MACROECONOMICS I ECON-2031

CHAPTER ONE
1. THE STATE OF MACROECONOMICS - INTRODUCTION
1.1 Definition of Macroeconomics
Macroeconomics is concerned with the structure, performance and behavior of the economy
as a whole. It explains the overall level of a nation‟s output, employment, prices, and foreign
trade. The prime concern of macroeconomists is to analyze and attempt to understand the
underlying determinants of the main aggregate trends in the economy with respect to the total
output of goods and services (GDP), unemployment, inflation and international transactions.
In particular, macroeconomic analysis seeks to explain the cause and impact of short-run
fluctuations in GDP (the business cycle), and the major determinants of the long-run path of
GDP (economic growth).
1.2 Focus areas of Macroeconomics
In macroeconomics we deal with the market for goods as a whole, treating all the markets for
different goods as a single market. Similarly, we deal with the labor market and the asset
market as a whole. The benefit of abstracting is increased understanding of the vital
interactions among the goods, labor, and assets markets. The cost of abstraction is that
omitted details sometimes matter.
It is difficult to overstate just how important satisfactory macroeconomic performance is for
the well-being of the citizens of any country. An economy that has successful
macroeconomic management should experience low unemployment and inflation, and steady
and sustained economic growth. In contrast, in a country where there is macroeconomic
mismanagement, we will observe an adverse impact on the living standards and employment
opportunities of the citizens of that country. In extreme circumstances, the consequences of
macroeconomic instability have been devastating. For example, the catastrophic political and
economic consequences of failing to maintain macroeconomic stability among the major
industrial nations during the period 1918–33 ignited a chain of events that contributed to the
outbreak of the Second World War, with disastrous consequences for both humanity and the
world economy. Macroeconomics deals with such major issues as: Economic growth,
Inflation, Unemployment and Foreign trade
Based on those problems the objectives of macroeconomics are:
 Generating a high level of production of economic goods and services for the population.
 High employment - providing jobs
 A stable or gently rising level of price level with prices and wages are determined by free
markets.
 Foreign economic relations marked by a stable foreign exchange rate and exports more or
less balancing imports.

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1.2 THE STATE OF MACROECONOMICS

1.2.1 Evolution and Recent Developments
The Great Depression gave birth to modern macroeconomics as surely as accelerating
inflation in the late 1960s and early 1970s facilitated the monetarist counter-revolution. It is
also important to note that many of the most famous economists of the twentieth century,
such as Milton Friedman, James Tobin and Paul Samuelson, were inspired to study
economics in the first place as a direct result of their personal experiences during this period.
While Laidler has reminded us that there is an extensive literature analyzing the causes and
consequences of economic fluctuations and monetary instability prior to the 1930s, the story
of modern macroeconomics undoubtedly begins with the Great Depression.
Although it is important to remember that economists before Keynes discussed what we now
call macroeconomic issues such as business cycles, inflation, unemployment and growth, as
we have already noted, the birth of modern macroeconomics as a coherent and systematic
approach to aggregate economic phenomena can be traced back to the publication in
February 1936 of Keynes‟s book The General Theory of Employment, Interest and Money.
2.2 The Classical and Neoclassical Macroeconomics School
Classical economists were well aware that a capitalist market economy could deviate from its
equilibrium level of output and employment. However, they believed that such disturbances
would be temporary and very short-lived. Their collective view was that the market
mechanism would operate relatively quickly and efficiently to restore full employment
equilibrium. If the classical economic analysis was correct, then government intervention, in
the form of stabilization policies, would be neither necessary nor desirable. Indeed, such
policies were more than likely to create greater instability.
It follows that the classical writers gave little attention to either the factors, which determine
aggregate demand, or the policies, which could be used to stabilize aggregate demand in
order to promote full employment. For the classical economist‟s full employment was the
normal state of affairs. But how did the classical economists reach such an optimistic
conclusion? In what follows we will present a „stylized‟ version of the classical model which
seeks to explain the determinants of an economy‟s level of real output (Y), real wage (W/P)
and nominal wages (W), the price level (P) and the real rate of interest (r) in this stylized
model it is assumed that:
1. All economic agents (firms and households) are rational and aim to maximize their profits
or utility; furthermore, they do not suffer from money illusion;
2. All markets are perfectly competitive, so that agents decide how much to buy and sell
based on a given set of prices, which are perfectly flexible;

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3. All agents have perfect knowledge of market conditions and prices before engaging in
trade
4. Trade only takes place when market-clearing prices have been established in all markets
5. Agents have stable expectations.
These assumptions ensure that in the classical model, markets, including the labor market,
always clear.
2.3 The Keynesian Macroeconomics School
For the early post-war years, the central distinguishing beliefs within the orthodox Keynesian
school can be listed as follows:
 The economy is inherently unstable and is subject to erratic shocks. These shocks are
attributed primarily to changes in the marginal efficiency of investment following a
change in the state of business confidence, or what Keynes referred to as a change in
investors‟ „animal spirits.
 Left to its own devices the economy can take a long time to return to the neighborhood of
full employment after being subjected to some disturbance; that is, the economy is not
rapidly self-equilibrating.
 The aggregate level of output and employment is essentially determined by aggregate
demand and the authorities can intervene to influence the level of aggregate „effective‟
demand to ensure a more rapid return to full employment.
 In the conduct of stabilization policy, fiscal as opposed to monetary policy is generally
preferred as the effects of fiscal policy measures are considered to be more direct,
predictable and faster on aggregate demand than those of monetary policy. These beliefs
found expression in the orthodox Keynesian model, known as the IS–LM model.
In the General Theory Keynes sets out to „discover what determines at any time the national
income of a given system and the amount of its employment. In the framework he constructs,
the national income depends on the volume of employment. In developing his theory, Keynes
also attempted to show that macroeconomic equilibrium is consistent with involuntary
unemployment. The theoretical novelty and central proposition of the book is the principle of
effective demand, together with the equilibrating role of changes in output rather than prices.
The emphasis given to quantity rather than price adjustment in the General Theory is in sharp
contrast to the classical model, where discrepancies between saving and investment decisions
cause the price level to oscillate.
2.4 The New Classical Macroeconomics School
During the early 1970s, there was a significant renaissance of the belief that a market
economy is capable of achieving macroeconomic stability, providing that the visible hand of
government is prevented from conducting misguided discretionary fiscal and monetary

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policies. In particular the „Great Inflation‟ of the 1970s provided increasing credibility and
influence to those economists who had warned that Keynesian activism was both over
ambitious and, more importantly, predicated on theories that were fundamentally flawed.

The central working assumptions of the new classical school are three:
1. Economic agents maximize. Households and firms make optimal decisions. This means
that they use all available information in reaching decisions and that those decisions are
the best possible in the circumstances in which they find themselves.
2. Expectations are rational, which means they are statistically the best predictions of the
future that can be made using the available information. Indeed, the new classical school
is sometimes described as the rational expectations school, even though rational
expectations is the only one part of the theoretical approach of the new classical
economists. Rational expectations imply that people will eventually come to understand
whatever government policy is being used, and thus that it is not possible to fool most of
the people all the time or even most of the time.
3. Markets clear. There is no reason why firms or workers would not adjust wages and
prices if that would make them better off. Accordingly, prices and wages adjust in order
to equate supply and demand; in other words, markets clear.

One dramatic implication of these assumptions, which seem so reasonable individually, is

that there is no possibility for involuntary unemployment. 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. Flexible adjustment of wages and prices leaves all individuals all the
time in a situation in which they work as much as they want and firms produce as much as
they want. The essence of the new classical approach is the assumption that markets are
continuously in equilibrium. In particular, new classical macroeconomics regard as
incomplete or unsatisfactory any theory that leaves open the possibility that private
individuals could make themselves better off by trading among themselves.

2.5 The New Keynesian Macroeconomics School

During the 1980s, there was a growth of interest in the early Keynes in order to better
understand the later Keynes of the General Theory. There is an increasing recognition and
acceptance that Keynes‟s philosophical and methodological framework had a significant
influence upon his economic analysis as well as his politics. Whilst much has been written
about the alleged content of Keynes‟s economics, very little has dealt with Keynes‟s method
and philosophy. The great stimulus to macroeconomic theory provided by Keynes is well
recognized but much less is said about his views on scientific methodology, „Keynes‟s

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methodological contribution has been neglected generally. The only major exception to the
change was the latter‟s earlier study, which endeavored to provide a serious extended analysis
of the connection between Keynes‟s philosophy and his economics. The more recent attempts
to explore the methodological and philosophical foundations of Keynes‟s political economy
have been termed „the new Keynes scholarship.‟

The main aim of the new scholarship is to highlight the need to recognize that Keynes‟s
economics has a strong philosophical base and to provide a detailed examination of Keynes‟s
rich and elaborate treatment of uncertainty, knowledge, ignorance and probability. The new
scholarship also gives prime importance to Keynes‟s lifelong fascination with the problem of
decision making under conditions of uncertainty.

The new classical school 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. the group includes among others George
Akerlof and Janet Yallen and David Romer of the University of California- Berkeley, Olivier
Blanchard of MIT, Greg Mankiw and Larry Summers of Harvard, and Ben Bernanke of
Princeton university. They do not believe that markets clear all the time but seek to
understand and explain exactly why markets can fail.

The new Keynesian argues that markets sometimes do not clear even when individuals are
looking out for their own interests. Both information problem 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 wage not only reduce the cost
of labor but also are also likely to wind up with a poorer quality labor force. Thus, they will
be reluctant to cut wages. If it is costly for firms to change the prices they charge and the
wages, they pay, the changes will be infrequent; but if all firms adjust prices and wages
infrequently, the economy wide level of wages and prices may not be flexible enough to
avoid occasional periods of even high unemployment.

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CHAPTER TWO
NATIONAL INCOME ACCOUNTING
INTRODUCTION

National income accounting refers to a set of rules and techniques that are used to measure
the national income of a country. National income is a measure of the value of goods and
goods produced by the residents of an economy in a given period of time, usually a quarter or
a year.

National income can be real or nominal. Nominal national income refers to the current year
production of goods and services valued at current year prices. Real national income refers to
the current year production of goods and service valued at base year prices.

In estimating national income, only productive activities are included in the computation of
national income. In addition, only the values of goods and services produced in the current
year are included in the computation of national income. Hence, gains from resale are
excluded but the services provided by the agents are counted. Similarly, transfer payments
are excluded as there is income received but no good or service produced in return. However,
not all goods and services from productive activities enter into market transactions. Hence,
imputations are made for these non-marketed but productive activities e.g. imputed rental for
owner-occupied housing. Thus, national income refers to the market value or imputed value
of additional goods and services produced and services performed in the current period.

National income in many countries is in either Gross Domestic Product (GDP) or Gross
National Product (GNP). Gross Domestic product (GDP) refers to the total value of goods
and services produced within the geographical boundary of a country before the deduction of
capital consumption. Net Domestic product (NPD) refers to the total value of goods and
services produced within the geographical boundary of a country after the deduction of
capital consumption.

Gross National Product (GNP) refers to the total value of goods and services produced by
productive factors owned by residents of the country both inside and outside of the country
before the deduction of capital consumption. Net National Product (NNP)) refers to the total
value of goods and services produced by productive factors owned by residents of the country
both inside and outside of the country after the deduction of capital consumption.

Relationship between GDP and GNP

GNP = GDP + NPIFA (Net Property Income from Abroad)

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Net Property Income from abroad refers to the difference between income from abroad and
income to abroad.
1. APPROACHES TO MEASURING GDP
1.1 The Value-Added Approach
The product approach measures economic activity by adding the market values of goods and
services produced, excluding any goods and services used up in intermediate stages of
production. This approach makes use of the value-added concept. The value added of any
producer is the value of its output minus the value of the inputs it purchases from other
producers. The product approach computes economic activity by summing the values added
by all producers.
Value added refers to the difference between the value of gross output of all goods and
services produced in a given period and the value of intermediate inputs used in the
production process during the same period.

Example
Stage of production Sales receipts Value added
Wheat 24 24
Flour 33 9
Baked dough 60 27
Bread 90 30
Total 207 90

1.2 The Income Approach

The income approach to GDP consists of the payments in terms of money to the factors of
production annually in a country. Thus, GDP is the sum total of the following items.
 Compensation of employees (W, S): this is the income from the sale of labor service
during the year. It includes wages, salaries, and fringe benefits such as employer
provided insurance and employer contribution to pension funds.
 Rental income(R): is earned by those who supply the service of land, mineral rights,
and building for use by others.
 Interest (I) - comprises items such as the interest payments households receive on
saving deposits, certificate deposits, and corporate bonds.
 Proprietor‟s income (Πp): is net income of sole proprietorships and partnerships.
 Corporate profit (Πc): include dividends, undistributed profits, and corporate profit
taxes.

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 Indirect business taxes (IBT): taxes levied on sales of final products by business
firms that increase the cost of these firms and are therefore reflected in the market
value of goods and services sold. Example: sales tax, excise tax, business property
tax, license fee.
 Capital consumption allowance ( depreciation) D
GDP= (W+S) +R+I+Π+D+IBT, where Π= Πc+ Πp
1.3 The Expenditure Approach
It only includes expenditure on goods and services to satisfy the needs of final buyers. It
excludes expenditure on intermediate of goods and services. Moreover, resale of consumer
and capital goods are excluded because the expenditures are on these resale goods, not goods
produced in the current period and hence expenditures on resale goods are not counted.

Economists and policymakers care not only about the economy‟s total output of goods and
services but also about the allocation of this output among other uses. The national income
accounts divide GDP into four broad categories of spending:
 Consumption (C)
 Investment (I)
 Government purchases (G)
 Net exports (NX).
Thus, letting Y stand for GDP,
Y C I G+ NX.
GDP is the sum of consumption, investment, government purchases, and net ex-ports. Each
dollar of GDP falls into one of these categories. This equation is an identity, an equation that
must hold because of the way the variables are defined. It is called the national income
accounts identity.

1.4 Other Social Accounts (GNP, NNP, NI, PI and DI)

The national income accounts include other measures of income that differ slightly in
definition from GDP. To see how the alternative measures of income relate to one another,
we start with GDP and add or subtract various quantities. To obtain gross national product
(GNP), we add receipts of factor income (wages, profit, and rent) from the rest of the world
and subtract payments of factor income to the rest of the world: GNP=GDP+ Factor
Payments from abroad-Factor Payments to Abroad.
Whereas GDP measures the total income produced domestically, GNP measures the total
income earned by nationals (residents of a nation). For instance, if Japanese resident owns an
apartment building in Addis Ababa, the rental income he earns is part of Ethiopian GDP

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because it is earned in the Ethiopia. However, because this rental income is a factor payment
to abroad, it is not part of Ethiopian GNP.

To obtain net national product (NNP), we subtract the depreciation of capital-the amount of
the economy‟s stock of plants, equipment, and residential structures that wears out during the
year:

NNP =GNP-Depreciation.
In the national income accounts, depreciation is called the consumption of fixed capital.
Because the depreciation of capital is a cost of producing the output of the economy,
subtracting depreciation shows the net result of economic activity.

The next adjustment in the national income accounts is for indirect business taxes, such as
sales taxes. These taxes place a wedge between the price that consumers pay for a good and
the price that firms receive. Because firms never receive this tax wedge, it is not part of their
income. Once we subtract indirect business taxes from NNP, we obtain a measure called
national income:
National income= NNP-Indirect Business Taxes
National income measures how much everyone in the economy has earned. The national
income accounts divide national income into five components, depending on the way the
income is earned. The five categories are:
 Compensation of employees: The wages and fringe benefits earned by workers.
 Proprietors' income: The income of non-corporate businesses, such as small farms, and
law partnerships.
 Rental income: The income that landlords receive, including the imputed rent that
homeowners “pay‟‟ to themselves, less expenses, such as depreciation.
 Corporate profits: The income of corporations after payments to their workers and
creditors.
 Net interest: The interest domestic businesses pay minus the interest they receive, plus
interest earned from foreigners.
A series of adjustments takes us from national income to personal income, the amount of
income that households and non-corporate businesses receive. Three of these adjustments are
most important. First, we reduce national income by the amount that corporations earn but do
not pay out, either because the corporations are retaining earnings or because they are paying
taxes to the government. This adjustment is made by subtracting corporate profits (which
equals the sum of corporate taxes, dividends, and retained earnings) and adding back
dividends. Second, we increase national income by the net amount the government pays out
in transfer payments. This adjustment equals government transfers to individuals minus social

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insurance contributions paid to the government. Third, we adjust national income to include
the interest that households earn rather than the interest that businesses pay. This adjustment
is made by adding personal interest income and subtracting net interest. (The difference
between personal interest and net interest arises in part from the interest on the government
debt.) Thus, personal income is
- Corporate Profits - Social Insurance
Contributions
- Net Interest
+Dividends
+Government Transfers to Individuals
+Personal Interest Income.
Next, if we subtract personal tax payments and certain non-tax payments to the government
(such as parking tickets), we obtain disposable personal income:

Disposable Personal Income = Personal Income - Personal Tax and Non tax
Payments.
We are interested in disposable personal income because it is the amount households and
non-corporate businesses have available to spend after satisfying their tax obligations to the
government.
4. REAL GDP VERSUS NOMINAL GDP
4.1 Nominal GDP
Consider the economy that produces only apples and oranges. In this economy GDP is the
sum of the value of all the apples and oranges produced. That is,

Quantity of Oranges)

Notice that GDP can increase either because prices rise or because quantities rise. It is easy to
see that GDP computed this way is not a good gauge of economic well-being. That is, this
measure does not accurately reflect how well the economy can satisfy the demands of
households, firms, and the government. If all prices doubled without any change in quantities,
GDP would double. Yet it would be misleading to say that the economy‟s ability to satisfy
demands has doubled, because the quantity of every good produced remains the same.
Economists call the value of goods and services measured at current prices nominal GDP.

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3.2 Real GDP

A better measure of economic well-being would tally the economy‟s output of goods and
services and would not be influenced by changes in prices. For this purpose, economists use
real GDP, which is the value of goods and services measured using a constant set of prices.
That is, real GDP shows what would have happened to expenditure on output if quantities
had changed but prices had not. To see how real GDP is computed, imagine we wanted to
compare output in 2002 and output in 2003 in our apple-and-orange economy. We could
begin by choosing a set of prices, called base-year prices, such as the prices that prevailed in
2002.Goods and services are then added up using these base-year prices to value the different
goods in both years. Real GDP for 2002 would be
Real GDP = (2002 Price of Apples ×2002 Quantity of Apples) + (2002 Price of

Similarly, real GDP in 2003 would be

+ (2002 Price

And real GDP in 2004 would be:

Real GDP= (2002 Price of Apples ×2004 Quantity of Apples) + (2002 Price of
Oranges ×2004 Quantity of Oranges).
Notice that 2002 prices are used to compute real GDP for all three years. Because the prices
are held constant, real GDP varies from year to year only if the quantities produced vary.
Because a society‟s ability to provide economic satisfaction for its members ultimately
depends on the quantities of goods and services produced, real GDP provides a better
measure of economic well-being than nominal GDP.

3. THE CONSUMER PRICE INDEX AND GDP DEFLATOR

3.1 The Consumer Price Index
A dollar today does not buy as much as it did 20 years ago. The cost of almost everything has
gone up. This increase in the overall level of prices is called inflation, and it is one of the
primary concerns of economists and policymakers Here we discuss how economists measure
changes in the cost of living.

The most commonly used measure of the level of prices is the consumer price index (CPI).
The central statistical Agency, has the job of computing the CPI. It begins by collecting the
prices of thousands of goods and services. Just as GDP turns the quantities of many goods
and services into a single number measuring the value of production, the CPI turns the prices

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of many goods and services into a single index measuring the overall level of prices. How
should economists aggregate the many prices in the economy into a single index that reliably
measures the price level? They could simply compute an average of all prices. Yet this
approach would treat all goods and services equally. Because people buy more chicken than
caviar, the price of chicken should have a greater weight in the CPI than the price of caviar.
The CSA weights different items by computing the price of a basket of goods and services
purchased by a typical consumer. The CPI is the price of this basket of goods and services
relative to the price of the same basket in some base year. For example, suppose that the
typical consumer buys 5 apples and 2 oranges every month. Then the basket of goods consists
of 5 apples and 2 oranges, and the CPI is

CPI 
 5  Current Price of Apples    2  Current Price of Oranges 
 5  2002 Price of Apples    2  2002 Price of Oranges 
In this CPI, 2002 is the base year. The index tells us how much it costs now to buy 5 apples
and 2 oranges relative to how much it cost to buy the same basket of fruit in 2002. The
consumer price index is the most closely watched index of prices, but it is not the only such
index. Another is the producer price index, which measures the price of a typical basket of
goods bought by firms rather than consumers. In addition to these overall price indices, the
CSA computes price indices for specific types of goods, such as food, housing, and energy.

4.2 The GDP Deflator

From nominal GDP and real GDP, we can compute a third statistic: the GDP deflator. The
GDP deflator, also called the implicit price deflator for GDP, is defined as the ratio of
nominal GDP to real GDP:
Nominal GDP
GDP Deflator 
Real GDP
The GDP deflator reflects what is happening to the overall level of prices in the economy. To
better understand this, consider again an economy with only one good, bread. If P is the price
of bread and Q is the quantity sold, then nominal GDP is the total number of dollars spent on
bread in that year, P Q. Real GDP is the number of loaves of bread produced in that year
times the price of bread in some base year, Pbase  Q . The GDP deflator is the price of bread

in that year relative to the price of bread in the base year, P .

Pbase
The definition of the GDP deflator allows us to separate nominal GDP into two parts: one-
part measures quantities (real GDP) and the other measures prices (the GDP deflator). That
is,
Nominal GDP=Real GDP ×

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Nominal GDP measures the current dollar value of the output of the economy. Real GDP
measures output valued at constant prices. The GDP deflator measures the price of output
relative to its price in the base year. We can also write this equation as

In this form, you can see how the deflator earns its name: it is used to deflate
(That is, take inflation out of) nominal GDP to yield real GDP.

4.3 The CPI versus the GDP Deflator

The GDP deflator and the CPI give somewhat different information about what is happening
to the overall level of prices in the economy.
There are three key differences between the two measures.
 The first difference is that the 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.
 The second difference is that the GDP deflator includes only those goods produced
domestically. Imported goods are not part of GDP and do not show up in the GDP
deflator. Hence, an increase in the price of a Toyota made in Japan and sold in this
country affects the CPI, because the Toyota is bought by consumers, but it does not
affect the GDP deflator.
 The third and most subtle difference results from the way the two measures aggregate
the many prices in the economy. 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. The
following example shows how these approaches differ. Suppose that major frosts
destroy the nation‟s orange crop. The quantity of oranges produced falls to zero, and
the price of the few oranges that remain on grocers‟ shelves is driven sky-high.
Because oranges are no longer part of GDP, the increase in the price of oranges does
not show up in the GDP deflator. But because the CPI is computed with a fixed basket
of goods that includes oranges, the increase in the price of oranges causes a
substantial rise in the CPI.

Economists call a price index with a fixed basket of goods a Laspeyres index and a price
index with a changing basket a Paasche index. Economic theorists have studied the

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properties of these different types of price indices to determine which is a better measure of
the cost of living. The answer, it turns out, is that neither is clearly superior. When prices of
different goods are changing by different amounts, a Laspeyres (fixed basket) index tends to
overstate the increase in the cost of living because it does not take into account that
consumers have the opportunity to substitute less expensive goods for more expensive ones.
By contrast, a Paasche (changing basket) index tends to understate the increase in the cost of
living. Although it accounts for the substitution of alternative goods, it does not reflect the
reduction in consumers‟ welfare that may result from such substitutions.

The example of the destroyed orange crop shows the problems with Laspeyres and Paasche
price indices. Because the CPI is a Laspeyres index, it overstates the impact of the increase in
orange prices on consumers: by using a fixed basket of goods, it ignores consumers‟ ability to
substitute apples for oranges. By contrast, because the GDP deflator is a Paasche index, it
understates the impact on consumers: the GDP deflator shows no rise in prices, yet surely, the
higher price of oranges makes consumers worse off. Luckily, the difference between the GDP
deflator and the CPI is usually not large in practice.

GDP AND WELFARE

GDP is a reasonably accurate and extremely useful measure of national economic

performance. It is not, and was never intended to be, an index of social welfare.
There are important items affecting our wellbeing that are not included in GDP.
 Non-market production- Underestimate by excluding non-market household‟s production.
 The value of leisure: the satisfaction you get from recreational activities and other use of
your leisure time also escapes inclusion in GDP.
 Improved product quality: GDP is a quantitative rather than a qualitative measure. It does
not accurately reflect improvements in the quality of products.
 The composition and distribution of output: reflects only the size of output and does not
tell us anything about whether this allocation of goods is right for the society.
 Cost of environmental damage: The costs of environmental damage are not subtracted
from the market value of final products when GDP is calculated. It over estimates the
value of output.
 The under-ground economy: this economy consists of transactions that never reported to
tax and other government authorities. It includes illegal goods and services- narcotics
trading, gambling, and prostitution. It also includes participants in legal activities, which
do not report their income to the revenue authority. Example: waitress.

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THE BUSINESS CYCLE

a) Definition and Characteristics of Business Cycle
Business cycle refers to the recurrent up and downs in the level of economic activity that
extends over a period of several years. The economy cycles continuously between growth and
contraction. Some periods of growth are greater than others, and some periods of contraction
are deeper than the others are. Peaks, troughs and periods of contraction or expansion
characterize the business cycle.

Potential output
Output

Peak Recovery

Trough
Recession

Time

Figure 2.1 the business cycle

Peak- the economy is at full employment and the national output is also at, or very close,
capacity. There is shortage of labor, parts and materials. National income and national
product correspond to a very high degree of utilization of labor, factories and offices.
Inflation is usually present in the peak of economic cycle.
Recession or contraction- is a period of at least six months after the peak and before the
trough during which, the economy declines as measured by GDP. During recession Output,
trade, income and employment both declines. Price also decline as unemployment starts to
increase.
Trough- is where output and employment „bottom out‟ at their lowest level. During this time,
there is an excess amount of unemployment and idle productive capacity. Businesses are
more likely to fail because if low demand for their product. At the trough, unemployment is
high and output is low.
Expansion (recovery): the economy‟s level of output and employment expand towards full
employment.

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UNEMPLOYMENT, INFLATION AND THE PHILIPS CURVE

a) Unemployment
Unemployment rate is the percentage of total labor force that is currently unemployed (total
unemployment divided by total employment force times 100). Let L denote the labor force, E
the number of employed workers, and U the number of unemployed workers. Because every
worker is either employed or unemployed, the labor force is the sum of the employed and the
unemployed:
L=E+U
In this notation, the rate of unemployment is U/L.
There are different types of unemployment:
Frictional unemployment: At any point of time, some workers will be „between jobs. That
is some workers will be in the process of voluntary switching jobs. Others will have job
connections but will be temporarily laid off because of seasonality or model change occurs.
Example: college graduates.

Structural unemployment; is unemployment resulting from permanent shifts in the pattern

demand for goods and services or from changes in technology. Structurally unemployed
workers have skills that are not in demand by employers because of permanent changes in the
economy.
Cyclical unemployment: is the amount of unemployment resulting from declines in real
GDP during periods of recession or in any period when the economy fails to operate at its
potential.
b) Inflation
Inflation is a rising general level of prices. There are different types of inflation:
Demand-pull inflation: changes in the price level have been attributed to an excess of total
demand. The business sector cannot respond to this excess demand by expanding real output
for the obvious reason that all available resources are already fully employed. Therefore, this
excess demand will bid up the price of the fixed real output, causing demand pull inflation.

Cost push inflation – inflation may arise on the supply or cost side of the market. Unions
have considerable control over wage rates. They obtain a wage increase. Large corporate
employers faced now with increased costs but also in the possession of considerable market
power, push their increased wage cost on to consumers by raising the prices of their
production.
Structural inflation-is due to the change in the structure of total demand. This is due to the
market power of big business and unions. Prices and wages tend to be flexible upward but
inflexible downward.

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c) The Trade offs between Inflation and Unemployment- the Philips Curve
Macroeconomic policies are implemented in order to achieve government‟s main objectives
of full employment and stable economy through low inflation. We can use Philips Curve as a
tool to explain the trade-off between these two objectives. Philips Curve describes the
relationship between inflation and unemployment in an economy. You already know that the
Inflation is defined by increase in the average price level of goods and services over time.
Unemployment exists when someone is actively seeking for job but unable to find any
despite their willingness to accept the going market wage rate. When there is inflation, value
of money falls. A low inflation rate indicates that average price of goods would not rise as
high.

New Zealand-born economist A.W Philips first put this theory forward in 1958 gathered the
data of unemployment and changes in wage levels in the UK from 1861 to 1957. He
observed that one stable curve represents the trade-off between inflation and unemployment
and they are inversely/negatively related. In other words, if unemployment decreases,
inflation will increase, and vice versa.

The Phillips Curve shows an inverse relationship between inflation and unemployment. It
suggested that if governments wanted to reduce unemployment it had to accept higher
inflation as a trade-off.

For example, after the economy has just been in recession, the unemployment level will be
fairly high. This will mean that there is a labor surplus. As the economy has just started
growing, the aggregate demand (AD) will increase and therefore leading to an increase in
employment. In the beginning, there will be little pressure for a raise in wages. However, as
the economy grows faster and more people are employed, wages will start rising slowly.

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This will increase the firm‟s cost of production and the high costs are usually passed on to the
customers in the form of higher prices. Therefore, a decrease in unemployment has led to an
increase in inflation and vice versa.

Not only that, unemployed might suffer from money illusion as they thought the increase in
wages offered to them represented a real wage. They underestimate inflation by not realizing
that higher wages will be eaten up by higher prices. Thus, they will accept job more readily
and this will reduce the frictional unemployment

The relationship we discussed above is a phenomenon in the short-run. But in the long run,
since unemployment always returns to its natural rate, there is no such trade-off.

Using the data from the 1950s and 1960s where the world economy tend to be stable, Philips
Curve relationship proved to be true for many economies such as United States and UK .
However, during 1967-1970 most countries such as US, Britain and France had doubled their
inflation. This was the first sign that the downward relationship in Philips Curve was not
always true. In 70‟s the concept of a stable Philips Curve shows a break down as the
economy suffered from both high inflation and high unemployment simultaneously. The
economists refer this kind of situation as stagflation where stagnant economies and rising
inflation occurs together.

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CHAPTER THREE
AGGREGATE DEMAND IN THE CLOSED ECONOMY
SECTION ONE: MACROECONOMIC FLUCTUATIONS

1.1 Quantity-Adjustment versus Price-Adjustment Paradigms

The devastating episode of Great Depression caused many economists to question the validity
of classical economic theory. Classical theory seemed incapable of explaining the
Depression. According to the classical economic theory, national income depends on factor
supplies and the available technology, neither of which changed substantially during the
years of Great Depression (1929 to 1933). In 1936 the British economist John Maynard
Keynes revolutionized economics and proposed a new way to analyze the economy. He
proposed that low aggregate demand is responsible for the low income and high
unemployment that characterize economic downturns. In the long run, prices are flexible, and
aggregate supply determines income. But in the short run, prices are sticky, so changes in
aggregate demand influence income.

Business cycle fluctuations suggest that the economy is often not at its long run or natural
equilibrium. The conditions that hold in the long-run equilibrium – like quantity demand
equals quantity supplied at full employment – do not always hold true in the short-run. A
theoretical framework to explain and interpret the rather strong and persistent short-run
deviations from long-run equilibrium is often called the Keynesian model. It is so called
because its origins are found in the work of John Maynard Keynes, a prominent British
economist of the interwar period. In the U.K. from the 1920s on, and in the U.S. and
elsewhere during the Great Depression of the 1930s, it was clear that market mechanisms
were not leading to an equilibrium that utilized all available resources. The terrible slowness
of adjustments in modern macroeconomics needed some explanation.

Dissatisfied with the inability of the classical equilibrium approach to provide an adequate
understanding of the macro phenomena of his time – massive and persistent unemployment –
Keynes developed a theory that provided at least some of the answers. Keynes‟ theory had an
overwhelming influence on post-war macroeconomic thinking. In fact, for sometimes,
Keynesian modeling became synonymous with macroeconomics.

The Keynesian approach examines the aggregate demand for goods in real terms and
describes the adjustments of the economy towards equilibrium. The simplest Keynesian
model abstracts entirely from price changes. Although this may sound unreasonable, the
model is useful for understanding how short-run output changes occur. The broader
Keynesian model sheds light on the interactions between the demand for goods and services

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and the financial sector. It will provide the basis for examining the short-run effects of
monetary and fiscal policy. The Keynesian model is useful for understanding how the
economy adjusts towards its long-run equilibrium.

The principal theme of classical price theory that underlies the study of microeconomics is: if
there is an imbalance between supply and demand in a competitive market, then prices
change to clear the market or establish equilibrium. The emphasis in price theory is on the
balancing role of prices. Real wage flexibility brings about labor sector equilibrium and the
real interest rate balances the allocation of output between investment goods and
consumption goods.

Together, the equilibrium labor supply and capital stock (in turn determined by the amount of
investment) determine the equilibrium output level.

The Keynesian real sector model takes a different approach. The underlying theme of this
approach is that output or quantity adjustments occur when there is an imbalance between
supply and demand. That is, in the short-run, disequilibrium leads to changes in the quantity
of output. In order to explore this approach, we will assume that prices remain constant and
examine the macroeconomic consequences of a model where quantity adjustments occur.

The simple Keynesian model is an application of the quantity adjustment paradigm. That is: if
there is an imbalance between supply (output or production) and demand (expenditure), then
producers will change the quantity of output produced. The argument of quantity adjustment
can best be made by citing an example of a manufacturing industry where adjustments in the
quantity of output are, at least in the short-run, more important and more pervasive than
adjustments in prices.

Clearly, both price and quantity adjustments take place in actuality; so, we will relax the
assumption of fixed prices in Unit Four. There, we will provide a more general discussion of
price changes and the reasons why they do not occur so frequently.

In general, in the short run, a change in price is often a costly and unreliable means of
equilibrating sales and production, particularly when the imbalance may well be a temporary
phenomenon and a rapid response is desired. Thus, quantity adjustments are the primary
adjustment mechanism used to maintain sales-production equilibrium in the short run. In a
modern economy with very rapid information flows and less emphasis on manufacturing and
greater emphasis on services, price changes do occur. Price changes are often made
infrequently and therefore the principal adjustments to supply and demand imbalances in the
short run are quantity changes.

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The above conclusion relies upon two characteristics of the product market. First, the
argument presumes that goods can be held in inventory (which is by and large true for
manufactured goods). If output were perishable, price adjustments would dominate. If we go
to the wholesale produce market, we will find that the market for strawberries is cleared daily
by price adjustments. Second, we assume that there is some degree of product differentiation.
If all output were homogeneous and markets perfectly competitive then price adjustments
would clear the market.

1.2 The IS–LM Model

Over long periods of time, prices are flexible, the aggregate supply curve is vertical, and
changes in aggregate demand affect the price level but not output. Over short periods of time,
prices are sticky, the aggregate supply curve is flat, and changes in aggregate demand do
affect the economy‟s output of goods and services.

In the short run when the price level is fixed, shifts in the aggregate demand (AD) curve led
to changes in national income. The IS – LM model, which is a model of aggregate demand,
aims at showing what determines national income for any given price level or equivalently at
showing what causes the aggregate demand curve to shift.

The two parts of the IS – LM model are the IS curve and the LM curve. IS stands for
“Investment” and “Saving”, and the IS curve represents what‟s going on in the market for
goods and services. LM stands for “Liquidity” (which represents the demand for many) and
“Money” (which is the supply/stock of money), and the LM curve represents what‟s
happening to the supply and demand for money.

As we will see, the interest rate is the variable that links the two halves of the IS – LM model
since it influences both investment and money demand. The IS – LM model shows how
interactions between these markets determine the position and slope of the aggregate demand
curve and, therefore, the level of national income in the short run.

In the subsections to follow (and before we derive the IS and the LM curves), we will take
discuss the determination of income, some macroeconomic identities, and the concept of the
multiplier. We will then derive the two curves – the IS curve and the LM curve – and then
bring them together to define a general equilibrium of the economy. In so doing, we analyze
the demand side of the economy only, assuming that the supply side is alright, i.e., we
assume that the fixed price we use is consistent with equilibrium in factor markets. Extending
the IS – LM analysis to the derivation of aggregate demand and introducing changes in price
level (on the supply side) is postponed to the next unit.

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1.2.1 The Goods Market and the IS Curve

The IS curve plots the relationship between the interest rate and the level of income that
arises in the market for goods and services. As to Keynes, an economy‟s total income is, in
the short run, determined largely by the desire to spend by households, firms, and the
government. The more people want to spend, the more goods and services firms can sell. The
more firms can sell, the more output they will choose to produce and the more workers they
will choose to hire. Thus, the problem during recessions and depressions, according to
Keynes, was inadequate spending, i.e., shortage of aggregate demand.

1.2.1.1 The Keynesian Cross and Income Determination

To develop the relationship between the interest rate and the level of income that arises in the
market for goods and services – i.e., the IS curve – we start with a basic model called the
Keynesian cross. This model is the simplest interpretation of Keynes‟s theory of national
income and is a building block for the more complex and realistic IS – LM model. The
Keynesian cross begins by drawing a distinction between actual expenditure and planned
expenditure.

Actual expenditure is the amount households, firms and the government spend on goods and
services, and it equals the economy‟s gross domestic product (income). Recall that the
expenditure approach is one of the approaches of measuring GDP. The fact that actual
expenditure equals real GDP or output is shown in Figure 3.1 below. In the figure, an actual
expenditure of say 10 billion Birr is translated to a 10 billion Birr value for GDP, giving rise
to a 450-line relating AE and GDP.

AE

90

10

450
10 90 Y (= output, GDP)

Figure 3.1: Actual Expenditure

Now consider planned expenditure and its determinants. Planned Expenditure (PE) is the
amount households, firms, and the government would like to spend on goods and services.
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Assuming that the economy is closed, so that net exports are zero, we can write planned
expenditure (PE) as the sum of consumption C, planned investment I, and government
purchases G:
PE = C + I + G.
To this equation, we add the consumption function C = C(Y − T). This equation states that
consumption depends on disposable income (Y − T), which is total income Y minus taxes
(net of subsidy) T (i.e., T = taxes – subsidies). Assume that fiscal policy – the levels of
government purchases and taxes – is fixed: G  G and T  T . To keep things simple, also
assume that planned investment is exogenously fixed: I  I .
Combining these equations, we obtain:
PE  C (Y  T )  I  G .
This equation shows that planned expenditure is a function of income Y, the level of planned
investment I , and the fiscal policy variables G and T .
Figure 3.2 graphs planned expenditure (PE) as a function of the level of income. The PE line
slopes upward because higher income leads to higher consumption and thus higher planned
expenditure.

PE

PE  C (Y  T )  I  G

MPC
1

Figure 3.2: Planned Expenditure

The slope of the PE line is the marginal propensity to consume, the MPC: it shows how much
planned expenditure increases when income rises by a unit (say, 1 Birr). This planned
expenditure function is the first piece of the model called the Keynesian cross.

Why would actual expenditure ever differ from planned expenditure? The answer is that
firms might engage in unplanned inventory investment because their sales do not meet their
expectations. When firms sell less of their product than they planned, their stock of
inventories automatically rises. Conversely, when firms sell more than planned, their stock of

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inventories falls. Because these unplanned changes in inventory are counted as investment
spending by firms, actual expenditure can be either above or below planned expenditure. Put
differently, while actual expenditure includes unexpected (undesired) changes in inventories
(∆inv), planned expenditure excludes the unexpected (undesired) changes in inventories. That
is, AE = C (Y – T) + I + ∆inv + G while PE = C (Y – T) + I +G. AE > PE when ∆inv > 0;
AE < PE whenever ∆inv < 0; and, AE = PE when ∆inv = 0.

The second piece of the Keynesian cross is the assumption that the economy is in equilibrium
when actual expenditure equals planned expenditure. This assumption is based on the idea
that when people‟s plans have been realized, they have no reason to change what they are
doing. Recalling that Y as GDP equals not only total income but also total actual expenditure
on goods and services, we can write this equilibrium condition as: Actual Expenditure (AE or
Y) = Planned Expenditure (PE).

Continuing with our previous assumption of exogenously fixed planned investment (I) and
fiscal policy variables (G and T), the actual expenditure (AE), the planned expenditure (PE),
and the equilibrium of the economy can be shown as follows. Figure 3.3 below shows three
pieces which constitute the Keynesian cross – AE, PE and equilibrium of the economy –
together with the role of inventories in the adjustment towards equilibrium.
AE=PE
PE
AE2
PE  C (Y  T )  I  G

E PE2
Ye

PE1

AE1

450
Y1 Ye Y2 Y, AE

Figure 3.3: The Keynesian Cross and Adjustment to the Equilibrium

The 450 line serves as a reference line that translates any horizontal distance into an equal
vertical distance. Thus, anywhere on the 450 line, AE = PE, the level of planned spending
(aggregate demand) is equal to the level of actual spending (output). The equilibrium of this
economy is at point E, where the planned expenditure function crosses the 45-degree line. At

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this point, the quantity of output produced (output) is exactly equal to the quantity demanded
(planned spending) – both are equal to Ye.

How does the economy get to the equilibrium if it were out of equilibrium? In this model,
inventories play an important role in the adjustment process. Whenever the economy is not in
equilibrium, firms experience unplanned changes in inventories (∆inv ≠ 0), and this induces
them to change production levels. Changes in production in turn influence total income and
expenditure, moving the economy toward equilibrium.

For example, suppose the economy were ever to find itself with GDP at a level greater than
the equilibrium level, such as the level Y2 in Figure 3.3. Then output or actual expenditure
(AE2) would exceed demand or planned expenditure (PE2). Firms would be unable to sell all
they produce and would find their warehouses filling with inventories of unsold goods. This
unplanned rise in inventories induces firms to lay off workers and reduce production, and
these actions in turn reduce GDP. This process of unintended inventory accumulation and
falling income continues until income Y falls to the equilibrium level (Ye). This is shown by
the horizontal arrow pointing left from the output level of Y2.

Similarly, suppose GDP were at a level lower than the equilibrium level, such as the level Y1
in Figure 3.3. In this case, planned expenditure PE1 is greater than production AE1. Firms
meet the high level of sales by drawing down their inventories. But when firms see their
stock of inventories dwindle, they hire more workers and increase production. GDP rises and
the economy approaches the equilibrium as shown by the horizontal arrow pointing to the
right from the output level of Y1.

Thus, at point E, the equilibrium level of output, firms are selling as much as they produce,
people are buying the amount they want to purchase, and there is no tendency for the level of
output to change. At any other level of output, the pressure from increasing or declining
inventories causes firms to change the level of output.

1.2.1.2 Some National Income Identities of the Closed Economy

1. Consumption and Saving Functions

We assume that consumption demand increases with the level of disposable or after-tax
income (Yd = Y – T): C  C  cY d . The component C , the intercept, represents the level of
consumption when income is zero. Regarding the second component, for every Birr increase
in income, consumption increases by c Birr. For example, if c is 0.75, then for every Birr
increase in income, consumption rises by 0.75 cents. The slope of the consumption function
is c.

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The coefficient c has a special name, the marginal propensity to consume. The marginal
propensity to consume is the increase in consumption per unit increase in income. The
marginal propensity to consume is less than 1, which implies that out of a Birr increase in
income, only a fraction, c, is spent on consumption. Thus, 0 < c < 1.

What happens to the rest of income, the fraction (1 – c), that is not spent on consumption? If
it is not spent, it must be saved. Income is either spent or saved; there are no other uses to
which it can be put. It follows that any theory that explains consumption is equivalently
explaining the behavior of saving. More formally, S  Y d  C , i.e., income that is not spent
on consumption is saved, or by definition saving is equal to (disposable) income minus
consumption C  C  cY d . Thus, the consumption function C  C  cY d corresponds to the
saving function S  Y d  C which simplifies to S  Y d  C  cY d  C  (1  c)Y d . From
this equation, we see that saving is an increasing function of the level of income because the
marginal propensity to save, s = 1 – c, is positive. In other words, saving increases as income
rises. For instance, suppose the marginal propensity to consume, c, is 0.75, meaning that 75
cents out of each extra Birr of income is consumed. Then the marginal propensity to save, s,
is 0.25, meaning that the remaining 25 cents of each extra Birr of income is saved.

Two points need to be made about the consumption function. First, individuals' consumption
demands are related to the amount of income they have available to spend, i.e., their
disposable income (Yd), rather than just to the level of output. Second, how can individuals
consume anything when their income is zero? For some time, they can sell off their assets
such as stocks, bonds, and the house. Eventually, though, it would be difficult to continue to
buy goods when income is zero.

2. Planned versus Actual Investment

There is a useful alternative formulation of the equilibrium condition that aggregate demand
(planned expenditure) is equal to output (actual expenditure). This is to state that, in
equilibrium, planned investment equals actual investment. This condition follows from
planned expenditure (PE) and actual expenditure (AE) equations we saw under Keynesian
cross and income determination.

There, we said that PE = C(Y – T) + I + G and AE = C(Y – T) + I + ∆inv + G; where I is

planned investment (IPLANNED) and I + ∆inv is actual investment (IACTUAL). Equating PE to
AE is consequently equivalent to equating actual investment to planned investment. Thus, it
always holds that actual investment equals planned investment plus undesired changes in
inventories (IACTUAL = IPLANNED + ∆inv). It follows that at equilibrium (where PE = AE)
planned investment must equal actual investment (IACTUAL = IPLANNED). This requires that

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there is no undesired or unplanned change in inventories, i.e., ∆inv = 0. Thus, the equilibrium
condition PE = AE could be stated as IACTUAL = IPLANNED or as ∆inv = 0.

3. The Saving-Investment Identities

There is still another useful alternative formulation of the equilibrium condition that
aggregate demand is equal to output. This condition is the saving-investment identity. With
our assumption of a closed economy (i.e., with zero net export), the equilibrium condition PE
= AE is the same as saying that investment equals saving.

To reiterate, planned expenditure PE is the sum of consumption and investment plans of

households and firms (C + I) and government purchases (G). That is to say, planned
expenditure is given by PE = C + I + G. Similarly, we also saw that actual expenditure (AE)
is the same as output or income (Y), i.e., AE = Y.

Hence, the condition PE = AE = Y is the same as saying that Y = C + I + G and this could be
rewritten in a number of ways. One way is to subtract taxes from both sides of this equation
to find:

Y – T = C + I + G – T.
Now, recall that Y – T is disposable income which is either consumed or saved. So,
Yd = C + I + (G – T).
If we take a hypothetical economy with no government (i.e., G = T = 0), it follows that: Yd =
C + I.
Subtracting C from both sides yields Yd – C = C + I – C. The left-hand side of this identity
(an equation which is always true by definition) is saving and the right-hand side is planned
investment. Thus, we have:
S=I
which is one version of the saving-investment identity.
For the case where there is the government in the economy, subtracting C from both sides of
Yd = C + I + (G – T) gives:
Yd – C = I + (G – T).
Moving (G – T) to the left of the equality sign, we will have:
Yd – C + (T – G) = I
Yd – C on the left is saving by the private sector of the economy, say denoted by SP. The
other term on the left, T – G, is the difference between what government collects as taxes (net
of transfer payments) and government purchases planned. In short, T – G is saving by
government or the public sector, denoted by SG. Now, consequently, the identity Yd – C + (T
– G) = I reduce to SP + SG = I. Replacing the sum of the savings of the private and public

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sectors by a single variable S (which is national saving) yields another version of the saving-
investment identity:
S (= SG + SP) = I.
In sum, the condition S = I is merely another way of stating the basic equilibrium condition.

4. The Injection – Leakage Identity

We will take a very short time to look at this alternative way of stating the equilibrium
condition. The national income identity of a closed economy Y = C + I + G gives the sources
of national income (Y) to be the (planned) spending by households (C), by firms (I) and by
the government (G).

Viewed from the income allocation side, the income earned in such a closed economy is
shared among tax payments, consumption and saving. What is left over after paying taxes (T)
– i.e., the disposable income will either be consumed (C) or saved (S). Hence, Y = T + C + S.
Bringing the two sides together:
C + I + G = Y = T + C + S.
In relation to the circular flow of economic activities in a simple closed economy, C, I and G
are injections or additions into the flow while C, S and T represent leakages or withdrawals
from the circle. The total of the injections should be equal to the total of the withdrawals at
the equilibrium of the economy. Thus, C + I + G = T + C + S (or after eliminating C from
both sides) I + G = S + T is another way of representing the equilibrium condition.
1.2.1.3 The Multiplier
We have seen the Keynesian cross in Subsection 1.2.1.1. The Keynesian cross we have seen
shows how income Y is determined for given levels of planned investment I and fiscal policy
variables G and T. In this subsection, we use this model to show how income changes when
one of these (exogenous) variables changes. More specifically, we will consider how output
(or GDP) responds to changes in government purchases, autonomous taxes, or autonomous
spending (on consumption or investment). We will also see the balanced budget multiplier, in
which case government increases both purchases and (autonomous) taxes by the same
amount.

First let us how changes in government purchases affect the economy. Because government
purchases are one component of expenditure (PE = C + I + G), higher government purchases
result in higher planned expenditure for any given level of income. This is shown by upward
shift in the PE curve from PE1 to PE2 in Figure 3.4.

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MACROECONOMICS I ECON-2031

AE = PE
PE PE2 = C + I + G2
B
PE2 = Y2
G
PE1 = C + I + G1

Y

PE1 = Y1 A
C

450
PE1 = Y1 PE2 = Y2 Y (Income, Output)

Figure 3.4: The Effect of a Change in Government Purchases on Equilibrium Output

Figure 3.4 shows that raising government purchases by G (from G1 to G2), causes the
planned-expenditure schedule to shift upward from PE1 to PE2 (by G). Consequently, the
equilibrium of the economy moves from point A to point B. This graph also shows that an
increase in government purchases leads to an even greater increase in income. That is, Y is
larger than G.

For the movement fro A to B, caused by the change in government purchases by G, the
change in Y is shown by the arrows from Y1 to Y2 both on the horizontal and the vertical
axes. It should be clear that the vertical distance between Y1 to Y2 (on the vertical axis) is the
same as the distance from Point B to Point C. Y shown by this distance is greater than the
distance between the two planned expenditure curves.

The ratio Y/G is called the government purchases multiplier; it tells us how much income
rises in response to a 1 Birr increase in government purchases. An implication of the
Keynesian cross is that the government-purchases multiplier is larger than 1.

Why does fiscal policy have a multiplied effect on income? The reason is that, according to
the consumption function C = C(Y − T), higher income causes higher consumption. When an
increase in government purchases raises income, it also raises consumption, which further
raises income, which further raises consumption, and so on. Therefore, in this model, an
increase in government purchases causes a greater increase in income.

How big is the multiplier? To answer this question, we trace through each step of the change
in income. The process begins when expenditure rises by G, which implies that income rises

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 MACROECONOMICS I ECON-2031

by G as well. This increase in income in turn raises consumption by MPC × G, where
MPC is the marginal propensity to consume. This increase in consumption raises expenditure
and income once again. This second increase in income of MPC × G again raises
consumption, this time by MPC × (MPC × G), which again raises expenditure and income,
and so on. This feedback from consumption to income to consumption continues indefinitely.
The total effect on income is:

Round The Effect of G

on Consumption on Income
1 - G
2 MPC x G MPC x G
3 MPC2 x G MPC2 x G
4 MPC3 x G MPC3 x G

  
SUM C = (MPC + MPC2 + MPC3 +…) x G Y = (1 + MPC + MPC2 + MPC3 +…) x G

Dividing the two sides of the final equation in the last row of the table above, the government
purchases multiplier is given by:
Y/G = 1 + MPC + MPC2 + MPC3 +…
This expression for the multiplier is an example of an infinite geometric series. With the first
term of 1 and a common ratio equal to MPC (0 < MPC < 1), the sum of this series converges
1 Y 1
to: . Thus,  .
1  MPC G 1  MPC

Alternatively, the government-purchases multiplier can be derived using calculus as follows:

Begin with the equation Y = C(Y − T) + I + G. Next, differentiate this equation with respect
to G to obtain:
dY d [C (Y  T )] dI dG dY dC dY dT dI
     [  ] 1
dG dG dG dG dG dY dG dG dG
dY dY dT dI
  MPC[  ] 1
dG dG dG dG
Holding T and I fixed (assuming that dT/dG = dI/dG = 0) we will have:
dY dY dY dY
  MPC  1   MPC  1
dG dG dG dG

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MACROECONOMICS I ECON-2031

dY dY 1
 (1  MPC )  1  
dG dG (1  MPC )

Inspection of the multiplier in this formula shows that the larger the marginal propensity to
consume, the larger the multiplier. With a marginal propensity to consume of 0.8, for
instance, the multiplier is 5; for a marginal propensity to consume of 0.9, the multiplier is 10.
A higher marginal propensity to consume implies that a larger fraction of an additional Birr
of income will be consumed, thereby causing a larger induced increase in demand.

Why focus on the multiplier'? The reason is that we are developing an explanation of
fluctuations in output. The multiplier suggests that output changes when government
purchases changes, and that the change in output is larger than the change in government
purchases. The multiplier is the formal way of describing a commonsense idea: if the
economy experiences a shock that reduces income, then people whose incomes have gone
down will spend less, thereby driving equilibrium income down even further. The multiplier
is therefore part of an explanation of why output fluctuates.

We can derive the multiplier not only for changes in government purchases but also for
changes in any of the components of planned expenditure. Substitute the consumption
function C  Ca  c(Y  T ) (where Ca is autonomous consumption and c is the MPC) into
the equilibrium condition Y = C + I + G yields:

Y  Ca  cY  cT  I  G which, upon rearranging, gives:

1
Y [C a  cT  I  G ]
1 c
Taking the derivative of this equilibrium income, we will have:
1
dY  [dCa  cdT  dI  dG]
1 c
From this final expression, it is now easier to derive different multipliers:
dY dY dY 1
  
dCa dI dG 1  c
That is, the multiplier we saw above, 1/(1-MPC) equally holds for changes occurring to
autonomous consumption spending as well as changes in autonomous investment spending.
dY c
From the same expression we also obtain:  . This expression is the tax multiplier,
dT 1  c
the amount income changes in response to a 1 Birr change in taxes. For example, if the

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MACROECONOMICS I ECON-2031

dY  0. 6
marginal propensity to consume is 0.6, then the tax multiplier is   1.5 . In
dT 1  0.6
this example, a 1 Birr cut in taxes raises equilibrium income by 1.5 Birr.
Finally, let us derive the balanced budget multiplier. What will be the change in income if
government raises both purchases and autonomous taxes by the same amount, i.e., if G =
T? While the increase in government purchases of G pushes up the national income by
1
Y  [ ]G , the rise in taxes pulls national income by the amount of
1 c
c
Y  [ ]T . The net effect on income is therefore given by:
1 c
1 c
Y  [ ]G  [ ]T .
1 c 1 c
1 c 1 c
Using the fact that G = T, Y  [ ]G  [ ]G  [ ]G
1 c 1 c 1 c
 Y  G  T
Y
Thus, the balanced budget multiplier is:  1.
G G  T

All the multipliers we have seen are based on the assumption of lumpsum taxes. A similar
analysis could be done when taxes are proportional to income (i.e., with variable taxes). What
it requires is a simple calculus.

1.2.1.4 Interest Rate, Investment and the IS Curve

The Keynesian cross is useful because it shows how the spending plans of households, firms,
and the government determine the economy‟s income. Yet it makes the simplifying
assumption that the level of planned investment I is fixed. But an important macroeconomic
relationship is that planned investment depends on the interest rate, r – i.e., I = I(r). Because
the interest rate is the cost of borrowing to finance investment projects, an increase in the
interest rate reduces planned investment. As a result, the investment function slopes
downward.

To determine how income changes when the interest rate changes, we can combine the
investment function with the Keynesian-cross diagram. Figure 3.5 depicts this. Because
investment is inversely related to the interest rate, an increase in the interest rate from r1 to r2
reduces the quantity of investment from I1 to I2. The reduction in planned investment, in turn,
shifts the planned-expenditure function downward, as in panel (b) of the figure above. The

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 MACROECONOMICS I ECON-2031

shift in the planned-expenditure function causes the level of income to fall from Y1 to Y2.
Hence, an increase in the interest rate lowers income. The IS curve, shown in panel (c) of the
figure, summarizes this relationship between the interest rate and the level of income.

Panel (b): The Keynesian Cross AE = PE

PE1 = C+I1+G
PE
B
PE1
PE2 = C+I2+G

I A
PE2

Y
0
45

Y2 Y1 Y (Income, Output)

Panel (a): The Investment Function

r r

Panel (c): The IS Curve

r2 r1
S

r1 r2 D
I(r) IS

I Y
I2 I1 I Y2 Y1 Y

Figure 3.5: Deriving the IS Curve

In essence, the IS curve combines the interaction between r and I expressed by the investment
function and the interaction between I and Y demonstrated by the Keynesian cross. Because
an increase in the interest rate causes planned investment to fall, which in turn causes income
to fall, the IS curve slopes downward.

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MACROECONOMICS I ECON-2031

The IS curve shows us, for any given interest rate, the level of income that brings the goods
market into equilibrium. As we learned from the Keynesian cross, the level of income also
depends on fiscal policy. The IS curve is drawn for a given fiscal policy; that is, when we
construct the IS curve, we hold G and T fixed. When fiscal policy changes, say G rises the IS
curve shifts (to the right). We can use the Keynesian cross to see how changes in fiscal policy
shift the IS curve. Because a decrease in taxes also expands expenditure and income, it too
shifts the IS curve outward. A decrease in government purchases or an increase in taxes
reduces income; therefore, such a change in fiscal policy shifts the IS curve inward.

We have shown that the IS curve is negatively sloped, reflecting the decrease in aggregate
demand associated with a rise in the interest rate. We can also derive the IS curve by using
the goods market equilibrium condition, that income equals planned spending, or Y = C + I +
G.

Let us use our consumption function we described earlier (C = Ca + c(Y – T)) and a linear
investment function (I = Ia – br) where Ia is autonomous investment, r is the interest rate and
b is a positive constant. The goods market equilibrium condition now becomes:

Y = Ca + c(Y – T) + Ia – br + G.
Rearranging and solving for r gives:
1
r [(1  c)Y  C a  cT  I a  G ]
b
From this equation, we see that a higher interest is associated with a lower level of
equilibrium income for given values of the other variables. The equation also gives us the
dr  (1  c)
slope of the IS curve:  .
dY b

The steepness of the IS curve depends on how sensitive investment spending is to changes in
the interest rate (b) and also on the multiplier. Suppose that investment spending is very
sensitive to the interest rate, so that b is large. Then, in terms of Figure 3.5, a given change in
the interest rate produces a large change in planned expenditure (aggregate demand), and thus
shifts the aggregate demand curve up by a large amount. A large shift in the aggregate
demand schedule produces a correspondingly large change in the equilibrium level of
income. If a given change in the interest rate produces a large change in income, the IS curve
is very flat. This is the case if investment is very sensitive to the interest rate, that is, if b is
large. Correspondingly, with b small and investment spending not very sensitive to the
interest rate, the IS curve is relatively steep.

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MACROECONOMICS I ECON-2031

 (1  c)
The point of the above paragraph can be inferred from the derivative of the slope 
b
 ( slope) (1  c)
with respect to b.  . Since (1 – c) and b2 are both positive, the relationship
b b 2

 (1  c)
between the slope of the IS curve ( ) and the sensitivity of investment to interest rate
b
(b) is a positive one. The more sensitive investment spending is to changes in interest rate, the
larger will be the slope of the IS curve. For instance, if b = 2 and c = 0.6, the slope of the IS
 (1  0.6)
curve will be  0.2 . If we take b = 4 and c = 0.6 (when investment is more
2
 (1  0.6)
sensitive to interest rate), the IS curve will have a slope of – 0.1 [=  0.1 ]. Note
4
that – 0.1 > – 0.2.

Similarly, we can examine how the slope of the IS curve is affected by the value of the
1
multiplier. Recall that the multiplier in our simple closed economy is . Substituting
1 c
1  (1  c)
 m into the expression for the slope of the IS curve (slope = ), we will have
1 c b
1  ( slope) 1
slope  . It, then, follows that:   0.
bm m bm 2

 (1  0.6)
For instance, if b = 4 and c = 0.6, the slope of the IS curve will be  0.1 . If we
4
take b = 4 and c = 0.8 (a case where the MPC and thus the multiplier is larger), the IS curve
 (1  0.8)
will have a slope of – 0.05 [=  0.05 ]. And note, once again, that – 0.05 > – 0.1.
4
The larger the marginal propensity to consume (c) and the larger the multiplier (m), the larger
will be the slope of the IS curve. That is, the larger the multiplier, the flatter the IS curve.
Equivalently, the larger the multiplier, the larger the change in income produced by a given
change in the interest rate; the larger the multiplier, the smaller the change in the interest rate
needed to bring about a given change in income.

Points above and to the right of the IS schedule such as Point S (refer Point S in Panel (c) of
Figure 3.5 above) correspond to an excess supply of goods, and points below and to the left
to an excess demand for goods. At a point such as S, for any level of income (Y), interest
rates are higher than at a point on the IS curve. At the higher interest rates, planned

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MACROECONOMICS I ECON-2031

investment spending is too low, and thus output exceeds planned spending and there is an
excess supply of goods. Points below and to the left of the IS curve are points of excess
demand for goods. At a point like D, the interest rate is too low and aggregate demand is
therefore too high relative to output.

1.2.2 The Money Market and the LM Curve

The money market is just one component of the broader concept of assets markets. The assets
markets are the markets in which money, bonds, stocks, houses, and other forms of wealth
are traded. So far, we have ignored the role of these markets in affecting the level of income,
and now will take it up.

We shall simplify matters by grouping all available assets into two groups, money and
interest-bearing asset. Thus, we proceed as if there are only two assets, money and all others.
It will be useful to think of the other assets as marketable claims to future income, such as
bonds, just as Keynes did in his Theory of Liquidity Preferences.

At any given time, an individual has to decide how to allocate his or her financial wealth
between alternative types of assets – say, money and bond. The more bonds held; the more
interest received on total financial wealth. The more money held, the more likely the
individual is to have money available when he or she wants to make a purchase. The person
who has 10,000 Birr in financial wealth has to decide whether to hold, say, 9,000 Birr in
bonds and 1,000 in money, or rather, 5,000 Birr in each type of asset, or even 10,000 Birr in
money and none in bonds. Such decisions on the form in which to hold assets are portfolio
decisions. This example makes it clear that the portfolio decisions on how much money to
hold and on how many bonds to hold are really the same decision.

Given the level of financial wealth, the individual who has decided how many bonds to hold
has implicitly also decided how much money to hold. There is a wealth budget constraint
which states that the sum of the individual's demand for money and demand for bonds has to
add up to that person's total financial wealth. This implies that we can discuss assets markets
entirely in terms of the money market. Why? Because, given real wealth, when the money
market is in equilibrium, the bond market will turn out also to be in equilibrium.

The LM curve plots the relationship between the interest rate and the level of income that
arises in the market for money balances. The building block for this relationship is called the
theory of liquidity preference, a theory of the interest rate. The explanation of how the
interest rate is determined in the short run is called the theory of liquidity preference, because
it posits that the interest rate adjusts to balance the supply and demand for the economy‟s
most liquid asset – money.

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MACROECONOMICS I ECON-2031

1.2.2.1 The Theory of Liquidity Preference

The supply of real money balances
If M stands for the supply of money and P stands for the price level, then M/P is the supply of
real money balances. The theory of liquidity preference assumes that there is a fixed supply
M s M
of real money balances. That is, ( ) = .
P P
The money supply M is an exogenous policy variable chosen by a central bank (National
Bank of Ethiopia in our case). The price level P is also an exogenous variable in this model.
We take the price level as given because the IS – LM model – our ultimate goal in this unit –
explains the short run when the price level is assumed fixed. These assumptions imply that
the supply of real money balances is fixed and, in particular, does not depend on the interest
rate.

The demand for real money balances

The demand for money is a demand for real balances because people hold money for what it
will buy. The higher the price level, the more nominal balances a person has to hold to be
able to purchase a given quantity of goods. If the price level doubles, then an individual has
to hold twice as many nominal balances in order to be able to buy the same amount of goods.

The demand for real balances depends on the level of real income and the interest rate. It
depends on the level of real income because individuals hold money to pay for their
purchases, which, in turn, depend on income. The theory of liquidity preference posits that
the interest rate is one determinant of how much money people choose to hold. The reason is
that the interest rate is the opportunity cost of holding money: it is what you forgo by holding
some of your assets as money, which does not bear interest, instead of interest-bearing assets
like bonds. When the interest rate rises, people want to hold less of their wealth in the form of
money. If the interest rate is 1 percent, then there is very little benefit from holding bonds
rather than money. However, when the interest rate is 10 percent, then it is worth some effort
not to hold more money than is needed to finance day-to-day transactions.

On these simple grounds, then, the demand for real balances increases with the level of real
income and decreases with the interest rate. The demand for real balances is accordingly
written as:

M d
( )  kY  hr ; where k, h > 0.
P

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MACROECONOMICS I ECON-2031

The parameters k and h reflect the sensitivity of the demand for real balances to the level of
income and the interest rate, respectively. A 1 Birr increase in real income raises money
demand by k real Birr. An increase in the interest rate by one percentage point (say, from 4%
to 5%) reduces real money demand by h real Birr.

The demand function for real balances shown above implies that for a given level of income,
the quantity demanded is a decreasing function of the rate of interest. Such a demand curve is
shown in Figure 3.6 for a level of income, Y. The higher the level of income, the larger is the
demand for real balances, and therefore the demand for real money balances curve shifts to
the right.

According to the theory of liquidity preference, the supply of and demand for real money
balances determine what interest rate prevails in the economy. That is, the interest rate adjusts
to equilibrate the money market. As the figure shows, at the equilibrium interest rate, the
quantity of real money balances demanded equals the quantity supplied.

(M/P)S
r

re

( M ) d  kY  hr
P

(M ) M/P
P

Figure 3.6: Supply of and Demand for Real Money Balances and Equilibrium in the
Money Market

How does the interest rate get to this equilibrium of money supply and money demand? The
adjustment occurs because whenever the money market is not in equilibrium, people try to
adjust their portfolios of assets and, in the process, alter the interest rate. For instance, if the
interest rate is above the equilibrium level, the quantity of real money balances supplied
exceeds the quantity demanded. Individuals holding the excess supply of money try to
convert some of their non-interest-bearing money into interest-bearing bonds. Banks and
bond issuers, who prefer to pay lower interest rates, respond to this excess supply of money

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MACROECONOMICS I ECON-2031

by lowering the interest rates they offer. Conversely, if the interest rate is below the
equilibrium level, so that the quantity of money demanded exceeds the quantity supplied,
individuals try to obtain money by selling bonds or making bank withdrawals. To attract
now-scarcer funds, banks and bond issuers respond by increasing the interest rates they offer.
Eventually, the interest rate reaches the equilibrium level, at which people are content with
their portfolios of monetary and non-monetary assets.

A fall in M reduces M/P, because P is fixed in the model. The supply of real money balances
shifts to the left, as in the figure below. The equilibrium interest rate rises from r1 to r2, and
the higher interest rate makes people satisfied to hold the smaller quantity of real money
balances. The opposite would occur if the money supply is increased. Thus, according to the
theory of liquidity preference, a decrease in the money supply raises the interest rate, and an
increase in the money supply lowers the interest rate.

1.2.2.2 Income, Money Demand, and the LM Curve

When income is high, expenditure is high, so people engage in more transactions that require
the use of money. Thus, greater income implies greater money demand. Earlier in this
subsection, we have said that the quantity of real money balances demanded is negatively
related to the interest rate and positively related to income.

Therefore, according to the theory of liquidity preference, higher income leads to a higher
interest rate. The LM curve plots this relationship between the level of income and the interest
rate. The higher the level of income, the higher the demand for real money balances will be,
and the higher the equilibrium interest rate. For this reason, the LM curve slopes upward, as
shown in panel (b) of Figure 3.7.

An increase in income (from Y1 to Y2 in Figure 3.7) shifts the money demand curve to the
right. With the supply of real money balances unchanged, the interest rate must rise from r1 to
r2 to equilibrate the money market. The figure shows combinations of interest rates and
income levels such that the demand for real balances exactly matches the available supply.
Starting with the level of income, Y1, the corresponding demand curve for real balances,
(M/P)d1, is shown in Panel (a). The existing supply of real balances, (M/P) 1, is shown by the
vertical line, since it is given and therefore is independent of the interest rate.

At interest rate rl the demand for real balances equals the supply. Therefore, the money
market is in equilibrium. That point is recorded in Panel (b) of the same figure as a point on
the money market equilibrium schedule, or the LM curve. Consider next the effect of an
increase in income to Y2. The higher level of income causes the demand for real balances to

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 MACROECONOMICS I ECON-2031

be higher at each level of the interest rate, and so the demand curve for real balances shifts up
and to the right, to(M/P)d2. The interest rate increases to r2 to maintain equilibrium in the
money market at that higher level of income. Accordingly, the new equilibrium point is
associated with a higher interest rate than the old one. Performing the same exercise for all
income levels, we generate a series of points that can be linked to give us the LM schedule
(in Panel (b)).

The LM schedule or money market equilibrium schedule shows all combinations of interest
rates and levels of income such that the demand for real balances is equal to the supply.
Along the LM schedule, the money market is in equilibrium. The LM curve is positively
sloped. An increase in the interest rate reduces the demand for real balances. To maintain the
demand for real balances equal to the fixed supply, the level of income has to rise.
Accordingly, money market equilibrium implies that an increase in the interest rate is
accompanied by an increase in the level of income.

r (M/P)S r LM

r2 r2

r1 r1

( M ) d2  kY2  hr
P
(M )1d  kY1  hr
P

(M ) M/P Y1 Y2 Y
P
Panel (a) Panel (b)

Figure 3.7: Change in Income Affecting the Equilibrium in the Money Market and the LM
Curve

The LM curve can be obtained directly by combining the demand curve for real balances, and
the fixed supply of real balances. For the money market to be in equilibrium, demand has to
equal supply, or
M
 kY  hr .
P
Solving for the interest rate:

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MACROECONOMICS I ECON-2031

1 M
r (kY  ) .
h P
This relationship between r and Y is the LM curve.

dr k
The slope of the LM curve is given by  . The greater the responsiveness of the
dY h
demand for money to income (larger k), and the lower the responsiveness of the demand for
money to the interest rate (lower h), the steeper the LM curve will be.

Points off the LM schedule are characterized as situations of excess demand or excess supply
of money. Any point to the right and below the LM schedule is a point of excess demand for
money since the interest rate is too low and/or the level of income too high for the money
market to clear. Similarly, any point to the left and above the LM curve is a point of excess
supply as the interest rate is too high and/or the level of income too low for the money market
to clear.

The LM curve is drawn for a given supply of real money balances. If real money balances
change – for example, if National Bank of Ethiopia (NBE) alters the money supply – the LM
curve shifts. Suppose that NBE decreases the money supply from M1 to M2, which causes the
supply of real money balances to fall from M1/P to M2/P. The figure that follows shows what
happens.

LM2
r r LM1

r2 r2

r1 r1

( M ) d  kY  hr
P

( M / P) 2 (M / P)1 M/P Y1 Y

Panel (a) Panel (b)

Figure 3.8: A Policy Change in Money Supply and the Resulting Shift in the LM Curve

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MACROECONOMICS I ECON-2031

Holding constant the amount of income and thus the demand curve for real money balances,
we see that a reduction in the supply of real money balances raises the interest rate that
equilibrates the money market. Hence, a decrease in the money supply shifts the LM curve
upward from LM1 to LM2 .

1.2.3 Simultaneous Equilibrium in the Goods and Money Markets

The IS and LM curves together determine the economy‟s equilibrium. Our model takes fiscal
policy, G and T, monetary policy M, and the price level P as exogenous. Given these
exogenous variables, the IS curve provides the combinations of r and Y that satisfy the
equation representing the goods market [Y = C(Y–T) + I(r) + G], and the LM curve provides
the combinations of r and Y that satisfy the equation representing the money market [M/P =
L(r, Y)].

r LM

r*

r*

IS

Y* Yr*
Figure 3.9: Equilibrium in the IS – LM Model

The equilibrium of the economy is the point at which the IS curve and the LM curve cross.
r*
This point gives the interest rate r and the level of income Y that satisfy conditions for
equilibrium in both the goods market and the money market. In other words, at this
intersection, actual expenditure equals planned expenditure, and the demand for real money
balances equals the supply.

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EXPLAINING FLUCTUATIONS WITH THE IS–LM MODEL

2.1 Changes in Fiscal Policy

The intersection of the IS curve and the LM curve determines the level of national income.
When one of these curves shifts, the short-run equilibrium of the economy changes and
national income fluctuates.

Let us begin this discussion with the effects of fiscal policy actions. Changes in the level of
government purchases or taxes influence planned expenditure and thereby shift the IS curve.
The following figure illustrates this using the case of an increase in G by ∆G.

r LM

B
r2
A C r*
r1
IS2

IS1

Y1 Y2 Y r*

Figure 3.10: The Effect of a Change in Government Purchases in the IS – LM Model

The government-purchases multiplier in the Keynesian cross r*

tells us that, at any given
interest rate, this change in fiscal policy raises the level of income by ∆G/(1−MPC).
Therefore, the IS curve shifts to the right by this amount (the distance from A to C). The
equilibrium of the economy moves from point A to point B. The increase in government
purchases raises both income and the interest rate.

When the government increases its purchases of goods and services, the economy‟s planned
expenditure rises. The increase in planned expenditure stimulates the production of goods and
services, which causes total income Y to rise. These effects should be familiar from the
Keynesian cross.

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Now consider the money market, as described by the theory of liquidity preference. Because
the economy‟s demand for money depends on income, the rise in total income increases the
quantity of money demanded at every interest rate. The supply of money, however, has not
changed so higher money demand causes the equilibrium interest rate r to rise.

The higher interest rate arising in the money market, in turn, has ramifications back in the
goods market. When the interest rate rises, firms cut back on their investment plans. This fall
in investment partially offsets the expansionary effect of the increase in government
purchases. Thus, the increase in income in response to a fiscal expansion is smaller in the IS
– LM model than it is in the Keynesian cross (where investment is assumed to be fixed).

In the IS – LM model, changes in taxes affect the economy much the same as changes in
government purchases do, except that taxes affect expenditure through consumption.
Consider, for instance, a decrease in taxes of ∆T. The tax cut encourages consumers to spend
more and, therefore, increases planned expenditure. The tax multiplier in the Keynesian cross
tells us that, at any given interest rate, this change in policy raises the level of income by ∆T
×MPC/(1 - MPC). The tax cut raises both income and the interest rate. Once again, because
the higher interest rate depresses investment, the increase in income is smaller in the IS – LM
model than it is in the Keynesian cross.

In general, fiscal policy is more effective at influencing national income if:

1. the LM curve is flatter – when demand for real money balances is less sensitive to
changes in income and/or more sensitive to changes in interest rate, and
2. the MPC and the shift in the IS curve are larger, and investment demand is less sensitive
to changes in interest rate – steeper IS curve.

2.2 Changes in Monetary Policy

A change in the money supply alters the interest rate that equilibrates the money market for
any given level of income and, thereby, shifts the LM curve.

Let‟s consider an increase in M. An increase in M leads to an increase in real money balances

M/P, because the price level P is fixed in the short run. The theory of liquidity preference
shows that for any given level of income, an increase in the supply of real money balances
leads to a lower interest rate. Therefore, the LM curve shifts downward as depicted below.
The equilibrium moves from point A to point B. The increase in the money supply lowers the
interest rate and raises the level of income.

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When the central bank increases the supply of money, people have more money than they
want to hold at the prevailing interest rate. As a result, they start depositing this extra money
in banks or use it to buy bonds. The interest rate r then falls until people are willing to hold
all the extra money that the central bank has created; this brings the money market to a new
equilibrium. The lower interest rate, in turn, has ramifications for the goods market. A lower
interest rate stimulates planned investment, which increases planned expenditure, production,
and income Y.

r LM1

LM2
A
r1
LM1
r2 B

LM2

IS

Y
Y1 Y Y2 LM2 Y
Figure 3.11: The Effect of a Change in Money Supply in the IS – LM Model

The IS – LM model shows that an increase in the money supply lowers the interest rate,
which stimulates investment and thereby expands the demand for goods and services a
process called the monetary transmission mechanism.

Monetary policy is more effective at influencing national income if:

1. the IS curve is flatter –lower MPC and sensitive investment to changes in interest rate is,
and
2. the LM curve is steeper – if the demand for real money balances is more sensitive to
changes in income and less sensitive to changes in interest rate.

2.3 The Interaction between Monetary and Fiscal Policies

When analyzing any change in monetary or fiscal policy, it is important to keep in mind that
the policymakers who control these policy tools are aware of what the other policymakers are
doing. A change in one policy, therefore, may influence the other, and this interdependence
may alter the impact of a policy change. For example, suppose government were to raise
taxes. What effect should this policy have on the economy? According to the IS – LM model,

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the answer depends on how the central bank responds to the tax increase. The figure below
shows three of the many possible outcomes.

In panel (a), the central bank holds the money supply constant. The tax increase shifts the IS
curve to the left. Income falls (because higher taxes reduce consumer spending), and the
interest rate falls (because lower income reduces the demand for money). The fall in income
indicates that the tax hike causes a recession.

Figure 3.12: The Interaction between Monetary and Fiscal Policy

In panel (b), the central bank wants to hold the interest rate constant. In this case, when the
tax increase shifts the IS curve to the left, the central bank must decrease the money supply to
keep the interest rate at its original level. This fall in the money supply shifts the LM curve
upward (to the left). The interest rate does not fall, but income falls by a larger amount than if
the central bank had held the money supply constant. Whereas in panel (a) the lower interest
rate stimulated investment and partially offset the contractionary effect of the tax hike, in
panel (b) the central bank deepens the recession by keeping the interest rate high.

In panel (c), the central bank wants to prevent the tax increase from lowering income. It must,
therefore, raise the money supply and shift the LM curve downward enough to offset the shift
in the IS curve. In this case, the tax increase does not cause a recession, but it does cause a
large fall in the interest rate. Although the level of income is not changed, the combination of

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a tax increase and a monetary expansion does change the allocation of the economy‟s
resources. The higher taxes depress consumption, while the lower interest rate stimulates
investment. Income is not affected because these two effects exactly balance.

From this example we can see that the impact of a change in fiscal policy depends on the
policy the central bank pursues – that is, on whether it holds the money supply, the interest
rate, or the level of income constant. More generally, whenever analyzing a change in one
policy, we must make an assumption about its effect on the other policy. The most
appropriate assumption depends on the case at hand and the many political considerations
that lie behind economic policymaking.

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CHAPTER FOUR
AGGREGATE DEMAND AND AGGREGATE SUPPLY
SECTION ONE: AGGREGATE DEMAND

1.1 From the IS–LM Model to the AD Curve

The last unit presented the Keynesian model of the real and monetary sectors of the economy.
It showed how real sector quantity adjustments interact with the demand for money via the
role of interest rates. The model determines the equilibrium values of real output and interest
rates. The Keynesian approach is useful because it shows how the real and monetary sectors
are affected by policy or any other shock to equilibrium.

However, the main drawback of the model is that it retains the assumption that the only
relevant real sector adjustments are quantities produced; prices were assumed unchanged for
the entire discussion. The assumption of fixed or sticky prices is in fact defensible when we
restrict ourselves to very short periods of time. However, any shock to the economy that is
likely to have effects that extend beyond six months or a year is also going to have
implications for price behavior. We will now extend the model so that we can discuss price
behavior and inflation.

We begin this unit with an extension of the Keynesian model that allows us to discuss price
flexibility and relate the Keynesian demand to the long-run neoclassical equilibrium. This
analysis is called aggregate demand and aggregate supply analysis and it relates the level of
output to the price level.

The aggregate demand curve shows how the Keynesian equilibrium changes for different
values of the price level. The aggregate demand curve shows how changes in the price level
affect the IS-LM or demand side equilibrium. We begin by deriving a total demand curve
from the IS-LM analysis.

The Keynesian IS-LM model developed in Unit Three is a model of only demand behavior. It
tells us how the equilibrium between planned aggregate demand and output is achieved. It
describes demand behavior but says absolutely nothing about supply behavior. The price
level is an exogenous variable in the Keynesian aggregate demand model. That is, it is not
determined by the system, although it does appear in the model structure. The price level
determines the real value, or purchasing power, of the nominal money supply, thus
positioning the LM curve and determining the aggregate demand equilibrium.

The position of the LM curve will change if prices change, and as it does, the output
equilibrium changes as well. That is, in the IS-LM model there will be a different equilibrium
output for each level of prices. The aggregate demand curve summarizes this relationship

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between the price level and the output level determined by the intersection of the IS and LM
curves. The aggregate demand curve is a locus of Keynesian aggregate demand equilibrium
for different price levels.

We have been using the IS – LM model to explain national income in the short run when the
price level is fixed. To see how the IS – LM model fits into the model of aggregate supply
and aggregate demand, we now examine what happens in the IS – LM model if the price
level is allowed to change.

1.2 Characterizing the Aggregate Demand Curve

The aggregate demand curve describes a relationship between the price level and the level of
national income. We use the IS – LM model to show why national income falls as the price
level rises – that is, why the aggregate demand curve is downward sloping. We also examine
what causes the aggregate demand curve to shift.

To explain why the aggregate demand curve slopes downward, we examine what happens in
the IS – LM model when the price level changes. If the price level changes while everything
else (including the nominal money supply, M) remains the same, then the resulting change in
the real money supply (M/P) causes the IS-LM equilibrium to change. To be more precise,
consider the situation shown in the Panel (a) of Figure 4.1 below. For the price level P1, the
LM curve is given by LM1 and output is Y1.

For any given money supply M, a higher price level P reduces the supply of real money
balances M/P. A lower supply of real money balances shifts the LM curve upward, which
raises the equilibrium interest rate and lowers the equilibrium level of income, as shown in
panel (a). An increase in the price level with a given nominal money supply is equivalent to a
contractionary monetary policy; it reduces the real money supply. The new LM curve is
given by LM2 and the demand side output equilibrium is Y2. Similarly, for each value of the
price level there will be a different aggregate demand equilibrium. Since a higher price level
contracts the real money supply, the output equilibrium is lower when the price level
increases.

Here the price level rises from P1 to P2, and income falls from Y1 to Y2. The aggregate
demand curve in panel (b) plots this negative relationship between national income and the
price level. In other words, the aggregate demand curve shows the set of equilibrium points
that arise in the IS – LM model as we vary the price level and see what happens to income.
The lower panel of Figure 4.1 shows the equilibrium level of output that corresponds to each
price level. The curve labeled D is a locus of IS-LM, or aggregate demand, equilibria. It is

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called the aggregate demand curve because it summarizes equilibrium on the demand side of
the economy.

r LM2
Panel (a)

LM1

IS

Y2 Y1 Y
Panel (b)
P

P1 P2
P1

AD

Y2 Y1 Y

Figure 4.1: The Aggregate Demand Curve

The negative slope of the total demand curve follows from the derivation shown in Figure 4.1
and also agrees with one‟s intuition. When prices increase, nominal income also increases
and the demand for money to be used for transactions goes up. If the nominal money supply
is unchanged, there will be a shortage of transactions balances. This “tightness” in financial
markets and/or the interest rate increases that will result restrain aggregate demand. The price
increase is equivalent to a tighter money policy and similarly leads to a fall in the demand for
output.

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What causes the aggregate demand curve to shift? Because the aggregate demand curve is
merely a summary of results from the IS – LM model, events that shift the IS curve or the LM
curve (for a given price level) cause the aggregate demand curve to shift. An important point
is the distinction between movements along and shifts of the aggregate demand curve.

The aggregate demand curve in Figure 4.1 is drawn for given values of all the exogenous
variables in the IS-LM model. A change in the level of government expenditure, taxes, or the
nominal money supply will affect the aggregate demand equilibrium for every price level and
thereby affect the position of the aggregate demand curve.

For instance, an increase in the money supply raises income in the IS – LM model for any
given price level; it thus shifts the aggregate demand curve to the right, as shown in panel (a)
of the figure that follows.

Similarly, an increase in government purchases or a decrease in taxes raises income in the IS

– LM model for a given price level; it also shifts the aggregate demand curve to the right, as
shown in panel (b). Conversely, a decrease in the money supply, a decrease in government
purchases, or an increase in taxes lowers income in the IS – LM model and shifts the
aggregate demand curve to the left.

LM1
r

IS2

IS1

P1

AD2

AD1
Figure 4.2: A Shift in Aggregate Demand

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Any change in exogenous variables that determines a shift in either the IS or the LM curve
(e.g. fiscal or monetary policy actions, changes in the exogenous components of aggregate
demand or money demand, changes in the parameters) will, under general conditions,
produce a shift in the aggregate demand schedule. The size of the response of aggregate
demand depends on the source of the shock and the characteristics of the transmission
channel.

Let us now derive the aggregate demand (AD) mathematically and examine its properties. As
a first step to this, recall that the IS equation Y = Ca + c(Y – T) + Ia – br + G can be rewritten
as:
1
r [(1  c)Y  C a  cT  I a  G ] ------------------------------------------------------ (1).
b
Similarly, the LM equation M/P = kY – hr can be rewritten as:
1 M
Y [  hr] ---------------------------------------------------------------------------- (2).
k P

We can now substitute equation (1) into equation (2) and solve for the level of Y, the
equilibrium output in the IS – LM model. We will then see how Y and P are related – the
aggregate demand function we are looking for.
1 M h
Y {  [(1  c)Y  C a  cT  I a  G ]}
k P b
Taking terms involve Y to the left of the equality sign:
h(1  c) 1 h
Y Y  {M  [C a  cT  I a  G ]}
bk k P b
bk  h(1  c) 1 h
[ ]Y  {M  [C a  cT  I a  G ]}
bk k P b
b h
Y  {MP 1  [C a  cT  I a  G ]}
bk  h(1  c) b
The last equation can equivalently be written as:
b h
Y [ MP 1 ]  [C a  cT  I a  G ] -------- The AD functions!
bk  h(1  c) bk  h(1  c)

The slope of the AD function is found as follows:

Y b M
 From the AD function we derived, we see that:  [ 2 ].
P bk  h(1  c) P
Y
 The slope is then the reciprocal of this expression for . That is,
P

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P bk  h(1  c) P 2
 [ ]
Y b M
As all the parameters (b, k, h, (1 – c)) and as well as M and P2 are strictly non-negative, the
slope is negative – verifying that the AD curve is downward sloping!

From the AD function we can also infer factors that shift the AD curve. For a given price
level, the AD curve shifts to the right (and upward) for an autonomous increase in Ca, Ia, G or
M, and for an autonomous reduction in T. This fact is clearer from the following partial
derivatives:
Y Y Y h
   0
C a I a G bk  h(1  c)

Y bP 1
  0 and
M bk  h(1  c)
Y hc
 0
T bk  h(1  c)

In summary,
1. a change in income in the IS – LM model resulting from a change in the price level
represents a movement along the aggregate demand curve.
2. a change in income in the IS – LM model for a fixed price level represents a shift in the
aggregate demand curve.

SECTION TWO: AGGREGATE SUPPLY

2.1 Introduction to Aggregate Supply

The aggregate demand curve describes the amount of output that people are willing to buy at
different price levels. But, the levels of equilibrium output and price that will actually emerge
also depend on supply behavior. We now turn to the determination of supply behavior and
develop different approaches to the aggregate supply curve. Aggregate supply describes the
amount of output that producers are willing and able to supply to the goods market.
Subsequently, we will take a more general view of price determination and develop an
explanation of inflation – the rate of price change.

Most economists analyze short-run fluctuations in aggregate income and the price level using
the model of aggregate demand and aggregate supply. In the previous section, we examined
aggregate demand in some detail. The IS – LM model shows how changes in monetary and

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fiscal policy shift the aggregate demand curve. We now turn our attention to aggregate supply
and develop theories that explain the position and slope of the aggregate supply curve.

The aggregate supply curve implicit in the Keynesian IS-LM model is based on the notion
that there are no supply constraints and that prices are pre-determined in the short-run. Thus,
whatever output level is demanded will be produced and the aggregate supply curve is a
horizontal line. There is sufficient excess capacity so that an increase in demand leads to
more production without increasing production costs and prices. For this reason, the early
Keynesian economists who were schooled by the experiences of the depression used IS-LM
analysis exclusively because they thought in terms of situations with a great deal of excess
productive capacity. In this framework, we can view the price level as being set by existing
contractual arrangements such as union contracts, sales agreements, and price lists. It is
assumed that any level of output can be supplied at this given level of prices.

At the opposite extreme to the Keynesian short-run horizontal supply curve lies the supply
curve of the classical (or the long-run equilibrium) view of the macroeconomic world. The
classical view implies a vertical supply curve. The classical view of macroeconomics is
rooted in the idea that the macro economy is the aggregate of an infinite number of perfectly
competitive markets. In this view each and every market for outputs and inputs reaches an
equilibrium which determines both the relative price and the quantity for that market. The
level of output supplied is simply the aggregate of all these outcomes for any overall price
level. This is the case because each and every market-equilibrium determines the relative
price of the good in that market. As long as relative prices stay in equilibrium, the same level
of aggregate output will be supplied.

A change in the aggregate price level does not disturb the relative price relationships between
all pairs of goods. Thus, the aggregate supply curve is vertical at this equilibrium output level
no matter what the aggregate price level happens to be. The vertical classical aggregate
supply curve can be understood if we imagine that the aggregate price level doubles. If every
price doubles in terms of the money unit of account in the economy, the aggregate price level
doubles as well. Moreover, no relative price between pairs of goods changes, and thus the
equilibrium level of output supplied remains unchanged. Therefore, the aggregate supply
curve in the classical model is vertical.

The classical vertical aggregate supply curve and the Keynesian horizontal aggregate supply
curve represent two theoretical extremes, neither of which is a satisfactory representation of
behavior in the real world. The traditional Keynesian approach leaves us without a theory of
price determination. The classical approach introduces a theory of price determination, but at
the cost of eliminating an explanation of fluctuations in real output. By assuming that

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competitive markets at all times generate equilibrium levels of output, the classical model
does away with fluctuations in output.

A more appropriate view of the total supply curve will be the middle road – a positively
sloped aggregate supply curve. Such an approach is relevant for adjustments that occur for
longer periods than the Keynesian short-run period (where quantity adjustments are
dominant) and less than the long run (the period for which the long-run equilibrium approach
is dominant).

In general, aggregate supply behaves differently in the short run than in the long run. In the
long run, prices are flexible, and the aggregate supply curve is vertical. When the aggregate
supply curve is vertical, shifts in the aggregate demand curve affect the price level, but the
output of the economy remains at its natural rate. By contrast, in the short run, prices are
sticky, and the aggregate supply curve is not vertical. In this case, shifts in aggregate demand
do cause fluctuations in output. So far we took a simplified view of price stickiness by
drawing the short-run aggregate supply curve as a horizontal line, representing the extreme
situation in which all prices are fixed. Our task now is to refine this understanding of short
run aggregate supply.

Unfortunately, one fact makes this task more difficult: economists disagree about how best to
explain aggregate supply. As a result, this section begins by presenting four prominent
models of the short-run aggregate supply curve. Among economists, each of these models has
some prominent adherents (as well as some prominent critics), and you can decide for
yourself which you find most plausible. Although these models differ in some significant
details, they are also related in an important way: they share a common theme about what
makes the short-run and long-run aggregate supply curves differ and a common conclusion
that the short-run aggregate supply curve is upward sloping.

After examining the models, we examine an implication of the short-run aggregate supply
curve. We show that this curve implies a tradeoff between two measures of economic
performance – inflation and unemployment. According to this tradeoff, to reduce the rate of
inflation policymakers must temporarily raise unemployment, and to reduce unemployment
they must accept higher inflation. The tradeoff between inflation and unemployment is only
temporary. One goal of this section is to explain why policymakers face such a tradeoff in the
short run and, just as important, why they do not face it in the long run.

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2.2 Four Models of Aggregate Supply

In this subsection we examine four prominent models of aggregate supply, roughly in the
order of their development. In all the models, some market imperfection (that is, some type of
friction) causes the output of the economy to deviate from the classical benchmark. As a
result, the short-run aggregate supply curve is upward sloping, rather than vertical, and shifts
in the aggregate demand curve cause the level of output to deviate temporarily from the
natural rate. These temporary deviations represent the booms and busts of the business cycle.

Although each of the four models takes us down a different theoretical route, each route ends
up in the same place. That final destination is a short-run aggregate supply equation of the
form:

Y  Y   (P  P e ) .

where Y is output, Y is the natural rate of output, P is the price level, Pe is the expected price
level, and  is a positive constant. This equation states that output deviates from its natural
rate when the price level deviates from the expected price level. The parameter  indicates
dY
how much output responds to unexpected changes in the price level (i.e.,   ).
dP
dP 1
Equivalently, 1 is the slope of the aggregate supply curve (i.e.,  ).
dY 
Each of the four models tells a different story about what lies behind this short-run aggregate
supply equation. In other words, each highlights a particular reason why unexpected
movements in the price level are associated with fluctuations in aggregate output.

2.2.1 The Sticky-Wage Model

To explain why the short-run aggregate supply curve is upward sloping, many economists
stress the sluggish adjustment of nominal wages. In many industries, nominal wages are set
by long-term contracts, so wages cannot adjust quickly when economic conditions change.
Even in industries not covered by formal contracts, implicit agreements between workers and
firms may limit wage changes. Wages may also depend on social norms and notions of
fairness that evolve slowly. For these reasons, many economists believe that nominal wages
are sticky in short run.

The sticky-wage model shows what a sticky nominal wage implies for aggregate supply. To
preview the model, consider what happens to the amount of output produced when the price
level rises:

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1) When the nominal wage is stuck, a rise in the price level lowers the real wage, making
labor cheaper.
2) The lower real wage induces firms to hire more labor.
3) The additional labor hired produces more output.

This positive relationship between the price level and the amount of output means that the
aggregate supply curve slopes upward during the time when the nominal wage cannot adjust.
To develop this story of aggregate supply more formally, assume that workers and firms
bargain over and agree on the nominal wage before they know what the price level will be
when their agreement takes effect. The bargaining parties – the workers and the firms – have
in mind a target real wage. The target may be the real wage that equilibrates labor supply and
demand. More likely, the target real wage is higher than the equilibrium real wage: union
power and efficiency-wage considerations tend to keep real wages above the level that brings
supply and demand into balance.

The workers and firms set the nominal wage W based on the target real wage ω and on their
expectation of the price level Pe. The nominal wage they set is

W    Pe
where W is nominal wage, ω is target real wage rate, and Pe the expected price level.

After the nominal wage has been set and before labor has been hired, firms learn the actual
price level P. The real wage turns out to be:

W Pe

P P
The real wage rate is the product of the target real wage rate and the expected to actual price
level ratio.

This equation shows that the real wage deviates from its target if the actual price level differs
from the expected price level. When the actual price level is greater than expected (Pe/P < 1),
the real wage is greater than its target; when the actual price level is less than expected (Pe/P
> 1), the real wage is greater than its target.

The final assumption of the sticky-wage model is that employment is determined by the
quantity of labor that firms demand. In other words, the bargain between the workers and the
firms does not determine the level of employment in advance; instead, the workers agree to

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provide as much labor as the firms wish to buy at the predetermined wage. We describe the
firms‟ hiring decisions by the labor demand function:
L = Ld (W/P).
According to this labor demand function, the lower the real wage, the more labor firms hire.
The labor demand curve is shown in panel (a) of Figure 4.3 below. Output is determined by
the production function:
Y = F(L),
which states that the more labor is hired, the more output is produced. This is shown in panel
(b) of the figure.

Panel (c) of the figure shows the resulting aggregate supply curve. Because the nominal wage
is sticky, an unexpected change in the price level moves the real wage away from the target
real wage, and this change in the real wage influences the amounts of labor hired and output
produced. The aggregate supply curve can be written as:
Y  Y   (P  P e ) .

Output deviates from its natural level when the price level deviates from the expected price
level.

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Figure 4.3: The Sticky Wage Model

2.2.2 The Worker-Misperception Model

This model also explains the up-ward sloping short-run aggregate supply curve by focusing
on the labor market. Unlike the sticky-wage model, however, the worker-misperception
model assumes that wages can adjust freely and quickly to balance the supply of and demand
for labor. Its key assumption is that unexpected movements in the price level influence labor
supply because workers temporarily confuse real and nominal wages.

The two components of the worker-misperception model are labor supply and labor demand.
As before the quantity of labor firms demand depends on the real wage:
Ld = Ld (W/P).

The labor supply is new:

Ls = Ls (W/Pe).
This equation states that the quantity of labor supplied depends on the real wage that workers
expect to earn. Workers know their nominal wage W, but they do not know the overall price
level P. When deciding how much to work, they consider the expected real wage, which
equals the nominal wage W divided by their expectations of the price level Pe.

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We can also write the expected real wage as:

W W P
e
 X e
P P P
The expected real wage is the product of the actual real wage W/P and the variable P/Pe.
Notice that P/Pe measures workers‟ misperception of the price level: if P/Pe is greater than
one, the price level is greater than what workers expected, and if P/Pe is less than one, the
price level is less than that expected. To see what determines labor supply, we can substitute
this expression for W/Pe and write:
Ls = Ls [(W/P) X (P/Pe)].
The quantity of labor supplied depends on the real wage and on worker misperception of the
price level.

To see what this model says about aggregate supply, consider the equilibrium in the labor
market, shown in the figure below.

As is usual, the labor demand curve slopes downward, the labor supply curve slopes upward,
and the wage rate adjusts to equilibrate supply and demand. Note that the position of the
labor supply curve and thus the equilibrium in the labor market depend on worker
misperception P/Pe.

Real wage, W/P

Ls = Ls [(W/P) X (P/Pe)]

(W/P)*

Ld = Ld (W/P)

L* Labor, L

Figure 4.4: Labor Supply and Demand under the Worker-Misperception Model

Whenever the price level P rises, the reaction of the economy depends on whether workers
anticipate the change. If they do, then Pe rises proportionately with P. In this case workers‟
perceptions are accurate, and neither labor supply nor labor demand changes. The nominal

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wage rises by the same amount as prices, and the real wage and the level of employment
remain the same.

By contrast, if the price increase catches workers by surprise, then Pe remains the same when
P rises. The increase in P/Pe shifts the labor supply curve to the right, as in Figure 4.5 below,
lowering the real wage and raising the level of employment. In essence, workers believe that
the price level is lower, and thus the real wage is higher, than actually is the case. This
misperception induces them to supply more labor. Firms are assumed to be better informed
than workers and to recognize the fall in the real wage, so they hire more labor and produce
more output.
Real wage, W/P Ls1
Ls2

(W/P)1

(W/P)2

Ld

L1 L2 Labor, L

Figure 4.5: The Worker-Misperception Model

To sum up, 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. The model implies an aggregate supply of the form:
Y  Y   (P  P e ) .

Once again, as with the sticky-wage model but for different reasons, output deviates from the
natural rate when the price level deviates from the expected price level.

In any model with an unchanging labor demand curve, such as the two models we just
discussed, employment rises when the real wage falls. In these models, an unexpected rise in
the price level lowers the real wage and thereby raises the quantity of labor hired and the
amount of output produced. Thus, the real wage should be countercyclical: it should fluctuate
in the opposite direction from employment and output. Keynes himself wrote in The General

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Theory that “an increase in employment can only occur to the accompaniment of a decline in
the rate of real wages.‟‟
Yet the real-world data (for economies like that of the US) show only a weak correlation
between the real wage and output, and it is the opposite of what Keynes predicted. That is, if
the real wage is cyclical at all, it is slightly procyclical: the real wage tends to rise when
output rises. Abnormally high labor costs cannot explain the low employment and output
observed in recessions.

How should we interpret this evidence? Most economists conclude that the sticky-wage and
the worker-misperception models cannot,;‟ by themselves, fully explain aggregate supply.
They advocate models in which the labor demand curve shifts over the business cycle. These
shifts may arise because firms have sticky prices and cannot sell all they want at those prices;
we discuss this possibility later.

2.2.3 The Imperfect-Information Model

The third explanation for the upward slope of the short-run aggregate supply curve is called
the imperfect-information model. Unlike the sticky-wage model (and like the worker-
misperception model), this model assumes that markets clear – that is, all wages and prices
are free to adjust to balance supply and demand. In this model, as in the worker-
misperception model, the short-run and long-run aggregate supply curves differ because of
temporary misperceptions about prices.

The imperfect-information model assumes that each supplier in the economy produces a
single good and consumes many goods. Because the number of goods is so large, suppliers
cannot observe all prices at all times. They monitor closely the prices of what they produce
but less closely the prices of all the goods they consume. Because of imperfect information,
they sometimes confuse changes in the overall level of prices with changes in relative prices.
This confusion influences decisions about how much to supply, and it leads to a positive
relationship between the price level and output in the short run.

Consider the decision facing a single supplier – a wheat farmer, for instance. Because the
farmer earns income from selling wheat and uses this income to buy goods and services, the
amount of wheat she chooses to produce depends on the price of wheat relative to the prices
of other goods and services in the economy. If the relative price of wheat is high, the farmer
is motivated to work hard and produce more wheat, because the reward is great. If the relative
price of wheat is low, she prefers to enjoy more leisure and produce less wheat.

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Unfortunately, when the farmer makes her production decision, she does not know the
relative price of wheat. As a wheat producer, she monitors the wheat market closely and
always knows the nominal price of wheat. But she does not know the prices of all the other
goods in the economy. She must, therefore, estimate the relative price of wheat using the
nominal price of wheat and her expectation of the overall price level.

Consider how the farmer responds if all prices in the economy, including the price of wheat,
increase. One possibility is that she expected this change in prices. When she observes an
increase in the price of wheat, her estimate of its relative price is unchanged. She does not
work any harder.

The other possibility is that the farmer did not expect the price level to increase (or to
increase by this much). When she observes the increase in the price of wheat, she is not sure
whether other prices have risen (in which case wheat‟s relative price is unchanged) or
whether only the price of wheat has risen (in which case its relative price is higher).The
rational inference is that some of each has happened. In other words, the farmer infers from
the increase in the nominal price of wheat that its relative price has risen somewhat. She
works harder and produces more.

Our wheat farmer is not unique. When the price level rises unexpectedly, all suppliers in the
economy observe increases in the prices of the goods they produce. They all infer, rationally
but mistakenly, that the relative prices of the goods they produce have risen. They work
harder and produce more.
To sum up, the imperfect-information model says that when actual prices exceed expected
prices, suppliers raise their output. The model implies an aggregate supply curve that is now
familiar: Y  Y   ( P  P e ) . Output deviates from the natural rate when the price level
deviates from the expected price level.

2.2.4 The Sticky-Price Model

Our fourth and final explanation for the upward-sloping short-run aggregate supply curve is
called the sticky-price model. This model emphasizes that firms do not instantly adjust the
prices they charge in response to changes in demand. Sometimes prices are set by long-term
contracts between firms and customers. Even without formal agreements, firms may hold
prices steady in order not to annoy their regular customers with frequent price changes. Some

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prices are sticky because of the way markets are structured: once a firm has printed and
distributed its catalog or price list, it is costly to alter prices.

To see how sticky prices can help explain an upward-sloping aggregate supply curve, we first
consider the pricing decisions of individual firms and then add together the decisions of many
firms to explain the behavior of the economy as a whole. Notice that this model encourages
us to depart from the assumption of perfect competition. Perfectly competitive firms are price
takers rather than price setters. If we want to consider how firms set prices, it is natural to
assume that these firms have at least some monopoly controls over the prices they charge.

Consider the pricing decision facing a typical firm. The firm‟s desired price p depends on two
macroeconomic variables:
 The overall level of prices P. A higher price level implies that the firm‟s costs are
higher. Hence, the higher the overall price level, the more the firm would like to
charge for its product.
 The level of aggregate income Y. A higher level of income raises the demand for the
firm‟s product. Because marginal cost increases at higher levels of production, the
greater the demand, the higher the firm‟s desired price.
We write the firm‟s desired price as:
p  P  a (Y  Y ) .
This equation says that the desired price p depends on the overall level of prices P and on the
level of aggregate output relative to the natural rate Y  Y . The parameter a (which is greater
than zero) measures how much the firm‟s desired price responds to the level of aggregate
output.
Now assume that there are two types of firms. Some have flexible prices: they always set
their prices according to this equation. Others have sticky prices: they announce their prices
in advance based on what they expect economic conditions to be. Firms with sticky prices set
prices according to:
e
p  P e  a (Y e  Y ) ,
where, as before, a superscript “e‟‟ represents the expected value of a variable. For simplicity,
assume that these firms expect output to be at its natural rate, so that the last term,
e
a (Y e  Y ) , is zero. Then these firms set the price:
p  Pe .
That is, firms with sticky prices set their prices based on what they expect other firms to
charge.

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We can use the pricing rules of the two groups of firms to derive the aggregate supply
equation. To do this, we find the overall price level in the economy, which is the weighted
average of the prices set by the two groups. If s is the fraction of firms with sticky prices and
1 − s the fraction with flexible prices, then the overall price level is:
P  sPe  (1  s)[P  a(Y  Y )] .
The first term is the price of the sticky-price firms weighted by their fraction in the economy,
and the second term is the price of the flexible-price firms weighted by their fraction. Now
subtract (1 − s)P from both sides of this equation to obtain:
sP  sPe  (1  s)a(Y  Y ) .
Divide both sides by s to solve for the overall price level:
P  P e  (1  s )(a )(Y  Y ) .
s
The two terms in this equation are explained as follows:
 When firms expect a high price level, they expect high costs. Those firms that fix
prices in advance set their prices high. These high prices cause the other firms to set
high prices also. Hence, a high expected price level Pe leads to a high actual price
level P.
 When output is high, the demand for goods is high. Those firms with flexible prices
set their prices high, which leads to a high price level. The effect of output on the
price level depends on the proportion of firms with flexible prices.
Hence, the overall price level depends on the expected price level and on the level of output.
Algebraic rearrangement puts this aggregate pricing equation into a more familiar form:
Y  Y   ( P  P e ) , where   s .
(1  s ) a
Like the other models, the sticky-price model says that the deviation of output from the
natural rate is positively associated with the deviation of the price level from the expected
price level.
Although the sticky-price model emphasizes the goods market, consider briefly what is
happening in the labor market. If a firm‟s price is stuck in the short run, then a reduction in
aggregate demand reduces the amount that the firm is able to sell. The firm responds to the
drop in sales by reducing its production and its demand for labor. Note the contrast to the
sticky-wage and worker misperception models: the firm here does not move along a fixed
labor demand curve. Instead, fluctuations in output are associated with shifts in the labor
demand curve. Because of these shifts in labor demand, employment, production, and the real
wage can all move in the same direction. Thus, the real wage can be procyclical.

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We have seen four models of aggregate supply and the market imperfection that each uses to
explain why the short-run aggregate supply curve is upward sloping. Keep in mind that these
models are not incompatible with one another. We need not accept one model and reject the
others. The world may contain all four of these market imperfections, and all may contribute
to the behavior of short-run aggregate supply.

Although the four models of aggregate supply differ in their assumptions and emphases, their
implications for aggregate output are similar. All can be summarized by the equation:
Y  Y   (P  P e ) .
This equation states that deviations of output from the natural rate are related to deviations of
the price level from the expected price level. If the price level is higher than the expected
price level, output exceeds its natural rate. If the price level is lower than the expected price
level, output falls short of its natural rate. The figure below graphs this equation. Notice that
the short-run aggregate supply curve is drawn for a given expectation Pe and that a change in
Pe would shift the curve.

Figure 4.6: The Short Run Aggregate Supply Curve

Now that we have a better understanding of aggregate supply, let‟s put aggregate supply and
aggregate demand back together. The following figure uses our aggregate supply equation to
show how the economy responds to an unexpected increase in aggregate demand attributable,
say, to an unexpected monetary expansion. In the short run, the equilibrium moves from point
A to point B. The increase in aggregate demand raises the actual price level from P 1 to P2.
Because people did not expect this increase in the price level, the expected price level

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remains at P2e , and output rises from Y1 to Y2, which is above the natural rate Y . Thus, the
unexpected expansion in aggregate demand causes the economy to boom.

Yet the boom does not last forever. In the long run, the expected price level rises to catch up
with reality, causing the short-run aggregate supply curve to shift upward. As the expected
price level rises from P2e to P3e, the equilibrium of the economy moves from point B to point
C. The actual price level rises from P2 to P3, and output falls from Y2 to Y3. In other words,
the economy returns to the natural level of output in the long run, but at a much higher price
level.

Figure 4.7: How Shifts in Aggregate Demand Lead to Short-Run Fluctuations

This analysis shows an important principle, which holds for each of the four models of
aggregate supply: long-run monetary neutrality and short-run monetary non-neutrality are
perfectly compatible. Short-run non-neutrality is represented here by the movement from
point A to point B, and long-run monetary neutrality is represented by the movement from
point A to point C. We reconcile the short-run and long-run effects of money by emphasizing
the adjustment of expectations about the price level.

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CHAPTER FIVE
OPEN ECONOMY MACROECONOMICS
SECTION ONE: EXCHANGE RATES AND EXCHANGE RATE REGIMES
1.1 Exchange Rate Definitions
The exchange rate is simply the price of one currency in terms of another, and there are two
methods of expressing it:
 domestic currency units per unit of foreign currency- for example USD as the domestic
currency (Birr), on 28 November 2009 there was approximately 12.66 birr required to
purchase one USD, that is Birr 12.66/$1.
 foreign currency units per unit of domestic currency-on 28 November 2009
approximately $ 0.08 were required to obtain one Ethiopian Birr, i.e., $0.08/1 Birr.
The spot and forward exchange rates: Foreign exchange dealers not only deal with a wide
variety of currencies but they also have a set of dealing rates for each currency, which are
known as spot and forward rates.

The spot exchange rate is the quotation between two currencies for immediate delivery. In
other words, the spot exchange rate is the current exchange rates of two currencies vis-à-vis
each other. In practice, there is normally a two-day lag between a spot purchase or sale and
the actual exchange of currencies to allow for verification, paper work and clearing of
payments.

The forward exchange rate- In addition to the spot exchange rate, it is possible for
economic agents to agree today to exchange currencies at some specified time in the future,
most commonly for 1 month, 3months, 6 months, 9 months and 1 year. The rate of exchange
at which such a purchase or sale can be made is known as the forward exchange rate.

1.2 Nominal, Real and Effective Exchange Rates

Nominal exchange rate: the exchange rate that prevails at a given date is known as the
nominal exchange rate, and the amount of USD that will be obtained for one Birr in the
foreign exchange market. The nominal exchange rate is merely the price of one currency in
terms of another with no reference made to what this means in terms of purchasing power of
goods/services.

Real exchange rate: the real exchange rate is the nominal exchange rate adjusted for relative
prices between the countries under consideration. The real exchange rate is normally
expressed in index form algebraically as;

P
Sr  S
P

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Where S r is the index of the real exchange rate, S is the nominal exchange rate in index

form, P the index of the domestic price level and P is the index of the foreign price level.

Effective exchange rate: since most countries of the world do not conduct all their trade
with a single foreign country, policy makers are not so much concerned with what is
happening to their exchange rate against a single foreign currency but rather what is
happening to it against a basket of foreign currencies with which the country trade. The
effective exchange rate as a measure pf whether pr not the currency is appreciating or
depreciating against a weighted basket of foreign currencies. In order to illustrate how an
effective exchange rate is compiled consider a hypothetical case of Ethiopia conducting 20%
of trade with the China and 80% of its trade with Europe. This means a weight 0.2 will be
attached to the bilateral exchange rate index with the dollar and 0.8 to the euro.

1.3 Alternative Exchange Rate Regimes

Floating Exchange Rate Regime: Under floating exchange rate regime, the authorities do
not intervene to buy or sell their currency in the foreign exchange market. Rather, they allow
the value of their currency to change due to fluctuations in the supply and demand of the
currency.

In the figure below the exchange rate is initially determined by the interaction of the demand
(D1) and supply (S1) of Birr at the exchange rate of $.08/Birr1. There is an increase in the
demand for Ethiopian exports, which shifts the demand curve from D1 to D2, and the increase
in the demand for Birr leads to an appreciation of the Birr from $0.08/ birr1 to $1/birr1.
Figure b examines the impact of an increase in the supply of Birr due to an increased demand
for US exports and therefore dollars. The increased supply of birr shift the S1 schedule top the
right to S2 resulting in a depreciation of the Birr to $0.06/birr1. The essence of a floating
exchange rate is that the exchange rate adjusts in response to changes in the supply and
demand for a currency.

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a) Increase in demand
b) Increase in supply
$/birr
$/birr
S1
S

S2
$1.00
$0.08
$0.08
$0.06

D2
D1 D1

O
O Q1 Q2
Q1 Q2 Quantity of
Quantity of Birr
Birr
Figure 5.1 Floating exchange rate regime

Fixed exchange rate regime: In figure 5.2 (a) the exchange rate is assumed to be fixed
by the authorities at the point where the demand schedule (D1) intersects the supply
schedule (S1) at $0.08/ birr1. If there is an increase in the demand for birr, which shifts
the schedule from D1 to D2, there is a resulting pressure for the birr to be revalued. To
avert an appreciation, it is necessary for the central bank to sell Q1Q2 of birr to purchase
dollars in the foreign exchange market, these purchases shift the supply of birr from S1 to
S2. Such intervention eliminates the excess demand for birr so that the exchange rate
remains fixed at $0.08/ birr1. The intervention increases the central banks reserves of
USD while increasing the amount of birr in circulation.

Figure 5.2 (b) depicts an initial situation where the exchange rate is pegged by the
authorities at the point where the demand schedule (D1) intersects the supply schedule
(S1) at $0.08/ birr1. An increase in the supply of birr (increased demand of USD) shifts
the supply schedule from S1 to S2. The result is an excess supply of birr at the prevailing
exchange rate. This means that there will be pressure for the birr to be devalued. To avoid
this, the national Bank of Ethiopia has to intervene in the foreign exchange market to
purchase Q1Q2 birr to peg the exchange rate. The intervention is represented by a
rightward shift of the demand schedule from D1 to D2. Such intervention removes the
excess supply of birr so that the exchange rate remains pegged at $0.08/ birr1.

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b) Increase in supply
a) Increase in demand
$/birr
S1 $/birr S1

S2
S2

$0.08 $0.08

D2
D2
D1
D1
Q1 Q2 Quantity
Q1 Q2 Quantity of Birr
of Birr

Figure 5.2 Fixed exchange rate regimes

SECTION 2: THE BALANCE OF PAYMENTS

2.1 Definition
The balance of payments is a statistical record of all the economic transactions between
residents of the reporting country and residents of the rest of the world during a given time
period. The usual reporting period for all the statistics included in the accounts is a year.
Without question balance of payments is one of the most important statistical statements for
any country. It reveals how many goods and services the country has been exporting and
importing and whether the country has been borrowing from or lending money to the rest of
the world. In addition, whether or not the central monetary authority has been added to or
reduced its reserves of foreign currency is reported in the statistics.

An important point a country‟s balance of payments statistics is that in an accounting sense it

always balances. This is because it is based upon the principle of double entry bookkeeping.
Each transaction between a domestic and foreign resident has two sides to it, a receipt and a
payment, and both of these are recorded in the balance of payments statistics. Each recipient
or currency from residents of the rest of the world is recorded as a credit item (a plus on the
accounts), while each payment to residents of the rest of the world is recorded as a debt (a
minus in the account).

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Traditionally, the statistics are divided into two main sections- the current account and the
capital account with each part being further sub-divided. The reason for dividing the balance
of payments into these two main parts is that the current account items refer to income flows,
while the capital account records changes in assets and liabilities.

2.2 An Overview of the Sub-Accounts in the Balance of Payments

The trade balance: The trade balance is the sum of the visible trade balance because it
represents the difference between receipts for exports of goods and expenditure on imports of
goods, which can be visibly seen crossing frontier. The receipts for exports are recorded as a
credit in the balance of payments, while the payment for imports is recorded as a debit. When
the trade balance is in surplus this means that country has earned more from its exports of
goods than it has paid for its imports of goods.

The Currents Account Balance: The current account balance is the sum of the visible trade
balance and the invisible balance. The invisible balance shows the difference between
revenue received for exports of services and payments made for imports of services such as
shipping, tourism, insurance, and banking. In addition, receipts and payments of interest,
dividends and profits are recorded in the invisible balance because they represent the rewards
for investment in overseas companies, bonds, and equity, while payments reflect the rewards
to foreign residents for their investment in the domestic economy. As such, they are receipts
and payments for the services of capital that earn and cost the country income just as do
exports and imports.

Note that there are item referred to as unilateral transfers included in the invisible balance;
these are payments or receipts for which there is no corresponding quid pro quo. Examples of
such transactions are migrant workers‟ remittances to their families back home, the payment
of pensions to foreign residents, and foreign aid. Such receipts and payments represent a
redistribution of income between domestic and foreign residents. Unilateral payments can be
viewed as a fall in domestic income due to payments to foreigners and so are recorded as a
debit,
while unilateral receipts can be viewed as an increase in income due to receipts from
foreigners and consequently are recorded as a credit.

The Capital Account Balance: The capital account records transactions concerning the
movement of financial capital into and out of the country. Capital comes into the country by
borrowing, sales of overseas assets and investment in the country by foreigners. These items

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are referred to as capital inflows and are recorded as credit items in the balance of payments.
Capital inflows are, in effect, a decrease in the country‟s holding of foreign assets or an
increase in liabilities to foreigners. The fact that capital inflows are recorded as credits in the
balance payments often presents students with difficulty. The easiest way to understand why
they are pluses is to think of foreign borrowing as the export of an IOU. Similarly, investment
by foreign residents is the export of equity or bonds, while sales of overseas investment is an
export of those investments to foreigners. Conversely, capital leaves the country due to
lending, buying of overseas assets and purchases of domestic assets owned by foreign
residents. These items are recorded as debits as they represent the purchase of an IOU from
foreigners, the purchase of foreign bonds or equity and the purchase of investments in the
foreign economy.

Items in the capital account are normally distinguished according to whether they originate
from the private or public sector and whether they are of a shot-term or long-term nature. The
summation of the capital inflows and outflows as recorded in the capital account gives the
capital account balance.

Official Settlements Balance: Given the huge statistical problems involved in compiling the
balance of payments statistics, there will usually be a discrepancy between the sum all the
items recorded in the current account, capital account and the balance of official financing
which in theory should sum to zero. To ensure that the credits and debits are equal it is
necessary to incorporate a statistical discrepancy for any difference between the sum of
credits and debits. There are several possible sources of this error. One of the most important
is that it is an impossible task to keep track of all the transactions between domestic and
foreign residents; many of the reported statistics are based on sampling estimates derived
from separate sources, so that some error is unavoidable. Another problem is that the desire
to avoid taxes means that some of the transactions in the capital account are underreported.
Moreover, some dishonest firms may deliberately under-invoice their imports so as to
artificially deflate their profits. Another problem is one of „leads and lags‟. The balance of
payments records receipts and payments for a transaction between domestic and foreign
residents, but it can happen that a good is imported but the payment delayed. Since the import
is recorded by the custom authorities and the payment by the banks, the time discrepancy
may mean that the two sides of the transaction are not recorded in the same set of figures.

The summation of the current account balance, capital account balance and the statistical
discrepancy gives the official settlements balance. The balance on this account is important

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because it shows the money available for adding to the country‟s official reserves or paying
off the country‟s official borrowing. A central bank normally holds a stock of reserves made
up of foreign currency assets. Such reserves are held primarily to enable the central bank to
purchase its currency should it wish to prevent it depreciating. Any official settlements deficit
has to be covered by the authorities drawing on the reserves, or borrowing money from
foreign central banks or IMF. If, on the other hand, there is an official settlements surplus this
can be reflected by the government increasing official reserves or repaying debts to the IMF
or other sources overseas (a minus since money leaves the country).
The facts that reserve increases are recorded as a minus, while reserve falls are recorded as a
plus in the balance if payments statistics is usually a source of confusion. It is the most easily
rationalized by thinking that reserves increase when the authorities have been purchasing the
foreign currency because the domestic currency is strong. This implies that the other items in
the balance of payments are in surplus, so reserve increases have to be recorded as a debit to
ensure overall balance. Conversely, reserves fall when the authorities have been supporting a
currency that is weak, that is, all other items sum to a deficit so reserve falls must be recorded
as a plus to ensure overall balance.
Table 5.1 Summary of balance of payments concepts
Trade balance
+exports of goods
-imports of goods
= trade balance
Current account balance
Trade balance
+exports of services
+ Interest, dividends and profits received
+ Unilateral receipts
-Import of services
- Interest, dividends and profits paid
- Unilateral payments abroad
= current account balance
Basic balance
Current account balance
+balance on long term capital account
+ Statistical error
= official settlements balance
________________________________________________________________________

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SECTION 3: OPEN ECONOMY IDENTITIES AND MULTIPLIERS

1.1 Some Open Economy Identities
In an open economy, gross domestic product (GDP) differs from that of a closed economy
because there is an additional injection, export expenditure that represents foreign
expenditure on domestically produced goods. There is also an additional leakage, expenditure
on imports that represents domestic expenditure on foreign goods and raise foreign national
income. The identity for an open economy is given by:
Y  C  I G X M (5.1)
Where Y is national income, C is domestic consumption, I is domestic investment, G is
government expenditure, X is export expenditure and M is import expenditure. If we deduct
taxation T from the right-hand side of equation (5.1), we have:
Yd  C  I  G  X  M  T (5.2)
Where Yd is disposable income.
If we denote private savings as S=Yd-C we can rearrange equation (5.2) to obtain;
X M   S  I   T  G 
(5.3)

Where,
X M  Current account balance

S  I  Net savings/ dis-savings of the private sector

T  G  Government deficit/surplus

Equation (5.3) is an important identity, it says that a current account deficit has a counterpart
in either private dissaving, that is private investment exceeding private saving and/or in a
government deficit, that is government deficit that is government expenditure exceeding
government taxation revenue. The equation is merely an identity and says nothing about
causation. Nonetheless, it is of the stated that the current account deficit is due to the lack of
private savings and/or the government budget deficit. However, it is possible that the
causation runs the either way, and it is the current account deficit that may be responsible for
the lack of private savings or budget deficit.

Equation (5.3) can be rearranged to yield

I  G  X  S T  M (5.4)

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This shows that the equilibrium level of national income is determined where injections (the
variables on the left-hand side of 4.4) are equal to leakages (the variables on the right-hand
side of 4.4). Injections are all those factors that work to lower national income.
1.2 Open Economy Multipliers
The assumptions underlying basic multiplier analysis are:
(i) both domestic prices and the exchange rate are fixed,
(ii) the economy is operating at less than full employment so that increases in
demand result in an expansion of output, and
(iii) The authorities adjust the money supply to changes in money demand by pegging
the domestic interest rate.
This later assumption is important, increases in output that lead to a rise in money demand
would with a fixed money supply lead to a rise in the domestic interest rate; it is assumed that
the authorities passively expand the money stock to meet any increase in money demand so
that interest rate do not have to change. There is no inflation resulting from the money supply
expansion because it is merely a response to the increase in money demand.
The starting point for the analysis is the following identity
Y  C  I G X M (5.5)
Keynesian analysis proceeds to make assumptions concerning the determinants of the various
components of national income. Government expenditure and exports are assumed
exogenous, government expenditure being determined independently by political decision,
and exports by foreign expenditure decisions and foreign income. Domestic consumption is
partly autonomous and partly determined by the level of national income. This is denoted
algebraically by the equation:
C  C a  cY (5.6)
Where C a is autonomous consumption, c is the marginal propensity to consume, that is the
fraction of any increase on income that is spent on consumption. In this simple model,
consumption is assumed a linear function of income. An increase in consumer‟s income
induces an increase in their consumption.
Import expenditure is assumed partly autonomous as partly a positive function of the level of
domestic income,

M  M a  mY (5.7)
Where M a is autonomous import expenditure and m is the marginal propensity to import,
that is the fraction of any increase in income that is spent on imports. In this simple
formulation import, expenditure is assumed a positive linear function of income. There are

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several justifications for this, on the one hand, increased income leads to increased
expenditure on imports and also more domestic production normally requires more imports of
intermediate goods. Since we have assumed that domestic prices are fixed this means, that
income Y also represents real income.
If we substitute equation (5.6) and (5.7) into equation (5.5) we obtain;
Y  C a  cY  I  G  X  M a  mY
Therefore
1  c  mY  Ca  I  G  X  M a
Given that 1  c  is equal to the marginal propensity to save, s, that is the fraction of any
increase in income that is saved, then we obtain:

Y
1
C a  I  G  X  M a  (5.8)
sm

Equation (4.8) can be transformed into difference form yield;

dY 
1
dCa  dI  dG  dX  dM a  (5.9)
sm
Where d in front of a variable represents the change in the variable. From equation (4.9), we
can obtain some simple open economy multipliers.

The Government Expenditure Multiplier: The first multiplier of interest is the government
expenditure multiplier, which shows the increase in national income resulting from a given
increase in government expenditure. This is given by:
dY 1
 0 (5.10)
dG s  m

The above equation says that an increase in government expenditure will have an
expansionary effect on national income, the size of which depends upon the marginal
propensity to save and the marginal propensity to import. Since the sum of the marginal
propensity to save and import is less than unity, an increase in government expenditure will
result in an even greater increase in national income. Furthermore, the value of the open
economy multiplier is less than the closed economy multiplier which is given by 1/s. The
reason for this is that increased expenditure is spent on both domestic and foreign goods
rather than domestic goods alone and the expenditure on foreign goods raises foreign rather
than domestic income.
Example

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Assume that the marginal propensity to save is 0.25 and the marginal propensity to import is
0.15. The effect of an increase in government expenditure of $100 million on national income
is given by:
1 1
dY  dG  $100m  2.5  $100m  $250m
sm 0.25  0.15
Hence, an increase of government expenditure of $100m will raise eventual national income
by $250m.
The Foreign Trade or Export Multiplier: In this simple model, the multiplier effect of an
increase in exports on national income is identical to that of an increase in government
dY 1
expenditure, and given by  . In practice, it is often the case that government
dX s  m
expenditure tends to be somewhat more biased to domestic output than private consumption
expenditure, implying that the value of m is smaller in the case of the government
expenditure multiplier than in the case of the export multiplier. If this is the case, an increase
in government expenditure will have a more expansionary effect on domestic output than an
equivalent increase in exports.
Example
Assume that the marginal propensity to save is 0.25 and the marginal propensity to import is
0.15. The effect of an increase in exports of $100 million on national income is given by:
1 1
dY  dX  $100  2.5  $100  $250
sm 0.25  0.15

In the figure below on the vertical axis we have injections/leakages and on the horizontal axis
national income. The savings plus import expenditures (s+m) are assumed to increase as
income rises, reflected by the upward slope of the injections schedule. Because the sum of the
marginal propensity to import and save is less than unity, this schedule has a slope less than
unity. Injections are assumed exogenous of the level of income and consequently this
schedule is a horizontal line. The equilibrium level of national income is determined where
injections into the economy (investment plus exports) equal leakages (saving and imports),
which is initially at income level Y1. An increase in exports or government expenditure or
investment results in an upward shift of the injections schedule from (G+I+X)1 to (G+I+X)2
and this rise in income induces more saving and import expenditure but overall, the increase
in income from Y1 to Y2 is greater than the initial increase in injections. The lower are the
marginal propensities to save and invest, the less steep the leakages schedule and the greater
the increase in income.

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s+m

(G+I+X)2
(s+m)2

(G+I+X)1
(s+m)1

O
Y1 Y2

Figure 5.3 the government expenditure/ foreign trade multiplier

The Current Account Multipliers: The other relationships of interest are the effects of an
increase in government expenditure and of exports on the current account (CA) balance.
Rearranging equation (5.5), we have:
Y C  I G  M  X  0
Substituting in equation (4.6) and (4.7) yields:
Y  cY  mY  Ca  M a  I  G  X  0

Since Y 1  c  m   Y  s  m  we have:

Y  s  m   Ca  M a  I  G  X  0

Multiplying by m
 s  m  yields
m
mY   Ca  M a  I  G  X   0
sm
Adding Ma and X to each side, recalling that M=Ma+mY and rearranging yields:
m
CA  X  M  X  M a   Ca  M a  I  G  X  (5.11)
sm
Equation (4.11) can now be expressed in difference form as:
m
dCA  dX  dM a   dCa  dM a  dI  dG  dX  (5.12)
sm
From the above equation we can derive the effects of an increase in government expenditure
on the current account balance which his given by dCA dG   m  0 . That is, an
 s  m

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increase in government spending leads to a deterioration of the current account balance,

which is some fraction of the initial increase in government expenditure. This is because
economic agents spend part of the increase in income on imports.
Assume that the marginal propensity to save is 0.25 and the marginal propensity to imports is
0.15. The effect of an increase in government expenditure of $100 million on the current
account is given by:
m  0.15
dCA   dG  $100  0.375  $100  $37.5
sm 0.25  0.15
That is, an increase in government expenditure leads to an eventual deterioration in the
current account of $37.5. The reason is that the increased government expenditure of $100
million because of the open economy multiplier increases national income by $250m.

The other multiplier of interest is the effect of an increase in exports on the current balance.
This is given by the expression:
dCA m sm m s
 1    0
dX sm sm sm sm
Since s s  m is less than unity, an increase in exports leads to an improvement in the

current balance that is less than the original increase in exports. The explanation for this is
that part of the increase in income resulting from the additional exports is offset to some
extent by increased expenditure on imports.
Example
Assume that the marginal propensity to save is 0.25 and the marginal propensity to import is
0.15. The effect of an increase in exports of $100 million on the current account is given by:
dCA s 0.25
  $100  $62.5m
dX s  m 0.25  0.15

The explanation is that the $100 increase in exports initially improves the current account
by a like amount. But it is also generating an eventual increase of national income of
$250 which induces an increase in imports of $37.5m, so the net improvement in the

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