UNIVERSITY OF NAIROBI

SCHOOL OF ECONOMICS

XET 302: FURTHER TOPICS IN MACROECONOMICS

COURSE OUTLINE

COURSE OBJECTIVES

This course is structured to meet the needs of intermediate macroeconomics. Students are
expected to have satisfactory skills in mathematical economics (see Chiang A.C, Fundamental
Methods of Mathematical Economics).

The course is meant to expose students to major macroeconomic theories and related
applications, mainly in developing economies. The end result of this course should give students
the ability to evaluate and analyze the various macroeconomic models in the context of their
suitability as instruments for appropriate economic policy development and decision making.

The model of assessment of this course will be anchored on a continuous assessment test and a
final examination at the end of the semester. Continuous assessment shall carry a total of 30
marks while the final exam shall carry 70 marks.

COURSE TEXTS

1. Dornbusch, R, Fisher, S. and Startz, R. 1998, Macroeconomic, Seventh Edition,

Irwin/Mc-Graw Hill.
2. Branson, W.H. Macroeconomic Theory and Policy, Harper and Row Publishers. 2 nd and
3rd Edition(s).
3. World Bank Institute and African Economic Research Consortium: Economic Policy
analysis and Management. CD-ROM, to use click on LOGIN 1.
4. Harvard Institute for International Development, Open Economy Macroeconomic
Foundations for Policy Managers, 1996.

SNOPIS OF TOPICS TO BE COVERED

1. INTRODUCTION AND MEASUREMENT OF ECONOMIC ACTIVITY

 Basic concepts and Methodology
 National Income and Product accounts
 Social and Inter-Industry Accounting
2. DETERMINATION OF NATIONAL INCOME: EQUILIBRIUM INCOME AND
MULTIPLIER THEORY.
 The Saving-Investment Balance

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  The Tax, Consumption, and Saving Functions
 Determination of Equilibrium Income
 The multiplier theory
3. AGGREGATE DEMAND AND SUPPLY ANALYSIS
 Aggregate Demand
 Aggregate Supply: Short and Long Run Aggregate Supply
 Equilibrium in Aggregate Supply and Demand Analysis
4. OPEN ECONOMY MACROECONOMICS
 The Current Account Balance Problem
 Models of the Small Open Economy (Keynesian Model for an Open Economy,
the Price Elasticity Approach, the Absorption approach, and the Australian Model
based on Swan Diagrams)
 Balance of Payment Policy Implications
5. MONEY AND MONETARY POLICY
 The meaning of money
 Money supply
 Money demand
 Money in the Australian model context
6. FISCAL BALANCES AND PUBLIC SOLVENCY
 Concepts of budget deficits
 Deficit financing and sustainability of budget deficits
 Approaches to fiscal policy analysis
7. FINANCIAL PROGRAMMING
 The Polak (1957, IMF) Model
 Response to Macroeconomic Shocks and Stabilization (Refer to CD-ROM)
8. INFLATION, UNEMPLOYMENT AND EXPECTATIONS
 Inflation
 Unemployment
 Short run and long run Phillips Curves
 Adaptive rationale expectations
 Anti-inflation policy
9. MODELS OF LONG RUN GROWTH
 Introduction to economic growth and measurement issues
 Analytical tools and models of growth (endogenous and exogenous growth
models)
10. FRONTIERS IN MACROECONOMIC THEORY AND APPLICATIONS
(OPTIONAL)

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OUTPUT AND AGGGATE DEMAND

Note: the four main macroeconomic accounts includes: National System of Account or Real
Sector Account, Fiscal Account, Monetary account, and External account or BOP)

System of National Accounts:

 The system of national account framework provides a comprehensive accounting method

of national economy.
 Countries develop their national account framework to examine economic performance

MAIN ACCOUNTS
The production account
The primary distribution of income a/c
The transfer(s) a/c
The household expenditure account
Domestic financial transactions a/c
Changes in assets value
The BOP- external account

Economic Agent: The five relevant groups of economic agents include:

 Household , enterprise, financial intermediaries, the government and nonresident

THE 5 INSTITUTIONAL SECTORS IDENTIFIED IN THE 2008 SNA:

 Financial corporations, non-financial corporation, general government, households, and

non-profit institutions serving households (NPISHs):
 Households supply land, labor, and capital to producers in factor markets and
demand goods and services in good markets
HHs may also work as producers by forming unincorporated enterprises.
Decide on how much to consume, save and invest based on the prevailing economic
condition.
 Non-financial corporations are mainly responsible to produce market goods or non
financial services.
 The financial sector provides financial intermediation services for the economy.

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 Financial corporations are mainly engaged in providing financial services including
insurance and pension funding services, to other institutional units.
 The general government’s economic role involves: creating an effective
regulatory and legal framework; providing certain public goods, such as
education, infrastructure, national security, and a social safety net; and levying
taxes to finance government expenditures
 Nonprofit institution serving households (NPISHs) consist of non-market NPIs
that are not controlled by gov’t.
 The rest of the world sector groups together all of an economy’s transactions with
nonresidents.

THE MAIN AGGREGATES.

The undermentioned concepts play a vital role in macroeconomic analysis:

 OUTPUT is the value of all goods and services produced in an economy.

This has a problem of double counting. E.g. The possibility of double counting of a
product. E.g. the value of wheat. First used to produce bread, and again as the value of
bread output.
 VALUE ADDED (VA) is the value of output less the value of intermediate consumption.
It represents the contribution of labor and capital to the production process. It is not faced
double accounting problem.
 GROSS DOMESTIC PRODUCT (GDP) is the sum of the gross value added of all
resident sectors engaged in production, plus any taxes, and less any subsidies on products
not included in the value of their output.
 CONSUMPTION includes: intermediate and final consumption
Intermediate consumption refers to value of goods and services consumed as inputs
into production excluding fixed assets whose consumption is recorded as fixed capital.

Final consumption refers to goods/services, imported and domestically produced items

used by HHs, NPISHs, and the general government sectors
 GROSS INVESTMENT OR GROSS CAPITAL FORMATION refers to the total
value of gross fixed capital formation, change in inventories and acquisitions less
disposals of valuables.

Also known to be output produced during the current year but not used for present
consumption

Gross fixed capital information in macroeconomic sense includes building of

machinery, factories, and houses.

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 Bond or stock purchase is not an investment, because it reflects the transfer of financial
assets among different economic agents

Consumption of fixed capital is used to differentiate net from gross investment.

Since capital stock wears out over time, the cost of replacing the capital used up during a
period is subtracted from gross investment to derive net investment.

Net investment is more appropriate measure of the addition to productive capacity than
gross investment.
 ABSORPTION (A) OR AGGREGATE DOMESTIC DEMAND refers to the sum of
total final consumption (C) and gross investment (I):
A=C+I
 NET EXPORT is the value of exports of goods and services less the value of imports of
goods and services.
This measures the impact of foreign trade on aggregate demand

MEASUREMENTS OF GDP.
There are 3 basic approaches used to measure macroeconomic aggregate (GDP).

Production Approach
The income approach
Expenditure approach

Note that all 3 approaches yield similar results.

Production Approach (GDP) is equivalent to the sum of value added across all sectors
in the economy.
GDP= ∑ VA + (taxes less subsides) on products

Income Approach is equal to the sum of incomes generated by resident producers

GDP= W+OS+TSP
Where: W= compensation of employees (includes wages and salaries in cash or kind, and
social insurance contributions payable by employers)
OS= gross operating surplus of enterprises (include profits, rents, interest, and
depreciation)
TSP= taxes less subsidies on production and imports

Expenditure Approach, GDP is equivalent to the sum of its final uses:

GDP=C+I+(X-M)

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 Where: C= final consumption of the government and private sectors (includes HHs and
non-profit institutions serving HHs)
I= gross investment; X= exports of goods and services; and M= imports of goods and
services

PROBLEMS WITH GDP MEASUREMENT:

 Volunteer and charitable services or subsistence farming they are inaccurately
measured because they may not be traded in the market.
Improvements in the quality of goods may not be adequately reflected in the national
accounts, thus production growth may be underreported.
 Black market or underground economy:
Economic agents do conceal transactions to avoid taxes, to evade laws or government
regulations, or to hide illegal activities such as drug trafficking and smuggling.
 Statistical discrepancy.
SD= GDP-(C+I+X+M)
I.e. SD=GDP from production approach- GDP from expenditure approach
These inaccuracies often reflect untrue values of growth rate.

These activities are not part of the true measurement of growth rate

OTHER STANDARD AGGREGATES

System of National Account further accounts of two additional aggregates:

 Gross national disposable income (GNI)

GNI=GDP+Yf
GDP often measures output produced by resident, and ignores income received from or
paid to nonresidents.
In contrast, gross national income (GNI) captures net factor income from abroad (Yf)
I.e. GNI is equal to GDP plus factor incomes receivable from nonresidents less factor
income payable to nonresidents.

TYPES OF FACTOR INCOME

1) Capital income, this includes investment income in the form of dividends on direct
investment and interest on external borrowing or lending
2) Labor income of migrant and seasonal workers
3) Service income on land, building rentals, and royalties

NOTE:

GDP is a concept of both production and income, while GNI only concerns income.

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 The previous version of SNA, GNI at market prices was called gross national product
(GNP)

 GROSS NATIONAL DISPOSABLE INCOME (GNDI)

This includes the total income available to residents for either final consumption or
saving. It is obtained by adding net current transfers received from abroad (TRf) to GNI:
GNDI=GNI+TRf
Net current transfers from abroad are equal to current transfers received from
nonresidents.

These are unrelated to income earned with factors of production, minus such transfers
remitted abroad.

The transfers could be private or public:

Private transfers include mostly workers’ remittances
Public transfers include government grant.

 GROSS NATIONAL SAVINGS

This is defined as the difference between GNDI and final consumption (C):
S= GNDI-C

ACCOUNTING RELATIONSHIPS

The national income account focuses on two important relationships that under pins on
macroeconomic analysis. This is derived from linking GDP with expenditure.

INCOME, ABSORPTION, AND THE EXTERNAL CURRENT ACCOUNT BALANCE

CAB= GNDI-A

CAB=GNDI<A, implies current account deficit

CAB= GNDI>A, implies current account surplus

Where; CAB – current account balance

GNDI – gross national disposable income

A- Domestic expenditure or absorption component

 The identity shows the interpretation of absorption approach linking to the CAB.
 It holds that current account deficit happens when an economy expenditure or absorption
over whelms its production capacity or GNDI<A
 Similarly, Current account deficit mirrors an excess of absorption over income

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 HOW TO MANAGE CAB Deficit?
a) Increase income and reduce absorption
b) Increase output (i.e. income) in the short term which demands unused production
capacity
c) In the medium term, increased production capacity through investment, labor force
participation, and adequate structural policies to improve gains in productivity.
d) Domestic absorption can be reduced by contracting final consumption (C) and/or
gross investment (I)

SAVING, INVESTMENT, AND THE EXTERNAL CURRENT ACCOUNT BALANCE.

National account aggregates and the external current account balance can be linked through
saving-investment balance in an economy.

CAB= S-I

CAB= S<I, implies CAB Deficit

CAB=S>I, implies CAB surplus

 In closed economy, ex post aggregate saving is necessarily equal to aggregate investment

 In an opened economy, the current account balance is the difference between aggregate
savings and invests.

HOW TO ADDRESS CAB DEFICIT

 In principle, CAB deficit can be minimized by increasing savings over investment

AGGREGATE INCOME AND DEMAND, AND THE EXTERNAL CURRENT

ACCOUNT BALANCE IDENTITY
Gross Domestic Product :

GDP = C+I+(X-M)…………………………………………………………………… (1)

A = C+I

GDP = A+(X-M)

Gross National Income:

GNI = GDP+Yf ……………………………………………………………………………………………………………..(2)

GNI = C+I+(X-M)+Yf = A+(X-M)+Yf

Gross National Disposable Income:

GNDI = GNI+TRf ………………………………………………………………(3)

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 = C+I+(X-M)+ Yf+ TRf
GNDI= C+I+(X-M)+ Yf+ TRf

GNDI = A+X-M+ Yf+ TRf,

GNDI-A= X-M+ Yf+ TRf , note: X-M+ Yf+ TRf =CAB

GNDI-A= CAB, hence GNDI<A, implies deficit CAB and GNDI>A , implies surplus
CAB
For savings: Recall the extended Eq 3 :

GNDI = C+I+(X-M)+Yf + TRf

GNDI-C= S, by definition

S= I+(X-M)+Yf + TRf…………………………………………………………….(5)

S-I=(X-M)+Yf + TRf, note: (X-M)+Yf + TRf = CAB, hence

S-I=CAB

Therefore; S<I, CAB deficit; S>I, implies CAB Surplus

Where:
A= Domestic absorption (A+C) or domestic demand
X= Exports of goods and nonfactor services
M=Imports of goods and nonfactor services
Yf=Net primary income from abroad
TRf= Net secondary income from abroad
C=Final consumption
I=Gross investment (including changes in inventories)
S=Gross national savings
CAB=Current account balance

NOMINAL AND REAL GDP

 Nominal GDP measures the value of output for a given year in the prices of that year.
 Changes over time in nominal GDP reflect changes in prices and volumes.
Note:
 To obtain the changes in volumes and real GDP, it is suggested to work on a detailed
level of nominal GDP. One can deflate each component by a strictly appropriate price
index.

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  In a case price deflation is not suitable, other approaches like revaluation and
extrapolation are normally applied.
 The implicit GDP deflator is an index that measures the average price level of an
economy’s output relative to the base year.
 In this case, the index has a value of 100 in the base year.
 Thus, the percentage change in the GDP deflator measures the rate of price increases for
all goods and services in the economy.

Real GDP refers to as “GDP at constant prices” in the SNA, measure the value of an economy’s
output using the prices of a fixed base year.

Real GDP is not an ideal measuring index for real income or living standards; therefore, GDP is
most commonly used to measure real income.

NOMINAL GDP, Real GDP, and the implicit price deflator are linked by the following
function:

GDP at current prices: Yt = Qt x Pt

Real GDP, at constant prices of the base year t=0: yt = Qt x Po

Pt
GDP Deflator: Pt = , note: for a given base year price, the change in the deflator mustbe
Po
identical to the change in prices

Yt Qt XPt Pt Yt
Thus: = = =P t → y t =
yt Qt X Po Po Pt

Nominal GDP
i.e.: Real GDP= ( ) x100
GDP deflator

For rate of growth:

v p
[1+ ¿=¿] x [1+ ¿
100 100

Where: v= the rate of growth of nominal GDP (%); q= the rate of real GDP growth (%); and p=
the rate of inflation, as measured by rate if growth of the GDP deflator (%)

CONTRIBUTIONS TO GROWTH

GDPt =C t + I t +Gt + X t −M t=∆ GDPt ≡GDP t−GDP t−t ¿

¿

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 ∆ GDPt ∆ Ct ∆ It ∆ Gt ∆( X t −M t )
= + + + =
GDPt−1 GDPt −1 GDP t−1 GDPt −1 GDPt −1

∆ GDPt ∆ C t C t ∆ I t I t −1 ∆ Gt Gt−1 ∆( X t −M t )
= + + +
GDPt−1 Ct −1 GDP t−1 I t−1 GDPt−1 Gt −1 GDP t−1 ( X −M t −1)
( X ¿ ¿ t−1−M t −1 ) t −1 =¿ ¿
GDPt −1

∆ GDPt ∆ C t C ∆ It I ∆ Gt G ∆(X t−M t ) X − M

= θt −1 + θ t−1 + θ + θ
GDPt−1 Ct −1 GDPt −1 GDP t−1 t−1 GDP t−1 t−1

It implies that the contribution of a GDP component to GDP growth= growth rate of that
component between periods t and t -1 over the share of that component in real GDP in
period t-1

CIRCULAR FLOW OF INCOME

HOUSEHOLD

INJECTIONS: LEAKAGES:
I+G+X S+T+M

FACTOR OF
CONSUMER GOODS & FACTOR OF INCOME
EXPENDITUR SERVICES PRODUCTION
E

FIRMS

 Circular flow of income is a good instrument to measure an economy of a nation.

 Shows the movement of income throughout an economy
 Household provides the four factors of production: land, labor, capital, and
entrepreneur
 Household earns income from the factors of production provided:

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 Reward for labor is wages and salaries
Reward for land is rent
Reward for entrepreneur is profit
Reward for capital is interest

 Firms produce goods and services and equally sell to households, and households spend
their income on goods and services.
 The injections and leakages account for Government and International sectors,
respectively.

FACTORS OF INCOME

ASUMPTION -I

 We assume that total income of HHs is spent on the goods and services
This is not true. Not all income is spent in an economy.
Part of the income is saved (S)
It is taxed (T)
Income is spent on imported goods and services and not only domestic (M)

i.e S+T+M are leakages/withdrawals from the circular flow.

ASSUMPTION – II
We assume that all expenditure incurs in an economy, is generated by HHs
(consumption)
Contrary, there are other ways expenditure does occur
 Firms can spend on investment (I)
 Government also spends in the production of goods and services (G)
 Nonresidents or foreigners do buy goods and service from our economy for exports (X)

Thus, I+G+X, implies injections into the circular flow of model

i.e refer to the ways and means money can enter into our economy outside consumer
expenditure (I+G+X)

These explanations capture the four components or agents of the circular flow of the
economy.

Two conclusions could be drawn from the diagram:

1) Evaluation of Economic growth

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 a) I+G+X > S+T+M = when injection is greater than leakages, i.e more money into the
economy, there is an economic growth.
b) I+G+X < S+T+M = Decrease in economic growth i.e injections less than leakages
c) I+G+X = S+T+M = here, injections and leakages are balanced (this is called
macroeconomic equilibrium).

2) GDP MEASUREMENT
This measures economic growth. We can measure GDP:
1) Goods and services; 2) factor of income; and 3) consumer expenditure.

This will provide us an index to examine whether there is a growth or not on yearly basis.

 Output Method: calculate GDP by summing all values of goods and services produced
in a given year in an economy.

 INCOME METHOD: it involves adding all factor of income in an economy in a given

year.
i.e wages and salaries plus profit plus interest plus rents (these are obtained from the four
factors of production.

 EXPENDITURE METHOD:
Add all total expenditure on goods and services in an economy per year.
i.e consumer expenditure: C+I+G+NX.

ALL THE THREE APPROACHES ARE EQUAL

i.e OUTPUT=INCOME=EXPENDITURE.

Intuitively, imagine you visit a mall to buy a bag:

Your SPENDING is going to be equal to the value of the OUTPUT (i.e the price of the bag) and
the price is equal to the INCOME of the shop owner.

This implies: OUTPUT=INCOME=EXPENDITURE

NOTE:

The 3 components are always going to be equal to each other, at any level of transactions.

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