Macroeconomic Stabilization

Chapter TWO

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Microeconomics and Macroeconomics

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Microeconomics and Macroeconomics

What is microeconomics?

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 Microeconomics and Macroeconomics
• Microeconomics
– Microeconomics is the study of particular markets, and segments of the economy. It
looks at issues such as consumer behavior, individual labour markets, and the theory
of firms.
– Centers on the forces working at the individual level (e.g. individual firms and consumers)
– Focuses on the needs, desires and buying habits of the individual consumer
– An example: studying how firms react to increasing costs of production by raising the price and
subsequently how consumer/household spending is adjusted when the price rises
– It is a function/interaction /walitti dhufeenya of: Supply, Demand and Markets
• Micro economics involves/itti hirmaachuu
– Supply and demand in individual markets.
– Individual consumer behavior. e.g. Consumer choice theory
– Individual labour markets – e.g. demand for labour, wage determination.
– Externalities arising from production and consumption. e.g. Externalities 4
Microeconomics and Macroeconomics

What is macroeconomics?

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 Microeconomics and Macroeconomics
• What is macroeconomics?
 Macroeconomics is the branch of economics that study the aggregate economic variables. On the other
hand, it is the study of the entire/guutummaa economy as a whole (aggregates) or with basic
subdivisions such as sectors and sub-sectors.
 Macro economics is the study of the whole economy. It looks at ‘aggregate’ variables,
such as aggregate demand, national output and inflation/gatiin qarshii gadii bu’uu.
 An aggregate is a collection of specific economic units treated as if they were one unit. Example,
aggregate consumption is the sum total of consumption by all consumers in the economy. Other
aggregate variables include aggregate savings, aggregate investment, aggregate output, aggregate
unemployment, aggregate price level, etc
 Sectors and sub-sectors refer to sub-divisions with in the economy such as agriculture, industry, services,
etc and the sub-sectors under each sector such as crop production, construction, hotel and tourism, etc.

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•
Macroeconomics
The four main areas of study - concern of macroeconomics
con…
(1) Growth (increase in total output) (Output growth) – aggregate output. Why??? because it
reflects the expansion of economic activity across the entire economy.

 A recession is a period during which aggregate output declines. Two consecutive quarters of decrease in output
signal a recession – Short –run growth rate The implications of a recession include decreased economic activity, rising
unemployment rates, declining consumer spending, and reduced business investment.

 A prolonged and deep recession becomes a depression - long-run growth rate

(2) Price level (inflation) – an increase of overall prices level ‘deflation’ Why??? An increase in the
overall price level, known as inflation, occurs when the demand for goods and services exceeds their supply, while
deflation happens when there is a decrease in demand compared to supply, leading to a fall in prices.

(3) Labor Markets (unemployment) Why???

(4) The balance in the foreign sector (exports/imports, exchange rates) Why??? 7
 Important Issues in Macroeconomics
• Macroeconomics, The study of the economy as a whole, addresses many topical issues:
• Why does the cost of living keep rising?
• Why are millions of people unemployed, even when the economy is booming?
• What causes recessions?
• Can the government do anything to combat/lola gochuu recessions/kufaatii dinagdee?
Should it?
• What is the government budget deficit/hanqina qabaachuu?

• How does it affect the economy?

• Why does the country have such a huge trade deficit?

• Why are so many countries poor? What policies might help them grow out of poverty?

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What questions Macroeconomics answer?

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 What is macroeconomics con…
• Macroeconomics answer the following question
– How do different economy grow at different rate?
– What is the cause of inflation?
– How does the economy fluctuate?
– How does government policy affect the economy?
– How does international trade affect the economy?
• By answering the above questions macroeconomics provide an overview of the
structure and performance of the economy and it suggest the possible
macroeconomic policy to solve the problems of the economy

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 Objective of macroeconomics
• Objective of macroeconomics

The following are the major four objective of

macroeconomics
1.Stable growth of gross national product
2.Stable level of prices
3.High employment level
4.Stable (equal) balance of payment

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What is the Importance of macroeconomic Stability?

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 Importance of macroeconomic Stability
• Importance of macroeconomic Stability
 Large fluctuation in output, employment and inflation add uncertainty for
firms consumer and public sector and can reduce the economy in the long
run growth potential. Why???

 Stability allow;
– Business individual and the government plan more
effectively for the long term
– Improving the quality of investment in physical and human
– Helping to raise productivity

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What are The most important macroeconomic policy instruments?

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 Macroeconomic policy instruments
• Macroeconomic policy instruments
 What can a country do to reduce inflation or unemployment, to speed economic growth, or to
correct a trade deficit?
 Government has certain instruments that can use to affect macroeconomic performance and
reduce macroeconomic problems of inflation, unemployment, Poverty, etc. through
macroeconomic policy instrument
 A macroeconomic policy instrument – is an economic variable under the control of the government
that can affect one or more of the macroeconomic goals (objectives) by affecting the
macroeconomic variables.
 The four most important macroeconomic policy instruments are:

1. Fiscal policy
2. Monetary policy
3. Income and price policy
4. Foreign trade policy

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What is fiscal policy?

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 Fiscal Policy
• Fiscal Policy
 Fiscal policy refers to the deliberate/Beekaa manipulation/akka fedhan gochuu of government income and
expenditure (budget) to influence income, output, employment, and prices. It consists of taxation
(revenue) and government expenditure.
 Government expenditure is divided in to two categories:
– Government purchases – spending on goods and services. e.g. purchase of such goods as
weapons, computers, machines, tools, stationary materials, etc, and such services as electricity,
telephone, postal, internet, the labor service of the police/defense force, the parliament, public
servants , judges, etc. When the government makes such expenditures, it gets in return either a
good or a service. Using these expenditures, the government in turn produces different goods
(public goods) and services.
– Transfer payments and subsidies/deggersa kennuu:-Transfer payments to a targeted group of
households to boost /guddisuu/humneessuu their income (i.e. pension payments, unemployment
benefits, payments to support the elderly, etc).
• Subsidies to targeted private businesses to help them under conditions of loss &
uncertainty or to help consumers indirect.
• Fisical policy is political decision. Why????

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 Fiscal Policy con..
Taxation affects the overall economy into ways :
– It reduces households’ spend able (disposable) income & reduce their spending on
goods and services
– Lowers the demand for goods and services and reduce output, income and
employment
– Taxes affect prices of inputs (factors) and output and thereby influence the behavior
of producers and the incentive to produce. An increase in tax on business profits
discourages production and a decrease in tax gives the incentive to produce by
increasing profit after tax

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What are the advantages of fiscal policy instruments?

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 Advantages of fiscal policy instruments
• Advantages of fiscal policy instruments
 In addition to the stabilization effects discussed above, they have the following two additional importance.

1. They may be used in discriminatory manner/akkaataa to alter/jijjiiruu the geographical and sectoral distribution of
resources.
• For example: tax burdens may be reduced for firms working in development areas (strategic industries).
• the government may impose/fe’a high tax burdens on firms engaged/kaadhimamuu in less
desirable/barbaadamaa areas.
2. They may also be used to reduce income inequalities and wealth by:
• Applying progressive/tarkaanfataa taxes which increase with income and wealth. Accordingly, the burden will be
high on high-Income people.
• Redistribute revenues in the form of social security benefits.

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 Difficulties in the use of fiscal policies

What are the difficulties in the use of fiscal policies?

.

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 Difficulties in the use of fiscal policies
 The following are the major difficulty to use fiscal policy

1. Government expenditures may become inflexible in a downward direction. And reduction in the
expenditures on education, health services, pensions and other social security measures will be
very strongly resisted (opposed). Unless the situation is very critical/xiyyeeffannoo kan barbaaduu,
the best the government can do is to postpone the implementation of certain programs.

2. Major changes in taxation also take a considerable time to implement since they usually involve an
immense/baay’ee guddaa amount of tax administration work.

3. While tax reductions will certainly increase demand, their effectiveness as stimulant/kakaasuu to
private investment is more uncertain. Hir’inni gibiraa fedhii akka dabalu beekamaa ta’us, bu’a
qabeessummaan isaanii akka kaka’umsa/kakaasuu invastimantii dhuunfaatti caalaatti mirkanaa’aa miti.

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What is Monetary Policy?

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 Monetary Policy
• Monetary Policy
 Monetary policy refers to policy that control money supply and regulate financial
institution. The following are the major instruments of monetary policy .
– Open market operation
– Reserve requirement
– Bank rate and discounting rate

 Open Market Operation (OMO): This refers to the purchase and sale of government
bonds by the national bank.

 Changes in the required reserve ratio: By changing the legal reserve ratio, the
national bank can change the amount of bank loans and thus the amount of money
in the economy .

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What is Foreign Trade Policy?

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 Foreign Trade Policy
• Foreign Trade Policy
 The government affects its imports and exports through its trade policy . To
reduce/remove trade deficit, achieve a balanced trade or even a trade
surplus.
 The following are the major elements of foreign trade policy:
– Subsidy
– Tariff
– Quota
– Administrative requirement
 The government may use such trade policies.
– To discourage the import and consumption of unwanted goods
– To protect domestic infant reefuu dhalatu industries
– To encourage the production of some goods those are expected to
earn higher foreign currency.

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 Foreign Trade Policy con..
• The government may increase exports by:
– Reducing export tariffs:- Other factors remaining constant,
the lower the tariff, the lower the price of the product(s)
abroad, the higher the demand for the product(s) by
foreign buyers and the higher the exports.
– Improve the investment codes, investment licensing and
renewing procedures (improving customer service
delivery)
– providing credit facilities to producers/exporters in the export
sector at lower interest rate,
– Providing land for export purposes freely or at lower lease
rates.

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 Examples of Micro vs. Macro
Micro Macro

Firm’s reaction to increased demand for its Studying the effects on all firms in the economy
product due to a general increase in demand

Decision of a worker to work less due to lower Total hours of labor (and unemployment)
wages

The effects on an industry (group of firms Effect on total production in the economy due to
producing similar goods) due to higher labor taxes taxes

Government legislation aimed at monopolies Government legislation aimed at increasing taxes

on profits for all firms

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Types and purpose of financial sector in Ethiopia

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What are the financial institutions in Ethiopia?

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 Types and purpose of financial sector in Ethiopia
Types of financial institutions in Ethiopia
• There are a number of financial institutions which operate in
the country.
• Financial institutions currently operating in the Ethiopian
financial system comprise:
– The central Bank (NBE)
– Commercial banks
– Specialized banks(Development bank …)
– Insurance companies
– Pension fund, savings and credit cooperatives (SACCs) and;
– Micro-finance institutions (MFIs).

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What are the major purpose of the national bank?

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 The purpose of National Bank of Ethiopia
The following are the major purpose of the national bank.

 print and issue legal tender currency;

 regulate the supply, availability of money and credit and applicable interest
and charges.
 implement exchange rate policy.
 license, supervise and regulate banks Insurance and other financial
institutions.
 set limits on gold and foreign exchange assets which banks and other finical
institutions authorize to deal in foreign exchange can hold in deposits.
 Set limits on the net foreign exchange and on the terms and the amount of
internal indebtedness of banks and other financial institutions.
 make short and long tern financing facilities available to banks and other
financial institutions.

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What are the major purpose of the commercial bank?

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 The purpose of Commercial Bank of Ethiopia
• The following are the purposes/roles of commercial bank in Ethiopia.

 To accept saving demand and time deposits.

 To dual, accept discount, buy and sell bills of exchange, drafts and
promissory note payable within or outside Ethiopia.
 To issue letters of credits.
 To provide short and medium loans
 To buy and sell foreign exchange.
 To buy and sell negotiable instruction and security issued by governments
private organization or any other persons.
 To accept and keep in states securities, jewels and other valuables.
 To issues cheques and traveler cheques and generally deal in cheques.
 To participate in equity investment

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FINANCIAL REFORM

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WHAT IS FINANCIAL REFORM?

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 WHAT IS FINANCIAL REFORM?

What is financial reform or liberalization?

• Financial liberalization refers to measures directed at diluting or

dismantling regulatory control over the institutional structures,
instruments and activities of agents in different segments of the financial
sector. These measures can relate to internal or external regulations.

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What are the main rational sababa irratti kan
huda’ee for financial reform or liberalization?

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 Main rational for financial reform or liberalization
• The main rational for financial reform are:
– to meet resource allocation objectives;
– to provide instruments of monetary control; and
– to correct perceived market failures and systemic externalities in the
financial.

• In details, the key components of financial liberalization are the

following:
 deregulation of interest rates;
 removal of credit control;
 privatization of government banks and financial institutions;
 liberalization of restrictions on the entry of private sector and/or foreign
banks and financial institution into domestic financial markets;
 introduction of market based instruments of monetary control; and
 capital account liberalization

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WHY FINANCIAL REFORM?

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 Financial reform
• The financial systems prevailing in most countries in the early 1970s.
• This were characterized by important restrictions on market forces which included controls on the
prices or quntities of business conducted by financial institutions, restrictions on market access and
controls on the allocation of finance among competing borrowers.

• These regulatory systems had evolved to serve a number of social and economic policy objectives of
governments.
 Direct controls were used in many countries to allocate finance to preferred industries during the
post-war reconstruction period;
 restrictions on market access and competition were partly motivated by a concern for financial
stability; and
 controls on banks and financial institutions were frequently used as instruments of
macroeconomic management.
• The substantial shift to more market-oriented financial systems during the past two decades was driven
by a number of interrelated factors which made direct controls increasingly ineffective in achieving their
intended purposes. Few of them are:
 Financial innovation and rapid technological development, which progressively increased the ease
with which regulations could be circumvented.
 Macroeconomic developments, particularly the increases in fiscal deficits and emergence of
inflationary problems in the 1970s, which increased the need for interest rate flexibility.

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 Prototypical Conditions of Pre-and Post-Financial Reforms
Dimension of Financial
Reforms
Privatization of Banks
Enhancement of Banking
Supervision
Capital Account Liberalization
Interest Rate Liberalization
Elimination of Credit Controls
Elimination of Entry Barriers on
Banks
Pre-Financial Reforms
Most banks are state owned
Lack of comprehensive legal framework,
and/or lack of enforcement of banking
supervision and prudent regulations
Many restrictions on capital
account transactions
Interests rates set by the central bank
Credit allocation determined by the central
bank, preferential credit allocation at subsidize
interest rates
No entry of new banks allowed, no new
branches allowed, restrictions on banks’
activities
Post-Financial Reforms
All banks privately owned
Comprehensive legal framework, strict
enforcement of banking supervision and
prudential regulation
Free movement of capital without
restrictions
Interests rates determined at market
rates
Credit allocation determined by banks,
no preferential credit allocation
Free entry of new banks, no branching
restrictions, banks’ wide range of
activities permitted
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Ethiopia’s financial reform

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 Ethiopia’s financial reform
• As an important instrument of stabilization, the monetary policies of the
reform have aimed at maintaining the sustainable macroeconomic
stability in the country. The reform includes:

 The removal of discriminatory credit and interest rates

 the introduction of a competitive financial sector which included the establishment of

private banking and insurance companies.

 Modernizing the financial sector

 Adjusting interest rates and introduction of open market operations for government
securities (Treasury Bills).

 The establishment of microfinance

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 Problems of the Financial Sector in Ethiopia
• The following factors may be cited as the main problems of the financial sector in Ethiopia

 The policies pursued by the Derge regime following the revolution of 1974 have played a principal
role in arresting the financial sector development.

 The financial sector was opened up for private participation only recently.

 Competition is not yet strong both in the banking and insurance segments.

 There are no money and capital markets in the country that could have competed with banks.

 Some types of non-bank financial institutions such as mutual funds, finance houses, investment
companies, etc. are historically unknown in Ethiopia.

 The absence of foreign banks and insurance companies from the financial sector has also
contributed to the lack of dynamism in the financial system

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 Fiscal policy reform in Ethiopia
 As mentioned before fiscal policy refers to the management of government
spending and taxation in the economy.

 Ethiopia, like most countries in Africa, has been making considerable efforts in
recent years to restructure its tax and expenditure system with a view to
increase tax revenue as well as reduce distortions in the economy.

 The impact these reforms have had on the poor is of considerable importance to
policymakers, given that the poor and the vulnerable constitute a significant
majority of the population in Ethiopia.

 The reforms also contribute for fast development of private sector in the country.

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END OF CHAPTER TWO

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