Chapter 1

The State of Macroeconomics – Introduction

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 1.1. What macroeconomics is about?
Economics is the study of how we can best increase a country’s wealth with the
resources that we have available to us. It is the study of how society manages
its Scarce Resources to produce valuable commodities & distribute them
among d/t people.
Fundamental Questions of Economic Organizations
Three Questions:-
1.What Commodity are Produced and in What Quantities?
• How much of goods & service the society demanded
2. How are goods Produced?:
• Who will do Production, With what Resources, with what Production
Techniques?
3. For whom are Goods Produced?
• Who gets to eat the fruit of economic activities
Fundamental Ways of Organizing an Economy, We do have four ways:
1. A Market Economy:- Individuals & Private Firms make the major
decisions about Production & Consumption ( E.g. US), But it is not
absolutely free there are some government role in it.
That is, the role of the government is limited to the most essential
Functions. For example
• Most decisions in the US are made in the Market Place(DD and SS) .
But Gov’t plays an important role in overseeing THE FUNCTION OF
THE MARKET;
• Gov’t pass Laws that regulate Economic Life, produce Educational &
Policy services & control Pollution.
2. Command Economy
 Government makes all decisions regarding production, prices, wages, interest
rates, and income distribution.
3. Mixed Economy
 Most economic decisions are made by the private sector, but the role of the
government is significant. Government spending and taxes are relatively high.
4. Laissez-fair Economy
 Extreme cases of Market economy- Gov’t keeps its hands off economic decisions.
(Practically- No contemporary Nation in the World)
NB.
SOCIALISM: You have two cows. State takes one and gives it to someone else.
COMMUNISM: You have two cows. State takes both of them and gives you milk.
CAPITALISM: You have two cows. You sell one and buy a bull.
 SCOPE OF ECONOMICS
Microeconomics examines how individual
• units, whether they be consumers or firms, decide how to
allocate resources and whether those decisions are desirable
Macroeconomics studies the economy as a
• whole; it looks at the aggregate outcomes of
• all the decisions that consumers, firms, and the government
make in an economy
• Macroeconomics is about aggregate variables such as the
overall levels of output, consumption, employment and
prices- and how they move overtime and between countries
• was born out of the Great Depression in the 1930s due to the
work of John Maynard Keynes, a British economist. It was the
result of people desperately wanting to know what caused
the Depression and how it could be ended.
 Reasons People To Study Macroeconomics
A. Curiosity: people want to figure out how what we observe
happens and there are two major questions people seek
answers for:
i) What causes the economy to grow over time?
ii) What causes the economy (output produced, the number of
people unemployed, and the rate of inflation) to experience
fluctuations?
B. To Become Educated :the development of character or
mental powers which is very different from being trained
which is to teach a person a specified skill by practice.
C. Employment: this can be gained directly through the
education and knowledge received at university
How Do We Study Macroeconomics?
Economics is a social science which means it involves studying society to
understand why people do what they do, but it tries to approach it
”scientifically". So there is a fundamental tool to be used that is
“Economic Models”.
• are theories that summarises, often in mathematical terms, relationships
among economic variables or
• a generalisation based on a few principles that enables us to understand
and predict the economic choices made by people
In developing a model we use two types of variables:
• Exogenous Variables: are determined outside of the model. So that they
do not capture the decisions made by people in which we are primarily
interested in learning about. Assuming that some variables are exogenous
helps to simplify matters by not having everything being decided at once. 
• Endogenous Variables: are determined within the model. And do capture
the decisions made by people in which we are primarily interested in
learning about.
In building economic models economists tend to assume two general
principles about how people and the societies in which they exist behave
in trying to understand the decisions made by people:
A. Optimisation Principle — people are motivated by self-
interest, or equivalently, that people try and do the best
they can.
B. Equilibrium Principle — that people’s actions tend to
become consistent with each other. In the limit the
economic forces are so balanced that there is no tendency
for people’s behaviour to change. Note that this doesn’t
mean that the world is static or unchanging but that if
people’s actions are inconsistent with each other that there
are economic forces that try and make them consistent.
A good model is one that:
1. Helps us to understand better what we observe.
2. Can be used to predict the macro variables of interest in the
future.
 Techniques for Developing Aggregate Models
• There are four basic methods used to develop macroeconomic models allowing for the
fact that we are dealing with whole economics instead of individual markets:
1. The “Macro Relationship” Paradigm
This just looks at the relationships between macro variables and examines if there are
systematic relationships and patterns between them.
• Uses micro economic theory to guide in exploring and modelling such relationships and
patterns.
2. The “Representative Agent” Paradigm
Everyone is the same so we can model the economy as though it behaves like one person,
or firm. This is really just a special case of 1), where the guidance of micro theory is
made explicit.
3. The “Small Number of Differences” Paradigm
Allow people and firms to be different, but only have a very small number of different
agents i.e. two types such as young and old, or rich and poor. This is an extension of 1),
and the hope is that it allows for the major distributional influences.
4. The “Large Number of Differences” Paradigm
Allow lots of differences, but only in very special ways. Typically this means that no agent
can have any measurable effect on economic activity by themselves. That is, there are
few individuals that are so rich (like Bill Gates) that can significantly influence the
economy. This is an extension of 3) with some restrictive assumptions imposed to make
it workable.
 1.2. Macroeconomics Goals & Instruments
Macroeconomics studies the working of an
economy in aggregation or as a whole. And it
aimed at how;
 To achieve high economic growth
 To reduce unemployment
 To attain stable prices
 To reduce budget deficit and balance of
payment (BoP) deficit
 To ensure fair distribution of income

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 Macroeconomic policy Instruments
Policy measures are geared at achieving moderate inflation rate, keeping
unemployment rate low, balancing foreign trade, stabilizing exchange and
interest rates, etc and in general attaining stable and well-functioning
macroeconomic environment
1.Monetary policy
• policy regarding control of money supply and the management of credit
(lending rates and interest rates)
• often administered by a central bank (national bank).
• important measure for adjusting aggregate demand to control inflation.
• a highly flexible stabilization policy tool.
 Recession (output falls with a fall in aggregate demand), monetary policy
aims at increasing demand and hence production as well as employment will
follow the same pattern of demand.
 Boom(demand exceeds production -> inflation), monetary policy instruments
are utilized that could offset the condition and achieve price stability by
counter cyclical action upon money supply

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 2. Fiscal policy

involves the use of government spending, taxation and borrowing. It

influences
A. the pattern of economic activity and
B. the level and growth of aggregate demand, output and employment.
• changes in fiscal policy affect both aggregate demand (AD) and aggregate
supply (AS).
• Mostly used to promote stable and sustainable growth while pursuing its
income redistribution effect to reduce poverty
• plays an important role in influencing the behavior of the economy as
monetary policy does.
• can have both short and long term influences.
• Traditionally fiscal policy has been seen as an instrument of demand
management (used to help smooth out some of the volatility of real national
output particularly when the economy has experienced an external shock.).
• have a widespread effect on the everyday decisions and behaviour of
individual households and businesses (achieve internal balance, by adjusting
aggregate demand to available supply).
• also promotes external balance by ensuring sustainable current account
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balance and by reducing risk of external crisis.
 Major functions of fiscal policy
Allocation:
• Funds allocation depends upon the collection of taxes and the government
using that revenue for specific purposes.
• The national budget determines how funds are allocated (a specific amount of
funds is set aside for purposes specifically laid out by the government).
• The budget allocation is done on the basis of aggregated development
objectives such as recurrent vs capital expenditures or sectoral allocation
(economic and social developments).
Distribution:
• Is implemented mainly through progressive taxation and targeted budget
subsidy.
• Virtually allocation determines how much will be set aside and for what
purpose
• The distribution function of fiscal policy is to determine more specifically how
those funds will be distributed throughout each segment of the economy.
• For instance, the government might apportion a share of its budget toward
social welfare programs, such as food security and asset building for the most
vulnerable and disadvantaged in society. 13
• or allocate for low-cost housing construction and mass transportation.
Stabilization:
• another important function of fiscal policy in that the purpose of
budgeting is to provide stable economic growth.
• Government expenditure needs particularly in developing countries
such as Ethiopia are unlimited. But its source of financing is limited.
• Thus without some restraints on spending or limiting the level of
expenditure with available financial resources the economic growth
of the nation could become unstable, creating imbalances in external
sector as well as resulting in high prices.
Development:
• True economic growth occurs when various projects are financed and
carried out using budgetary finance.
• This stems from the belief that the private sector cannot grow the
economy by itself.
• Instead, government input and influence are needed. The
government is responsible for providing public goods, reduce
externalities and correct market distortions in order to pave the way
for private sector. 14
 1.3. Macroeconomic Thoughts
• This charts the development of economic thinking about the
various economic problems of coping with scarcity through ages.
• Macroeconomic thought (thinking) has evolved considerably
over time.
• In the following sections we will try to discuss the main schools
of macroeconomic thought
A. Classical Macroeconomic Thought
Is really the start of economics
Did not have a macroeconomic theory as such, but their ideas could
be interpreted in a macroeconomic framework
Attacked and successfully refuted the mercantilist doctrine.
Influential classical economists included:David Hume (1711-1776),
Adam Smith (1723-1790), David Ricardo (1772-1823), John Stuart
Mill (1806-1873), Knut Wicksell (1851-1926), Irving Fisher (1867-
1947) etc.
Basic tenets of the classical school
1.The economy is inherently stable/full employment since prices and wages are fully
flexible.
• no need for government intervention
2. All economic agents (firms and households) are rational and aim to maximize
their profits or utility & absence of money illusion.
• money is super neutral [changes in nominal variables (like change in money
supply) will not affect the real variables instead affect only nominal variables like
prices.
3. All markets are perfectly competitive.
• agents decide how much to buy and sell on the basis of a given set of prices
which are perfectly flexible.
4. All agents have perfect knowledge of market conditions and prices before
engaging in trade.
• no economic agent will cheat any other economic agent as a result of perfect
information or absence of information imperfection or information asymmetry.
5. Trade only takes place when market-clearing prices have been established in all
markets, this being ensured by a fictional Walrasian auctioneer whose presence
prevents false trading. According to this principle, in all markets transaction will
take place when equilibrium price is set after negotiations (via fictional
auctioneer).
6. Economic agents have stable expectations.
 B. Keynesian Macroeconomic Thought
• Keynesians replaced the Classical school by the 1930s great
depression since it couldn't solve the 25% unemployment for many
years
Basic Tenets Of The Keynesian School
1. The Economy is inherently Unstable and Is Subject to Erratic Shock
“animal spirits” in investment plans could produce sudden and large
changes in AD and output.
there is always the possibility that an economy may get “stuck”
producing less than full employment level of output, like Great
Depression .
2. The Economy Can Take a Long Time to Return to Being Close To Full
Equilibrium after Being Subjected To a Shock
The economy is not rapidly self-equilibrating and could have high
unemployment and low output for long spells (i.e. because the
effective demand curve was different from the notional demand
curve).
3. Need for Government Intervention
given 1. and 2. is that there are times when government intervention may be
required. Furthermore, given the animal spirits nature of investment plans,
governments should always be watchful and ready to “fine-tune” when
necessary.
4. AD Is the Predominant Determinant of Output and Employment, and AD Can
Be Altered By the Authorities
The fall in investment demand and the demand for exports was used as evidence
for this claim. Government policies can affect aggregate demand and return an
economy to full-employment.
5. Fiscal Policy Is Preferred To Monetary Policy in Carrying Out Stabilization
Policies
Monetary policy takes too long & have a weak effect but fiscal policies are
immediate and strong.
6. Information is The Key
Keynesian theories put the spotlight on the key facet of the working of markets,
that the price system acts to efficiently transmit all the necessary information
to market participants so as to co-ordinate all of their plans. If prices are not
allowed to change to carry new information, or if people are not capable of
seeing all of the relevant new information, then the market system may not
work well.
 C. Neo-classical Macroeconomics
1870 – 1936, basically it is not different from the classical school. The main distinction
is the tool of analysis, such as the marginal analysis( The only different and
contribution that can be mentioned of this school of thought was the noble idea
“absolute and comparative advantage” of nations in international trade.
Principles and Assumptions
a)Theoretical
i)Behavioral assumptions atomistic rational actor, maximizing utility on the basis of
defined preferences which are complete and transitive or actors with consistent
revealed choice behavior
ii)Market assumptions (Competitive markets):
Large number of buyers and sellers, Homogeneity of products, Absence of transaction
costs, Perfect information, Free entry and free exit, Market force (Demand and
supply) override other factors
b) Methodological assumption
Marginal analysis
Partial equilibrium analysis
• Alfred Marshall is well known in this school.