Macroeconomics I (AgEc222)

3 credit hrs. (5 ECTS)

Course Outline
1. Introduction to Macroeconomics
2. National Income Accounting
3. Economic Performance and Business Cycle
4. Aggregate Demand and Aggregate Supply Analysis
5. Macroeconomic Problems
6. Macroeconomic Policies

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 1. INTRODUCTION TO MACROECONOMICS
 Economics is the study of the economy and the behaviour
of people in the economy.
 From the point of view of elements of analysis (scope of
study), economics is divided into:
 microeconomics, which studies the behaviour of
individuals and organizations (consumers, firms and the
like) at a disaggregated level, and
 macroeconomics, which studies the overall or aggregate
behaviour of the economy.

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 1.1. Concepts and Definition of Macroeconomics

 Macroeconomics is concerned with the behaviour of the

economy as a whole.

 It is concerned with booms and recessions, the economy’s total

output of goods and services and the growth of output/
income, the rate of inflation and unemployment, and the
balance of payments and exchange rates.

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 Moreover, macroeconomics focuses on the economic
behavior and policies that affect consumption and
investment, the determinants of changes in wages and prices,
monetary and fiscal policies (taxation, the money stock,
government budget and interest rate), trade balance and
national debt.
 It deals with both long-run economic growth and the
short run fluctuations which are constituents of the
business cycle.

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 In brief it deals with major economic issues and problems
and therein possible solutions.
 For instance, during high unemployment the policies aim
at reducing unemployment rate.
 During high inflation it tries to stabilize price level.
 During trade deficit, aim to expand export etc.
 In Ethiopia, most of these macroeconomic elements are
controlled by: Ministry of Finance and Economic
Development (MoFED) and National Bank of Ethiopia
(NBE).
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 Macroeconomic issues play a central role in political
debate.
 Voters are aware of how the economy is doing, and they
know that government policy can affect the economy in
powerful ways.
 popularity of the incumbent president rises when the
economy is doing well and falls when it is doing poorly.
 Macroeconomic issues are also at the center of world
politics.
 world leaders debate on European common currency,
financial crisis and the United States’ borrowings to
finance trade deficits.

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 In macroeconomics, we usually do two things.
 1st, we seek to understand the economic functioning of the
world- explanation
 explain the behavior of the economy in the long run and in
the short run.
 2nd, we ask if we can do anything to improve the performance
of the economy- policy prescription.
 Once we understand the behavior of national economic
variables such as unemployment rate, inflation rate and
aggregate demand, it is easy for the policy makers to
prescribe policy to achieve various macroeconomic goals.

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1.2. Major Elements of Macroeconomics/National Economy
a) Gross Domestic Product (GDP): the sum of values of total
final goods and services produced in a given country in a
given period of time (a year).

b) Government expenditure: the amount of resources that the

government sector of a country spends in a given fiscal year
(budget year).
 investment expenditure such as construction of roads,
schools, clinics and hospitals, water supply, electrification
and others.
 consumption expenditure on non-durable goods in
government offices and on national defense.

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c) Total money supply: the sum of total currencies in
circulation. Controlled to the appropriate level by Central Bank
(Federal Bank) of the country-National Bank of Ethiopia (NBE).

d) Inflation: a rise in general price level- decreases the

purchasing power of money.

e) Trade Balance: the net inflow of foreign exchange from trade

(difference between export and import).

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f) Current Account Balance (CA): the net inflow of resource
from trade, services and unrepeated transfer. In addition to
import and export items, it includes the flow of payment to
factors (labour, capital, land etc.) such as dividends, profits and
wage as well as payments to services such as shipping, banks
and tourism; and unrepeated transfers such as remittance from
abroad.

g) Balance of Payment (BOP): the net of inflow of resources

to a given economy from the rest of the world. In addition to the
current account balance, the BOP includes the flow of resources
from foreign investment, borrowings from the rest of the world
and repayments of such borrowings.

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h) Exchange rate: the rate at which domestic currency is
exchanged for foreign currency. For instance, in Ethiopia, about
2.07 Birr for one dollar during the Imperial and Dergue periods,
but under EPRDF the exchange rate is changed to 5 Birr per one
US dollar and now to about 40 Birr per one US dollar. Birr is
losing its value against dollar- devalued or depreciated.

i) Consumer price Index (CPI): the measure of weighted

average of prices of goods and services used by consumers.
Measures cost of living.

j) Per capita Income (PCI): the measure of average output of a

country per person. It is the ratio of the total output (GDP) to
total population (N) of the country.
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1.3. Macroeconomics Schools of Thoughts

 Different macroeconomic ideas have evolved over time

beginning from the mercantilist (1500s–1600s) period to
present.
 The focuses of most of these ideas are on the way national
development can be achieved.
 According to Mercantilists, national development (wealth
of nation) can be achieved through accumulating precious
metals, especially gold.

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 Later, the thinking of national economic development
changed to the need or type of government actions that
should or should not be undertaken in the economy.
 The Classical and Keynesians are the dominant thoughts.
 The other major schools of economic thought share some
points both with Keynesians or Classical economists.
 In general term, these schools can be either as
interventionist (similar position with Keynesians) and non-
interventionist (similar position with classical economists).

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 1.3.1. Classical (1776-1870) and Neo classical (1870-1939)
Thoughts
 During classicalism, the distinction between micro and
macro was not very clear.
 The focus was on micro economy only.
 They believed that by maximizing individuals’ wealth one
can maximize country’s wealth assuming that individuals
are rational and markets are efficient.
 The ruling principle was the invisible hand coined by
Adam Smith.
 During this time there was no government intervention in
economic activities.

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 The neoclassical school which criticized some of the ideas
of classical economists but more or less their ideas is the
same.
 The main distinction between them is the tool of analysis,
such as the marginal analysis of microeconomics theory.
 The classical ideas are highly influenced by the work of
J.B. Say a French classical economist.

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 Say’s Law
 Say's Law holds that every supply creates its own demand.
 He agreed that over production will soon be corrected by
supplier once they know that there is no demand for the
over production.
 He has deduced three conclusions from his law of markets.
These are:
 Higher number of markets and its coverage helps in
increasing the demand and a rise in price.
 Each class is interested in the prosperity of the other
(agriculture, manufactures and commerce all grow
together).
 Imports are good for the home country and does not harm
the home industry.
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 We can sum up the important implications of the Classical
model as follows:
1. Money supply changes have no effect on current output,
and it only affects the price level.
2. Changes in government expenditure have no effect on
current output and only affect the interest rate, and the
amount of investment and consumption undertaken.
3. Changes in the overall level of taxation do not affect
current output.

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1.3.2. Keynesian’s (1936 - 1970) school of thought

 The great depression of 1933 initiated economists to

recommend government intervention.

 The first economist was John Maynard Keynes-economy is

subjected to failure as markets are not efficient and economy

may not achieve full employment level.

 Following the failure of all attempts of central banks to

keep the economy on the right track, John Mynard Keynes

published his book of ‘General Theory of Employment,

Interest and Money’ in year 1936.

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 Keynesian’s economic theory is also known as ‘Theory of
Recession’.
 For Keynes to deal with recessions, is to make people satisfy
their demand for more cash without cutting their spending,
thereby preventing the downward spiral of shrinking spending
and shrinking income.
 The simplest way to do this is by increasing government
spending or increasing the supply of money.
 Therefore, one of the fundamental Keynesian answers to
recessions is monetary expansion.
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 But Keynes admitted that sometimes even this might not

be enough, particularly if a recession had been allowed to

get out of hand and become a true depression.

 Once the economy is deeply depressed, households and

especially firms may be unwilling to increase spending (may

add monetary expansion to their hoarding).

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 Such a situation, in which monetary policy has become

ineffective, has come to be known as a “liquidity trap”.

 In such a case, the government has to do what the private

sector will not: spend.

 Such a fiscal expansion can break the vicious circle of low

spending and low incomes and help the economy to return

back to its normal path.

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 Implications of the fundamental Keynesian thought are:
1. The economy is inherently unstable and is subject to
erratic shocks.
2. The economy can take a long time to return to being close
to full equilibrium after being subjected to a shock.
3. Government intervention is necessary for the smooth
function of the economy.
4. Aggregate demand is the predominant determinant of
output and employment, and it can be altered by the
authorities.
5. Fiscal policy is preferred to monetary policy for carrying
out stabilization policies.
6. The access to information about the economic variables is
the key.
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1.3.3. Monetarism

 Monetarism, as advocates of free market started

challenging Keynes’s theory in the 1970.
 Friedman began with a factual claim that most recessions
did not follow Keynes’s script.
 They did not arise because the private sector was trying to
increase its holdings of a fixed amount of money rather
because of a fall in the quantity of money in circulation.
 According to Friedman, if economic slumps begin people
spontaneously decide to increase their money holdings.

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  Then the monetary authority must monitor the economy
and pump money in when it finds a slump is imminent.
 If such slums are always created by a fall in the quantity of
money, then the monetary authority needs only to make
sure that the quantity of money not slump.
 In other words, a straightforward rule “keep the money supply
steady” is good enough so that there is no need for a
“discretionary’ policy of the form “pumps money in only when
your economic advisers think a recession is imminent”.

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1.3.4. The New Classical School
 Monetarism and Keynesian economics debated the
unsettled issues until the early 1970s, after which a
combination of two things were to lead to their demise as
the main schools of macroeconomic thought.
 The successor macroeconomic way of thinking was the
New Classical school.
 The new classical macroeconomics remained influential in
the 1980s.
 This school of macroeconomics shares many policy issues
with Friedman.
 It sees the world as one in which individuals act rationally
to meet their self-interest in the market that adjust itself
rapidly to changing conditions.
 They claim that government is likely only to make things
worse by intervening in economic activities.
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 Three central working assumptions of the new classical

school:

1. Economic agents maximize.

 households and firms make optimal decisions given all

available information and that those decisions are the best

possible in circumstances in which they find themselves.

 It is such maximization behavior that leads to the common

interest of economic agents (market equilibrium, where

both demanders and suppliers are satisfied).

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2. Expectations are rational.
 expectations of economic agents are statistically the best
predictions about the future that can be made using the
available information.
 Rational expectations imply that people will eventually
come to understand whatever government policy used, and
thus it is not possible to fool most of the people all the time
or even most of the time.
 Government interventions are effective only if economic
agents have no correct information about the policy actions
undertaken by the government.

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3. Markets clear.
Market is efficient enough to adjust supply with demand in
each and every market.
 The wages and prices adjust (flexible all the time) till
market clears i.e. supply is equal to the demand.
 For instance, any unemployed person who really wants a
job will offer to cut his/her wage until the wage is low
enough to attract and offer from an employer.
 Similarly, anyone with an excess supply of goods will cut
prices so as to sell.

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1.3.5. The New Keynesians
 The new Keynesians, trained mostly in the Keynesian
tradition, but moving beyond it, emerged in the 1980s.
 They do not believe that markets clear all the time, but seek
to understand and explain exactly why markets fail.
 both information problems and costs of changing prices
lead to some price rigidities and that they cause
macroeconomic fluctuations in output and employment.
 For example, in the labour market, firms that cut wage not
only reduce the cost of labour, but also are likely to wind
up with poorer quality labour/workers.
 Thus, firms will be reluctant to cut wages.

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 According to the New Keynesian economists, prices and
wages are not flexible owing to the following major
reasons:
 Imperfect information: since every change in consumer
tastes and change in producers plan are not easily observable
in the market and even if it is observable there is information
lag.
 As a result, markets do not instantly adjust to the
equilibrium market clearing wages and prices.
 For example, if producer wants to reduce wage rate and
also wants to reduce the price-it takes time to produce and
finally sell in the market.
 wage reduction may not be acceptable by the labourers and
hence market may not clear instantly.

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 Long-term contract: consumers and producers and/or
workers and employers stick to the agreed upon prices and/or
wages in spite of changing market clearing wages and prices.
 Any reduction in wage may not be acceptable to the
laborers despite the fall in prices because of strong trade
unions.
 Menu costs: To change its price a firm may need to change its
price menu and inform the consumers about the new price
menu- adds cost to the firms, hence may not change their price
frequently.

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 Minimum wage rate legislation: This is imposed by the
government economic policy with the aim to meet the
inevitable wellbeing of the low income groups or workers.
 refers to the case that the government fixes minimum wage
rate that employers have to pay for a worker they employ
and is intended to avoid unnecessary exploitation.
 Monopoly power of labour unions:
 Under this pressure, producers are forced to pay high wage
to avoid labour unionization even if it is not the market
clearing one.

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 Efficiency wage hypothesis: producers are forced by the
market to pay higher wages above the market clearing one
with the intention to retain quality workers.
 For example, in highly technical jobs it is difficult to get
trained manpower. So in order to retain them employers
pay high wage.
 Nutrition Condition: Since better paid workers can have
better nutrition and efficiency on their work, employers
usually pay wage rate above the market clearing one.
 For example, some employers pay food allowances to the
workers who engage in heavy physical labour.

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 1.3.6. Real Business Cycle (RBC) economists
 have similar position to new classical economists in several
aspects.
 According to this group of economists:
1. Expectations are formed rationally.
2. Markets are always clearing.
3. Money is neutral: Change in nominal money supply does
not affect real variables such as output.
4. Economic fluctuations are due only to supply side factors.
 RBC economists argue that output and employment
change because of the rate of technological change, natural
disasters or good growing seasons, tax rates, input price
changes and changes to incentives from things like the social
welfare system.

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Summary:
 All schools of macroeconomics agree on the purpose/
objectives of macroeconomic policy such as growth in
national output, lower rate of inflation, lower
unemployment rate and level, improved or positive trade
balance and balance of payment, etc.
 However, they disagree on how to achieve these
macroeconomic goals.
 Currently, there is no single dominant school of
macroeconomic thought.
 Thus, different economic views are used in different
economies under different circumstances.
 More developed countries are closer toward the free
market than developing countries.

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2. NATIONAL INCOME ACCOUNTING
 National Income Accounting’ refers to the process of
record keeping for the overall economic activities of a
given country.
 It includes the goods and services produced in a country
a fiscal year.

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2.1. The Basic Model: The Circular Flow Diagram
 The circular-flow diagram offers a simple way of organizing
all the economic transactions that occur between different
sectors in the economy.
 From the point of view of the number of sectors involved in
the analysis, there are three major macroeconomic models:
a) Two sector model
b) Three sector model (closed economy model)
c) Four sector model (open economy model)

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a) Two sector model
 This model represents only two sectors in the economy:

household sector and the firm sector.

 The households either consume or save their income given by:

 Y = C + S, Where, Y = income, C = Consumption

expenditure, S = Saving

 Since saving is used for investment or saving is by itself a

form of investment, S=I, the above equation can be rewritten:

 Y = C + I, Where, I = investment spending.

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Figure 2.1: Circular flow of income and spending in two
sector model

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 Households sector is the owner of factors of production
like land, labour and capital.
 These factors of payments are exchanged in resource
market.
 The factors of production are used by the firms.
 The payments to the factors of production are the income
(Y) from firms in the form of wage for labour or in the
form of rent for land or interest in the form of capital.

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  These factors of production spend part of their income on
consumption goods (C) produced by firms and save (S) the
rest.
 For simplicity assume that all the income received by the
households is consumed.
 Business sectors produce the outputs to be sold in product
market.
 These outputs are consumed by the households by
spending their income.
 Business sector receives revenue from the consumption.
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b) Three sector model (closed economy model)
 In this model, households, firms/business sector and
government are involved in the economy represented by
the equation:
 Y = C + S + G or Y = C + I + G,
Where, G = Government spending/ expenditure
 In addition to activities mentioned in two sector models,
households receive income from government transfer
payments and pay tax to the government.
 Business firms also sell their goods and services to the
government and pay tax to the government.
 Government sector use the tax income to finance its
expenditure.

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Figure 2.2: Circular flow of income and spending in three
sector model

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c) Four sector model (open economy model)
 Y = C + I + G + NX

Where: C= Consumption expenditure, I= Investment

expenditure, G= Government expenditure, NX= Net export (X–

M), M= Import value, and X= export value

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Figure 2.3: Circular flow of income and spending in four
sector model

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2.2. ‘National Income Accounts’ Measures
 The national income accounting process involves additions of
all the goods and services produced in a particular period
(usually fiscal year) in the country and
 deductions of all losses and costs incurred and all payments
made by the country to the external economy.

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 The single most important measure of overall economic
performance is gross domestic product (GDP).
 GDP is the market value of all final goods and services
produced within a country in a given period of time (normally
one year).
 Measuring GDP is an attempt to summarize all economic
activity over a period of time in terms of a single
figure/number.
 It is a measure of the economy’s total output and total income.
 GDP is a flow variable (its value changes from time to time)
not a stock variable.

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2.2.1. Real GDP versus Nominal GDP
 Nominal GDP is the value of all final goods and services
based on the prices existing during the time period of
production- the price we pay in the market.
 Nominal GDP can grow in three ways:
 When output rises and prices remain constant.
 Prices rise and output remains unchanged.
 When both prices and output rise
 The problem is how to adjust GDP to reflect only changes in
output and not changes in prices.
 This adjustment helps us in comparing the GDP over time when
prices are changing.
 In order to know this we must understand the meaning of real
GDP.

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 Real GDP is the value of all final goods and services
produced during a given time period based on the prices
existing in a selected base year.
 It is known as GDP in constant price or GDP adjusted for
inflation.
 The base year may change from time to time-a given base
year price may be used for five or more years.
 To get the most appropriate measure of national economic
performances, nominal GDP should be adjusted to the real
GDP by deflating NGDP when price is rising and by
inflating it when price is falling.

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 The adjustment factor is known as GDP deflator- the ratio of
nominal GDP to real GDP.
i.e. GDP deflator =  No min al GDP

 = NGDP
Re al GDP 

RGDP
 Rearranging this equation, the value of real GDP is obtained:

 GDP deflator can also be calculated from the outputs and

services produced and their respective base year as well as from
the current prices as follows.

Where; QCi = current unit of output or service or item ‘i’ (i = 1, 2,

3, ………), PCi = current price of output or service or item ‘i’
(i = 1, 2, 3, ………), PBi = base year price of output or service
or item ‘i’ (i = 1, 2, 3, ………)
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 Example: Given the data (Table 2.1) on total output (goods
and services) and price level (average price) in respective
years, we can calculate nominal GDP, real GDP and GDP
deflator.
 Assume that all goods and services are measurable in similar
units for the sake of simplicity.
 Let us take year 1970 as the base year and assume that the base
year is changed to the year 1990.
 From the table, in the selected base year both nominal GDP
and real GDP are equal.
 Nominal GDP may change because of change in price level
even if no change in fiscal output.

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 However, real GDP remains unchanged if there is no change in
physical output.
 For instance, compare both values of real GDP and nominal
GDP of the years 1980 and 1985.
 Since no change in physical output (15 units in both years), no
change in real GDP too, which remains 30 million Birr in both
years.
 The same is true in years 1994 and 1996 where no change in
real GDP whereas the nominal GDP has increased because of
an increase in price level (from 10 to 11 Birr per unit) even if
there is no change in physical output which remains at 30
million Birr in both years.

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Table 2.1: Real GDP and nominal GDP
Year Unit of goods Price Nominal GDP Real GDP GDP
and services level (NGDP) (RGDP) deflator
(in millions) (in million (in million (NGDP/
Birr) Birr) RGDP)
1970 10 2 20 20 1
1975 12 3 36 24 1.5
1980 15 4 60 30 2
1985 15 6 90 30 3
1988 20 7 140 40 3.5
1990 25 8 200 200 1
1994 30 10 300 240 1.25
1996 30 11 330 240 1.375
1998 32 15 480 256 1.875
1999 34 18 612 272 2.25
2000 35 20 700 280 2.5
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 Note that consumer price index is calculated in the same
manner as is the GDP deflator.

CPI=
Qc1 Pc1   Qc 2 Pc 2   .....
Qcl PB1   Qc 2 PB 2   .....
Where; QCi = current unit of consumption good or service or item
‘i’. (i = 1, 2, 3, …),
PCi = current price of consumption good or service or item ‘i’.
(i = 1, 2, 3, ……),
PBi = base year price of consumption good or service or item
‘i’. (i = 1, 2, 3, .…)

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 The difference between GDP deflator and CPI are that:
 GDP deflator measures the prices of all goods and services
(including expenditure of both firms and households)
whereas
 CPI measures the prices of all goods and services
purchased by consumers.
 GDP deflator includes only outputs produced domestically
whereas the CPI includes price of imported consumer
goods as well.

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2.2.2. Gross domestic product and Gross national product
 The terms Gross Domestic Product (GDP) and Gross National
Product (GNP) are usually used as an approximate of each
other though there is a distinction.
 GDP is the value of final goods and services produced by
domestically owned factors of production within a given
period.
 It is the sum of values of goods and services produced in
the country by citizens of the country and foreigners-
something related to territory of the country (i.e. GDP is
territorial).
 GNP refers to the sum of values of goods and services
produced by all citizens of a nation/ a country all over the
world- in the country plus outside the country.
 GNP is something related to citizenship (i.e. GNP is
national).
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 Let us take an example, Mr X is a citizen of Ethiopia and he is
working in USA.
 Since he is not utilizing the resources of Ethiopia to earn, his
income can be included in GDP/income of USA.
 The difference between GNP and GDP equals to the net
income earned by foreigners (NFP).
 NFP= GNP – GDP, NFP is the net factor payment to citizens.
 This is the difference between income received by citizens of
the country outside the country like Mr. X and the income
received by foreigners in the country.

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 GNP can be greater than or equal to or less than GDP
depending on the value of the net factor payment.
 If the value of net factor payment (NFP) is positive, then GNP
is greater than GDP.
 i.e., the output produced by citizens of the country is larger
than what is produced in the territory of the country.
 When GDP exceeds GNP, residents of a given country are
earning less abroad than foreigners are earning in that country.

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 Example: Suppose Ethiopians abroad have produced output
worth of 200 million Birr in the year 2005, and at the same
time foreigners working in Ethiopia have produced output
worth of 150 million Birr in the same year.
 If the Ethiopian GDP in that year is 800 million Birr, assuming
that other things are constant, find the net factor payment
(NFP) and the GNP.
 NFP = income received by Ethiopians abroad minus income
received by foreigners in Ethiopia.
 NFP = 200 – 150 = 50 million Birr,
 GNP = GDP + NFP = 800 + 50 = 850 million birr
 Most of the time NFP is negligible- thus, GDP is used as a
proxy of GNP.

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2.2.3. Precautions to be made in measuring GNP and/or GDP
1) Money must be used as common unit of measurements.
 Convert all products and services to money terms (e.g. to
Birr).
2) Market values of goods and services should be applied.
 Multiply the number of units of goods and services
produced by their per unit price.
 value of owner-occupied housing is estimated by its rental
value assuming that the owner pays rent to himself, so that
the rent is included both in his expenditure and in his
income-called an imputed value.
3) Only final goods and services should be considered or
included in the calculation of GDP.
 We need to avoid measuring intermediate inputs to avoid
double counting.
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 Exception: an intermediate good produced and added to a
firm’s inventory of goods to be used or sold at a later date is
taken to be “final” for the moment, and its value as inventory
investment is added to GDP.
 When the inventory is later used or sold, the firm’s
inventory investment is negative, and GDP for the later
period is reduced.
4) Non-productive transactions should not be included in
GDP. a) Sales of second-hand goods or used goods: already
recorded during its sale for the first time.

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  If we record again then it will be double counting.
Example: Someone purchased a new car in 1995 paying 20000
birr and his purchase had been recorded in that year’s national
income.
 If in 1996 he wanted to sell his car at 15000 birr-nothing
produced.
 It is just a registration of the same car in some other name.
b) Financial transaction: changes of ownership of money and
some financial securities or documents include :
 Buying and selling of bonds and stocks-transfer of
ownership; no new values are generated in the process.

62
  Transfer payments-giving money to your brother or sister
to cover her/his educational expenses or other costs-do not
create any new product or value.

5) Products in informal sectors should be included in GDP.

 Since these sectors are productive, generating employment and

income generating opportunities, outputs that are produced in

these sectors should be included in GDP.

 Yet, very difficult to account for outputs in such sectors since

no formal or official records kept for them.

63
2.2.4. Other National Income Accounts Measures

Gross Domestic Product (GDP) and Net Domestic Product

(NDP):

 Capital used in production process wears out, or depreciates

while it is being used to produce output.

 NDP is the difference between Gross Domestic Product

and the capital consumption allowance which is a measure

of depreciation of capital goods used in production (D).

 NDP = GDP – (depreciation) = GDP – D

64
 For instance, if the total output of a country (GDP) in a given
year is 100 million US dollar and the lost part of capital goods
in generating this national output is 9.5 million US dollar, then
the net domestic product (NDP) of the country in that
particular year is 90.5 million USD.
 NDP measures net amount of goods and services produced
in a country in a given period-It is the value of production
minus the amount of capital used up in producing that output.
 In developed countries, depreciation is about 11% of GDP, so
NDP is about 89% of GDP.
 No such formal estimation of depreciation in less developed
countries due to lack of data.
65
 Net National product (NNP) or Net Domestic product (NDP)
 These values are usually used interchangeably because
there is no significant difference between the two values.
 The only difference between the two is that NDP is calculated
from GDP whereas the NNP is calculated from the (GNP).
 NDP = GDP – D and NNP = GNP – D
 The difference between the left hand side (NDP and NNP) is
equal to the difference between the right hand side terms of
the equations.
 NDP – NNP = (GDP – D) – (GNP – D)
= GDP – D – GNP + D = GDP – GNP
 So, (NDP – NNP) = (GDP – GNP)

66
National income (NI or Y)

 It is the difference between the net national product (NNP)

or the net domestic product (NDP) and Indirect Taxes (IT).
 These taxes are deducted from Net National Product (NNP) or
Net Domestic Product (NDP) before making factor payments.
 NI or Y = NNP – IT or NI = NDP – IT, Where, IT=indirect
taxes.
 National income is the payments to the factors of production.
 Note that about 75% of factor payments go to labour- the largest
component of factors of production throughout the world.
 For example, from the above example (on NDP), if the sum of
indirect taxes in the period amounts to 8 million USD, the value
of the National Income (NI) is 82.5 million USD.
67
 Personal income (PI)
 It is the net value of national income and different personal
payments and receipts.
 PI = NI – {(Social security payments + corporate income taxes
+ retained earnings + related payments)}
+ {(transfer payments received + subsidies + net interest income
+ related earnings)}
 Social security payments: collected from individuals to help
the poor, the disabled and the senior citizens of the country.
 Corporate income tax: collected from profit or revenue of
corporate organizations by the government.

68
 Retained earnings: part of income generated by corporate
organizations and kept in the organization for generation of
more profit or for strengthening the capacity of the
organization or company. Revenue or profit that is not
disbursed/paid out to members for personal uses.
 Transfer payments: amount of money people receive from
their relatives or friends for free.
 money you give for your mother, father, brother, sister or
friend without expectation of repayment.
 Subsidies: money or the equivalent amount of other goods and
services given by the government to individuals, companies or
organizations to help them.
 Interest Income: income received on the saved amount of
money in banks.
69
Disposable income (Yd)
 It is the amount of income that is left for a person after
payment of any taxes and transfers.
 It is the amount that the person is free to spend on whatever
he/she likes or to save.
 Yd = PI – (direct or personal income taxes).
 However, sometimes all transfers and taxes are considered at
the same time.
 In that case, the disposable income is directly calculated from
national income (Y).
 Thus, Disposable income (Yd) = Y + Transfers – Taxes
 Yd = Y + TR – T

70
 In most macroeconomics texts the value of national income
‘Y’ is represented by values of GDP to avoid complexity in
computation and no loss of much accuracy because of the
substitution.
 Suppose that the GDP of a country is $100 billion.
 If total paid tax is $10 billion and net transfers received are $5
billion, what is disposable income?
 Solution: Yd = GDP + TR – T = $100 billion + $5 billion -$10
billion = $95 billion

71
Personal savings (S)
 Personal saving is the amount of disposable income that is
left over and above consumption expenditure.
 It is the difference between disposable income (Yd) and
consumption expenditure (C): S = Yd – C
Where, ‘C’ is consumption expenditure;
S is personal saving and
Yd is disposable income
 For example, from the above example of disposable income,
we can calculate the value of personal saving (S) as follows if
related personal consumption expenditure (C) is 65 billion
USD.
 S = Yd – C = $95 billion – $65 billion = $30 billion
72
 2.3. Approaches to ‘National Income Accounting’ Process

 There are three major approaches/methods of measuring

GDP or GNP.

 These are:
 the value added approach,
 the expenditure approach; and
 the income approach.

73
2.3.1. Value Added Approach

 According to the value added approach, the total output of

a country (GDP) is obtained by adding the new values of

goods and services created at different stages of process or

in different sectors.

 For instance, take one ‘quintal’ of wheat, costing 200 Birr

in the farm.

 In the process of making sandwich from the wheat , the

following should be recorded at each stage (Table 2.2).

74
  If the wheat was produced one year earlier it would be
recorded in GDP of the previous year, so that year’s
income or GDP includes only 330 Birr.

 We exclude the value of wheat at the farm (200 birr) since

it should be recorded in the GDP of previous year.

 Since the value of the item should be recorded several
times (at different stages of the production process), this
method is very prone to error of double recording.

 Because of this defect this method is not frequently used.

75
Table 2.2: Computing value added in production
Stage of process Total value of the Value
quintal wheat at added
each stage (in Birr) (in Birr)

Wheat at farm 200 200

Wheat in the market including 250 50
transportation
Wheat flour in the market 310 60
Bread in the market 460 150
Sandwich at cafeteria 530 70
If all the process are 530
undertaken in the same year

76
 2.3.2. Expenditure Approach
 In expenditure approach, the total output of a country
(GDP) is measured as the sum of expenditures made in all
sectors of the country.
 The underlying assumption is that the expenditure of one sector
or person is the income of the other (receivers of that money
spent by other sectors).
 Thus, the national income identity is given as follows:
 GDP = Y= C + I + G + X – M = C + I + G + NX
Where; GDP = Y = Gross domestic income/product, C =
Personal consumption expenditures, I = Gross private domestic
investment expenditures, G = Government expenditure, NX =
net export (export (X) minus import (M)) = X – M
77
Personal consumption expenditure (C)

 It accounts for the largest portion of GDP.

 It consists of the goods and services bought by households.

 It is divided into three subcategories:

 Nondurable goods- that last only a short time, such as food

and clothing.

 Durable goods- that last a long time, such as cars and TVs.

 Services include the work done for consumers by

individuals and firms, such as haircuts and doctor visits.

78
Private domestic investment expenditure (I)
 It includes expenditure on raw materials (factors of
production) and final goods such as capital investments to
generate more output.
 This includes land, labour, machineries, buildings, inventories of
unsold goods (for merchants) and so on.
 Investment is divided into three subcategories:
 Business fixed investment: is the purchase of new plant and
equipment by firms.
 Residential investment: is the purchase of new housing by
households and landlords.
 Inventory investment: is the increase in firms’ inventories of
goods.
 Interest is the price and profit is the reward for investment.
 Replacement of old machinery represents a negative value in
national income because it is depreciation.
79
Government expenditure (G)
 It is the goods and services bought by federal, state, and local
governments.
 It represents all expenditure on goods and services by
government on behalf of the nation.
 This category includes such items as military equipment,
highways, and the services that government workers provide.
 It also includes goods of immediate consumption (car, planes,
stationary etc), investment goods (buildings and machineries for
production) and so on.
 It does not include transfer payments to individuals, such as
Social Security benefits, unemployment compensations and
subsidies.
 Because transfer payments reallocate existing income and are not
made in exchange for goods and services, they are not part of G.

80
Net export (NX)
 It is the value of goods and services exported to other
countries minus the value of goods and services that
foreigners provide us.
 Exports (X) represents foreign expenditure on our goods
and services which should be added on our national income
while
 Imports (M) represent our expenses on foreign goods and
services which overstate our output to be deducted from the
national income.
 Example: Given the summarized information about the values
of national output, we can calculate the value of the total
output (GDP) of the country as follows (Table 2.3).

81
Table 2.3: GDP value of using Expenditure approach
Components Value in
Birr
Personal consumption expenditure (C) 11,400

Gross private domestic investment (I) 6,500

Government expenditure (G) 7,300

Exports (X) 900

Imports (M) (1,100)

Total Expenditure (equivalent to national 25,000

income/output, GDP)

82
2.3.3. Income Approach

 In the income approach the GDP/GNP is measured by

adding up all incomes earned by different factors of
production: land, labour, capital and so on.
 Thus, the national income identity is given by:
 GDP = Y = W + R + I + Π + IT – D.
Where, GNP = Y = Gross national product, W = Wages of all
workers (compensations of employees), R = Rents paid to
property owners (reward for services), I= Interest on
borrowed capitals, Π = Profit of business organizations, IT =
Indirect business taxes, and D = Depreciation (Capital
consumption allowance)

83
 Profits (Π) include dividends and retained earnings of
corporate organizations; proprietors’ income and so on.
 Indirect taxes (IT) are said to be indirect because consumers
pay it indirectly.
 When we calculate GDP or GNP, we take different taxes as
positive as it is income of the government.
 In some cases, the depreciation element is considered only in
calculating NDP or NNP which, we have discussed in earlier
sections.
 Yet depreciation does not bring much significant difference
or it doesn’t change the logic or the underlying concept.
 Example: GDP can be calculated as follows (Table 2.4).
84
Table 2.4: GDP using Income Approach
Income Components Value (in million
Birr)
Compensation of employees (W) 14,750
Rents paid to property owners (R) 1,090
Interest on borrowed capital (I) 2,180
Proprietor’s incomes 2,040
Retained earnings 1,800
Dividends 1,720
Corporate income taxes 1,670
Indirect taxes (IT) 2,500
Depreciation allowances (D) (2,750)
Total income = GDP = Y 25,000

85
2.4. The Drawbacks/Shortcomings of GDP and/or GNP
 GDP and/or GNP is reasonably accurate and extremely
useful measure of social and economic wellbeing and level
of economic performances.
 Yet, these figures are not free from weakness as some of the
problems are:
1) The figure of GDP or GNP does not tell us the long term
sustainability of gains from production.
 These values do not tell us whether the current trend of
growth is going to continue in the future.
 A year value(s) of GDP and/or GNP does not tell us what
its value will be in the coming year or in the future.
2) The values of GDP and/or GNP do not indicate
composition of national outputs.

86
  We can see the composition of the national aggregate output
only during the computation of GDP or GNP.
 Thus, readers of the GDP or GNP report cannot observe the
composition of values.
3) Relative improvement in quality of some items and relative
growth in some sectors is not known from the value of GDP
or GNP.
 GDP or GNP measures are quantitative and do not account
for quality improvement. Moreover, one cannot identify
from which sector (agricultural, industrial, service and
trade) that improvement in the value of GDP or GNP
comes.
4) Income distribution is not known from the figure of GDP or
GNP.
87
  One of the major determinants of social welfare is proper or
fair income distribution among citizens of the country.
 However, the single value of GDP or GNP does not tell us
anything about such distribution.
5) GDP or GNP accounts only for marketed transactions.
 Some economic activities have no place in market-home
based activities such as cooking, child caring, homemade
laundries and so on.
 Goods and services that are not marketed are not included in
GDP or GNP. In this case, GDP does not properly account for
such production.
6) GDP or GNP also ignores leisure time.
 Leisure time and recreation are part of or related to economic
activities which should have been considered.

88
  Different countries at different level of development
provide different leisure times.
 This cannot be observed from the values of GDP or GNP.
7) GDP or GNP ignores underground economy.
 The underground economy is the part of the economy that
people hide from the government either because they wish
to evade taxation or the activity is illegal.
 Services generated in the black markets, unregistered small
businesses, drug dealers, and so on are not considered in
GDP/GNP.
 In this case, the GDP or GNP is understating the value of
national economy.
89
8) The side effects of economic growth on environment are

not accounted for by GDP or GNP.

 The higher the production, the larger the amount will be of

polluting by products generated by factories and through

consumption activities of different sectors.

 These are not usually considered in measuring national

output. In this case, the GDP or GNP is overstating the

value of total output of the country.

90
9) GDP or GNP is again very difficult for international
comparison.
 This is because countries’ GDP or GNP are calculated
using their respective countries currencies.
 Even after changing to similar currency difficult to
compare GDP and GNP because price of commodities are
different in different countries and thus cost of living are
different.
 To minimize such differences, attempts are made to use
Purchasing Power Parity (PPP) in place of Official
Exchange Rate (OER).
 PPP is the rate at which one currency would be exchanged
for the other for cost of living between countries was to be
comparable.
91
3. ECONOMIC PERFORMANCE AND BUSINESS CYCLE

 Economic performances of countries change from time to

time due to different factors such as weather condition,
political situation and economic policies followed by
countries.
 Such fluctuation in economic performance of a country is
best depicted by almost regularly fluctuating curve or
path known as Business Cycle.
 The concept of Business Cycle was developed in formal way
only after The World Economic Crises of 1933, known as
Great Depression.
92
 3.1. Definition and Concepts of Business Cycle

 Business cycle can be defined as a more or less regular

pattern of path or line fluctuating with the level of

economic activity of a country or an economy around the

trend path.
 It shows alternating periods of economic growth and
contraction, which can be measured by the changes in real
Gross Domestic Product (RGDP).
 The total national output of a country changes from time
to time depending on different negative and positive
factors.
93
 Negative factors adversely affect total national output.
 When real GDP falls, businesses have trouble.
 Firms experience declining sales and profits.
 For instance, drought reduces agricultural outputs; civil wars
or war between countries divert resources from production to
war and inappropriate economic policies mislead countries
economic growth path thereby leading to reduction or fall in
total national output.
 The fall in total output is represented by downward
moving curve or path of the business cycle.

94
 Positive factors increase the total national output.
 When real GDP grows rapidly, business is good.
 Firms find that customers are plentiful and that profits are
growing.
 For instance, favorable climate conditions increases
agricultural output; political stability also helps people
concentrate on production and government use resources for
production and good trade polices enable a country to get
more foreign exchange.
 These all increases total output (values of goods and
services) of a country.
 This increase in economic performance is depicted by
increasing path of the business cycle.

95
 Since economic variables are related, any change in real Gross
Domestic Product (RGDP) brings similar changes in
employment, trade and other key indicators of the economy.
 In other words, all other aggregate economic activities get
affected.
 The upswing and downswing in the level of real output are
cyclical in nature and move around its trend path.
 The trend path is given by straight-line that shows the
movement of the economy if it is in full employment.
 In other words, the trend path of aggregate economic activities
is the normal path the indicators (GDP, employment, trade,
growth etc.) would take if factors of production were fully
employed.

96
3.1.1. Phases of the Business Cycle
 The phases are stages an economy passes to complete the
business cycle (to complete one cycle).
 The business cycle has two phases: Recession (Contraction)
and Recovery (Expansion) and two turning points: Peak
(Boom) and Trough (Bottom).
 The sequence of changes is recurrent (is repeating itself),
but not periodic and varies in duration depending on
factors like good or bad economic policies and favorable
or unfavorable natural conditions.
 The sequence of different phases of the business cycle is
represented by:
 (A) Peak (Boom) → (B) Contraction (Recession) → (C)
Trough (Bottom) → (D) Expansion (Recovery) → (A) Peak
(Boom) →…..
97
 This sequence repeats itself in different length of periods for
different economies from ‘A’ to ‘B’, ‘B’ to ‘C’, ‘C’ to ‘D’, ‘D’
to ‘A’, ‘A’ to ‘B’ and so on.
 Normal business cycles vary from one year to ten or twelve
years.
 Recovery represents an upturn in the business cycle during
which real GDP rises.
 During peak, economic activities reach their maximum after
rising during a recovery.
 In recession or contraction, generally economy witnesses a
downturn in the business cycle during which real GDP
declines.
98
 During trough economic activities reach its minimum after
falling during recession.
 We can see from the figure 3.1 that economic activities
fluctuate from time to time leading to output fluctuations
in the economy.
 In the figure, X-axis represents the time period and Y-axis
represents the aggregate economic activities.
 Trend Line is indicated by the straight dotted line and
business cycle which passes through points of actual
economic activity measured by GDP is shown by bold line.

99
 From ‘O’ to ‘P1’ in the figure, the economy is moving upward
known as expansion phase.
 Economy reaches its peak, which is at point ‘P1’.
 From ‘P1’ to ‘T’ economic activities are slowing down shown
by the downward movement of the cycle known as
contraction phase.
 The contraction phase brings or leads to the bottom of the
economic activities, which is known as trough represented by
point ‘T’.
 From bottom point the economy again starts recovering
because of some corrective measures created for the economy;
i.e. expansion phase begins.
 This process continues again that is by reaching peak followed
by trough.
100
Figure 3.1: Business Cycle

101
3.1.2. Sources of Economic Fluctuations
 Why GDP moves from its trend?
 Over time, real GDP (which is a measure of aggregate
economic activities) changes for two reasons.
 First, more resources become available which allow the
economy to produce more goods and service, thereby
resulting in rise over the trend level of output.
 Second, factors are not fully employed all the time due to
many reasons so that economy produces below its capacity
and deviates from its trend path.
 Each phase of the business cycle has its own sources or
factors leading the economy to take that phase and the
phases have some characteristics.
102
 Economic recessions (contractions) and economic troughs
are the result of the following major factors: natural
factors such as drought caused by shortage of rainfall; war
which diverts resources from production; inappropriate
economic policies; and underemployment of the existing
economic resources or factors of production.

 These phases are again characterized by the following

cyclical recession or cyclical trough: low output or GDP;
high unemployment (or low employment); low aggregate
demand for both products and factors of production; and low
per capita income (PCI); and so on.

103
 Economic expansion (recovery) and peak are the result of
the following major factors: political stability; use of
appropriate economic or macroeconomic policies; discovery
and use of new economic resources or factors of production
such as minerals like petroleum or oil and deposits of
precious metals like gold; utilization of idle resources or
factors of production such as labour; and use of improved
quality workers through training and so on.

 These phases of cyclical expansion or recovery and peak

are characterized by: higher aggregate output or GDP; low
unemployment of factors of production such as labour and
capital; high aggregate demand for products and factors of
production; and larger Per capita Income (PCI); and so on.

104
Business Cycle and Output Gap

 Trend path is the level corresponding to full employment

of the factors of production but actual output fluctuates
around the trend level (average performance).
 The output gap measures the gap between the output the
economy could produce at full employment (trend line) given
the existing resources and actual output (cyclical line).
 Output Gap = Potential Output (Trend) - Actual Output

= Yt -Ya
Where; Yt: is trend or potential output and
Ya : is actual output or cyclical output 105
 There are three possibilities (values) of output gaps.
 1: From A to B (Figure 3.1), when actual output is greater
than potential output, output gap is Negative indicating over
employment, overtime for workers, more utilization of the
capacity of the machineries.
 2: From B to C in the above figure, (Figure 3.1), when actual
output is less than potential output, output gap is Positive
indicating unemployment, underutilization of capacity.
 3: At point A, B and C (figure 3.1) when actual output is
exactly equal to potential output, output gap is zero
indicating that the economy is at full employment of existing
resources or factors of production.
106
3.2. Theories of Business Cycle

 The uneven historical pattern of economic growth gives

rise to the question about the factors that cause business

cycle.

 Many theories have been developed to explain the business

cycle; however, no single theory has had outstanding success

in explaining and successfully predicting business cycle.

 Most of the theories concentrate on Aggregate Demand and

Aggregate Supply (AD-AS) model.

107
 In all of the theories economists make certain assumption
pertaining to fluctuations in Aggregate Demand (AD) or
Aggregate Supply (AS) and assumption regarding how they
interact with each other to create a business cycle.
 Impulses can affect supply factors or demand factors or both.
 But there are no pure supply-side theories.
 Broadly, these theories can be classified as either:
A. Aggregate Demand Theories (Keynesian theory,
Monetarist theory and Rational expectations), or
B. Real Business Cycle Theories.

108
3.2.1. Keynesian theory
 Keynesian theory holds that changes in aggregate spending
are the cause of variations in real GDP.
 The aggregate spending includes the sum of expenditures by
households (C), business (I), government (G) and foreign
buyers (X-M).
 If the total spending increases, business firms find it profitable
to invest. When firms increase the output, they use more land,
labour and capital.
 Hence, increased spending leads to increase in output,
employment and incomes, thereby leading to expansion phase
of the business cycle.
 When total spending falls, businesses or producers will find
them profitable by producing a lower volume of goods and
services and avoid inventory.
 This low demand for products leads to recession.
109
3.2.2. Monetarist Theory of Business Cycle
 In this theory, a fluctuation in the money stock is the main
source of economic fluctuations.
 The impulse in the monetarist theory of business cycle is the
growth or the quantity of money.
 An increase in the money supply brings expansion and a
decrease in money supply brings recession.
 When the money growth rate increases, the quantity of real
money in the economy also increases.
 At the same time, interest rates falls and real money balance
increases.
 The foreign exchange rate also falls.

110
 These initial financial market effects begin to spread to other
markets.
 Again, investment demand and exports increases and
consumers spend more on the durable goods.
 These changes have multiplier effect and finally aggregate
demand curve shifts to the right from AD1 to AD2 and brings
expansion (Figure 3.2).
 Assuming upward slopping supply curve, a rightward shift in
aggregate demand brings not only an increase in GDP, but also
the price level.
 Similarly, one can analyze for a decrease in the money supply
and show that the result of it is recession or trough of the
business cycle.

111
Figure 3.2: Money Supply and Aggregate Output

112
3.2.3. Rational Expectation Theory
 A rational expectation theory is a forecast that is based on
the available and relevant information.
 According to this theory, an anticipated fluctuation in
aggregate demand has no impact on economic performance.
 It is unanticipated changes in aggregate demand that bring
fluctuation which leads to business cycle.
 A larger than anticipated increase in aggregate demand brings
expansion whereas a smaller than anticipated increase in
aggregate demand brings a recession.

113
 When aggregate demand decreases, if money wage doesn’t
change, then real GDP and price level decreases.
 The fall in price level in turn leads to an increase in the real
wage rate and unemployment rate.
 These changes in the economy lead to recession.
 This is because when prices fall producers become less
profitable and they thus cut their production and reduce
employment or their workers.
 This happens if the decrease in aggregate demand is
unanticipated.

114
3.2.4. Real Business Cycle Theory (RBC)
 Real Business Cycle Theory asserts that fluctuations in
the output and employment are due to a variety of real
shocks that hit the economy.
 According to this theory markets adjust rapidly due to these
shocks and always remain in equilibrium.
 These real shocks are basically due to random fluctuations in
productivity.
 Scholars who belong to this theory assume that random
fluctuations in productivity are the result of fluctuations in
the pace of technological changes, international disturbances,
climatic changes and natural disasters.

115
 The origin of RBC can be traced to the rational expectations
approach developed by Robert E. Lucas, who says that
anticipated monetary policy has not real effects as people will
correctly anticipate and nullify the impact is aimed at.
 This theory explains business cycle through shocks or
disturbances and propagation of shocks throughout the
economy.
 Disturbances are due to the shocks to productivity, supply
shocks and shocks to government.
 This thereby asserts that productivity shocks are due to change
in weather and new method of production.

116
 For example, if due to favorable productivity shocks people
want to take advantage, they would work hard to increase
their output.
 They also invest more capital to spread the productivity shock
into future periods by raising the stock of capital leading to
cyclical expansion or peak.
 The shocks due to the disturbances are spread through the
economy.
 This principle is known as propagation mechanism.
 This propagation mechanism basically tries to explain
why people work more sometimes than during other
times.
117
 During peak, employment is generally high and jobs are easy
to get; during recession employment is lower and jobs are
difficult to get.
 Again people supply more labor when wage is high.
 By intertemporal substituting of leisure between years, they
work the same total amount, but earn more total income.
 This clearly generates large movements in the amount of work
done in response to small shifts in wages and this could
account for large output changes in the cycle accompanied by
small changes in wages.
118
3.2.5. Political Business Cycle
 Another explanation is where government deliberately
causes business cycle is known as political business cycle.
 It is caused by policy makers to improve re-election chances.
 Governments adopt tight monetary and fiscal policy soon after
an election, but then adopt more expansionary policies as the
election approaches to encourage a ‘feel-good’ factor.
 This theory views politics to be a short-run game where the
self-interest of the politicians is to maximize votes.
 Voters are also short sighted and want good news now rather
than being promised.
 For example, just prior to election if a politician comes with
attractive benefits for the voters then he is likely to be
favourite candidate.

119
 The difference of this theory of creating recession from
other theories is that political business cycle is deliberate
and created by politicians while other theories are not
deliberately created.
 In case of developing countries, business cycles have not
received much attention.
 This is because the cyclical movements are caused by highly
unpredictable factors like droughts, famine and contraction of
exports.
 These factors are mostly natural or an act of god.
 In such cases, the study or forecasting of business cycle
becomes an extremely difficult task.
120
3.3. Forecasting Business Cycle: Indicator Forecasting

 Economic variables are inter-related and they show

cyclical movements.
 Some of these variables or indicators are known as lead
indicators.
 These indicators turning points occur before those of total
economic activity.
 For instance, capacity utilization of manufacturing sector,
residential construction, stock prices etc. start turning up and
down before aggregate economic variables like changes in
GNP and employment.
 This means that a stimulation of large scale residential
construction leads to increased demand for construction
materials.

121
 This will then contribute to boosting in production and income
of the sector, which in turn adds to cyclical expansion.
 Variables like industrial production and business expenditures
roughly coincide with the overall cycle while some other
variables like job vacancies and unit labour costs lag behind
the business cycle called lag variables.
 Based on the historical experiences of business cycles
across the world the economy can decide about which the
lead is and which is the lag variable.

122
 The lead and the lag variables differ depending on the
development level of an economy, institutional set-up of the
economy and structure of the economy.
 The indicators for a county whose economy is dominated by
agricultural sector is not the same as the indicators (or lead
variables) of an industrially advanced economy.
 In the former, the lead variables may be natural factors such
as good weather condition, whereas in the later the lead
variables may be market factors such as demand and income.

123
 4. AGGREGATE DEMAND AND AGGREGATE
SUPPLY ANALYSIS
 Economists use the model of aggregate demand and
aggregate supply to explain short-run fluctuations in
economic activity around its long-run trend.
 Aggregate demand-aggregate supply model (AD-AS model),
enables us to analyze changes in both real GDP and the price
level simultaneously.
 The AD-AS model therefore, provides insights on inflation,
unemployment, and economic growth.
 It also explains the logic of macroeconomic stabilization
policies.

124
4.1. Aggregate Demand

 Aggregate demand (AD) refers to the total amount of

goods and services demanded in the economy at a given
overall price level in a given time period.
 It shows the level of real GDP including the purchases by
households, business, government, and foreigners (net
exports) at different possible price levels during a given time
period.
 The relationship between the price level and the amount
of real GDP demanded is inverse or negative, which is
depicted by the downward sloping aggregate demand
curve (Figure 4.1).

125
Figure 4.1: Aggregate Demand Curve

126
Why the aggregate-demand curve slopes downward?
 The quantity of real GDP demanded equals the sum of
consumption expenditure (C), investment (I), government
purchases (G), and net export (NX).
 Consumption, investment, and net exports-depend on
economic conditions and, in particular, on the price level.
 Therefore, we must examine how the price level affects the
quantity of goods and services demanded for consumption,
investment, and net exports.
 The explanation rests on three effects of a price-level
change. These are real-balances effect, the interest-rate effect
and the exchange-rate.

127
a) Real-Balances Effect/ The Wealth Effect
 A higher price level reduces the purchasing power of the
public’s accumulated saving balances.
 The real value of assets with fixed money values, such as
savings accounts or bonds, diminishes.
 Hence, the public is poorer in real terms and will reduce its
consumption spending.
b) The interest-rate Effect
 When we draw an aggregate demand curve, we assume that
the supply of money in the economy is fixed.
 But when the price level rises, consumers need more
money for purchases, and businesses need more money to
meet their payrolls and to buy other resources (increases
demand for money).

128
 Given a fixed supply of money, an increase in money
demand will drive up the price paid for its use.
 The price of money is the interest rate.
 Higher interest rates restrain investment spending and interest-
sensitive consumption spending.
 Firms that expect a 6% rate of return on a potential purchase
of capital will be unprofitable and will not invest when the
interest rate has risen to 7%.
 Similarly, consumers may decide not to purchase a new house
or automobile when the interest rate on loans goes up.
 So, by increasing the demand for money and consequently
the interest rate, a higher price level reduces the amount of
real output demanded.
129
c) The Exchange-Rate/Foreign-Trade Effect

 When the Ethiopian price level rises relative to foreign price

levels, foreigners buy fewer Ethiopian goods and Ethiopians

buy more foreign goods.

 Therefore, Ethiopian exports fall and Ethiopian imports rise.

 The rise in the price level reduces the quantity of

Ethiopian goods demanded as net exports.

130
Changes in Aggregate Demand
 Other things equal, a change in the price level will change the
amount of real GDP demanded by the economy-Movement
along a fixed AD curve.
 If one or more of “other things” changes, the entire
aggregate demand curve will shift.
 Those “other things” (determinants of aggregate demand)
include: change in consumer spending (Consumer wealth,
expectations, borrowing and taxes); change in investment
spending (interest rates and expected returns); change in
government spending and change in net export spending
(national income abroad and exchange rate)
 The rightward shift of the curve (AD1 to AD2) shows an
increase in aggregate demand while leftward shift of the curve
(AD1 to AD3) shows a decrease in aggregate demand (Figure
4.2).
131
Figure 4.2: Change in aggregate demand

132
4.2. Aggregate Supply
 Aggregate supply (AS) refers to the amount of total
national output that businesses willingly produce and sell
in a given period.
 It is the relationship between the quantity of real GDP
supplied and the price level.
 The relationship between the quantity of real GDP
supplied and the price level varies depending on the time
horizon and how quickly output prices and input prices
can change.
 The two time horizons are: the short run and the long run
periods.

133
4.2.1. Short Run Aggregate Supply Curve
 The short-run aggregate supply curve (SRAS) is the
relationship between the quantity of real GDP supplied
and the price level when the money wage rate, the prices of
other resources, and potential GDP remain constant.
 The short-run aggregate supply curve slopes upward because
with input prices fixed, changes in the price level will raise or
lower real firm profits (Figure 4.3).
 Consider an economy that has only a single multi-product
firm called ABC and the firm’s owners must receive a real
profit of Dollar 20 in order to produce the full-employment
output of 100 units.

134
 Assume the owner’s only input is 10 units of hired labour at
Dollar 8 per worker, for a total wage cost of Dollar 80 and the
100 units of output sell for Dollar 1 per unit, so total revenue
is Dollar 100.
 ABC’s nominal profit is Dollar 20 (= Dollar 100 – 80), and
using the Dollar 1 price to designate the base-price index of
100 its real profit is also Dollar 20 (= Dollar 20/1.00).
 Doubling of the price level will boost total revenue from
Dollar 100 to 200, but since it is the short run input prices are
fixed, so that total costs stay at Dollar 80.

135
 Nominal profit will rise from Dollar 20 to Dollar 120 (=200–
80) dividing Dollar 120 profit by the new price index of 2, we
find that ABC’s real profit is Dollar 60.
 The rise in the real reward from Dollar 20 to 60 prompts the
firm (economy) to produce more output.
 So, there is a direct relationship between the price level and
real output.
 The result is an upward-sloping short-run aggregate
supply curve.
 Macroeconomists have proposed four theories for the upward
slope of the short run aggregate-supply curve: sticky wage
model, workers misperception model, imperfect information
model and sticky price model.

136
Figure 4.3 Short Run Aggregate Supply curve

137
4.2.2. Long Run Aggregate Supply Curve
 The long-run aggregate supply curve (LRAS) is the
relationship between the price level and real GDP when
real GDP equals potential GDP which is vertical at the
economy’s full-employment output (GDPf) (Figure 4.4).
 The vertical curve means that in the long run the economy will
produce the full-employment output level no matter what the
price level is.
 In the long run when both input prices and output prices
are flexible, profit levels will always adjust to give firms
exactly the right profit incentive to produce exactly the
full-employment output level GDPf.
 To see why this is true, look back at the short-run aggregate
supply curve shown in Figure 4.3 above.

138
 Consider what will happen in the long run when prices are
free to change.
 Firms can produce beyond the full-employment output level
only by running factories and businesses at extremely high
rates of utilization.
 This creates a great deal of demand for the economy’s limited
supply of productive resources, in particular, labour because
the only way to produce beyond full employment is if
workers are working overtime.
 As time passes and input prices are free to change, the high
demand will start to raise input prices.
 In particular, overworked employees will demand and receive
raises as employers scramble to deal with the labour shortages
that arise when the economy is producing at above its full-
employment output level.
139
 As input prices increase, firm profits will begin to fall and
so does the motive firms have to produce more than the
full-employment output level.
 This process of rising input prices and falling profits continues
until the rise in input prices exactly matches the initial change
in output prices (in our example, both double).
 Hence, firm profits in real terms return to their original level
so that firms are once again motivated to produce at exactly
the full-employment output level.
 This adjustment process means that in the long run the
economy will produce at full employment regardless of the
price level (at either P = 100 or P = 200).
 That is why the long-run aggregate supply curve LRAS is
vertical above the full-employment output level.
140
Figure 4.4 Long Run Aggregate Supply curve

141
4.2.3. Determinants of Aggregate Supply
 Since the behavior of short run aggregate supply and long run
aggregate supply are different, we examine the factors which
determine the quantity of goods and services supplied in the
short run and in the long run separately.
A. Changes in the Short-Run Aggregate-Supply Curve
 Aggregate supply curve identifies the relationship between
the price level and real output, other things equal.
 But when one or more of these “other things” change, the
curve itself shifts.
 The rightward shift of the curve (AS1 to AS3) represents an
increase in aggregate supply-firms are willing to produce and
sell more real output at each price level while the leftward
shift of the curve (AS1 to AS2) represents a decrease in
aggregate supply (Figure 4.5).
142
 Changes in “other things” or determinants cause per-unit
production costs to be either higher or lower than before
affects profits, which leads firms to alter the amount of
output they are willing to produce at each price level.
 Determinants of the short-run aggregate supply are:
1. Change in input prices (price of domestic and imported
resources)
2. Change in productivity
3. Change in legal-institutional environment (business taxes
and subsidies and government regulation)

143
Figure: 4.5. Shift in Short Run Aggregate Supply curve

144
B. Changes in the Long-Run Aggregate-Supply Curve
 Any change in the economy that alters the natural rate of
output (potential output or full-employment output, GDPf)
shifts the long-run aggregate-supply curve.
 Output in the classical model depends on labour, capital,
natural resources (land, minerals, and weather), and
technological knowledge.
 shifts in the long-run aggregate-supply curve are arising from
these sources.
 Shifts arising from labour:
 Immigration from abroad would increase number of
workers, so that the quantity of goods and services
supplied would increase and shifts long-run aggregate-
supply curve to the right.

145
 Shifts arising from capital (physical capital or human
capital) :
 An increase in the number of machines or college degrees
will raise the economy’s ability to produce goods and
services, shifts the long-run AS curve to the right.
 Shifts arising from natural resources (land, minerals, and
weather):
 A discovery of a new mineral deposit shifts the long-run
aggregate-supply curve to the right.
 A change in weather patterns that makes farming more
difficult shifts the long-run aggregate-supply curve to the
left.
146
 Shifts arising from technology:
 The invention of the computer, for instance, has allowed
us to produce more goods and services from any given
amounts of labor, capital, and natural resources, which
shifts the long-run aggregate-supply curve to the right.
 There are many other events that act like changes in
technology, for instance,
 Opening up international trade has effects similar to
inventing new production processes, so it also shifts the
long run aggregate-supply curve to the right.
 New government regulations preventing firms from using
some production methods, perhaps because they were too
dangerous for workers, the result would be a leftward shift
in the long-run aggregate-supply curve.
147
4.2.4. Aggregate Supply Models
 There are four major aggregate supply models which are
developed by different scholars viewing the markets from
different angles.
 These models are: sticky wage model, workers misperception
model, imperfect information model and sticky price model.
 These models differ from one another depending on the
market (labour market or commodity market) to which the
individuals who first developed the concepts gave emphasis
and on their beliefs whether these markets clear or not.
 These models try to explain the relationship between the price
and the aggregate supply of goods and services.

148
A. Sticky Wage Model
 The sticky wage model focuses on the wage setting process
in the labour market to explain the relationship between
price and output in the commodity market and so the slope
of the aggregate supply curve.
 According to this model wage is set based on long term
contracts.
 So wage is sticky or remains unchanged in the short run or
during the period on which the agreement is made.
 This means workers’ salaries are not changed with every event
that alters their employers’ profits.

149
 The sticky-wage model starts with the presumption that

when a firm and its workers sit down to bargain over the

wage, they have in mind some target real wage upon which

they will ultimately agree.

 But the contract to which they ultimately agree is written in
terms not of the real wage but of the nominal wage.
 Since the wage is set in advance in a contract, the actual
price level (P) may turn out to be different from the
expected price level (Pe).
150
B. Workers Misperception Model
 Like the sticky wage model, this model also emphasizes the
labour market.
 As opposed to the sticky wage model, this model assumes that
wages are fully flexible and the labour market clears, but
workers have imperfect information, in that they suffer from
money illusion, so they temporarily mistake/confuse nominal
wage increases for real wage increases.
 Firms, on the other hand, have better information and their
demand for labour depends on the actual real wage.
 The worker-misperception model says that deviations of prices
from expected prices induce workers to alter their supply of
labor and that this change in labor supply alters the quantity of
output firms produce.

151
C. Imperfect Information Model
 According to this model, lack of information about the
other side of a market determines the relationship
between the price and the output or aggregate supply.
 This model is believed to be the simplest model since it
doesn’t distinguish between firms and workers.
 For the analysis of this model, simplifying conditions or
assumptions are:
a) A supplier produces a single good or product and consumes
many goods.
b) Because the number of goods and services produced is so
large, suppliers cannot observe all prices at all the times.
c) Suppliers more closely monitor their own products than their
own consumption goods.

152
d) Changes in overall price level are often confused with
relative price change or individual product price.
 According to this model, producers know the nominal price
of their product; but not the overall price level on basis of
which they have to estimate the relative price change of their
product.
 So a producer observes the price of her/his product and
increases her/his output when the price increases and all
other producers do the same.
 They all act rationally but mistakenly.

153
 They act rationally because the rational response for producers
to an increase in demand for their product is to increase
production or supply, sell more and get more revenue.
 But they act mistakenly because the information they have is
not correct and the change they observe does not have the
incentive to which they respond by producing and supplying
more.
 So, according to the imperfect information model, suppliers
increase their output when prices exceed expected prices.

154
D. Sticky Price Model
 This model emphasizes the product market itself to be the
area where the major factors that determine the relationship
between price and aggregate supply or output exist.
 The analysis of the model focuses on the process how
prices are set.
 According to the model, the prices are not flexible or free to
adjust to clear the market once it is fixed or agreed upon and
implemented.
 The model assumes that some firms cannot quickly change
prices as a result of variations in aggregate demand, because
either, they may have long-term contracts or it is costly to
alter prices once they have been published in catalogues.

155
 Firms do not instantly adjust prices in response to changes in
demand because of the following major reasons.
A. Sometimes prices are fixed through agreement on a long
term contracts between firms and customers.
B. Firms hold prices steady in order not to annoy their regular
customers with frequent price changes.
C. Sometimes, prices are sticky because of market structure.
 The kinked demand curve market model is the best
example for this.
D. Once price catalog is prepared or printed and distributed to
customers, firms tend to continue charging the same price
since it is costly to change it from time to time.

156
 Although these four models differ in assumption and
emphasis, their implications for an economy are similar
and can be summarized by the equation:

Y  Y   P  Pe 
 If price level (P) is higher than the expected price level (P e),
output (Y) exceeds its natural rate (Ῡ).
 So we need not accept one and reject other of these models.
 The world may contain all such imperfections and all may
contribute to the analysis of the behavior of short run
aggregate supply.

157
 4.3. Macroeconomic Equilibrium and Changes in
Equilibrium
 The intersection of the aggregate demand curve and the
aggregate supply curve establishes the economy’s
equilibrium price level and equilibrium real domestic output.
 Since the aggregate supply curve behaves differently in the
short run than in the long run we illustrate the
macroeconomic equilibrium in both cases.

158
4.3.1. Short-Run Macroeconomic Equilibrium
 Short-run macroeconomic equilibrium occurs at the price
level at which aggregate quantity demanded and short-
run aggregate quantities supplied are equal.
 Initially, the equilibrium price level and level of real output
are 100 and dollar 510 billion, respectively (Figure 4.11).
 Suppose the price level were 92 rather than 100.
 The lower price level (dollar 92) would encourage businesses
to produce real output of dollar 502 billion (point a on the AS
curve) while buyers would want to purchase dollar 514
billion of real output (point b on the AD curve).

159
 Competition among buyers to purchase the lesser available
real output of dollar 502 billion will eliminate the dollar 12
billion (=514 billion –502 billion) shortage and pull up the
price level to 100.

 The excess demand for the output of the economy causes the
price level to rise from 92 to 100, which encourages producers
to increase their real output from dollar 502 billion to dollar
510 billion, thereby increasing GDP.

160
 In increasing their real output, producers hire more

employees, reducing the unemployment level in the

economy.

 Finally, the economy has achieved equilibrium (at dollar 510

billion of real GDP).

 Note also that any shift in aggregate demand and/or

aggregate supply curves may change equilibrium level of

the output and price level.

161
Figure 4.11: Short run macroeconomic equilibrium

162
4.3.2. Long-Run Macroeconomic Equilibrium

 In the long run equilibrium, the quantity demanded of real

GDP equals the long run quantity supplied of real GDP.
 As can be seen from Figure 4.12 that the long run
equilibrium output level is Y1 and the price level is P1.
 Note that: the impact of any changes in aggregate demand
when the long run aggregate supply is constant will be on
the price level only.

163
Figure 4.12: The long-run equilibrium

164
5. MACROECONOMIC PROBLEMS
 Inflation and unemployment are the most important
and recurrent economic problems that have
characterized modern economic history throughout the
world.
 The problem unemployment is associated with
recessions and
 inflation is associated with the loss of purchasing power
of our incomes.
 Most economic policy focuses on mitigating these, most
serious, of problems in the macroeconomics.

165
5.1. Unemployment

5.1.1. Definitions and Concepts of Unemployment

 The participation of labours in different productive
activities helps in bringing wellbeing of the economy as a
whole.
 Labours come from household sector of the economy and a
larger proportion of the aggregate demand arises from the
household sector or their income.
 The income of labour depends on employment and their
ability to purchase in turn determines national output.

166
 Unemployment refers to a situation where workers of the
working age could not find job while they are ready to
work at prevailing market wage rate.

 The working age range can be denoted as 15≤X<65 years.

 The problem of unemployment and its intensity is usually

measured in terms of unemployment rate.

 This is because talking about the actual number of

unemployed people makes no sense for countries of different
population size.
167
 Unemployment of 10,000 people in a given country with
total population of 500,000 people is much compared to
unemployment of 10,000 people in a country with total
population of 500,000,000 people.
 we can say there is unemployment problem in the former
where as there is no significant unemployment problem in
the later.
 Thus, better to measure unemployment problem in terms of
unemployment rate.
 Unemployment rate is defined as the percentage or the
proportion of the labour force that is unemployed.

168
 Labour force (L) is the sum of both employed (E) and
unemployed people of working age and working or ready to
work (U).
 L = E + U ----------------------------------------- (5.1)
 Labour force does not include part of the working age
population which are not working or looking for work, that
is, the working age population that is not in the labour
market.
 Retired persons, children, those who are either incapable
of working or those who choose not to participate in the
labor market are not counted in the labor force.
 Labour force participation is the percentage of adult or
working age population who are in the labour force.

169
 These two concepts are summarized by the equations:
 Number of Unemployed 
Unemployment Rate    X (100)
 Labour Force 
 Labour Force 
Labour Force Participat ion Rate    X (100)
 Adult Population 
 The concept of natural rate of unemployment is used as
reference to the existence of unemployment problem.
 Natural rate of unemployment is the average rate of
unemployment around which an economy fluctuates given by
U/L = n at that point.
 It is related to the rate at which workers lose job (job loss
rate) and the rate at which jobless workers find or get job
(job finding rate).

170
 This can be more elaborated as follows using the steady state
unemployment rate.
 Steady state unemployment rate is the point or condition in
which the number of workers leaving or losing job are equal
to the number of unemployed getting or finding job given by
the following equation:
 fU=sE --------------------------------------------- (5.2)
Where, ‘f’ is rate of job finding,
‘s’ is rate of job separation or loss
‘U’ is unemployed population,
‘E’ is Employed population

171
 Rearranging equation (5.1) into E = L – U and substituting in
(5.2), we obtain:
fU = s(L – U) dividing both sides by L →fU/L = (s/L)(L – U)
fU/L = s( 1 – U/L) dividing both sides by ‘f’ we obtain
U/L = s/(s + f) = n --------------------------------- (5.3)
Where, U/L = n is the natural rate of unemployment
 Any policy aimed at reducing the natural rate of
unemployment should either reduce the rate of job separation
(losing job), or increase the rate of job finding (f).
 Moreover, any policy that affects the rate of job separation
(s) or job finding (f) also affects the natural rate of
unemployment ‘n’.

172
Examples:
1) If 90% of labour force of a given country with 10 million
labour force population are employed on average, find the
unemployment rate of the country.
2) If 3% of workers are on average leaving or losing their job
and on average 40% of unemployed workers and workers
newly joining labour market are finding or getting job, then
what is the natural rate of unemployment?
3) In question number ‘1’ if the size of the adult population of
the country is 12 million, what is the labour force
participation rate?

173
Solutions:

1. L=E+U=90%(L)+U, L-0.9L=U, U/L=0.1=10%

2. Given: job separation rate (s)=3%=0.03 and
Job finding rate (f)=40%=0.4
U/L=n=(s/(s+f))=(0.03/(0.03+0.4))
=0.0698=6.98%
3.   Labour Force
Labour Force Participat ion Rate    X (100)
 Adult Population 
= (10 million /12 million) x100
=83.33%

174
5.1.2. Types of Unemployment
 The major causes of unemployment are contraction of
aggregate demand or national output which, may arise from
natural or manmade disasters; and/or temporary shifts
between different jobs or other types of frictions in the labour
market such as technological change.
 Depending on the causes or sources of the unemployment
and the duration of the unemployment, we can divide
unemployment into three or four major categories.
 These are frictional unemployment, structural
unemployment, cyclical unemployment and/or seasonal
unemployment.

175
I. Frictional unemployment

 Frictional unemployment is usually caused by constant

changes in the labour market.
 It occurs due to two reasons.
1. when employers are not aware of the available workers
and their job qualifications.
2. when workers are not fully aware of the jobs being
offered.
 The basic cause of frictional employment is thus lack of
information flow among workers and employers called
imperfect information.
 So for workers this is the period of unemployment until they
get a job and the duration of unemployment is equal to the
time it takes workers to search for a job.

176
 New graduating student from colleges and universities or
training institutions are usually frictionally unemployed.
 This is the period when such people look for vacancies and
apply to different offices getting interviewed and so on.
 The change in composition of demand among economic
sectors, industries or regions is called sectoral shift.
 Due to this shift, the demand for workers also shift and
some workers have to leave some sectors, industries or
regions and look for jobs and join some other sectors which
always involve frictional unemployment.
 The main characteristics of frictional unemployment are:
 it affects large number and wide range of people

177
  it tends to be of short period
 certain amount of fractional unemployment is
unavoidable
 One of the policy options to solve such unemployment is
improving labour market information (e.g. establishment
of information office about workers and vacancies).
 Note that in trying to reduce frictional unemployment, some
policies inadvertently increase the amount of frictional
unemployment.
 One example of such policy is unemployment
insurance.
 In this case, people will be reluctant in looking for job as
soon as possible since they can collect some money
because of their unemployment and prefer to stay for
certain period after unemployment. 178
II. Structural Unemployment
 Structural unemployment occurs due to the structural
changes in the economy.
 These changes eliminate some jobs while they create some
new jobs for people with new skill level.
 The skill sets take time to develop and hence some people
lose their job simply because they do not have the new
required skill(s).
 This problem arises from mismatch between the types of jobs
that are available and type of job seekers.

179
 Such mismatch may be related to skill, education level,
geographical area, age, etc.
 For instance, some skills may no longer be demanded.
 For instance, typing machines are replaced by computers.
 In this case type writers who do not have computer skill would
lose their job and potentially become unemployed.
 Some of the characteristics of this type of unemployment
are that:
 It tends to be concentrated among certain group of people
who are adversely affected by technological change.

180
  It tends to be long lasting (e.g. it takes time to the victims
until they train themselves under new situation or new
technology).
 In this respect, one of the policy options used to reduce such
unemployment is training workers and improving labour
mobility.
 Structural unemployment also arises from real wage
rigidity leading to failure of the labour market to adjust to
equilibrium or the point where demand for and supply of
labour are equal (see figure 5.1).
 Wage rigidity is the failure of wages to adjust to the point
where the demand for labour equals its supply.
181
 If the real wage is stuck above the equilibrium level given
by the point of intersection between labour supply and labour
demand curves point ‘e’, then the supply of labour exceeds its
demand.
 This results in unemployment equal to the distance between
point ‘a’ and point ‘b’.
 During wage rigidity and job rationing, workers are
unemployed not because they cannot find job that suits them
or their skills, but at the prevailing wage rate the supply of
labour exceeds its demand.
182
Figure 5.1: Real Wage and Structural Unemployment

183
III. Cyclical Unemployment
 Cyclical unemployment occurs due to general downturn
in the business activities including production and
demand for the products and services.
 During recession, only few goods are produced and for
such low production, only few employment opportunities
would be available.
 Employers are therefore, obliged to lay-off workers and
cut back employment.
 Unemployment rate fluctuates around a line known as
‘natural rate of unemployment’.
 It is a rate where there is no cyclical unemployment or
when all the unemployment is frictional and structural
ones.

184
 Generally, there is always some amount of unemployment and
economists very frequently use the term full employment.
 Full employment occurs when the unemployment rate is
equal to the natural rate of unemployment.
 However, full employment does not mean that all workers are
employed or zero unemployment.
 The natural rate of unemployment is thought to be about 4%
and is a portion of structural unemployment and frictional
unemployment.
 However, there is no complete professional agreement
concerning the natural rate, some economists argue that the
natural rate, is about 5%.
185
 The disagreement centers more on observation of the secular
trend, than any particular technical aspect of the economy.
 Cyclical unemployment is also known as demand deficient
unemployment.
 Cyclical unemployment is the result of insufficient aggregate
demand in the economy to generate enough jobs for those
seeking them.
 It occurs during cyclical contraction of an economy
(recession).
 The policy instrument to solve this problem is fiscal policy
(for instance increasing government expenditure and
reducing tax rates) and/or monetary policy (such as reducing
interest rate and increasing money supply).
186
IV. Seasonal Unemployment
 Seasonal unemployment arises from a decline in the
economic activity in some seasons (particular time in a year)
and in some sectors.
 Therefore, seasonal unemployment results from fluctuations
in demand for labour in these sectors and/or seasons.
 The special characteristic of this type of unemployment is
that fluctuation can take a regular course of action and can
be anticipated so that workers also make their own plan to
move to particular sector in specific seasons to avoid such
unemployment.
 For instance, workers can seek job in agricultural sector
during the first season of cultivation and during harvest time.
 In other seasons the demand for labour in agriculture
becomes low and as a result workers would look for job in
other sectors.
187
Conclusion

 With fractional and structural unemployment there could

be enough jobs, but difficult to match job seekers with job
vacancies.

 With cyclical unemployment, there are no enough jobs for

job seekers.

 The duration of cyclical unemployment can be in between

frictional (short duration) and structural (long duration)
unemployment if the recession is handled and solved quickly
otherwise, it will take longer duration.
188
 Underemployment, disguised unemployment and open
unemployment are used to demonstrate different degrees
of unemployment.
 Underemployment refers to the people who work below their
capacity.
 For instance, a person may be employed for only 5 hours a
day while he/she can and wants to work more than that.
 Disguised unemployment is the case where the worker is
employed but adding nothing to the output.
 Open unemployment represents the formal definition we
have discussed above where the person has no job at all while
he/she is ready to work at the prevailing market wage rate.
189
5.1.3. Relationship between Unemployment and Output
 Unemployment is not just a single dimensional problem.
 Based on empirical observation an economist determined that
there was a fairly stable relation between unemployment and
lost output in the macroeconomics.
 This relation has a theoretical basis.
 As we move away from an economy in full employment,
noninflationary equilibrium, we find that we lose jobs in a
fairly constant ratio to the loss of output.

190
 This means unemployment and output of the economy are
inversely related; as unemployment increases output also
decreases.
 As a result, one can say that the largest single cost of
unemployment is loss of production.
 People who do not work they do not produce.
 Then, the cost of output lost becomes very high and this is the
reason why many economists studied the relationship between
these two important variables.
 The relationship between income or output and unemployment
is first considered and explained by Arthur Okun.

191
5.1.4. Labour Market Equilibrium
 It is important to understand different positions of different
schools of economic thought about labour market
equilibrium.
 The two opposite labour market reaction (labour demand and
labour supply) theories are the positions of:
 the classical frictionless labour market and
 the Keynesian position of the labour market equilibrium.

192
5.1.4.1. Classical Frictionless Labour Market Equilibrium

 Both the demand for and supply of labour depend on the

real wage, W/P.
 Real wage measures the amount of goods that can be
bought with a reward of an hour of work or received wage
income.
 According to classical economists the real wage adjusts to the
point where demand for labour equals its supply.
 During low demand for labour unemployment will be high.
 During such period there is no reason why workers do not
cut their wage rate to get job.
 That means workers would be ready to cut their wage or to
work at lower wage rate during high unemployment.

193
 Similarly, during high employment, which is the case of high
demand for labour, employers are ready to pay higher wage
rate.
 This means that wage rate increases to the point where the
demand for labour equals its supply.
 Due to this the labour market is always in equilibrium given
by the following graph.
 At market clearing condition, ‘e’, there is only natural or
voluntary unemployment. (Fig. 5.2)

194
 The equilibrium is said to be frictionless because the
classical economists believe that the market always clears
i.e. there is no unemployment.
 In equilibrium, everyone who wants to work is working.
 But there is always some unemployment.
 That level of unemployment is accounted for by labour
market frictions, which occur because the labour market is
always in a state of flux.
 Some people are moving and changing jobs; other people
are looking for job for the first time; some firms are
expanding and hiring new workers while others have lost
business and are obliged to reduce employment by firing
workers.

195
Figure 5.2: Classical Frictionless Labour market equilibrium

196
 The frictionless classical model is an idealized case and is

based on the idea that:

 wages and prices are fully flexible;

 no costs to either workers in finding jobs or firms in

increasing or reducing their labour force;

 firms behave competitively;

 a firm is expected to sell all its products at prevailing

prices;

197
 According to classical economists whatever the wage level
is the labour supply must not increase because there is no
involuntary unemployment.
 At equilibrium real wage (W/P)* the equilibrium
employment level is L* defined at the point of
intersection between short run labour supply curve (SRLs)
and labour demand curve (Ld). (Fig. 5.3)
 According to classical economists, the distance or the
difference between L* and Lf is the Natural rate (voluntary)
unemployment.
 ‘Lf’ is full employment level of labour supply equal to
long run labour supply level.

198
Figure 5.3: Frictionless Labour market equilibrium and
voluntary unemployment

199
5.1.4.2. New–Keynesian view of unemployment
 Keynesian economists say that the market does not clear
because of commodity price rigidity in commodity
market and real wage rigidity in the labour market for
several reasons.
 For new Keynesians, the real wage can be (fixed) at (W/P)*
and employment will be at L*. (Fig. 5.4)
 Thus, the difference between Lf and L* is wait
unemployment or involuntary unemployment.
 This arises from wage rigidities and job rationing.
 However, what are the reasons for real wage rigidities?
 The following are some of the major reasons.

200
Figure 5.4: Keynesian Labour market Equilibrium

201
1) Minimum wage rate legislation
 This is the result of government policy of welfare protection
or of labour- union pressure.
 It represents the case where the real wage rate is fixed above
the market clearing one (figure 5.5).
 When minimum wage is fixed at (W/P)min, the difference
between L1 and L2, (L2-L1), will be involuntary
unemployment.
 This amount of unemployment exists even people are willing
to work at wage rate below minimum wage rate (W/P)min for
instance, at (W/P)*.
 If the minimum wage is set at a point less than equilibrium
wage rate, (for instance at W1), this will not be a constraining
factor.
202
Figure 5.5: Minimum wage rate

203
2) Monopoly power of labour unions
 Sometimes firms might be interested to pay high wage
(which is larger than the equilibrium wage rate) to avoid
unionization.
 Wage tends to be rigid because of interest conflict
between insiders and outsiders.
 Outsiders (employers and unemployed workers) argue for
or accept low wage while insiders (employed workers)
argue for high wage.
3) Efficiency wage hypothesis
 Firms prefer to pay above the equilibrium wage rate for
several reasons-some of the reasons are:
a. Nutrition condition: Better paid worker is well-fed, healthy
and efficient.
 This in turn reduces absenteeism from work.
204
b. To reduce labour turn over: By paying higher wage firms
can avoid or reduce frequent recruitment costs, advertisement
cost and training costs.
 Because higher wage rate make workers prefer to stay with
the high paying firm.
c. To keep quality workers and improve work effort:
 Qualified workers seek for high paying firms.
 High payment also avoids shirking constraints.
4) Imperfect information
 Imperfect information about changes in prices in the
commodity market may lead to lag in change of wage rate
in the labour market.
 Thus, because of lack of information, the real wage rate
may also fail to adjust to the market clearing one.
205
5.1.5. Labour supply and Business Cycle
 Labour supply responds not only to changes in economic
opportunities over a worker’s life time, but may also show
adjustments to changes in labour opportunities induced
by business cycle.
 In this respect, two major hypotheses are developed
namely added worker effect hypothesis and discouraged
worker effect hypothesis.
 The added worker effect hypothesis suggests that secondary
workers (who lack commitment to the labour market such as
students, house wives, retired persons, etc) will tend to
become labour market participant during economic
recessions; and then withdraw their labour during prosperity.
206
  The added worker effect thus implies that the labour force
participation rate of secondary workers has a counter
cyclical trend (i.e. it moves in opposite direction to the
business cycle).
 This is because, for primary workers, there are no enough
jobs during recession.
 The discouraged workers effect hypothesis, on the other
hand, argues that unemployed primary workers finds so
difficult to get work that they eventually are discouraged and
stop looking for work.
 As a result the labour force participation rate (labour
supply) declines.
 So the supply of primary workers has a pro-cyclical trend
(it falls during recession and increases during boom).
207
5.2. Inflation
5.2.1. Concepts and Definition of Inflation
 A birr today doesn’t buy as much as it did ten years ago.
 The cost of almost everything may go up.
 This increase in the overall level of prices is called
inflation.
 The inflation rate measures how fast prices are rising.
 Inflation rate is the rate at which the average of these prices or
overall price level increases from period to period and can be
calculated as:  
 P1 P0  X 100

Inflation rate 
 
 P 0 
Where, P0= previous year price index,
P1=current year average price
208
 If the inflation rate is very high, it is known as
hyperinflation.
 There is no consensus on when a particular rate of inflation
becomes hyper but most of the economists would agree that
inflation rate of about 100% per year would be hyper or the
level of inflation that exceeds 50% per month or a level of
inflation which is greater than 1% per day.
 For example, if a person is having 200 birr in 2012 then
the value of the same money is around 100 birr in 2013.
 During hyperinflation, everything on the market becomes too
costly.

209
 The purchasing power of money will fall down since one needs a
larger amount of money to purchase small good or service.
 Thus, during hyperinflation money loses its role as store of
value, unit of account and medium of exchange.
 Under this condition, the demand for money will be very low
and people resort to using commodity money or bartering
system where commodities are exchanged for commodity.
 In some countries people go wild by rioting and breaking the
shops and stores in order to get food.
 Sometimes they even blame the government for the rise in price
level leading to the toppling down of heads of the state.

210
5.2.2. Price indexes
 Economists measure changes in the cost of living using
the price indexes.
 Price indexes are the way we attempt to measure inflation
and adjust aggregate economic data to account for price
level variations.
 The three ways of measuring price index/ average price are:
 GDP deflator,
 consumer price index and
 producer price index.

211
a. GDP deflator:
 Nominal GDP reflects both the prices of goods and services
and the quantities of goods and services the economy is
producing.
 By contrast, by holding prices constant at base-year levels,
real GDP reflects only the quantities produced.
 From these two statistics, we can compute the GDP
deflator which reflects the prices of goods and services but
not the quantities produced.


GDP deflator  Nominal GDP
Real GDP
x100
212
 Because nominal GDP is current output valued at current
prices and real GDP is current output valued at base-year
prices, the GDP deflator reflects the current level of prices
relative to the level of prices in the base year.
 Because nominal GDP and real GDP must be the same in the
base year, the GDP deflator for the base year always equals 100.
 Imagine that the quantities produced in the economy rise over
time but prices remain the same.
 In this case, both nominal and real GDP rise together, so the
GDP deflator is constant.
 Now suppose, instead, that prices rise over time but the
quantities produced stay the same.

213
 In this second case, nominal GDP rises but real GDP remains
the same, so the GDP deflator rises as well.
 In both cases, the GDP deflator reflects what’s happening to
prices, not quantities.
 Numerical example: Suppose that for year 2001, nominal
GDP is dollar 200, and real GDP is dollar 200, so the GDP
deflator is 100.
 Again assume that for the year 2002, nominal GDP is
dollar 600, and real GDP is dollar 350, so the GDP deflator
is 171.
 Because the GDP deflator rose in year 2002 from 100 to
171, we can say that the price level increased by 71
percent.

214
b. Consumer price index (CPI):
 It is a measure of the overall cost of the goods and services
bought by a typical consumer.
 CPI measures the cost of buying a fixed basket of goods and
services representative of the purchases of urban consumers.

 Total expenditur e on market basket in current year 

CPI   
 Total expenditur e on market basket in base year 
 To calculate the consumer price index and the inflation
rate, data on the prices of thousands of goods and services
is required.
 However, to see exactly how these statistics are
constructed let’s consider a simple economy in which
consumers buy only two goods-bread and apple.

215
 Table 5.1 shows the five steps that we follow.
 In the example in the table, the year 2001 is the base year and
hence, the consumer price index is 100.
 The consumer price index is 175 in 2002.
 This means a basket of goods that costs dollar 100 in the
base year costs dollar 175 in 2002.
 Finally, use the consumer price index to calculate the
inflation rate, which is the percentage change in the price
index from the preceding period.

 CPI in year 2  CPI in year 1 

Inflation rate in year 2   
 CPI in year 1 
 The inflation rate is 75 percent in 2002 and 43 percent in
2003.
216
Table 5.1: Calculating the consumer price index and the inflation rate
Step 1: Survey Consumers to Determine a Fixed Basket of Goods
Basket of 4 bread and 2 apples
Step 2: Find the Price of each Good in each Year
Year Price of Bread Price of Apple
2001 dollar1 dollar2
2002 dollar2 dollar3
2003 dollar3 dollar4
Step 3: Compute the Cost of the Basket of Goods in each Year
2001 (dollar1per bread x 4 bread) + (dollar2 per apple x 2 apples)=dollar8
2002 (dollar2 per bread x 4 bread) + (dollar3 per apple x 2 apples)=dollar14
2003 (dollar3 per bread x 4 bread) + (dollar4 per apple x 2 apples)=dollar20
Step 4: Chose One Year as a Base Year (2001) and Compute the Consumer Price Index in each Year
2001 (dollar8/dollar8) x100=100
2002 (dollar14/dollar8)x100=175
2003 (dollar20/dollar8)x100=250
Step 5: Use the Consumer Price Index to Compute the Inflation Rate from Previous Year
2002 (175-100)/100 x100=75%
2003 (250-175)/175x100=43%
217
The GDP Deflator versus the Consumer Price Index
 The following are the three main differences between CPI and
GDP deflator:
 The deflator measures the prices of a much wider group of
goods than the CPI does.
 The CPI measures the cost of a given basket of goods, which
is the same from year to year.
 The basket of goods included in the GDP deflator,
however, differs from year to year, depending on what is
produced in the economy in each year.
 When corn crops are large, corn receives a relatively large
weight in the computation of the GDP deflator.
 The CPI directly includes prices of imports, whereas the
deflator includes only prices of goods produced in the
country, say Ethiopia.
218
c. Producer price index (PPI):

 It measures the cost of a basket of goods and services bought

by firms rather than consumers.
 Because firms eventually pass on their costs to consumers in
the form of higher consumer prices, changes in the producer
price index are often thought to be useful in predicting
changes in the consumer price index.

 Cost of production in current year 

PPI   
 Cost of production in base year 

219
Quiz-1
In a hypothetical economy, goods X and Y are the only two
goods produced and consumed domestically in 2012 and 2013.
Answer the questions below assuming that 2012 is the base year.
Years Prices (Birr) Quantities
Good X Good Y Good X Good Y
2012 50 100 30 20
2013 40 110 25 30

a) Determine the Consumer Price Index (CPI) in both years.

b) Calculate the rate of inflation in 2013.
5.2.3. Causes and Effects of inflation
5.2.3.1. Causes of inflation
 Some of the major causes or sources of inflation are an
increase in money supply, high demand for goods and
services and shortage of supply of goods and services.
 There are three theories of inflation that arise from the real
conduct of the macroeconomics.
 These three theories are demand-pull, cost-push, and pure
inflation.
 There is also a fourth theory that suggests that inflation has
little or nothing to do with the real output of the economy,
this is called the quantity theory of money.

221
a. Demand - Pull Inflation

 When there is high demand for goods and services

individuals or users of the goods and services would be
ready to pay higher price.
 Suppliers have the incentive to charge higher price when there
is high demand for their product, hence, the price level will
swing upward-demand pull inflation.
 As the aggregate demand shifts to the right (AD1 to
AD2), all prices increase (P1 to P2) which again increases
total output (Y1 to Y2) (see figure 5.6.)
 Increase in aggregate demand causes inflation, but does not
result in lost output, hence unemployment.
 Policy measures designed to control demand-pull inflation,
will shift the aggregate demand curve to the left and this
reduction in aggregate demand is associated with loss of
output, hence increased unemployment.
222
Figure 5.6: Increase in the aggregate demand

223
b. Cost - Push Inflation
 When there is high cost of production, there will be
shortage of supply of goods and services.
 Then to cover their high cost of production and get profit
margin producers of goods and services charge higher
prices.
 Moreover, when there is shortage of supply, consumers or
users of goods and services are willing to pay higher price to
get the limited goods and services.
 This means, both actions lead to an increase in price level.
 Such inflation or an increase in price level arises from the
supply side or from the cost of production and is therefore,
called cost push inflation.
224
 For instance, there was a supply shock of oil during 1970s
across the world and this increased cost of production and
distribution that finally resulted in inflation during the period.
 If the problem of inflation arises along with low aggregate
output or during economic stagnation or recession the
situation is called stagflation.
 Again using an aggregate supply-aggregate demand approach,
cost-push inflation results from a decrease in the aggregate
supply curve.
 The following diagram (figure 5.7) shows a shift to the left or
decrease in aggregate supply curve (from AS1 to AS2) and a
price increase from P1 to P2.
225
Figure 5.7: Decrease in the aggregate supply

226
c. Pure Inflation
 Pure inflation results from an increase in aggregate
demand and a simultaneous decrease in aggregate supply.
 For output to remain unaffected by these shifts in aggregate
demand and aggregate supply, then the increase in aggregate
demand must be exactly offset by an equal decrease in
aggregate supply.
 Notice in this diagram (figure 5.8), that aggregate supply
shifted to the left, or decreased (from AS1 to AS2) by
exactly the same amount that the aggregate demand curve
shifted to the right or increased (from AD1 to AD2).
 The result is that output remains exactly the same, but the
price level increased.
227
Figure 5.8: Change in both aggregate demand and aggregate
supply

228
d. Quantity Theory of Money

 Inflation, in the monetarist view, can only occur if the money

supply is increased which permits all prices to increase.

 If the money supply is not increased there can be changes in

relative prices, for example, oil prices can go up, but there has

to be offsetting decreases in the prices of other commodities.

 An increase in all prices or in the price of a particular good,

therefore, is a failure of the central bank (Fed) to

appropriately manage the money supply.

229
5.2.3.2. Effects/consequences of Inflation
 Whatever its sources or its causes, inflation has some
common major effects on the society or the country where
inflation occurred.
 Some of these effects are
 high living costs,
 higher wage rates,
 excess nominal money supply over the real products,
 shortage of supply of goods and services due to high cost
of production,
 very low value of domestic currency (or money),
 expensive imports, and so on.

230
 When inflation occurs, each unit of consumer goods is bought
at higher price and living expenses become higher unless the
income of individuals increases as well.
 This is why workers push wage rate upward during inflation
period.
 This implies that the purchasing capacity of money or
domestic currency deteriorates.
 Compared to foreign currencies the value of domestic
currency becomes very low and becomes subject to be
changed to smaller amount of foreign currency.

231
 Thus, when one purchases smaller amount of foreign

commodity or imports becomes expensive.

 There will be inflow of foreign currency if exports and imports

are elastic.

 But normally, in developing countries petroleum products

constitute the major part of imports and hence imports are

inelastic.

 Imports remain the same despite it becomes costly for the

domestic country, the country becomes poorer.

232
 The effects of inflation may impact different people in
different ways.
 Creditors and those living on a fixed income will
generally suffer.
 However, debtors and those whose incomes can be
adjusted to reflect the higher prices will not, and perhaps
this group may even benefit from higher rates of inflation.
 If inflation is fully anticipated and people can adjust their
nominal income or their purchasing behavior to account
for inflation then there will likely be no adverse effects,
however, if people cannot adjust their nominal income or
consumption patterns people will likely experience
adverse effects- effect of unanticipated inflation.

233
 Normally, if you cannot adjust income, are a creditor with a
fixed rate of interest or are living on a fixed income you will
pay higher prices.
 The result is that those individuals will see their standard of
living eroded by inflation.
 Debtors, whose loans specify a fixed rate of interest,
typically benefit from inflation because they can pay loans-
off in the future with money that is worth less.
 It is this paying of loans with money that purchases less that
harms creditors.

234
 Savers may also find themselves in the same position as
creditors.
 If savings are placed in long-term savings certificates that
have a fixed rate of interest, inflation can erode the earnings
on those savings substantially.
 Savers that anticipate inflation will seek assets that vary with
the price level, rather than risk the loss associated with
inflation.
 Inflation will affect savings behavior in another way.
 If a person fully anticipates inflation, rather than to save
money now, consumers may acquire significant debt at fixed
interest rates to take advantage of the potential inflationary
leverage caused by fixed rates.
 Rather than to save now, consumers spend now.
235
 Therefore, inflation typically creates expectations among
people of increasing prices, and if people increase their
purchases aggregate demand will increase.
 An increase in aggregate demand will cause demand-pull
inflation.
 Therefore, inflationary expectations can create a spiralling of
increased aggregate-demand and inflationary expectations that
can feed off one another.
 At the other extreme, recessionary expectations may cause
people to save, that results in reduced aggregate demand,
and another spiral effect can result (but downwards).

236
5.3. Relationship between Unemployment and Inflation

 The relationship between inflation and unemployment

is a topic that has attracted the attention of some of the

most important economists of the last half century.

 These theories show why the trade off between inflation

and unemployment holds in the short run, why it does not

hold in the long run, and what issues it raises for

economic policymakers.

 This relation can be described by Phillips curve.

237
Phillips Curve
 The Australian economist, A.W. Phillips plotted data on
unemployment rates and rate of change in wage rates
between 1861 and 1957 in UK and found a more or less stable
relationship between these two variables.
 Later he and other economists extended the concept to cover
larger range of data and found out that there is negative
relationship between unemployment rates and rate of change
in wage rates. Then they termed the curve showing this
relationship as Phillips Curve.
 The Phillips Curve is a downward sloping curve that shows
an inverse relationship between the inflation rate and the
unemployment rate.
 When unemployment rate is very low (employment is high),
then workers have the market power to push up wages.

238
  Higher wage rate again implies that the cost of production
is high and that sellers charge high prices.
 When unemployment rate is very high, then workers do not
have much bargaining power; rather they would be ready to
accept lower wage to get job.
 Due to this, the pressure on prices also remains low ( see
figure 5.9).
 Such relationship between inflation and unemployment
generated the idea of policy trade off.
 It suggests that policymakers could choose different
combinations of unemployment and inflation rates.

239
Figure 5.9: Short run Phillips Curve

240
 If the world works the way Phillips Curve suggests then policy
makers must choose inflation and unemployment
combinations along Phillips Curve.
 This is because the curves suggest that less unemployment
can always be attained by incurring more inflation so that
the inflation rate can always be reduced by incurring the
costs of more unemployment.
 However, after 1960, the Phillips Curve became unstable
and people started questioning about the trade off.
 In mid-1960s, economists like Milton Friedman and Edmund
Phelps suggested that the unemployment rate and rate of
inflation are vertical straight line in long run.

241
 In long run there is always natural rate of unemployment (N).

 The natural rate of unemployment depends on various

features of the labor market, such as minimum-wage laws, the

market power of unions, the role of efficiency wages, and the

effectiveness of job search.

 By contrast, the inflation rate depends primarily on growth in

the money supply, which a nation’s central bank controls.

 In the long run, therefore, inflation and unemployment are

largely unrelated problems.

242
 The implication of the vertical long run in Philips Curve is
that there is change or deviation in unemployment rate
from the natural rate is only of short run.
 An increase above the natural rate of unemployment or a fall
below it would be adjusted in the long run.
 On the contrary, it is expected that inflation has positive
impact on the labour market.
 Some economists argue that some level of inflation may
make labour markets work better.
 They say that it “greases the wheels” of the labour
markets.
 This is because with some level of inflation, the wage rate
increases and workers get initiated simply by increased
nominal wage rate.
243
Figure 5.10: Long Run Phillips Curve

244
6. MACROECONOMIC POLICIES
 Macroeconomic policies affect the overall performance of

the economy.

 Two main macroeconomics policies are the financial/

monetary and fiscal policy.

 These policies will be used to achieve macroeconomics

objectives, such as full employment, price stability and

satisfactory economic growth.

 Monetary and fiscal policies can each influence aggregate

demand.
245
6.1. Monetary Policy
 Monetary policy is the process by which the monetary
authority (Central Bank) of a country controls the supply
of money, often targeting a rate of interest to attain a set
of objectives oriented towards the growth and stability of
the economy.
 In a recession, expansionary monetary policy-"easy money"
involves lowering interest rates and increasing the money
supply.
 In an overheated expansion, contractionary monetary
policy-"tight money" raises interest rates and decreases the
money supply.

246
6.1.1. Monetary policy tools

 The tools of monetary policy are those available to the

central bank to control the excess reserves of banks.
 They include open market operations, changes in
required reserve ratios and changes in the discount
rate.
 It is normal to believe that control over the physical
printing of bank notes is the essence of monetary policy,
but that is not entirely correct.
 Banks have the ability to create money through monetary
multiplier.
247
Reserve requirement:

 Banks are required to hold a certain percentage (cash

reserve ratio, or CRR) of their deposits in reserve in order
to ensure that they always have enough cash to meet
withdrawal requests of their depositors.
 The CRR is usually around 10%, which means banks are
free to lend the remaining 90%.
 By changing the CRR requirement for banks, the Central
Bank can control the amount of lending in the economy,
and therefore the money supply with reserve requirements.

248
 An increase in reserve requirements means that banks must

hold more reserves and, therefore, can loan out less of each

dollar that is deposited; as a result, it raises the reserve ratio,

lowers the money multiplier, and decreases the money supply.

 Conversely, a decrease in reserve requirements lowers the

reserve ratio, raises the money multiplier, and increases the

money supply.

249
Open market operations:

 Open market operations consist of buying and selling of

government securities/ bonds by the central bank.
 To increase the money supply, the central bank buys bonds
in the nation’s bond markets.
 The cash the central bank pays for the bonds increase the
number of dollars in circulation.
 Some of these new dollars are held as currency, and some
are deposited in banks.

250
 To reduce the money supply, the Central bank sells

government bonds to the public in the nation’s bond markets.

 The public pays for these bonds with its holdings of currency

and bank deposits, directly reducing the amount of money in

circulation.

 In addition, as people make withdrawals from banks, banks

find themselves with a smaller quantity of reserves.

 In response, banks reduce the amount of lending, and the

process of money creation reverses itself.

251
 Open-market operations are easy to conduct thus, most

often used by the Central bank.

 In fact, the Central bank’s purchases and sales of government

bonds in the nation’s bond markets are similar to the

transactions that any individual might undertake for his own

portfolio.

 In addition, the Central bank can use open-market operations to

change the money supply by a small or large amount on any

day without major changes in laws or bank regulations.

252
Discount rate:
 It is the interest rate on the loans that the central bank
makes to banks.
 It is the cost of borrowing or, essentially, the price of money.
 The Central bank can alter the money supply by changing the
discount rate.
 This means by manipulating interest rates, the central bank
can make easier or harder to borrow money.
 A higher discount rate discourages banks from borrowing
reserves from the Central bank- reduces the money supply.

253
 Conversely, a lower discount rate encourages bank borrowing
from the central bank, increases the quantity of reserves, and
increases the money supply.
 When money is cheap, there is more borrowing and more
economic activity.
 Lower rates also discourages saving and induce people to
spend their money rather than save it because they get so little
return on their savings.

254
6.1.2. Monetary Policy and Aggregate Demand

6.1.2.1. Interest Rate Effect

 Keynes proposed the theory of liquidity preference to
explain what factors determine the economy’s interest
rate.
 According to Keynes, the interest rate adjusts to balance the
supply and demand for money.
 Economists distinguish two interest rates: the nominal
interest rate and the real interest rate.

255
 The nominal interest rate is the interest rate as usually
reported, and the real interest rate is the interest rate corrected
for the effects of inflation.
 In the analysis, we hold the expected rate of inflation
constant.
 The first piece of the theory of liquidity preference is the
supply of money.
 The Central Bank alters the money supply through the
purchase and sale of government bonds or by changing
reserve requirements or the discount rate.
256
 The quantity of money supply in the economy is fixed at
whatever level the Central Bank decides to set it.
 Hence, it does not depend on the interest rate.
 We represent a fixed money supply with a vertical supply
curve (Figure 6.1).
 The second piece of the theory of liquidity preference is
the demand for money.
 The quantity of money demanded depends on the interest
rate (the opportunity cost of holding money).

257
 That is, when you hold wealth as cash in your wallet,
instead of as an interest-bearing bond, you lose the interest
you could have earned.
 An increase in the interest rate raises the cost of holding
money and, as a result, reduces the quantity of money
demanded and vice versa.
 Thus, the money-demand curve slopes downward (Fig. 6.1).

258
 The equilibrium interest rate balances the quantity of money
demanded and the quantity of money supplied.
 If the interest rate is at any other level, people will try to adjust
their portfolios of assets and, as a result, drive the interest rate
toward the equilibrium.
 For example, suppose that the interest rate is above the
equilibrium level, such as r1 (Figure 6.1) where, the quantity
of money that people want to hold, Md1, is less than the
quantity of money that the Central Bank has supplied.

259
 Those people who are holding the surplus of money will try
to get rid of it by buying interest-bearing bonds or by
depositing it in an interest-bearing bank account.
 Because bond issuers and banks prefer to pay lower interest
rates, they respond to this surplus of money by lowering the
interest rates they offer.
 As the interest rate falls, people become more willing to hold
money until, at the equilibrium interest rate, people are happy
to hold exactly the amount of money the Central Bank has
supplied.
260
 Conversely, at interest rates below the equilibrium level,
such as r2 (Figure 6.1), the quantity of money that people
want to hold, Md2, is greater than the quantity of money that
the Central Bank (Fed) has supplied.
 As a result, people try to increase their holdings of money by
reducing bonds and other interest-bearing assets.
 As people cut back on their holdings of bonds, bond issuers
have to offer higher interest rates to attract buyers.
 Thus, the interest rate approaches the equilibrium level.

261
Figure 6.1: money market equilibrium

262
 The price level is one determinant of the quantity of
money demanded.
 At higher prices, more money is exchanged every time a
good or service is sold (people choose to hold a larger
quantity of money).
 That is, a higher price level increases the quantity of
money demanded for any given interest rate.
 Thus, an increase in the price level (P1 to P2) shifts the
money-demand curve to the right (MD1 to MD2), (panel (a)
of Figure 6.2).

263
 Yet the quantity of money supplied is unchanged, so the
interest rate must rise from r1 to r2 to discourage the
additional demand.
 At a higher interest rate, the cost of borrowing and the
return to saving are greater.
 Fewer households choose to borrow to buy a new house, so
the demand for residential investment falls.
 Fewer firms choose to borrow to build new factories and buy
new equipment, so business investment falls.

264
 Thus, when the price level rises from P1 to P2, increasing
money demand from MD1 to MD2 and raising the interest
rate from r1 to r2, the quantity of goods and services
demanded falls from Y1 to Y2 (panel (b) of Figure 6.2).
 The end result of this analysis is a negative relationship
between the price level and the quantity of goods and services
demanded, which is illustrated with a downward-sloping
aggregate-demand curve.

265
Figure 6.2 change in price level and aggregate demand curve

266
6.1.2.2. Changes in the Money Supply
 One important variable that shifts the aggregate-demand
curve is monetary policy.
 Suppose that the Central Bank (Fed) increases the money
supply by buying government bonds in open-market
operations.
 An increase in the money supply shifts the money-supply
curve to the right (MS1 to MS2), (panel (a) of Figure 6.3).
 Because the money-demand curve has not changed, the
interest rate falls from r1 to r2 to balance money supply and
money demand.
267
 That is, the interest rate must fall to induce people to hold the
additional money the Central Bank has created.
 The lower interest rate reduces the cost of borrowing and
the return to saving.
 Households buy more and larger houses, stimulating the
demand for residential investment, and firms spend more
on new factories and new equipment, stimulating business
investment.

268
 As a result, the quantity of goods and services demanded at a
given price level, P, rises from Y1 to Y2, (panel (b) of Figure
6.3).
 The monetary injection shifts the entire aggregate-demand
curve to the right.

269
Figure 6.3 change in money supply and aggregate demand curve

270
To sum up:

 When the Central Bank increases the money supply, it

lowers the interest rate and increases the quantity of goods

and services demanded for any given price level, shifting the

aggregate-demand curve to the right.

 The reverse is also true.

 Changes in monetary policy that aim to expand aggregate

demand can be described either as increasing the money

supply or as lowering the interest rate.

 The opposite is true as well.

271
6.2. Fiscal Policy

 Fiscal policy is changes in the taxing and spending of the

government for purposes of expanding or contracting the

level of aggregate demand thereby achieving objectives of

price stability, full employment and economic growth.

 In a recession, an expansionary fiscal policy involves

lowering taxes and increasing government spending.

 In an overheated expansion, a contractionary fiscal

policy requires higher taxes and reduced spending.

272
 When government spends more than the income tax

collected, it suffers a budget deficit whereas

 it will have a budget surplus if its revenue is more than its

expenditure.

273
6.2.1. Changes in Government Purchases

 When the government alters its own purchases of goods

and services, it shifts the aggregate-demand curve
directly.
 Suppose the government purchase of goods has increased
by Birr 20 billion.
 This order raises the demand for the output, which induces
the company to hire more workers and increase production.
 The increase in the demand for product means shift in
aggregate-demand curve to the right but not exactly by Birr
20 billion.
274
 There are two macroeconomic effects that make the size
of the shift in aggregate demand differ from the change in
government purchases.
 The first- the multiplier effect- suggests that the shift in
aggregate demand could be larger than government purchase,
Birr 20 billion.
 The second- the crowding-out effect- suggests that the shift
in aggregate demand could be smaller than Birr 20 billion.

275
The Multiplier Effect

 When the government buys Birr 20 billion of goods from a

company, that purchase has repercussions.

 The immediate impact of the higher demand from the

government is to raise employment and profits at company.

 Then, as the workers see higher earnings and the firm owners

see higher profits, they rise spending on consumer goods

(raises the demand for the products of many other firms in

the economy).

 This multiplier effect continues even after this first round.

276
 When consumer spending rises, the firms that produce
these consumer goods hire more people and experience
higher profits.
 Higher earnings and profits stimulate consumer spending
once again, and so on.
 Thus, there is positive feedback as higher demand leads to
higher income, which in turn leads to even higher demand.

277
 Once all these effects are added together, the total impact
on the quantity of goods and services demanded can be
much larger than the initial impulse from higher
government spending.
 The increase in government purchases of Birr 20 billion
initially shifts the aggregate-demand curve to the right from
AD1 to AD2 by exactly Birr 20 billion.
 But when consumers respond by increasing their spending, the
aggregate-demand curve shifts further to AD3 (Figure 6.4).

278
 This multiplier effect arising from the response of
consumer spending can be strengthened by the response of
investment to higher levels of demand.
 For instance, the company might respond to the higher
demand for goods by deciding to buy more equipment or
build another plant.
 In this case, higher government demand spurs higher demand
for investment goods.
 This positive feedback from demand to investment is
sometimes called the investment accelerator.
279
Figure 6.4 Government purchase multiplier effect

280
 A formula for the size of the multiplier effect arises from

consumer spending.

 An important number in this formula is the marginal

propensity to consume (MPC)- the fraction of extra

income that a household consumes rather than saves.

 For example, MPC of ¾ means that for every extra Birr that a

household earns, the household spends Birr 0.75 (3/4 of the

Birr) and saves Birr 0.25.

281
 To gauge the impact on aggregate demand of a change in
government purchases, we follow the effects step-by-step.
 The process begins when the government spends Birr 20
billion, which implies that national income (earnings and
profits) also rises by this amount.
 This increase in income in turn raises consumer spending by
MPC*Birr20 billion, which in turn raises the income for the
workers and owners of the firms that produce the consumption
goods.
 This second increase in income again raises consumer
spending by MPC(MPC*Birr 20 billion).

282
 These feedback effects go on and on.
 To find the total impact on the demand for goods and
services, we add up all these effects:
 Change in government purchases…… Birr20 billion
 First change in consumption ………MPC*Birr20 billion
 Second change in consumption …MPC2*Birr20 billion
 Third change in consumption ……MPC3*Birr20 billion
 Total change in demand…...(1+MPC+MPC2+MPC3+…)*Birr
20 billion.

283
 Thus, Multiplier=1+MPC+MPC2+MPC3+• • •
 This multiplier tells us the demand for goods and services
that each Birr of government purchases generates.
 Recall that this expression is an infinite geometric series.
 For X between -1 and +1, 1+X+X2+X3• ••=1/(1-X).

X=MPC.
 Thus, Multiplier (dY/dG) =1/(1-MPC).

284
 The size of the multiplier depends on the marginal
propensity to consume.
 Whereas an MPC of 3/4 leads to a multiplier of 4, an MPC of
1/2 leads to a multiplier of only 2.
 Thus, the larger the MPC is, the greater is this induced
effect on consumption, and the larger is the multiplier.

285
The Crowding-Out Effect

 While an increase in government purchases stimulates the

aggregate demand for goods and services, it also causes
the interest rate to rise, and a higher interest rate reduces
investment spending and chokes off aggregate demand.
 The reduction in aggregate demand when a fiscal expansion
raises the interest rate is called the crowding-out effect.
 The increase in demand raises the incomes of the workers
and owners of this firm (and, because of the multiplier effect,
of other firms as well).

286
 As incomes rise, households plan to buy more goods and
services and choose to hold more of their wealth in liquid
form (raises the demand for money).
 Since the money supply is not changed, when the higher
level of income shifts the money-demand curve to the right
from MD1 to MD2, the interest rate must rise from r1 to r2
to keep supply and demand in balance, (panel (a) of Fig 6.5).
 The increase in the interest rate, in turn, reduces the
quantity of goods and services demanded.

287
 Because borrowing is more expensive, the demand for
residential and business investment goods declines.
 That is, an increase in government purchases may crowd
out investment (partially offsets the impact of government
purchases on aggregate demand), (panel (b) of Figure 6.5).
 The initial impact of the increase in government purchases
is to shift the aggregate-demand curve from AD1 to AD2, but
once crowding out takes place, the aggregate-demand curve
drops back to AD3.

288
Figure 6.5 Crowding out effect

289
6.2.2. Changes in Taxes

 When the government cuts personal income taxes, for

instance, it increases households’ take-home pay.
 Households will save some of this additional income and will
spend some of it on consumer goods.
 Because it increases consumer spending, the tax cut shifts the
aggregate-demand curve to the right and vice versa.
 The size of the shift in aggregate demand resulting from a
tax change is also affected by the multiplier and crowding-
out effects.

290
 When the government cuts taxes and stimulates consumer

spending, earnings and profits rise, which further stimulates

consumer spending (This is the multiplier effect).

 At the same time, higher income leads to higher money

demand, which tends to raise interest rates, which reduces

investment spending (This is the crowding-out effect).

 Depending on the size of the multiplier and crowding-out

effects, the shift in aggregate demand could be larger or smaller

than the tax change that causes it.

291
 There is also another important determinant of the size of

the shift in aggregate demand that results from a tax

change: households’ perceptions about whether the tax

change is permanent or temporary.

 For example, suppose that the government announces a tax

cut of Birr 1,000 per household.

 In deciding how much of this Birr 1,000 to spend, households

must ask themselves how long this extra income will last.

292
 If households expect the tax cut to be permanent, they will
view it as adding substantially to their financial resources and,
therefore, increase their spending by a large amount- a
large impact on aggregate demand.
 By contrast, if households expect the tax change to be
temporary, they will view it as adding only slightly to their
financial resources and, therefore, will increase their spending
by only a small amount- a small impact on AD.

293