Introduction 2021

Chapter One
1. The state of Macroeconomics -Introduction
1.1. Basic Concepts and Methods of Macroeconomics Analysis
What is Economics?
It is not only customary but also logical to begin in the study of any subject with its definition.
But, we are seriously handicapped in the definition of economics, as there is neither a single
comprehensive definition of the subject nor a general agreement amongst economists on the
appropriateness of a particular definition.
Economics being a developing and dynamic subject, its exact scope is not yet fixed. This is
because economics moves with time; and time is never static. Things change with time; so does
economics; its scope changes when time moves.
This does not mean that economics does not have a definition. Different definitions are given but
all have the same meaning.
 Economics is the study of how people allocate their limited resources in an attempt to
satisfy their unlimited wants.
 Economics is the study of the use of scarce resources to satisfy unlimited human wants.
 Economics is a branch of social science which deals with how economic agents behave
in allocating and making decision to use the limited economical resources for production,
exchange, distribution, and consumption of goods and services.
 And others.
The above statements define economics differently, but all have the same meaning. The elements
that make up the above definition are:
 Resources: constitute land, forest, minerals, humans, machinery, buildings, etc.
They are scarce by nature.
 Wants: it is a human desire with an ability of having a thing. Human wants are unlimited.
Having these elements, to summarize the definition of economics;
 Economics is a science that studies the use of limited (scarce) resources.
 Resources are used to produce goods and services.
 These goods and services satisfy human wants.
 And human wants are unlimited.

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So, the main objective of economics is to study how to satisfy the unlimited human wants to the
maximum possible by producing goods and services using limited (scarce) resources. Economics
has two branches; that are macroeconomics and microeconomics.
Macroeconomics Vs. Microeconomics
Although there is actually only one economics the overall field is divided in to two areas i.e.
Macroeconomics & microeconomics.
 Macroeconomics: is concerned with total output, total employment, or total
spending, but microeconomics is concerned with the output of particular goods
and services by a single firm or industries and with the spending on particular
goods and services by a single household or by households in a single market.
 In microeconomics the unit of measurement is the part rather than the whole.
For Example;
 How a single firm determines the price for a particular product?
 What amount of output will maximize its profit and?
 How it determines the lowest cost combination of labor and capital?
Even though macroeconomics and microeconomics are different by the above stated Criteria;
macroeconomics theory has a foundation in microeconomics theory and vice versa. In practice,
analysis of the economy is not conducted separately in the two fields.
Meaning of Macroeconomics
Definition- Macroeconomics, branch of economics concerned with the aggregate, or overall,
economy. Macroeconomics deals with economic factors such as total national output and
income, unemployment, balance of payments, and the rate of inflation. It is distinct from
microeconomics, which is the study of the composition of output such as the supply and demand
for individual goods and services, the way they are traded in markets, and the pattern of their
relative prices.

At the basis of macroeconomics is an understanding of what constitutes national output, or

national income, and the related concept of gross national product (GDP). The GDP is the total
value of goods and services produced in an economy during a given period of time, usually a
year. The measure of what a country‘s economic activity produces in the end is called final
demand. The main determinants of final demand are consumption (personal expenditure on items

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such as food, clothing, appliances, and cars), investment (spending by businesses on items such
as new facilities and equipment), government spending, and net exports (exports minus imports).
The state of macroeconomics affects everyone‘s life; they 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. As a result, the popularity of the incumbent president (political
party) rises when the economy is doing well and falls when it is doing poorly. It is also the center
of world politics. Countries fix their relation with the others based on their macroeconomic
policies. It is also the base for the regional economic integration. Example, Europe has moved
towards a common currency, COMESA set a tax exemption region among the member countries
etc. Although the job of making economic policy falls to world leaders, the job of explaining
how the economy as a whole works fall to macroeconomists
1.2. Macroeconomic Goals and Instruments
Goal of Macroeconomics-
The macroeconomics policy of any country focuses in achieving the following three most
important objectives. These are:
1. Economic Growth
2. Full employment
3. Stable Price
1. Economic growth- This refers to the growth of output (GDP) in an economy. Usually,
letter Y represents output or GDP in macro models.
 Economists monitor economic growth by keeping track of real gross domestic product
(real GDP), Total quantity of goods and services produced in a country over a year.

 During high economic growth real GDP has actually increased faster than the population
 Over long periods of time small differences in growth rates can cause huge differences in
living standards.
 Economists and government officials are very concerned when economic growth slows
down
 Macroeconomics helps us understand a number of issues surrounding economic growth
For Example; Growth rate of GDP in Ethiopian Economy

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Growth rate of GDP and per capita GDP

20

15

10

5
percentage

0 GDP

-5 per capita GDP

-10

-15

-20
year

2. Reducing or addressing unemployment-

Unemployment rate Percentage of the workforce that would like to work, but cannot find jobs
Used to keep track of employment.

Unemployment particularly the cyclical unemployment, which is the outcome of poverty.

Poverty is the outcome of many factors. Some of the factors include socio-economic
backwardness, natural hazards, war, and poor governance (administration) of a nation and
policies. Frictional and structural unemployment, which are caused due to poor or imperfect
information and change in technology respectively, can be addressed easily. Therefore, their
effect on an economy is temporary. As a result, economic policy makers give due attention or
emphasize to address the cyclical unemployment, which could be permanent unless they are
capable using different macroeconomics instruments.
When firms produce more output, they hire more workers—when they produce less output, they
tend to lay off workers. Thus we would thus expect real GDP and employment to be closely
related, and indeed they are.
3. Stability of the economy- This refers to achieving low or stable inflation, nominal
interest rate (r), and exchange rate (USD to Birr ratio).

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Macroeconomics instruments: -
To achieve the above three objectives economic policy makers of countries use mix of
macroeconomics instruments. The most important instruments among others include monetary
policy, fiscal policy, income policy, and labor policy. Macroeconomics thinking has stages of
evolutions. Throughout its stages of development there has been consensus that the above three
are the main objectives of macroeconomics. However, schools of thoughts disagree on the policy
instruments they prescribe to achieve them. This disagreement is discussed in detail in the
section that follows.
1.3. Origin and development of macroeconomics
Since today‘s knowledge of the economics evolves over time based on preexisting knowledge
and some historical events. To do so, we have to look different schools of thought of
macroeconomics.
 Schools of thought in macroeconomics
 Classical 1776-1970
 Neoclassical 1870- 1936
 Keynesian 1936- 1970
 After 1970 there is no dominant school of thought in macroeconomics .there are different
schools of thought with different ideas (new classical, new Keynesians, institutional and
others).
I. Pre classical school
1. Mercantilist
They try to explain how growth of an economy achieved based on their observation about
situation that Britain experiences at the time. During 17thand 18th centuries Britain
becomes a prosperous nation due to over sea trade.
From this mercantilist develop a theory (thought) that export surplus (balance of trade
surplus) add a wealth of nation .as a result they become advocator and supporter of
government policies that could secure and maintain balance of trade surplus .

→according to them,

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 When there is balance of trade deficit, which means import greater than export a
country pays or spending more on foreign goods than spending on domestic goods. i.e.
more money(gold)flow abroad and boosts (increase) foreign income through increasing
effective demand and reduces effective demand for domestic output.
 on the other hand when there is balance of trade surplus(export is greater than import)
there is more money(gold) inflow which increases effective demand for domestic goods
(output) then increase output production then which bring economic growth for the nation.
This implies a country should keep balance of trade surplus to expand its economy.
According to mercantilist, such as Locke (1632- 1704). The volume of money in a given
country determines the volume of transaction of goods and services produced at specific
time period.
Symbolically MsV=PT where
M =money supply (stock of money)
V=is the velocity of circulation of each unit of currency
P =is average price level
T =is the volume of traction.
An increase in the stock of money growth (Ms) in a given economy resulted from trade
surplus; stimulate economic growth through increasing the volume of transaction (T)
according to mercantilist.
 William Petty (1665) observe it differently, accumulation of money (gold)(Ms) in
an economy makes goods expensive, and reduces trade by generating inflation.
Inflation in turn makes domestic goods less competitive on world markets, so that
reduce exports of the nation. Therefore the effect of increase in money on real
output depends on the net impact it has on both price and output expansion.
This leads mercantilist to advocate protectionist policies to reduce import inflow relative
to the value of export of the country.

2. Physiocrates
Physiocrates deal with feudal economy of French and illustrates the flow of commodities
through the process of production and consumption like the modern input –output analysis.

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In feudal economy there are three social classes: land lords, peasant and Artisans. At the
beginning of the year the peasants own a stock of seed corn from last year harvest. This stock of
corn used to feed themselves and used as input for the year. In the next season they produce
twice as the stock they started with. Then they used the production for replacing the stock that is
used for production process and the surplus pay to the land lord as a rent. The land lord
consumes directly part of it and the rest would be used to buy different products from artisans.
Artisans on the other hand, used the revenue generated from the sales of their product, to buy
raw materials, replace worn-out machinery and to feed themselves. What they earn is equals to
what they spend on consumption. They do not contribute to the surplus of the economy. This
implies the surplus comes only from the land and accrues to the peasants.
They are peasants that contribute to the economy‘s surplus therefore to economic growth. Based
on their analysis, Physiocrates draw two policy implications to bring economic growth (output
expansion).
1) It was wrong for the government to tax peasants since taxation depletes the stock that is
necessary for them to use in the course of reproducing the surplus.
2) It was necessary to improve method of production to increase the productivity of land to
expand the total surplus.
II. Classical school of thought
It is a macroeconomics idea of 1776-1936 periods. During this time, there was no unified or
formalized theory of aggregate employment and origin of business cycle.
In this period the distinction between micro and macro was not clear. The ruling principle was
the invisible hand coined by Alfred Marshall.
According to classical model, all markets including labour market always clear (the economy
always operates at equilibrium and at equilibrium all resources are fully employed). They
emphasize market mechanisms to maintain full employment equilibrium. Classical economists
are aware of the fact that capitalist economy could deviate from its equilibrium level of output
and employment. Such disturbances however would be temporary and very short lived.
Market mechanism operate quickly and efficiently to restore full employment level of
equilibrium.

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For classical economists no government intervention is needed in the form of stabilization

policies, it is neither desirable nor necessary to achieve full employment. Such policies create
havoc (disturbance) rather than harmony to the system. In their view the government should
confine its activities to ensure environment in which market force act to achieve market clearing
outcomes.
Classical full employment notion based on the assumption of flexibility of prices (wages,
interest rate and output prices) i.e., prices are determined by the supply and demand forces in
the market. If there is disequilibrium condition in the market since prices are assumed to be
flexible, demand and supply forces adjusts employment level to full employment position.
According to the classical macroeconomic system, a downward shift of aggregate
(effective)demand will bring into play corrective forces involving falling prices so that the final
impact of a reduction in aggregate demand will be a lower price level with real output and
employment quickly returning to their full employment levels. In the classical world self-
correcting market forces, operating via the price mechanism, restore equilibrium without the help
of government intervention..
They based on the following assumptions.
 All economic agents (firms and households) are rational and aim to maximize their profit
or utility.
 All markets are perfectly competitive so that agents decide how much to buy and sell on
the basis of a given set of prices which are perfectly flexible.
 All agents have perfect knowledge of market conditions and prices before engaging in
trade.
 Trade only takes places when market –clearing prices have been established in all
markets.
 Agents have stable expectation.
Classical macroeconomists explain the determination of crucial macro variables by dividing the
economy in to two sectors: the real sector and monetary sector. This is usually known as
classical dichotomy. They should be studied separately.
Demand-side policies mainly affect nominal variables such as interest rate and prices while
supply side polices affect real variables such as real wage, employment and output.

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Students, to examine the behavior of real and monetary sector, we need to consider the
following three components of classical models:
 the classical theory of employment and output determination,
 Say‘s law of markets and
 The quantity theory of money.
The first two component show how the equilibrium Values of the real variables in the model are
determined exclusively in labor and commodity markets. The third component shows how the
nominal variables in the system are determined. Thus, let us outline how the equilibrium level of
both sector are achieved by describing the components of classical models.
 Output determination
According to classical, the level of real output will be determined independent of the quantity of
money in the economy. This is known as classical neutrality proposition. If that is the case, what
determine real output level of an economy? The main idea here is that the profit and utility-
maximizing behavior of rational economic agents operating under competitive conditions will,
via the ‗invisible-hand’ mechanism, translate the activities of millions of individuals into a
social optimum.
Classical used short run production function to explain the determinants of real output. At micro
level production function shows the relationship between the maximum outputs levels produced
from a given amount of inputs. The more input, labor and capital that a firm uses, the greater will
be the output produced. When we consider the economy as whole the quantity of total output
(GDP) will also depends on the amount of input used and how efficiently they are used.

GDP  Y  fA( K , L)

Where; Y - real output, L-amount labor used, K-capital used, and

A- Technological coefficient.
From the above representation, we can conclude a country can expands the total amount of
output produced in given period through increasing the amount of input under production and
increases their productivity through technological progress.
 Employment determination
On the other hand the aggregate level of employment determined through labor market
equilibrium established from profit maximization behaviors of firms and utility maximization
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behavior of households. Firms operating in perfectly competitive market hire labor to get
maximum profit at a point where extra cost of producing a unit of output (w*L) is equal to
additional revenue generated from firm‘s products (P*Q).
P∆Q=W ∆L where p=unit price of the product, W is wage rate is labor
input and Q is quantity out put
Q W
 ,
L P
Q W
 MPL is the marginal productivity of labor and -real wage.
L P
W
Since firms equate marginal productivity of labor ( MP L) with real wage ( ), to determine level
P
of labor to be hired, MPL curve becomes the demand curve of labor by firms. Aggregating
together the demand for labor by individual we get aggregate demand curve for labor, which is
inversely related with real wage.
Moreover classical derive labor supply which is a positive function of real wage from the
utility maximization behavior of households. How much labor is supplied for given populations
depend on household preference for consumption and leisure, both yields positive utility.
Now we explain how classical derived demand and supply for labor. The next step is putting
these demand and supply curves together to establish labor market equilibrium. That is the
W 
supply and demand forces establish market cleaning equilibrium level of real wage   and
P
employment level (Le).
Since classical economists assumed perfectly competitive markets, flexible price and full
information, the level of employment at equilibrium represents a full employment level. All
those members of labor force who desire to work at the equilibrium wage can get job. Classical
full employment equilibrium associated with the existence of frictional (involuntary)
unemployment, but does not admit the possibility of involuntary unemployment. Unemployment
in excess of equilibrium level is the result of artificial restrictions that keep real wage above
equilibrium. Such forces which keep real wage above equilibrium level include the existence of
trade union with monopoly power, minimum wage legislation, efficiency wage argument and
others. Once the equilibrium level of employment is determined in the labor market, the level of

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output is determined by the position of aggregate production function at equilibrium level of

employment.
 Say’s Law
For Keynes the full employment of classical takes place where aggregate demand was just
sufficient to absorb the level of output produced. But there is no such grant that aggregate
demand would be at such level. For classical however, there is no possibility of deficiency of
aggregate demand by appealing to say‘s law. This law would be stated as: supply creates its
own demand. In other words, the act of production simultaneously creates income and
purchasing power, so there would be no impediment to full employment caused by deficiency of
aggregate demand.
For classical the equality of aggregate demand and supply consistent with labour market
equilibrium. That is the aggregate spending in the economy will always be sufficient to purchase
the full employment level of output.
III. Keynesian School (1936 – 1970s)
Under classical school we have seen how full employment of resources are determined under
flexible price assumption and increase in general price using Quantity theory of money.
However the classical market clearing (full employment) cannot handle the 1930‘s great
depression. From 1929 to 1932 there was collapse of industrial production and GDP of major
capitalist economies. Unemployment rises at alarming rate and commodity and whole sale price
collapse. The market mechanism of classical could not restore full employment of output.
Reaction to the empirical observation of persistent mass unemployment during the great
depression gives rise to the birth of Keynesian school.
 The main thesis of the Keynesian stream is that the economy is subjected to failure so
that it may not achieve full employment level. Thus, government intervention is
inevitable.
Keynes‘s explanation of interest rate determination differs from classical predecessors. For
classical interest rate was a reward for postponement of current consumption (saving). In
general theory of Keynes interest rate is purely a monetary phenomenon determined by the
liquidity preference (demand for money) of the public in conjunction with the supply of money
which is determined by monetary authorities.

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Keynesian rejects the classical notion of neutrality of money owing to the dependence of
aggregate output and employment on aggregate expenditure, which consists of investment
spending and consumption spending. Investment spending is not stable since it depends on
business expectation which is related to uncertainty in the future. Uncertain future creates the
desire for liquidity, so that variations in the demand for money as well as change in money
supply can influence output and employment through its impact on aggregate demand.
The theory of prices level is another area of difference between Keynes and classical. For
Keynesian, rise in the general price (Inflation) is the result of increase in nominal wage. An
increase in wage causes an increase in aggregate demand. These will cause excess demand over
the amount of output supplied resulting inflationary condition.
In a very simplified form we can present Keynes‘s theory of recessions. Imagine an economy
that is chugging along happily at full employment. Alongside the smoothly functioning ‗real‘
economy there will be a smooth financial flows, as firms earn money from their sales, pay out
their earnings in wages and dividends, and household spend these receipts on new purchases
from the firms.
But now suppose that for some reason each household and firm in this economy decides that it
would like to hold a little more cash. Keynes argued, in particular, this happens when
businessmen lose confidence and start to think of potential investments as risky, leading them to
hesitate and accumulate cash instead; today we might add the problem of nervous households
who worry about their jobs and cut back on purchases of big-ticket consumer items. Either way,
each individual firm or household tries to increase its holdings of cash by cutting its spending so
that its receipts exceed its outlays.
But as Keynes pointed out, what works for an individual does not work for the economy as a
whole, because the amount of cash in the economy is fixed. An individual can increase her cash
holding by spending less, but she does so only by taking away cash that other people had been
holding. Obviously, not everybody can do this at the same time. So what happens when everyone
tries to accumulate cash simultaneously?
The answer is that income falls along with spending. I try to accumulate cash by reducing my
purchases from you, and you try to accumulate cash by reducing your purchases from me; the
result is that both of our incomes fall along with our spending, and neither of us succeeds in
increasing our cash holdings.

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If we remain determined to hold more cash, we will react to this disappointment by cutting our
spending still further, with the same disappointing result; and so on and so on. Looking at the
economy as a whole, you will see factories closing, workers laid off, stores empty, as firms and
households throughout the economy cut back on spending in a collectively vain effort to
accumulate more cash. The process only reaches a limit when incomes are so shrunken that the
demand for cash falls to equal the available.
 Keynes and Economic Policy
For Keynes to do about recessions, the first and most obvious thing to do is to make it possible
for people to satisfy their demand for more cash without cutting their spending, preventing the
downward spiral of shrinking spending and shrinking income. The way to do this is simple to
print more money, and somehow get it into circulation.
So the usual and basic Keynesian answer to recessions is a monetary expansion. But Keynes
worried that even this might sometimes 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 no matter how much cash
they have; they may simply add any monetary expansion to their hoarding. 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. When monetary
expansion is ineffective, fiscal expansion must take its place. Such a fiscal expansion can break
the vicious circle of low spending and low incomes and getting the economy moving again.
In summary the Keynesian School of macroeconomics differ from others by the following
features.
 The economy is inherently unstable and subject to erratic shocks. These shocks are
attributed primary to changes in the marginal efficiency of investment following from a
change in the state of business confidence, or what Keynes referred to as change
investors‘ animal spirits.
 The economy can take long time to return to full employment level after being subjected
to some disturbance, i.e. the economy is not rapidly self-equilibrating because of the
rigidities of prices. As a result involuntary unemployment of labor is the major feature
of Keynesian macroeconomics. Therefore fiscal and monetary policies play an important
role in stabilizing the economy.
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 In modern industrial economies prices and wages are not perfectly flexible and therefore
changes in aggregate demand both anticipate or unanticipated, will have great effect in
the short run on real output and employment rather than on nominal variable.
 The aggregate level of output and employment is essentially determined by aggregate
demand. The authorities can intervene to influence the level of aggregate effective
demand to ensure a more rapid return to full employment to improve the performance of
the economy.
IV. Macroeconomics school after Keynesian
 Monetarism
Monetarism, as advocates of free market, started challenging Keynes‘s theory in the 1970s.
Milton Friedman, the founder of monetarism, attacked Keynes idea of smoothing business cycle
on the ground that such active policy is not only unnecessary but actually harmful, worsening the
very economic instability that it is supposed to correct, and should be replaced by simple,
mechanical monetary rules. This is the doctrine that came to be known as ―monetarism‖.
Friedman began with a factual claim: most recessions, including the huge slump that initiated the
Great Depression, did not follow Keynes‘s script. That is, they did not arise because the private
sector was trying to increase its holdings of a fixed amount of money. Rather, they occurred
because of a fall in the quantity of money in circulation.
 Policy Rule under Monetarism
If economic slumps begin when people spontaneously decide to increase their money holdings,
then the monetary authority must monitor the economy and pump money in when it finds a
slump is imminent. If such slumps are always created by a fall in the quantity of money, then the
monetary authority need not monitor the economy; it need only make sure that the quantity of
money doesn‘t 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, ―Pump money
in when your economic advisers think a recession is imminent.
 The New Classical School
The new classical macroeconomics remained influential in the 1980s. This school of
macroeconomics shares many policy views with Friedman. It sees the world as one in which
individuals act rationally in their self-interest in markets that adjust rapidly to changing
conditions. The government, it is claimed, is likely only to make things worse by intervening.
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The central working assumptions of the new classical school are three:
 Economic agents maximize. Households and firms make optimal decisions given all
available information in reaching decisions and that those decisions are the best possible
in the circumstances in which they find themselves.
 Expectations are rational, which means they are statistically the best predictions of 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
that it is not possible to fool most of the people all the time or even most of the time.
 Markets clear. There is no reason why firms or workers would not adjust wages or prices
if that would make them better off. Accordingly prices and wages adjust in order to
equate supply and demand; in other words, market clear. For instance, any unemployed
person who really wants a job will offer to cut his or her wage until the wage is low
enough to attract an offer from some employer. Similarly, anyone with an excess supply
of goods on the shelf will cut prices so as to sell.

The essence of the new classical approach is the assumption that markets are continuously in
equilibrium.
 The New Keynesians
The new classical group remains highly influential in today‘s macroeconomics. But a new
generation of scholars, the new Keynesians, mostly trained 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.
The new Keynesians argue that markets sometimes do not clear even when individuals are
looking out for their own interests. Both information problems and costs of changing prices lead
to some price rigidities, which help cause macroeconomic fluctuations in output and
employment. For example, in the labor market, firms that cut waged not only reduce the cost of
labor but are likely to wind up with a poorer quality labor. Thus they will be reluctant to cut
wages.
To recap, we identified the following schools of thought that have made a significant
contribution to the evolution of twentieth –century macroeconomics: Keynesians, monetarist,

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new classical real business cycle and new Keynesian schools. The debate among the school
show that the evolution of modern macroeconomics has been rooted to the classical and
Keynesian macroeconomics.

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