 Macroeconomics is the study of

the structure and performance of

national economies and of the
policies that governments use to
try to affect economic
performance.
 The word ‘macro’ is a Greek
word which means large.
 Macro economics focus on the
magnitude (i.e. aggregates) not
on the composition. i.e. the
forest as a whole not the
individual trees that make up the
forest.

1
 Macroeconomics is a branch of
economics that dealing with the
performance, structure, behavior, and
decision-making of an economy as a
whole, rather than individual markets.
 This includes national, regional, and

global economies.
 With microeconomics, macroeconomics
is one of the two most general fields
in economics.

2
 Economic theory is traditionally divided
into two broad categories; Macro and
micro economics
 Macroeconomics is further subdivided
into; theory and applied.
 Applied economics is also subdivided into
policy and econometrics.
 There are various terminologies that are
normally used for macroeconomics,
sometimes referred to as INCOME THEORY
and also referred to as AGGREAGATE
ECONOMICS ANALYSIS or ECONOMICS OF
THE TOTAL.
3
 What determines a nation’s long-run economic
growth?
 What causes a nation’s economic activity to
fluctuate?
 What causes unemployment?
 What causes prices to rise?
 How does being a part of a global economic
system
affect nations’ economies?
 Can government policies be used to improve
economic performance?

4
❑ Major macro-economic problems
 Low level of income
 Inflation
 Unemployment
 High rate of interest
 Trade imbalance which lead to shortage of
foreign exchange supply
❑ Indicators of economic performance
 Level of employment
 Level of income
 Level of interest rate
 Level of trade imbalance
 National debt

5
 Economics is said to begin with
Adam Smith in 1776.
 Prior to that, nobody thought of
economics, or markets, as an object
of study.
 It is not that they didn't pay
attention to economic matters, it is
simply that they didn't think of it in
any systematic or coherent manner.
 It is common to denote the period
before 1776 as "Mercantilism".
6
 This "mercantile system" was based on the
premise that national wealth and power were
best served by increasing exports and
collecting precious metals in return.
 It wasn't a coherent school of thought, but a
hodge-podge of varying ideas about improving
tax revenues, the value & movements of gold
and how nations competed for international
commerce & colonies.
 Mercantilists advocated the use of the state's
military power to ensure local markets and
supply sources were protected.

7
 They were opinion in 18 and 19 C.
 Focus on economic growth ,economic
freedom, laissez-faire and Free competition.

❖ Classical economists include :-

✓ Karal marx

✓ Weber

✓ Durkheim

✓ Adam Smith

✓ J.S Mill were pioneer thinker and

8
 The invisible hand of Economics: General welfare
will be maximized (not the distribution of wealth)
if:
 there are free markets;
 individuals act in their own best interest.
 To maintain markets’ equilibrium – the quantities demanded
and supplied are equal:
 Markets must function without impediments.

 Wages and prices should be flexible.

 Thus, according to the classical approach, the

government should have a limited role in the
economy.

9
 Classical schools (1776-1871)

Name
Adam smith Scottish An enquire into nature and the causes of 1776
wealth of nation
Robert Malthus English An essay on the principle of population 1798

Jen Baptiste Say French 1803

David Ricardo English On the principle of political economy and 1817

taxation
John stuart Mill English Principle of political economy 1848

Karal Marx German 1867-94

10
 The first serious attempt to systematically study and
look for "laws" in the marketplace was the Scottish
philosopher Adam Smith in his Wealth of Nations
(1776).
 He didn't get everything right, but at least he opened
the door to a new field of study. It is for this reason
Adam Smith is commonly regarded as the "father of
economics".
 The followers of Smith's original principles are
commonly called the “Classical School” of economics.
 They dominated thinking in at least the first half of
the 19th C.

11
 The most important figure here is probably David
Ricardo, a Dutch-born London stockbroker, who
was perhaps the most systematic thinker of the
bunch.
 Ricardo was the one who turned Smith's 'first
draft' of ideas and propositions into a coherent,
clear and rigorous theory.
 It became the dominant school of thought in the
19th C., particularly in Britain.
 As a result, the Classical school is sometimes also
called the "Ricardian" or "British“ school.
 Karl Marx built his economic analysis upon
Ricardo's theories.
 As a result, Marxian economics is usually
considered part of the Classical School tradition.

12
 They are classical because they are linked with the
process of modernization.
 Classical schools of thought known as supply side
economists because of the opinion that whatever is
produced in economies sold, nothing remain unsold.
 Say’s Law: “supply creates its own demand”
 Market is always in equilibrium , there is quick
adjustment among wages, prices, and interest
rates, there is lesser role of the government.
 The market forces through economic freedom and
free competition play a strong role to attain
Employment in the economy through quick
adjustment of wages, monitory values ,and interest
rate .
 Classical economic theory assumes that a product
value is derived from the cost of material plus the
cost of labour.
13
 The fundamental principle of the classical
theory is that the economy is self‐regulating.
 Classical economists maintain that the economy
is always capable of achieving the natural level
of real GDP or output, which is the level of real
GDP that is obtained when the economy's
resources are fully employed.
 While circumstances arise from time to time
that cause the economy to fall below or to
exceed the natural level of real
GDP, self‐adjustment mechanisms exist within
the market system that work to bring the
economy back to the natural level of real GDP.

14
 The classical doctrine—that the economy is
always at or near the natural level of real GDP—is
based on two firmly held beliefs: Say's Law and
the belief that prices, wages, and interest rates
are flexible.
 According to Say's Law, when an economy
produces a certain level of real GDP, it also
generates the income needed to purchase that
level of real GDP.
 In other words, the economy is always capable of
demanding all of the output that its workers and
firms choose to produce.
 Hence, the economy is always capable of
achieving the natural level of real GDP.

15
 But, while it is true that the income obtained from
producing a certain level of real GDP must be
sufficient to purchase that level of real GDP, there
is no guarantee that all of this income will be
spent.
 Some of this income will be saved.
 Income that is saved is not used to purchase
consumption goods and services, implying that
the demand for these goods and services will
be less than the supply.
 If aggregate demand falls below aggregate supply
due to aggregate saving, suppliers will cut back
on their production and reduce the number of
resources that they employ.

16
 When employment of the economy's resources falls below
the full employment level, the equilibrium level of real GDP
also falls below its natural level.
 Consequently, the economy may not achieve the natural
level of real GDP if there is aggregate saving.
 The classical theorists' response is that the funds from
aggregate saving are eventually borrowed and turned
into investment expenditures, which are a component of
real GDP.
 Hence, aggregate saving need not lead to a reduction in real
GDP.
 Consider, however, what happens when the funds from
aggregate saving exceed the needs of all borrowers in the
economy.

17
 In this situation, real GDP will fall below its natural
level because investment expenditures will be less
than the level of aggregate saving.
 This situation is illustrated in the following Figure .

18
 Aggregate saving, represented by the curve S, is
an upward‐sloping function of the interest rate; as
the interest rate rises, the economy tends to save
more.
 Aggregate investment, represented by the curve I,
is a downward‐sloping function of the interest
rate; as the interest rate rises, the cost of
borrowing increases and investment expenditures
decline.
 Initially, aggregate saving and investment are
equivalent at the interest rate, i.
 If aggregate saving were to increase, causing
the S curve to shift to the right to S′, then at the
same interest rate i, a gap emerges between
investment and savings.
19
 Aggregate investment will be lower than aggregate saving,
implying that equilibrium real GDP will be below its natural
level.
➢ Flexible interest rates, wages, and prices
 Classical economists believe that under these circumstances,
the interest rate will fall, causing investors to demand more
of the available savings.
 In fact, the interest rate will fall far enough—from i to i′ in
Figure —to make the supply of funds from aggregate saving
equal to the demand for funds by all investors.
 Hence, an increase in savings will lead to an increase in
investment expenditures through a reduction of the interest
rate, and the economy will always return to the natural level
of real GDP.

20
 The flexibility of the interest rate as well as
other prices is the self‐adjusting mechanism of
the classical theory that ensures that real GDP is
always at its natural level.
 The flexibility of the interest rate keeps
the money market, or the market for loanable
funds, in equilibrium all the time and thus
prevents real GDP from falling below its natural
level.
 Similarly, flexibility of the wage rate keeps
the labor market, or the market for workers, in
equilibrium all the time.
 If the supply of workers exceeds firms' demand
for workers, then wages paid to workers will fall
so as to ensure that the work force is fully
employed. 21
 Classical economists believe that any
unemployment that occurs in the labor market or
in other resource markets should be
considered voluntary unemployment.
 Voluntarily unemployed workers are unemployed
because they refuse to accept lower wages. If they
would only accept lower wages, firms would be
eager to employ them.
 In a recession, the classicalists view
❑ Consider the following graph

22
23
 The immediate, short‐run effect is that the economy
moves down along the SAS curve labeled SAS 1, causing the
equilibrium price level to fall from P 1 to P 2, and
equilibrium real GDP to fall below its natural level
of Y 1 to Y 2.
 If real GDP falls below its natural level, the economy's
workers and resources are not being fully employed.
 When there are unemployed resources, the classical theory
predicts that the wages paid to these resources will fall.
 With the fall in wages, suppliers will be able to supply
more goods at lower cost, causing the SAS curve to shift to
the right from SAS 1 to SAS 2.
 The end result is that the equilibrium price level falls
to P 3, but the economy returns to the natural level of real
GDP.
 During the great depression 1930 rate of unemployment
for several years affected the world economies and
doctrine of invisible hand was seen useless.
24
25
 The great depression of 1930s, initiated economists to
recommend government intervention.
 The first economist was John Maynard Keynes.
 The economists following his trend are called Keynesian
economists.
 The main thesis of the Keynesian paradigm is that
economy is subjected to failure as markets are not
efficient and economy may not achieve full employment
level.
 The Keynesian thinkers believed that government
intervention is inevitable.
 Following the failure of all attempts of central banks to
keep the economy on the right track, John Mynard
Keynes published his book of ‘General Theory of
Employment, Interest and Money’ in year 1936.

26
 Keynes (1936) assumed that wages and
prices can be adjusted slowly.
 Thus, markets could be out of equilibrium
for long periods of time and unemployment
can persist.
 Therefore, according to the Keynesian
approach, governments can take actions to
alleviate unemployment.
 The government can purchase goods and
services, thus increasing the demand for
output and reducing unemployment.
 Newly generated incomes would be spent
and would raise employment even further.
27
 Economists famous for consumption theorist are
 John caw
 Malthus
 The Birmingham school of Thomas Attnood
 Keynesian focus on economic growth and price
stability rather than full employment.
 If father of economics is Adam smith the
following father of macroeconomics is John
Mynard Keynes (1883-1946)
 His most famous work ‘the general theory of
employment, interest rate and money was
published in 1936
 Keynesians opinion was that government should
intervene in time of crises.
28
 The idea is that reduction in aggregate demand
is the primary causes of recession in the short-
run.
 Wages and prices can be sticky and in an
economic downturn unemployment can result.
 Macroeconomic become popular after great
depression 1929-1933,when Keynes identified
the inflation and unemployment in the economy
lasting for several years.
 The opinion of classical school of thought were
the market is always in equilibrium where as
the Keynesians identified disequilibrium in the
market, unemployment, and inflation during the
great depression period.

29
 The Keynesians opinion was there is slow
adjustment of wage, price, and interest rates.
 The government with the expert fiscal policy can
enhance purchases by trimming the tax rates be
added to enhance the demand for goods and
services and can solve the macroeconomic
problems of unemployment and business cycle.
 That is why Keynesians are also known as
demand side economists.
 However, the supply side economists are the
classical school of thought with the opinion that,
whatever is produced is sold i.e. nothing remains
unsold.

30
 While the keyisians are called demand side
economists because they said that the
government knows better through fiscal
policy can increase the demand and control
unemployment.
 The Keynesians macroeconomic theory
dominated till 1970 then monetarist
macroeconomists came.

31
32
 The original equilibrium of this
economy occurs where the
aggregate demand function (AD0)
intersects with AS.
 Since this intersection occurs at
potential GDP (Yp), the economy is
operating at full employment.
 When aggregate demand shifts to
the left, all the adjustment occurs
through decreased real GDP.
 There is no decrease in the price
level. Since the equilibrium occurs
at Y1, the economy experiences
substantial unemployment.

33
 In summary, the implications of the fundamental
Keynesian thought are the following.

➢ The economy is inherently unstable and is

subject to erratic shocks.
➢ The economy can take a long time to return to
being close to full equilibrium after being
subjected to a shock.
➢ Government intervention is necessary for the
smooth function of the economy.
➢ Aggregate demand is the predominant
determinant of output and employment.

34
 Economists in the 20th century; the famous
monetarists includes

✓ Milton Friedman
✓ Alen greenspan
 Monetarist macroeconomists believe that the
government step to increase purchases by
rising demand for goods and services would
lead towards inflationary pressure in the
country and the economy would be weaken.
 Thus they refuted the Keynesian notion.

35
 According to monetarists the government
administration by bringing changes and
controlling money supply be capable to
control inflation in the country.
 Classical schools of thought were of opinion
that market is in equilibrium and there is no
unemployment.
 However, unemployment appeared in the
great depression in 1930s.
 Who identified it ? Unemployment was
identified by Keynes.

36
 Keynes suggest that a government through
fiscal measures can control unemployment.
 The monetarist against the Keynesians school
of thought suggested with the change in the
fiscal policy, however, control can be
possible on unemployment with the decrease
in the tax rate and with an increase in
demand that in turn increases inflation.
 Such inflation can be controlled through the
monetary policy by controlling the money
supply.
 Basically this was the idea of the classical,
Keynesians and the monetarists.
37
 The Neo-Classical School is a synthesis of
the Keynesian and Classical ideas.
 It adopts the Keynesian aggregate
supply (horizontal) curve for the short-
run and the Classical aggregate supply
(vertical) curve for the long-run.
 Thus the Neo-classical AS curve has
upward sloping and vertical segments.
 Therefore, an increase in the AD leads
to an increase in the national income in
the first range, a simultaneous increase
in the national income and the price
level in the second range, and an
increase in the price level in the last
range.

38
 Intermediate Zone: portion of
SRAS curve where GDP is below
potential but not so far below
as in the Keynesian zone.
 The SRAS curve is up-ward
sloping but not vertical in the
intermediate zone.
 Keynesian Zone: Portion of the
SRAS curve where GDP is far
below potential and the SRAS
curve is flat.
 Neoclassical Zone: portion of
the SRAS curve where GDP is
at or near potential output
where the SRAS curve is steep.

39
 Monetarism and Keynesian economics debated the
unsettled issues until the early 1970s, after which a
combination of two things were to lead to their demise
as the main schools of macroeconomic thought.
 The successor macroeconomic way of thinking was the
New Classical School.
 The major new classical economists were; Robert Lucas,
Thomas J. Sargent and Robert Barro.
 The new classical macroeconomics remained influential
in the 1980s.
 This school of macroeconomics shares many policy issues
with Friedman.
 It sees the world as one in which individuals act
rationally to meet their self-interest in the market that
adjust itself rapidly to changing conditions.
 They claim that government is likely only to make
things worse by intervening in economic activities.

40
 There are three central working assumptions of the new
classical school:
 Economic agents maximize:
 Households and firms make optimal decisions given all
available information in reaching decisions and those
decisions are the best possible in circumstances in which
they find themselves.
 It is such maximization behavior that leads to the common
interest of economic agents (market equilibrium, where
both demanders and suppliers are satisfied).
 Expectations are rational:
 Expectations of economic agents are statistically the best
predictions about the future that can be made using the
available information.
 Rational expectations imply that people will eventually
come to understand whatever government policy used, and
thus it is not possible to fool most of the people all the time
or even most of the time. 41
 Markets clear:
 It means market is efficient enough to adjust
supply with demand in each and every market.
 According to new classical economists, prices and
wages are flexible all the time allowing all
individuals all the time to be in a satisfactory
working situation and firms to produce and supply
as much as they want.
 The essence of the new classical approach is the
assumption that markets are efficient enough to
bring the economy into equilibrium.
 Despite these explanations, they failed to explain
the occurrence of the ‘great depression’ and
occasionally large unemployment rates around the
world which are the cases of market failure.

42
 A new generation of scholars called the new Keynesians,
trained mostly in the Keynesian tradition, but moving
beyond it, emerged in the 1980.
 The representatives of the New Keynesian
Economics are Alan S. Blinder, N. Gregory Mankiw,
John Taylor, David Romer.
 They do not believe that markets clear all the time, but
seek to understand and explain exactly why markets fail.
 The new Keynesians argue that markets sometimes do
not clear even when individuals are looking out for their
own interests.
 According to them, both information problems and costs
of changing prices lead to some price rigidities and that
causes macroeconomic fluctuations in output and
employment.
43
 For example, in the labour market, firms that cut
wage not only reduce the cost of labour, but also are
likely to wind up with poorer quality labour/workers.
 Thus firms will be reluctant to cut wages.
 According to the New Keynesian economists, prices
and wages are not flexible as opposed to the
classical economists’ position owing to the following
major reasons:-
 Imperfect information
 Long-term contract
 Menu costs
 Minimum wage rate legislation
 Monopoly power of labour unions

44
 In general, all schools of macroeconomics agree on the
purpose/objectives of macroeconomic policy such as:-
 Growth in national output,
 Lower rate of inflation,
 Higher employment rate or lower unemployment rate
and level,
 Improved or positive trade balance and balance of
payment etc.
 However, they disagree on how to achieve these
macroeconomic goals of higher output, lower of
unemployment and low rate of inflation.
 Currently there is no single dominant school of thought
in the area of macroeconomics.
 Thus, different economic views are used in different
economies under different circumstances.
45
END OF CHAPTER ONE

46
 In the 1930s it was impossible for
macroeconomics to exist in the form we know it
today because many aggregate concepts had
not yet been formulated, or were lacking rigor.
 In the mid-1930s, two Keynesians, Simon
Kuznets and Richard Stone, began to develop
this terminology.
 They developed national income accounting – a
set of rules and definitions for measuring
economic activity in the aggregate economy –
that is, in the economy as a whole.
 National income accounting is a way of
measuring total, or aggregate production.
47
 Gross Domestic Product (GDP):
 The total income earned by domestically-located
factors of production, regardless of nationality.
 Gross domestic product (GDP) is the sum of values
of the final goods and services produced in the
country by citizens of the country and foreigners.
 Final goods here refer to those goods which are
directly consumed and not used in further
production.

 Therefore, GDP is something related to territory of

the country (i.e. GDP is territorial).

48
 Gross National Product (GNP):
 GNP refers to the sum of values of goods and
services produced by all citizens of a nation/a
country all over the world in the country plus
outside the country.
 GNP is something related to citizenship (i.e. GNP is
national).
 The difference between GNP and GDP equals to the
net income earned by foreigners (NFP) or net
factor income (NFI).
 GNP= GDP + NFP (Net factor income).
 NFI=[Factor income received from abroad]-[factor
income paid to abroad].
49
 When GDP exceeds GNP, the value of NFI of NFP is
negative which implies residents of a given country
are earning less abroad than foreigners are earning
in that country.
 If the value of the net factor payment (NFP) is
zero, it means both GDP and GNP are equal.
 If the value of net factor payment (NFP) is positive,
then GNP is greater than GDP.
 This means, the output produced by citizens of the
country is larger than what is produced in the
territory of the country.

50
 Net domestic product (NDP): GDP minus
depreciation
 Depreciation:- The capital used in production
process wears out, or depreciates while it is being
used to produce output. or
 Depreciation: the process by which capital ages
and loses it’s value.
 Net national product (NNP) is calculated by taking
GNP and then subtracting the value of how much
physical capital is worn out, or reduced in value
because of aging, over the course of a year.
 The NNP can be further subdivided into national
income, which includes all income to businesses
and individuals after indirect tax, and

51
 Personal income, which includes only income to
people (the difference between national income
and different personal payments and receipts).
 Disposable income (Yd): is the amount of income
that is left for a person after payment of any taxes
and transfers.

It is the amount that the person is free to spend on

whatever he/she likes or to save.
 It is given by the following identity.
Yd = PI – (direct or personal income taxes).

52
 The national economy involves all households,
businesses, and governments that make decisions
about employment, output and expenditures.
 The results of individual decisions made by these
economic units are measured by the economy’s
total spending, output, and income.
 The circular flow diagram in Figure below shows
the relationship between spending, output, and
income.
 Circular flow diagrams: show the flows of money
payments, real resources, and goods and services
between households and businesses.

53
 Figure shows the circular flow of inputs to
production, outputs of goods and services,
costs of the inputs to production, and receipts
from sales.
 The right side half of the diagram, above the
horizontal line, shows the outputs of goods
and services supplied by businesses to
households and household expenditures on
those goods and services.
 The left side half of the diagram shows the
factor services of labour, land, capital, and
entrepreneurship supplied by households to
businesses in exchange for the factor incomes:
wages, rent, interest, and profit.
54
 Fig 2.1: Circular flow of the economy (two sector)

Injections (investment, government expenditure and export)

leakages (saving, net tax and import)
 It is through measure of GDP or GNP of a
country that economists can identify or know
whether a country’s economy is growing or
not.
 There are different approaches to the
national income accounting process, which is
the measure of Gross Domestic Product
(GDP).
 There are three major approaches/methods
of measuring GDP or GNP.

56
  The three measurements of GDP:
1. Output-based GDP is the sum of value added
(output less the cost of goods and services
purchased from other business) in different sectors.
2. Income-based GDP records the earnings
generated by the production of goods and services;
and
3. Expenditure-based GDP is equal to expenditure
on final goods and services produced.
 The three approaches will give the same GDP/GNP
figure because whatever produced (value added) in an
economy must be accrue to some economic agent as
some form of income and must disposed of in one way
or the other as expenditure.

57
 Total value added in a nation is the difference
between the market value of all products of
business firms and the market value of all
intermediate products.
 Value added is the increase in value that a firm
contributes to a product or service.
 To find the value added (net output) of a

particular business or industry, the costs of the

goods and services purchased from other
businesses and industries are deducted from the
value of the final product.
 GDP is obtained by adding the new values of

goods and services created at different stages

of process or in different sectors.
58
➢ Only the value added at each stage of process in different
sectors is recorded.

✓ Example: value added in five stage production process.

Stage of production Sales value of Value added
materials or products
Firm A, sheep ranch 120 120 (=120-0)
Firm B, wool processor 180 60(=180-120)
Firm C, suit manufacturer 220 40(=220-180)
Firm D, clothing wholesaler 270 50(=270-220)
Firm F, retail clothier 350 80(=350-270)
Total sales values 1140
Value added (Total 350
income)
59
 The double arrow shows that either final value of
the product or the total value added can be used
to calculate the GDP or GNP of a nation since the
result is identical.
 On the other hand, GDP/GNP is calculated by
adding up all value added at each sector of the
economy; increase in the market value, or a
product that takes place at each stage of the
production process.
 It would be difficult to record everything at
every stage in this approach and this may result
in double counting.

60
 Example: Economic Sector based on Aggregation of GNP/GDP

No Economic sector Value in million

1 Agriculture 1670
2 Industry (manufacturing) 1430
3 Mining 890
4 Construction 350
5 Transport and services 435
6 Whole sale trade 80
7 Other services 10.10
8 Government enterprises 500
9 Others 98
GDP/GNP 5463.10

61
 To determine GDP through expenditure approach, we
add up all types of spending on finished or final goods
and services.
 National expenditure is the sum of all the spending on
the final goods and services produced during the year.
 It is categorized into four sectors such as households,
business (firms), all levels of governments, and
foreigners (rest of the world).
 Thus, the national income identity is given as follows:
➢ GDP = Y= C + I + G + X – M = C + I + G + NX
✓ Where; GDP = Y = Gross domestic income/product
✓ C = Personal consumption expenditures
✓ I = Gross private domestic investment expenditures
✓G =Government expenditure (on defense,
infrastructures, etc.)
✓ NX = net export (export (X) minus import (M)) = X – M

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 In expenditure approach, the total output of a country,
gross domestic product (GDP), is measured as the sum
of expenditures made in all sectors of the country.
i. Personal consumption expenditure (C):
❑ Accounts for the largest portion of GDP.
❑ It consists of the goods and services bought by
households.
❑ It is divided into three subcategories: nondurable
goods, durable goods, and services.
❑ Non-durable goods are goods that last only a short
time, such as food and clothing.
❑ Durable goods are goods that last a long time, such
as cars and TVs.
❑ Services include the work done for consumers by
individuals and firms, such as haircuts and doctor
visits.
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 ii.
Gross domestic investment (I):
 This refers to all investment spending by
business firms:-
a) All final purchases of machinery, equipment and
tools by business enterprise.
b) All construction (building a new factory, warehouse)
c) Changes in business inventories

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 iii. Governments spending (purchases) on goods
and services (G):
 Include all governmental spending on finished products of
businesses and all direct purchases of resources.
 It excludes all government transfer payments, because such
outlays do not reflect current production.
 Transfer payments are payments to recipients who have not
supplied current goods or services in exchange for these
payments
 IV. Net export (NX):
 Are the value of goods and services exported to other
countries minus the value of goods and services that
foreigners provide us.
 Exports (X) represents foreign expenditure on our goods
and services which should be added on our national
income.
 While imports (M) represent our expenses on foreign
goods and services which overstate our output to be
deducted from the national income.
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 Example: Given the following summarized
information,
Components Value (in Billion Birr)
Personal consumption expenditure 11.4
(C)
Gross domestic investment (I) 6.5
Government expenditure (G) 7.3
Exports (X) 9
Imports (M) (1.1)
Total Expenditure (GDP) 33.1
 We can do it by adding the components as follows,

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 It measures the level of GDP in terms of income
earned, it is the sum of all of incomes of all factors
of production that contribute to production
process.
 In this case the national income is the sum of all
incomes of all factors of production, those
producing intermediate goods as well as those
producing final goods by excluding transfer
payments.
 National income is the total income earned by
citizens and businesses in a country in one year.
 It consists of employee compensation, rent,
interest, and profits.

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 Thus, the national income identity is given by the
following relation (components of national income).
▪ GDP = W + R + I + Π + IT – D
Where,
✓ GNP = = Gross national product,
✓ W = Wages of all workers (compensations of
employees)
✓ R = Rents paid to property owners (reward for
services),
✓ I= Interest on borrowed capitals
✓ Π = Profit of business organizations,
✓ IT = Indirect business taxes
✓ D = Depreciation (Capital consumption allowance)
should be deducted only if we intend to get NDP/NNP.

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 Limitation of GDP/GNP as a measure of National Income
 It only measures the material welfare being of the society.
Real GDP/GNP is not an accurate measure of economic
welfare because it undervalues quality improvements,
which leads to over-adjustment of inflation.
 Omits some household production and underground
/illegal/informal economic activity.
 Ignores indicators of economic welfare such as health and
life expectancy, leisure time, environmental quality and
political freedom as well as social justice.
 Income distribution is not known from the figure of GDP or
GNP.
 what is not considered in GDP
 Intermediate goods that have been turned into final goods
and services
 Used goods
 Transfer payments
 Non-market activities
 Illegal goods

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  Nominal GDP/GNP: is the value of all final goods and service
valued at current year price.
 Real GDP/GNP: is the value of all final goods and services valued
at base year price (constant price).`We use a base year price to
remove the effect of change in price and to see the real change.
 Example: Country X produces two product namely A and B in 2006 and 2008 as
follows.

GDP2008 − GDP2006 5400 − 3500

Nominal economic growth rate = = = 0.543 = 54.3%
GDP2006 3500
Real GDP2008 − GDP2006 3700 − 3500
Real economic growth rate = * 100% = * 100% = 5.71%
GDP2006 3500

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 Economic growth is the growth rate of the real GDP.
 It can also define as it is the expansion of the economy’s
production.
 It can be pictured as an outward shift of production
possibility curve/possibilities (PPC).
 Economic growth is defined as an increase in real GDP, and the
annual rate of economic growth is the annual percentage
change in real GDP.
 This is the first key indicator of economic performance since it
is adjusted for changes in prices.
 The rate of growth in real GDP is calculated as follows:

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 Example:
 In the year 2016, real GDP of Ethiopia measured
in US dollars was $1,781 billion.
 One year earlier, in 2015, real GDP in US dollars
was $1,751 billion. Using these data

 The price level in the economy is a measure of

the weighted average of prices of a wide variety
of goods and services.

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 GDP per capita: GDP divided by the population; often
used as a measure of standard of living.
 Standard of Living: all elements that affect people’s
happiness, whether these elements are obtained
through market transactions or not
 When economists talk about the standard of
living, they are referring to the average quantity
(and quality) of goods and services that people in
a country can afford to consume.
 Since real GDP measures the quantity of goods
and services produced, it is common to
use GDP per capita, that is real GDP divided by
population, as a measure of economic welfare or
standard of living in a nation.
GDP
GDP per capita =
Population
 Inflation rate:- the percentage increase in the
overall level of prices.
 One measure of the overall price level is GDP

Deflator.
 GDP Deflator is the ratio of nominal GDP to

Real GDP.

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 This simply means that to get the most appropriate
measure of national economic performances,
nominal GDP (NGDP) should be adjusted to the real
GDP (RGDP).
 This can be done by deflating NGDP when price is
rising and by inflating it when price is falling.
 The adjustment factor is known as GDP deflator.
 Thus, GDP deflator is the ratio of nominal GDP to
real GDP and
 The GDP deflator is an index measure of change in
the general price level.

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 Example: Calculating Nominal GDP, Real GDP, the
GDP Deflator ,and inflation rate in the following
table.
Year Unit of goods Price Nominal GDP Real GDP GDP deflator =
and services level (NGDP) (RGDP) (NGDP/
(in millions) (in million (in RGDP)*100
Birr) million
Birr)
2000 10 2 20 20 1 = 100
2001 12 3 36 24 1.5 = 150
2002 15 4 60 30 2 = 200
2003 15 6 90 30 3 = 300
2004 20 7 140 40 3.5 = 350

 From the table we can understand that in the year

selected as base year both nominal GDP and real
GDP are equal.

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 The Consumer Price Index (CPI) is an instrument
to measure inflation.
 It compares the cost of a fixed basket of goods
and services bought by the typical household at a
the current time with the cost of that same
basket of goods and services in the base year
price.

 The table below gives us the cost of weekly

expenditures on a basket of five items and the
weight of each item in the total expenditure.

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 Example:- Suppose a survey of expenditures by university
students in the year 2006 gives the information reported in
the first three columns in the following table:

❖ Now let we see in the last two columns of the table that the
same basket of goods and services in the prices of 2011 would
cost $87.20.

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 Then our SPI in 2011 would be: (Cost of basket in
2011)/(Cost of basket in 2006) ×100
= ($87.20)/($80.50) ×100
= 108.3
 The index tells us that even though the prices of some
things went up and others went down the Student
Price Index increased by 8.3%.
 The inflation rate is calculated using the same method
used for calculating the growth rate in real GDP.
 For example: Given CPI values for 2015 = 126.8 and for
2016 CPI = 128.7, then:

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END OF CHAPTER TWO

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