Chapter Six

Fundamental Concepts of
Macroeconomics

1
 Introduction

• Conventionally, economics is divided into microeconomics and

macroeconomics.

 Macroeconomics, studies about overall or aggregate behaviour of

the economy, such as economic growth, employment, inflation,
distribution of income, macroeconomic policies and international
trade.

• So in this chapter we will discuss major macroeconomic issues such

as measurement of a country‘s economic performance,
macroeconomic problems (fluctuations in economic system mainly
reflected by inflation and unemployment), how budgetary deficit
and trade deficit occur and macroeconomic policies applied to cure
the macroeconomic problems
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 Chapter objectives

After completing this chapter, you will be able to:

• define GNP and GDP and able to measure national income
• differentiate between nominal GDP and real GDP and decide
which is better to measure economic performance;
• explain the concept of business cycle;
• briefly discuss the types of unemployment;
• understand about inflation, causes of inflation and its impact on
the economy and
• explain budgetary deficit and its ways of financing;

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 6.1. Goals of Macroeconomics

• Macroeconomics aimed at how

 To achieve high economic growth

To reduce unemployment

To attain stable prices
To reduce budget deficit and balance of payment (BoP)
deficit
To ensure fair distribution of income.

 In general, the goals of macroeconomics can be given as ways

towards full employment, price stability, economic growth and fair
distribution of income among citizens of a country.

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 6.2. The National Income Accounting(NIA)
o is an accounting record of the level of economic activities of an
economy.
o It is a measure of an aggregate output, income and expenditure in
an economy.
o It enables us to measure the level of total output and explain the
causes for such performance thereby providing information to
formulate policies and design plans.

Measures of economic performance

 Gross Domestic Product (GDP): it is the total value of currently
produced final goods and services that are produced within a
country‘s boundary during a given period of time, usually one year.

From these definition we can infer that-

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 It measures the current production only.
 It takes in to account final goods and services or do not include the
intermediate products.
 Intermediate goods are goods that are completely used up in the
production of other products in the same period that they
themselves are produced.
 It measures the values of final goods and services produced within
the boundary/territory of a country irrespective of who owns that
output.
 In measuring GDP, we take the market values of goods and
services ( GDP =∑PiQi)
where: Pi = series of prices of outputs produced in
different sectors of an economy in certain period and Qi = the
quantity of various final goods and services produced in an economy.
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 Gross National Product (GNP): is the total value of final goods and
services currently produced by domestically owned factors of
production in a given period of time, usually one year, irrespective
of their geographical locations.
GNP=GDP + NFI
 NFI denotes Net Factor Income received from abroad which is
equal to factor income received from abroad by a country‘s citizens
less factor income paid for foreigners to abroad.

– If NFI >0, then GNP > GDP

– If NFI<0, then GNP < GDP
– If NFI =0, then GNP =GDP

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 Approaches to measure national income (GDP/GNP)
 Basically, there are three approaches to measure GDP/GNP.
I. Product/value added approach,
II. Expenditure approach and
III. Income approach
I. Product Approach
GDP is calculated by adding the market value of goods and services
currently produced by each sector of the economy.

o In this case, GDP includes only the values of final goods and
services in order to avoid double counting.

o Double counting will arise when the output of some firms are
used as intermediate inputs of other firms.
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• For example, we would not include the full price of an automobile
in GDP and then also include as part of GDP the value of the tires
that were sold to the automobile producer.
• The components of the car that are sold to the manufacturers are
called intermediate goods, and their value is not included in GDP.
• There are two possible ways of avoiding double counting.
 Taking only the value of final goods and services
 Taking the sum of the valued added by all firms at each stage
of production.

 We can illustrate the two scenarios using some hypothetical

examples as follows.

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.

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.

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II. Expenditure Approach
• GDP is measured by adding all expenditures on final goods and
services produced in the country by all sectors of the economy.
Thus GDP =C+G+I+NE
 C-Personal consumption expenditure- includes expenditures by
households on durable consumer goods (automobiles,
refrigerators, video recorders, etc), non-durable consumer goods
(clothes, shoes, pens, etc) and services.
 I-Gross private domestic investment- is the sum of all spending of
firms on plants, equipment, and inventories, and the spending of
households on new houses.
• Investment is broken down into three categories:
 residential investment (the spending of households on the
construction of new houses),
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 business fixed investment (the spending of firms on buildings and
equipment for business use), and
 inventory investment (the change in inventories of firms).
o Note that gross private domestic investment differs from net
private domestic investment
Net private domestic investment = gross private domestic
investment- depreciation.
 G-Government purchases of goods and services- include all
government spending on finished products and direct purchases of
resources less government transfer payments because transfer
payments do not reflect current production although they are part
of government expenditure.
 NX-Net exports refer to total value of exports less total value of
imports.
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III. Income approach:
• GDP is calculated by adding all the incomes accruing to all factors
of production used in producing the national output.
 Note that: some forms of personal incomes are not incorporated
in the national income.
• For instance, transfer payments-payments which are made to the
recipients who have not contributed to the production of current
goods and services in exchange for these payments- are excluded
from national income, as these are mere redistribution of income
from taxpayers to the recipients of transfer payments.
• Transfer payments may take the form of old age pension,
unemployment benefit, subsidies, etc.

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• Thus GDP is the sum incomes to owners of factors of production
plus some other claims on the value of output (depreciation and
indirect business tax) less subsidies and transfer payments.

GDP = Compensation of employees (wages & salaries )

+ Rental income
+ Interest income
+ Profits (proprietors‘ profit plus corporate profit)
+ Indirect business taxes
+ Depreciation
- Subsidies
- Transfer payments.

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17
Limitation of GDP measurement:
 Definition of a nation:
• while calculating national income, nation does not mean only the
political or geographical boundaries of a country for calculating the
value of final goods and services produced in the country.
• It includes income earned by the nationals abroad.
 Stages of economic activities:
• it is also difficult to determine the stages of economic activity at
which the national income is determined.
• i.e. whether the income should be calculated at the stage of
production or distribution or consumption.
 Transfer payments:
• this also creates a great difficulty in calculating the national
income. 18
 Underground economy:
• no imputation is made for the value of goods and services sold in
the illegal market.
• The underground economy is the part of the economy that people
hide from the government either because they wish to evade
taxation or because the activity is illegal.
• Ex. The parallel exchange rate market.
 Non-monetized sector:
• this difficulty is special to developing countries where a substantial
portion of the total produce is not brought to the market for sale.
• It is either retained for self-consumption or exchanged for other
goods and services.
 Valuation of depreciation:
• But the valuation of depreciation is full of difficulties.
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 Changes in price levels:
• since the national income is in terms of money whose value itself
keeps on changing, it is difficult to make a stable calculation
which is assessed in terms of prices of the base year.

 No focus on quality:
• it is difficult to account correctly for improvements in the quality
of goods.

 Inadequate data:
• in almost all the countries, difficulty has been faced in the
calculation of national income due to lack of adequate data.
• Sometimes, the data are not reliable.

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 Other income accounts
 Apart from GDP and GNP, there are also other social accounts
which have equal importance in macroeconomic analysis.
These include:
 Net National product (NNP) :
• GNP as a measure of the economy‘s annual output may have
defect because it fails to take into account capital consumption
allowance, which is necessary to replace the capital goods used up
in that year‘s production.
• Hence, net national product is a more accurate measure of
economy‘s annual output than gross national product and it is
given as:

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 National income (NI):
• is the income earned by economic resource (input) suppliers for
their contributions of land, labour, capital and entrepreneurial
ability, which are involved in the given year‘s production activity.
• However, from the components of NNP, indirect business tax,
which is collected by the government, does not reflect the
productive contributions of economic resources because
government contributes nothing directly to the production in
return to the IBT.
• Hence, to get the national income, we must subtract indirect
business tax from net national product.

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 Personal Income (PI):
• refers to income earned by persons or households.
• Persons in the economy may not earn all the income earned as
national income.

 Personal Disposable Income:

• It is personal income less personal tax payments.
DI = PI – Personal taxes
=C+S
where, C = personal consumption expenditure, S = Personal savings
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 6.3. Nominal versus Real GDP

I) Nominal GDP
• is the value of all final goods and services produced in a given year
when valued at the prices of that year.
NGDP = ∑PiQi.
• Any change that can happen in the country‘s GDP is due to changes
in price, quantity or both.
• Hence, GDP that is not adjusted for inflation is called Nominal GDP.
II) Real GDP
• is the value of final goods and services produced in a given year
when valued at the prices of a reference base year.
• By comparing the value of production in the two years at the same
prices, we reveal the change in output.
• Hence, to be able to make reasonable comparisons of GDP
overtime we must adjust for inflation 24
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 6.4. The GDP Deflator and the Consumer Price Index(CPI)
 The GDP Deflator: is the ratio of nominal GDP in a given year to
real GDP of that year.
• It reflects what‘s happening to the overall level of prices in the
economy.

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 The Consumer Price Index(CPI)-
• Is the other useful measure of inflation.
• is an indicator that measures the average change in prices paid by
consumers for a representative basket of goods and services.
• It compares the current and base year cost of a basket of goods of
fixed composition.
• If we denote the base year quantities of the various goods by q'0
and their base year prices by р'0, the cost of the basket in the base
year is Σр'0*q'0, where the summation is over all the goods in the
basket.
• The cost of a basket of the same quantities but at today's prices is
Σp't,q'0, where pt is today's price.
• The CPI is the ratio of today's cost to the base year cost.

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 The CPI versus the GDP Deflator
• Give somewhat different information about what‘s happening to the
overall level of prices in the economy.
1. GDP deflator measures the prices of all goods and services
produced, whereas the CPI measures the prices of only the goods
and services bought by consumers.
• Thus, an increase in the price of goods bought by firms or the
government will show up in the GDP deflator but not in the CPI. .
2. GDP deflator includes only those goods produced domestically.
Imported goods are not part of GDP and do not show up in the GDP
deflator.
3. The CPI assigns fixed weights to the prices of different goods,
whereas the GDP deflator assigns changing weights.
• In other words, the CPI is computed using a fixed basket of goods,
whereas the GDP deflator allows the basket of goods to change over
time as the composition of GDP changes.
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 6.5. The Business Cycle
• refers to the recurrent ups and downs in the level of economic
activity.
• is a fluctuation in overall economic activity, which is characterized
by the simultaneous expansion or contraction of output in most
sectors.

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 We can identify four phases in the business cycle
i. Boom/peak: it is a phase in which the economy is producing the
highest level of output in the business cycle. Due to very high
degree of utilization of resources, unemployment level is low;
business is good; and it is a period of prosperity.
• the economy‘s output is growing faster than its long-term
(potential) trend and is therefore unsustainable.
• marks the end of economic expansion and the beginning of
recession.
ii. Recession/contraction: the level of economic performance
generally declines. Total output declines, national income falls,
and business generally decline. As a result, unemployment
problem rises.
• When the recession becomes particularly severe, we say the
economy reaches depression or trough causing hardship on
business and citizens. 30
iii. Trough/Depression: is the lowest point in a business cycle.
• It marks the end of a recession and the beginning of economic
recovery/expansion.
• there is an excessive amount of unemployment and idle
productive capacity.
iv. Recovery/Expansion: - the economy starts to grow or recover.
• , more and more resources are employed in the production
process; output increases, unemployment level diminishes and
national income rises.

 Note that:
 One business cycle includes the point from one peak to the next
peak or from one trough to the next.
 A business cycle is a short-term fluctuation in economic activities.
 Business cycles may vary in duration and intensity.
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 6.6. Macroeconomic Problems
1. Unemployment
• refers to group of people who are in a specified age (labour
force), who are without a job but are actively searching for a job.
 The whole population of a country is classified into two major
groups: those in the labour force and those outside the labour
force.
 Labor force –Productive population-includes group of people
within a specified age (14-60) who are actually employed and
those who are without a job but are actively searching for a job,
according to the Ethiopian labour law.
 Therefore, the labour force does not include: Children <14 and
retired people age >60, and also people in mental and
correctional institutions, and very sick and disabled people etc.
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• A person in the labour force is said to be unemployed if he/she is
without a job but is actively searching for a job.
Labour force = Employed + Unemployed

 Types of unemployment
1. Frictional unemployment: refers to a brief period of unemployment
experienced due to.
 Seasonality of work E.g. Construction workers
 Voluntary switching of jobs in search of better jobs
 Entrance to the labor force E.g. A student immediately after
graduation
 Re-entering to the labor force

2. Structural unemployment: results from mismatch between the skills

or locations of job seekers and the requirements or locations of the
vacancies. 33
o E.g. An agricultural graduate looking for a job at ―Piassa.
o The causes could be change in demand pattern or technological
change

3. Cyclical unemployment: results due to absence of vacancies.

• usually happens due to deficiency in demand for commodities/ the
low performance of the economy to create jobs.
• E.g. During recession

Note:
o Frictional and structural unemployment are more or less
unavoidable; hence, they are known as natural level of
unemployment.
o When the unemployment rate is equal to the natural rate of
unemployment, we say the economy is at full employment.
o Therefore, full employment does not mean zero unemployment.34
Measurement of rates of unemployment

Ex. -Consider the following information for a particular economy.

Total population =60 million Total Labor force=40 million

No of employed = 30 million NR of employment = 12%

a) Find the total unemployment rate

b) Calculate the cyclical unemployment rate 35
2. Inflation
• is the sustainable increase in the general or average price levels of
commodities.
• the increase price must be a sustained one, and it is not simply
once time increase in prices.
• it must be the general level of prices, which is rising; increase in
individual prices, which can be offset by fall in prices of other
goods is not considered as inflation.
 Price index (CPI)serves to measure inflation.

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 Causes of inflation
A. Demand pull inflation:
• inflation results from a rapid increase in demand for goods and
services than supply of goods and services.
• This is a situation where ―too much money chases too few goods.

B. Cost push or supply side inflation:

• it arises due to continuous decline in aggregate supply.
• This may be due to bad weather, increase in wage, or the prices of
other inputs.

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 Economic effects of inflation
1. Inflation reduces real money balance or purchasing power of
money. This will in turn reduce the welfare of individuals.
2. Banks charge their customers nominal interest rate for their
loans.
• Nominal interest rate however is determined based on inflation
rate as it is represented by Fisher‘s equation. I= r+П where, I is
nominal interest rate, r is real interest rate and П is inflation rate.
• Increase in inflation rate will raise the nominal interest rate and
the opportunity cost of holding money. If people are to hold
lower money balances on average, they must make more frequent
trips to the bank to withdraw money.
• This is called the shoe-leather cost of inflation.
3. Inflation reduces investment by increasing nominal interest rate
and creating uncertainty about macroeconomic policies. 38
4. Inflation redistributes wealth among individuals.
• Most loan agreements specify a nominal interest rate, which is
based on the rate of inflation expected at the time of the
agreement.
• If inflation turns out to be higher than expected, the debtor wins
and the creditor loses because the debtor repays the loan with less
valuable dollars.
• If inflation turns out to be lower than expected, the creditor wins
and the debtor loses because the repayment is worth more than
the two parties anticipated.
5. Unanticipated inflation hurts individuals with fixed income and
pension.
6. High inflation is always associated with variability of prices which
induces firms to change their price list more frequently and requires
printing and distributing new catalogue.
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• This is known as menu cost of inflation.
3. Budget deficit
• The overriding objectives of the government‘s fiscal policy are
building prudent public financial management, financing the
required expenditure with available resource and refrain from
possibility of unsustainable fiscal deficit.
• The government receives revenue from taxes and uses it to pay for
government purchases.
• Any excess of tax revenue over government spending is called
public saving, which can be either positive (a budget surplus) or
negative (a budget deficit).
• When a government spends more than it collects in taxes, it faces a
budget deficit, which it finances by borrowing from internal and
external borrowing.
• The accumulation of past borrowing is the government debt.

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• In Ethiopian , to augment available domestic financing options, the
government opted to finance its fiscal deficit from external sources
on concessional terms.
• As a rule of thumb, non-concessional loans cannot be used to
finance the budgetary activities.
• On the other hand, external non-concessional loans are used to
finance projects that are run by State Owned Enterprises.
• In recent years, the government accessed loans from international
market on non-concessional terms to finance feasible and
profitable projects managed by State Owned Enterprises (SOEs).
• The country‘s total public debt contains central government,
government guaranteed and public enterprises.

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4. Trade deficit
• The national income accounts identity shows that net capital
outflow always equals the trade balance.
S−I = NX.
Net Capital Outflow = Trade Balance
Net cash out flow is Saving(S) – Investment (I)
Balance of Trade = Merchandize Exports – Merchandize Imports

 If S − I and NX are positive, we have a trade surplus.

• In this case, we are net lenders in world financial markets, and we
are exporting more goods than we are importing.
 If the balance between S − I and NX is negative.
• we have a trade deficit then we say that there is a deficit in the
current account.
• In this case, we are net borrowers in world financial markets, and
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we are importing more goods than we are exporting.
 If S − I and NX are exactly zero,
• balanced trade because the value of imports equals the value of
exports.

 If domestic saving exceeds domestic investment, the surplus

saving is used to make loans to foreigners.
• Foreigners require these loans because we are providing them
with more goods and services than they are providing us.
• That is, we are running a trade surplus.

 If investment exceeds saving, the extra investment must be

financed by borrowing from abroad.
• These foreign loans enable us to import more goods and services
than we export.
• That is, we are running a trade deficit.
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 6.7. Macroeconomic policy instruments

• The ultimate policy objective of any country in general is to have

sustainable economic growth and development.
• Policy measures are geared at achieving moderate inflation rate,
keeping unemployment rate low, balancing foreign trade,
stabilizing exchange and interest rates, etc and in general
attaining stable and well-functioning macroeconomic
environment.
• To achieve these objectives countries adopt-
1. Monetary policy
• refers to the adoption of suitable policy regarding the control of
money supply and the management of credit .
• It is concerned with the money supply, lending rates and interest
rates.
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 Monetary policy is a highly flexible stabilization policy tool.
• During economic recession where output falls with a fall in AD,
monetary policy aims at increasing demand and hence production
as well as employment will follow the same pattern of demand.
• In contrast, at the time of economic boom where demand exceeds
production and treat to create inflation, the monetary policy
instruments are utilized that could offset the condition and achieve
price stability by counter cyclical action upon money supply.
 Government monetary policy regulation is under responsibilities of
Central Banks.
 CBs controls the money supply to control nominal interest rates.
• Investment and saving decisions are based on the real interest rate.
• When government lowers interest rate, firms borrow more and
invest more.
• Higher interest rates mean less investment. 45
2. Fiscal policy
• involves the use of government spending, taxation and borrowing
to influence both the pattern of economic activity and also the
level and growth of aggregate demand, output and employment.
• affect both aggregate demand (AD) and aggregate supply (AS).
• Most governments use fiscal policy to promote stable and
sustainable growth while pursuing its income redistribution effect
to reduce poverty.
• The most important tools of implementing the government fiscal
policy are taxes, expenditure and public debt.
• Traditionally fiscal policy has been seen as an instrument of
demand management.
• This means that changes in government spending, direct and
indirect taxation and the budget balance can be used to help
smooth out some of the volatility of real national output
particularly when the economy has experienced an external shock.
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• Fiscal policy decisions have a widespread effect on the everyday
decisions and behaviour of individual households and businesses.
• Thus, it is mainly used to achieve internal balance, by adjusting
aggregate demand to available supply.
• It also promotes external balance by ensuring sustainable current
account balance and by reducing risk of external crisis.
• In general, it helps promote economic growth through more and
better education and health care.

 Major functions of fiscal policy

i. Allocation
• The national budget determines how funds are allocated.
• This means that a specific amount of funds is set aside for purposes
specifically laid out by the government.
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• The budget allocation is done on the basis of aggregated
development objectives such as recurrent vs capital expenditures or
sectoral allocation (economic and social developments).

ii. Distribution
• The distribution functions of the fiscal policy are implemented
mainly through progressive taxation and targeted budget subsidy.
• The distribution function of fiscal policy is to determine more
specifically how those funds will be distributed throughout each
segment of the economy.
• For instance, the government might apportion a share of its budget
toward social welfare programs, such as food security and asset
building for the most vulnerable and disadvantaged in society.
• It might also allocate for low-cost housing construction and mass
transportation. 48
iii. Stabilization
• the purpose of budgeting is to provide stable economic growth.
• Government expenditure needs particularly in developing countries
such as Ethiopia are unlimited. But its source of financing is limited.
• Thus without some restraints on spending or limiting the level of
expenditure with available financial resources the economic growth
of the nation could become unstable, creating imbalances in
external sector as well as resulting in high prices.
iv. Development
• True economic growth occurs when various projects are financed
and carried out using budgetary finance.
• Without Government input and influence private sector cannot
grow the economy by itself.
• The government is responsible for providing public goods, reduce
externalities and correct market distortions in order to pave the way
for private sector. 49
 The underlying principles of the tax policies in Ethiopia are as
follows:
 To introduce taxes that enhance economic growth, broaden the tax
base and increase government revenue;
 To introduce taxes that are helpful to implement social policies that
discourage consumption of substances that are hazardous to
health and social problems;
 To introduce tax system that accelerate industrial growth and
achieve transformation of the country and to improve foreign
exchange earnings, as well as create conducive environment for
domestic products to become competitive in the international
commodity markets;

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 To ensure modern and efficient tax system that supports the
economic development;
 To make the tax system fair and equitable;
 To minimize the damage that may be caused by avoidance and
evasion of tax; and
 To promote a tax system that enhances saving and investment.

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End of the chapter

End of the course !!

Thank you!!!
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