNP) and its growth

 Macroeconomics deals with issues that affect society’s well-being such

 Macroeconomics research aims to understand how the

 Uninterrupted controversies among economists lead to alternative

 As Blanchard (1997a) points out macroeconomics:

 Economists may disagree on theories, empirical evidence and policy

1. Trade-offs: These goals may not be mutually compatible.

1. Trade-offs: Goals may not be mutually compatible. For instance:

Macroeconomists use different policies such as monetary and fiscal

 MP uses policy instruments (interest rate, reserve requirements,

 Contractionary Policy: Reduced money supply (MP) and declined

 Example: If tax increases (contractionary measure) government

As money supply increases; unemployment decreases and

P* MP is used to make advantage of money

3 Main arguments by the new classical school

(b). Keynesian-style macro-econometric models do not accurately

(c).Remove discretionary government powers to improve

 The school argues:

2.2. GDP: Definition and Measurement

 Thus, there are 3 approaches of measuring GDP: Product

B. Expenditure Approach (EA): Total expenditure on domestically –

 Investment (I): Includes

Income Approach (IA): Total income earned by domestically –

With certain adjustments GDP is calculated as follows:

 GDP at current market prices:

Apple 40 150 6000 42 170 7140

Quant Price Total Quan Price Value(Bi

 Apparently, instead of a growth in GDP by 11%, we have

 Inflation is a certain percentage increase in the overall level of

The Consumer Price Index (CPI):

 Goods and services are given weights when deflators are

• GDP Deflator is calculated by National Planning Commission

 Growth in real GDP may not correctly measure people’s

 GDP and GDP growth rates are crude indicators of change in

where Pt is general price index (either CPI or

4. Relative price distortions: If prices change at different times, they lead

6. Distorted real depreciation expenses: If fixed assets are not re-valued

 This may in turn create uncertainties to private investors and the

(3) Y-T = C+S

• Given constant C0, c1 and T, C0/(Y-T) declines as Y increases.

 The product market equilibrium is designated by the IS curve; where I and S

 Money market equilibrium is captured by the LM curve. L and M stand for

 Disequilibrium occurs when planned expenditure and actual expenditure are

 Actual expenditure (AE) is the amount that households, firms and

 Planned expenditure (PE) is the amount that households, firms and

 PE is given by Equation (9) or displayed by Figure 3.2. PE increases less

Figure 3.2: Planned Expenditure as a Function of Income

Fig 3.3: The Keynesian Cross