CHAPTER-1

INTRODUCTION

1.1. Concepts of Economics and Elements in Macroeconomics

1.1.1. Overview:

Before coming to the specific points of macroeconomics it is better to understand and start with the
general concept and definition of the word ‘economics’ itself first. It is a fact that, we can’t have
everything we want - because our wants exceed the means (resources)-which helps us to have everything
we want. For e.g. we only have 24 hours in a day-but we might have a lot of different works to do with in
a day. This simply tells us we have to make choices – with regard to what, how much and for what
purpose (prioritizing) to do each activities within a day. You can take a similar case that a farmer has a
hectare of land faces a number of decisions/choices to make; for instance the type of crop to be grown….?
The problem here is how to satisfy multifarious wants with in scarce/limited means - the background here
is that wants are unlimited and the means to satisfy them are limited/scarce. Therefore, we need best
method/s to solve or answer the above questions – this is the fact where the foundation for the field of
economics lays.

Economics, literally, is a science which studies human behavior as a relationship between ends and scarce
means which have alternative uses. In its broad sense it can be defined as: the study of how society
allocates their scarce/limited resources to satisfy their nearly unlimited wants – in the production,
consumption and distribution of goods and services. Economics can also be defined as the study of how
individuals manage its scarce resources. It is a science that studies human behavior in making rational
decisions – i.e. on how to use scarce resources that have alternative uses. Therefore, economics is all
about the science of making rational choice, among alternative uses to be made. Economics thus helps us
to understand human behavior and make scientific/rational decision (both quantitative and qualitative) in
production, consumption and distribution of products (goods and services), using its principles in solving
real world problem. The objective is to attain the greatest satisfaction or the maximum social welfare.

Nowadays several branches of economics are existed; among these Environmental economics, Land
economics, Development economics, Resource economics, Agricultural economics, Industrial economics,
Urban and/or Rural economics, Monetary economics, Trade economics, Defense economics, Health
economics, Energy economics etc. are worthwhile mentioned.

Despite all the above-mentioned areas, nearly all economic issues (field of economics) fall into two
categories; Microeconomics and Macroeconomics.

Microeconomics (Theory of price): It is the study of the individual units that make up the economy.
Microeconomics involves in the study of issues that do not encompass the entire economy and are in the
sense “small”; it examines the economic behavior of individuals or of relatively small groups of them
operating in a specific/single market. It focuses on the analysis of choices made by individual decision
making units in the economy, typically consumers and firms/industries - and the impacts those choices
have on individual markets. I.e. it studies how those individual parts of the economy make economic
decision and how the interactions/interrelationships among these units determine the pattern of

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production, consumption and distribution of goods and services in a specific market. It studies how the
interaction between demand and supply determine the price of a particular product and/or resource in a
specific market. For instance, microeconomics might study how the interaction between demand and
supply determine the price of a particular product and/or resource in a specific market; the reason why the
price of coffee increases or decreases in a specific market place; the effects of rent control on housing in
Addis Ababa city; the impact of foreign competition on the Ethiopian growing auto industry etc. Thus,
microeconomics deals with individual quantities such as: output level of firms/industries, income level of
households/families, employment level in an industry, the price level of particular goods/services, etc.

Macroeconomics (Theory of income and employment), on the other hand, focuses on the impact of
choices on the total or aggregate level of economic activity as a whole. It is the study of the overall
aspects and workings of an economy as a whole, such as, the overall level of national output, employment
level, level of prices (inflation) and productivity of the economy. It is concerned with economic
aggregates (grand totals). Macroeconomics is the study of issues that are economy-wide or “large” and it
is concerned with the combined aggregate effects of millions of individual choices on such variables
(national output, the overall level of employment, the general level of prices etc.). It focuses on the
analysis of economic aggregates (grand totals) and averages pertaining to the entire economy: such as the
gross domestic product (GDP), the overall/average level of prices of goods and services, total
employment level, aggregate demand, aggregate supply, etc. These are the issues that macroeconomics
address and because these aggregates are large in relation to the national economy, a change in one macro
variable tend to affect all other variables. Through the tools of macroeconomics such as the national
income and output account the general level of the economic activity (output growth rate, rate of
inflation, unemployment rate etc.) can be measured and regulated. As a result, macroeconomists attempt
both to explain economic events and at the same time devise policies to improve economic performance:
for instance, Is the total level of economic activity (output) rising or falling? Is the rate of inflation
increasing or decreasing? What is happening to the unemployment rate? What are the effects of
borrowing by the federal government? and the alternative policies to raise growth in national living
standards etc.

However, Microeconomics and macroeconomics are closely intertwined. Because changes in the overall
economy arise from the decisions of millions of individuals, it is impossible to understand
macroeconomic developments without considering the associated microeconomic decisions. For example,
a macroeconomist might study the effect of a federal income tax cut on the overall production of goods
and services. But to analyze this issue, he or she must consider how the tax cut affects the decisions of
households about how much to spend on goods and services. Therefore a complete understanding of
economic science requires the study of both micro and macro-economics.

1.1.2. Key Elements in Macroeconomics

As discussed above, macroeconomics looks to the nation's total economic activity to determine economic
policy and promote economic progress in general. It also helps to understand the functioning of a
complicated economic system in the world as it also studies the functioning of global economy.

 Major Macroeconomics Variables/Issues

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In general the following variables are the macroeconomic variables on which the macro economic
analysis is based on most of the time.

Real Gross Domestic Product (RGDP): it measures the total income of everyone in the economy
(adjusted for the level of prices).

The Unemployment rate: it measures the fraction of the labor force that is out of work.

The inflation rate: it shows how fast prices are rising and measures a general rise in prices throughout the
economy.

The interest rate: it shows the real long term interest rate in the principal determinant of the level of
investment and future production growth.

The exchange rate (and hence balance of payment): Exchange rate determines the relative price of
foreign made goods in-terms of home-produced goods. Economists work with an
index of the value of the dollar against other currencies.

Stock market: it summarized in to one single index, has a large number of influences on investment, and
includes investors’ optimism, expected future profit and the real interest rate.

 Major objectives of macroeconomics

From the above four issues we can also identify the four major macroeconomic policy objectives that
governments typically pursue:

Full employment: the main objective of the government economic policy is maintaining the demand for
labor at high level so that there is full employment of the labor force. His doesn’t mean that everyone
willing to work will always be in employment. There are serious imperfections in the labor market owing
to the mobility of labor. As a result large number of people to be out of work even when there are many
vacancies.
High and stable economic growth (output): Governments try to achieve high rates of economic growth
over the long term: in other words, growth that is sustained over the years and is not just a temporary
phenomenon.

Low inflation: Government policy here is to keep inflation both low and stable. One of the most
important reasons for this is that it will aid the process of economic decision making. For example,
businesses will be able to set prices and wage rates, and make investment decisions with far more
confidence

Satisfactory balance of payments equilibrium: it mostly depends on the county’s foreign currency
reserve and the situation of import and export.

Redistribution of income and wealth: general dissatisfaction with extremely unequal distribution of
income and wealth brought by the uncontrolled operation of market forces has obliged governments to
adopt policies designed to reduce these inequalities.

 The instruments of Government Economic Policy

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In order to carry out economic policies, states may intervene in the operation of the economy in three
main ways

Fiscal Policy: this is a deliberate manipulation of government income and expenditure with a view to
influencing income, output, employment and price. For instance, during inflationary situation (where total
demand exceeds total supply) at current price, government mar reduce its spending and increase the rate
of taxation on income and expenditure.

Monetary policy: the government able to control the total money supply through central banks (National
Bank of Ethiopia in our case).

Direct control: state has a power to institute a vast range of physical controls on the economic system.
For instance it has a political power to bring the means of production (land and capital) in to public
ownership and to decide the volume of and pattern of production.

 The incompatibility of Objectives (Macroeconomic Paradoxes)

The conduct of economic policy is a most difficult task because, so often, the principal objectives of that
policy are mutually incompatible.

1. In macroeconomic variables aggregates are regarded as homogeneous whole despite internal

heterogeneity. e.g. Inflation: It shows the increase in the general price level. But there may be some
products with low price.
2. Macroeconomic behavior involves fallacy of aggregation. What is true for an individual may not be
necessarily true for the entire economy when taken as a whole. e.g. Saving
3. Macroeconomics is concerned with general economic welfare. General welfare disregards individual
welfare. E.g. Increase in the national income does not necessarily imply improvement in welfare of
particular individual.

1.2. Macroeconomics School of Thought

In order to better understand current controversies within macroeconomics it is necessary to trace their
origin back to the ‘Classics versus Keynes’ debate which began in the 1930’s and has continued in
various forms ever since. For example, during the 1980’s the two schools of thought at the centre of the
mainstream debate were represented by the New classical ‘(real) equilibrium business cycle theorists’ and
the ‘New Keynesian school’. The former carry on the tradition of the classical economists and emphasize
the optimizing power of economic agents acting within a framework of free market forces. The latter
believes that understanding economic fluctuations requires not just studying the intricacies of general
equilibrium, but also appreciating the possibility of market failure on a grand scale (Mankiw, 1989).

1.1.1. Classical and Neoclassical School of Thought

1.1.1.1. Classical (from 18th up to 19th century)

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The Classical school, which is regarded as the first school of economic thought and it is primarily
associated with the 18th Century Scottish economist Adam Smith (1723-1790), who is credited as being
the virtual founder of this thought and the other contemporary British economists, such as Tomas Robert
Malthus, David Ricardo and John Stuart Mill also followed this thought. The School was grand in its aims
i.e. in providing theories of value, growth, distribution, international trade, public finance and money.
Classical economists hold that prices, wages and interest rates are flexible and markets always clear. The
main idea of the Classical school was that markets work best when they are left alone, and that there is
nothing but the smallest role for government. The main role for the government was to provide ‘sound
finance’ (i.e. not to print too much money), so as to maintain stable prices. Markets should be left to work
because the price mechanism acts as a powerful 'invisible hand' to allocate resources to where they are
best employed. The approach is firmly one of laissez-faire and a strong belief in the efficiency of free
markets to generate economic development.
The free-market economy works to equate demand and supply in all markets. This element of classical
theory assumes flexible prices (of goods and services), flexible wage rates (of labor) and flexible rate of
interest (of money). The classical economists also argued that flexible prices would ensure that saving
equaled investment and that imports equaled exports. Through price flexibility an economy will always
reach full employment equilibrium in the long run.

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/ or every market equilibrium determines the relative price of the good in that
market. Therefore, it is the supply side that drives the economy ‘supply creates its own demand’ and it
will always be at equilibrium and a full employment. Temporary outside forces causes fluctuations in
output, once they are back to normal the economy will be at full employment. It is widely recognized that
the Classical period lasted until 1870.

1.1.1.2. Neoclassical (1870-1930’s)

The method of Neoclassical is clearly scientific, with assumptions, hypotheses and attempts to derive
general rules or principles about the behavior of firms and consumers. Neoclassical economics assumes
that people have rational expectations and strive to maximize their utility. This school presumes that
people act independently on the basis of all the information they can attain. The idea of marginalizm and
maximizing marginal utility is attributed to the neoclassical school, as well as the notion that economic
agents act on the basis of rational expectations. Since neoclassical economists believe the market is
always in equilibrium, macroeconomics focuses on the growth of supply factors and the influence of
money supply on price levels. Neoclassical economics is associated with the work of William Jevons,
Carl Menger and Leon Walras.

Neoclassical economics are based on three (3) assumptions: People (economic agents) are rational in
their behavior i.e. they have rational preferences among outcomes that can be identified and associated
with a value; and that individuals (consumers) look to maximize utility and firms look to maximize
profits; People act independently on the basis of full and relevant information. The contrasting objectives
of maximizing utility and profits therefore, form the basis of demand and supply theory. This approach

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focuses on the determination of prices, outputs and distributions through supply and demand. The most
important thing that neoclassical economics has contributed to economics is micro-foundations and
marginal values, such as marginal cost and marginal utility.

Difference between Classical and Neoclassical school of thought

Classical and neoclassical are the names for two philosophical approaches to economics. As the names
suggest, classical economics was a predecessor of neoclassical economics. The differences between the
two, however, aren't merely a matter of one coming before the other. Each had distinctive approach to
analyzing the economy.
a. Attitude of Analysis: Classical economics focuses on what makes an economy expand and contract.
As such, the classical school emphasizes production of goods and services as the key focus of
economic analysis. Neoclassical economics focuses on how individuals operate within an economy.
As such, the neoclassical school emphasizes the exchange of goods and services as the key focus of
economic analysis.
b. Methods of Analysis: Because the classical school aims at explaining how economic systems grow
and contract, economists from this school take a holistic view of such systems. All their analyses and
predictions are based on this wide perspective on the economy as a whole system. The neoclassical
school, on the other hand, explains the behaviors of individual people or companies within a whole
system. The neoclassical method takes a focused view of one small part of an entire system.
c. Value in Analysis: Because classical economics focuses so heavily on economic systems and on the
production of those systems, the school emphasizes the inherent value of goods and services. These
goods and services are thought to be worth something regardless of who produces them and who uses
them. Neoclassical economics, with its focus on individuals within systems, emphasizes the variable
value of goods and services. These goods and services are only thought to be worth something
depending upon who produces them, who uses them and how they are used. But both the classical–
neoclassical view focuses on the efficiency of the price mechanism in solving the fundamental
allocation and production problems which arise from the scarcity of resources. Thus this was
Keynes’s iconoclastic vision which highlights the shortcomings of the invisible hand, at least with
respect to the general level of output and employment.

1.1.2.Keynesian’s School of Thought (1930’s -1970’s)

The inability of the classical school/model (which assumes that factor and product prices are completely
flexible so that there are no rigidities which prevent market clearing and such an economy will have full
employment of its resources when it is in equilibrium) to account adequately for the collapse of output
and employment in the 1930s (i.e. during the Great Depression) paved the way for the Keynesian
revolution. The theories forming the basis of Keynesian economics were first presented by the British
economist John Maynard Keynes in his book, The General Theory of Employment, Interest and Money,
published in 1936, during the Great Depression. Keynesian economists broadly follow the main
macroeconomic ideas of Keynes; Keynesian economics is not actually by Keynes, but by economists like
Okun, Samuelson, and many others. Keynes contrasted his approach to the aggregate supply-focused by
classical economics. Keynes is widely regarded as the most important economist of the 20 th Century,

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despite falling out of favor during the 1970s, following the rise of monetarist and new classical
economics. Keynesian economists are skeptical that, if left alone, free markets will inevitably move
towards full employment equilibrium. The Keynesian approach is interventionist i.e. government
intervention in the market/economy, coming from a belief that the self interest which governs micro-
economic behavior does not always lead to long run macro-economic development or short run macro-
economic stability.

Keynesian economics is essentially a theory of aggregate demand, and how best to manipulate it through
macro-economic policy. Keynesians economists focus on aggregate demand which can be defined as the
total amount of goods and services demanded in an economy in a given time and price level, as the
principal factor in issues like unemployment and the business cycle, i.e. in the short run, especially during
recessions, economic output is strongly influenced by aggregate demand (total spending in the economy).
In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the
economy; instead, it is influenced by a host of factors and sometimes behaves erratically, affecting
production, employment, and price level (inflation).

Therefore, it is the demand that drives the economy, and problems in the economy stem directly from
changes in Aggregate Demand. They believe that the business cycle can be managed by active
government intervention through fiscal policy (spending more in recessions to stimulate demand) and
monetary policy (stimulating demand with lower rates). Since the government is the largest force that can
control demand, it must intervene to correct fluctuations in demand. This theory is basically faced on the
fact of the economy and how it affects output and inflation and the total spending in the economy. In a
broad sense, Keynesian economics is the foundation of modern macroeconomics. In a narrower sense,
Keynesian refers to economists who advocate active government intervention in the economy.

1.1.3.New Classical and New Keynesian’s School of thought

1.1.3.1. New Classical
During the late 1960’s and early 1970’s 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 policies. In particular during
the ‘Great Inflation’ which was a period of stagflation (a period of inflation and stagnant economic
growth) 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. Among those groups of economists at that time the most influential ones – the new
classical economists – provided a much more damaging critique of Keynesian economics, their main

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argument against the Keynesians was that they had failed to explore the full implications of endogenously
formed expectations on the behavior of economic agents.

The New classical economists, a modern USA and British school of economics, which combines the use
of the rational expectations hypothesis with monetarism (Monetarism is one of the economic school of
thought emerged in early 1970’s, and it is most widely associated with Milton Freidman and supports
primarily a free market economy with little government intervention save for, as the name would imply,
monetary policy, (money supply), the concern of the monetarists is that as productivity increases, without
an increase in the money supply prices will fall) and a laissez-faire approach to economic policy.

As the label infers, the new classical school has sought to restore classical modes of equilibrium analysis
by assuming continuous market clearing within a framework of competitive markets. All markets are
assumed to be perfectly competitive in their behavior and all unemployment is voluntary because it arises
only when employers and employees make mistakes. Central to this technically sophisticated theory is the
belief that markets clear. New classical macroeconomics school of thought was first brought forth by
Chicago economist Robert Lucas and his followers Sargant from USA; and Patrick Minford and Michael
Beenstock from UK are the principal proponents of these views. The new classical combined a unique
market-clearing equilibrium (at full employment) with rational expectations. The new classical school in
particular supports the view that the authorities cannot, and therefore should not; attempt to stabilize
fluctuations in output and employment through the use of activist demand management policies.

Specifically the new classical school is built largely on the neoclassical school of thought. It attempt to
explain macro economic problems and issues using micro-economic concepts like rational behavior and
rational expectations. It emphasizes the importance of microeconomics and models based on that
behavior. The new classical assumed that price and wage adjustment would automatically attain full
employment in the short run. They also believe that the markets are highly competitive and clears at all
times very rapidly. The assumption of market clearing, which implies perfectly and instantaneously
flexible prices, represents the most controversial aspect of new classical theorizing. Thus, to new classical
theorists, the ultimate macroeconomics is a fully specified general equilibrium microeconomics.

New classicists maintain that markets clear very quickly and expectations adjust virtually instantaneously
to new situations. These expectations are based on firms’ and workers’ rational assessment of what is
happening in the economy and in their particular sector of it. They also believe that unemployment is
largely voluntary and that discretionary fiscal policy is destabilizing, while inflation can be controlled
with monetary policy. The new classical theory focuses on low taxes and less regulation in order to
stimulate the supply side of the economy. Though it remained influential in the 1980s, the new classical

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equilibrium approach to explaining economic fluctuations has in turn been challenged by a revitalized
group of new Keynesian theorists who prefer to adapt micro to macro theory rather than accept the new
classical approach of adapting macro theory to neoclassical market-clearing micro foundations.

1.1.3.2. New Keynesian

The new classical group remains highly influential in today’s macroeconomics. But new generations 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 Akerl of and Janet Yellen and David Romer of the
University of California. Berkely, Oliver Blanchard of MIT, Greg Mankiw and Lary 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 fail. New Keynesian economics strives to provide
microeconomic foundations for Keynesian economics, i.e. microeconomic ingredients that could produce
Keynesian macroeconomic effects. It developed partly as a response to criticisms of Keynesian
macroeconomics by adherents of new classical macroeconomics. The development of new keynesian
theory incorporated and allowed an analysis of aggregate demand within a micro founded framework, and
which integrated ideas like rational expectations and the assumption that markets may fail to clear, due to
wage and price stickiness into Keynesian analysis.

According to proponents of new Keynesian economics there is a need for stabilization policy as capitalist
economies are subjected to both demand- and supply-side shocks which cause inefficient fluctuations in
output and employment. New Keynesian analysis usually assumes a variety of market failures. In
particular, imperfect competition in price and wage setting to help explain why prices and wages can
become "sticky", which means they do not adjust instantaneously to changes in economic conditions.
Wage and price stickiness, and the other market failures, imply that the economy may fail to attain full
employment – which can be achieved only in the long run, since prices are "sticky" or ‘unresponsive’ in
the short run. Government and central-bank policies are needed because the "long run" may be very long.
Therefore, New Keynesians argue that macroeconomic stabilization by the government (using fiscal
policy) or by the central bank (using monetary policy) can lead to a more efficient macroeconomic
outcome than a laissez faire policy would. New Keynesian economics has sought to base Keynes's ideas
on more rigorous theoretical foundations. There was a lack of consensus among macroeconomists in the
1980s. However, the advent of New Keynesian economics in the 1990s modified and provided
microeconomic foundations of Keynesian theories. These modified models now dominate the main
streams of macroeconomic thinking. Significant early contributions to New Keynesian theory were
compiled in 1991 by N. Gregory Mankiw and David Romer.

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Section summary:
From the above discussion we can easily observe that there have long been
two main intellectual traditions in macroeconomics. One school of thought
believes that markets work best if left to themselves i.e. who advocate
almost complete laissez-faire. The other believes that government
intervention can significantly improve the operation of the economy i.e. they
advocate the virtual abandonment of markets. In between comes a whole
spectrum of opinions and theories about the relative effectiveness of
markets and the government in achieving the various macroeconomic goals.
In the 1960s, the debate on these questions involved monetarists, led by
Milton Friedman on one side, and Keynesians, including Franco Modigliani
and James Tobin, on the other. In the 1970s, the debate on much the same
issues brought to the fore a new group the new classical macroeconomists,
who by and large replaced the monetarists in keeping up the argument
against using active government policies to try to improve economic
performance. On the other side are third- generation Keynesians; they may
not share many of the detailed beliefs Keynesians three or four decades ago,
except the belief that government policy can help the economy perform
better.

To wind out the discussion on schools of macroeconomics let’s say some

words on the controversies which are existing among contemporary
economists. There is no denying that there are conflicts/ disagreements of
opinion and even theory between different camps. And because
macroeconomics is about the real world, the differences that exist are sure
to be highlighted in political and other discussions of economic policy.
Despite these disagreements, for instance, most economists would agree on
the following points: changes in aggregate demand have a direct effect on
output and employment in the short run, but either no effect or a far less
certain effect in the long run; there is no simple long-run trade-off between
inflation and unemployment; expectations have an important effect on the
economy; excessive growth in the money supply causes inflation; it is easier
to achieve inflation targets by controlling interest rates than by controlling
money supply; changes on the supply side of the economy are the major
determinant of long-term growth; globalization reduces individual countries’
ability to control their economies. In general in the main streams of
macroeconomic thinking there are conflicts of opinion as there are significant
areas of agreement.

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