Macroeconomics Lecture Note for Accounting dep’t 2nd year students (R- 2019)

Chapter 3: Macroeconomic Problems and Policies Instruments

Macroeconomic Problems: Macroeconomic problems will occur if the macroeconomic goals of the
economy are not achieved. Here are some of the common macroeconomic problems are
 Business Cycle fluctuation ,
 Unemployment and
 Inflation
3.1.The Business Cycle
The Business Cycle: The business cycle is the term used to describe the fluctuations in aggregate
production as measured by the ups and downs of the real GNP. The business cycle is characterized by
peaks & troughs and periods of contraction & expansion. This illustrate in the figure below

Peak

Peak

Trough
Contraction or
Recession Recovery

Figure 1.1.The Business Cycle

Peak: the peak is highest level of real GNP in the business cycle. A peak is a point which marks the end
of economic expansion (rising aggregate output) and the beginning of a recession (decline in economic
activity). Each peak indicates an economy operating at close to full capacity so that national product &
national income correspond to a very high degree of utilization of labor, factories & offices.
Contraction or Recession: A contraction is downward from peak economic activity during which real
GNP declines from the previous values. During contraction, real GNP falls and therefore earnings also
decline.
Trough: a trough is the lowest level of real GNP observed over the business cycle. A trough marks the
end of a recession and the beginning of economic recovery. During this time, there is an excessive
amount of unemployment & idle productive capacity. Businesses are more likely to fail because of low
demand for their products.
Expansion or Recovery: an expansion is an upturn of economic activity between a trough and a peak
during which real GNP increases.
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 Macroeconomics Lecture Note for Accounting dep’t 2nd year students (R- 2019)

Deviations of output from trend are referred to as the output gap. The output gap measures the gap
between actual output and the output the economy could produce at full employment given the existing
resources. Full employment output is also called potential output or trend output (we use these terms
interchangeably).
Output gap =actual output -potential output

These determinants of macro performance are

• Internal market forces: population growth, spending behaviour, invention and innovation,
and the like.
• External shocks: wars, natural disasters, terrorist attacks, trade disruptions, and so on.
• Policy levers: tax policy, government spending, changes in the availability of money and
regulation.
3.2.Unemployment

Unemployment: refers to the situation where workers of the working age could not get job while they are
ability and willing or actively looking for work to work at prevailing market wage rate in a given periods
of time.
3.2.1. Measures, Causes and Types of Unemployment
Measuring Unemployment: The problem of unemployment and its intensity is usually measured in
terms of unemployment rate. This is because talking about the actual number of unemployed people
makes no sense for countries of different population size.
Unemployment rate: is defined as the percentage or the proportion of the labour force that is
unemployment or has no job while they are ready to work at prevailing wage rate.
Labor force (L) is the sum of both employed (E) and unemployed people of working age and working
(E) or ready to work (U).
L = E + U ------------------------------------------------------------------(3.1)
Then, unemployment rate (R) is calculated as follows;

 Number of Unemployed 
  X (100)
 Labour Force 
Unemployment Rate (UR) =

U 
  X (100)                  (3.2)
(R) =  L 

Numberofemployedperson
Employment rate (ER) =
Labourforce
 Labour Force 
Labour Force Participat ion Rate    X (100)
 Adult Population 

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Labor force participation not counted: Those people retired and choose to stay at home, full-time
students, people do not want to work, unable to work, discouraged work: A person who has dropped out
of the labor force because of lack of success in finding a job.
Types of Unemployment
Depending on the causes or sources of the unemployment and the duration of the unemployment, we can
divide unemployment into different categories. In this respect, economists divided unemployment into
four major categories. These are:
i. Frictional unemployment
ii. Structural unemployment
iii. Cyclical unemployment and/or
iv. Seasonal unemployment
i. Frictional unemployment
Frictional unemployment is a type of unemployment usually caused by constant changes in the labour
market. The basic cause of frictional employment is thus:
a. Lack of labor market information: lack of information flow among workers and employers called
imperfect information. The first reason is when employers are not aware of the available workers and
their job qualifications.
Example: New graduating students from colleges and universities or training institutions are usually
frictionally unemployed. This is the period when such people look for vacancies and apply to different
offices getting interviewed and so on.
Note: There will always be some frictional unemployment in an economy because information isn’t
perfect and it takes time to find work.
One of the policy options to solve such unemployment is improving labor market information (e.g.
establishment of information office about workers and vacancies).

ii. Structural Unemployment

Is unemployment due to mismatch between the type of jobs and the skill or location of job seekers. The
mismatch may be happen due to technological change or system change in the country.

Example: typing machines are replaced by computers. Advanced technology, such as computers
or robots, replaces worker tasks with machines. Most of the workers need retraining to obtain the
skills required to get a new job.

In addition structural unemployment arises due to real wage rigidity, the failure of wages to adjust to a
level at which labor supply equals labor demand. When the real wage exceeds the equilibrium level and
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 Macroeconomics Lecture Note for Accounting dep’t 2nd year students (R- 2019)

the supply of workers exceeds the demand, we might expect firms to lower the wages they pay. Three
causes of this wage rigidity: minimum-wage laws, the monopoly power of unions, and efficiency
wages/high wage.
iii. Cyclical Unemployment
Cyclical unemployment occurs due to general downturn in the business activities including production
and demand for the products and services. When the economy decreasing or stagnant and difficult to
absorb the newly emerged labor forces in the country cyclical unemployment will be occurs. Cyclical
unemployment is the result of insufficient aggregate demand or supply in the economy to generate
enough jobs for those seeking them. It occurs during cyclical contraction and stagnation of an economy
(recession).
Policy instrument: The policy instrument to solve this problem is fiscal policy (for instance increasing
government expenditure and reducing tax rates) and/or monetary policy (such as reducing interest rate
and increasing money supply).
iv. Seasonal Unemployment
Seasonal unemployment is the type of unemployment that arises from a decline in some economic
activity in some seasons (particular time in a year) and in some sectors. Therefore, seasonal
unemployment results from fluctuations in demand for labor in some sectors and/or seasons. This type of
unemployment results from seasonal fluctuations in demand.
Example: - Employment in ice factories is only for the summer season.
- Agricultural workers who remain employed during harvesting and sowing recourse remain idle to for
the rest of the year.
To demonstrate different degrees of unemployment used the term:
 disguised unemployment
 underemployment and
 Open unemployment
Disguised unemployment: is the case where the workers is employed but when evaluate their
contribution to the organization or GDP of the country it is insignificant. This type of unemployment
occurs when more labourers are tied up in different lines of production, mainly agriculture, than are
necessary for producing certain output. It is unemployment that does not affect aggregate output. An
economy demonstrates disguised unemployment when productivity is low and too many workers are
filling too few jobs.
 The case people are working full-time, yet have a low marginal product
Underemployment: refers to the people who work below their capacity. In certain circumstances, people
doing part-time work may qualify if they desire to obtain, and are capable of performing, full-time work.

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It also includes those accepting employment well behind their skill set. In these cases, disguised
unemployment may also be referred to as the underemployed, covering those who are working in some
capacity but not at their full capacity.
Open unemployment: represents the formal definition we have discussed above where the person has no
job at all while he/she is ready to work at the prevailing market wage rate.
3.2.2. Job Loss, Job Finding and the Natural Rate of Unemployment
Every day some workers lose or quit their jobs, and some unemployed workers are hired. This perpetual
ebb and flow determines the fraction of the labor force that is unemployed. In this section we develop a
model of labor-force dynamics that shows what determines the natural rate of unemployment.
Natural rate of unemployment is the average rate of unemployment around which an economy
fluctuates given by U/L = n at that point. It is related to the rate at which workers lose job (job loss rate)
and the rate at which jobless workers find or get job (job finding rate). It is a rate where there is no
cyclical unemployment or when all the unemployment is frictional and structural ones. Components of
the natural rate of unemployment are:
 Frictional Unemployment
 Structural Unemployment
 Surplus Unemployment: This is caused by minimum wage laws, unions and wage/price controls.
Even a healthy economy will have this level of unemployment because workers are always coming and
going, looking for better jobs. This jobless status, until they find that new job, is the natural rate of
unemployment.
 The Federal Reserve of USA estimates that natural rate of unemployment rate is between 4.7%
and 5.8%.
 Both fiscal and monetary policy use, that rate as the goal for full employment. At natural rate of
unemployment the target inflation rate is 2.0%. The ideal GDP growth rate is from 2% - 3%.
Note: Attempt to lower unemployment rate below natural rate of unemployment result in accelerating
inflation. The natural rate of unemployment depends on the rates of job separation and job finding.
Calculated by:
n = [s/(s + f)]
Where ‘f’ is rate of job finding
‘s’ is rate of job separation or loss
The policy implication of this is that any policy aimed at reducing the natural rate of unemployment
should either reduce the rate of job separation (losing job), or increase the rate of job finding (f).
Moreover, any policy that affects the rate of job separation (s) or job finding (f) also affects the natural

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rate of unemployment ‘n’. Generally, there is always some amount of unemployment and economists
very frequently use the term full employment.
Full employment occurs when the unemployment rate is equal to the natural rate of unemployment.
Note:the concept of full employment does not mean that all workers are employed.
Examples:
1) If 90% of labour forces of a given country with 10 million labour force populations are employed
on average, find the unemployment rate of the country.
2) If 3% of workers are on average leaving or losing their job and on average 40% of unemployed
workers and workers newly joining labour market are finding or getting job, then what is the
natural rate of unemployment?
3) In question number ‘1’ if the size of the adult population of the country is 12 million, what is the
labour force participation rate?
Solution :
1) L=E+U
L = 90%(L) + U
L – 0.9(L) = U
0.1L = U
U/L = 0.1 = 10%
2) Given: job separation rate (s) = 3% = 0.03
job finding rate (f) = 40% = 0.4
U/L = n = [s/(s + f)] proved above
= [0.03/(0.03 + 0.4)]
= 0.03/0.43
= 0.0698
n = 6.98%

 Labour Force 
Labour Force Participat ion Rate    X (100)
 Adult Population 
3)
= (10 million/ 12 million) X 100
= 83.33%
Causes of unemployment
 Lack of labour market information
 Sectoral shift result in demand for workers also shift and some workers have to leave some
sectors, and look for jobs and join some other sectors

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 Macroeconomics Lecture Note for Accounting dep’t 2nd year students (R- 2019)

 Structural changes in the economy related to skill, education level, geographical area,
technological change, age, etc
 Real wage rigidity: the failure of wages to adjust to a level at which labour supply equals labour
demand.
 General downturn/recession in the business activities including production and demand for the
products
 fluctuations in demand for labour in some seasons or sectors
 Voluntary unemployment: There are some people who are between jobs because of choices they
have made. They may have resigned from a job in anticipation of a move to another location
before they have another job lined up or be planning to return to school.
Effects/ consequences of unemployment: The effects of unemployment are wide-ranging and include:
High costs to the government: The government takes on higher costs since it has to provide security to
the unemployed, so when fewer people have jobs, the government has to pay more to support them.
Reduction in spending power for consumers: The spending power of both the unemployed and those
still working goes down, since those without jobs can't pay for goods while those who are employed face
increased taxes and economic uncertainty.
Economic recession: The combination of reduced work forces and reduced spending can lead to
recession. With the increase rates of unemployment other economy factors are significantly affected, such as: the
income per person, health costs, quality of health-care, standard of leaving and result in recession.
3.3. Inflation
A dollar today doesn’t buy as much as it did twenty years ago. The cost of almost everything may go up.
This increase in the overall level of prices is called inflation, and it is one of the primary concerns of
economists and policymakers.
Inflation: is defined as a sustainable or continuous increase in the general or average price level of goods
and service. Disinflation is a decrease in the rate of inflation. The slowing of the rate of inflation per unit
of time
Inflation rate: is defined as the rate at which general price level in a country increases. If the inflation
rate is very high, it is known as hyperinflation. There is no consensus on when a particular rate of
inflation becomes hyper but most of the economists would agree that inflation rate of about 100% per
year would be hyper.

Measuring Inflation
The most common and most well-known measure of inflation is the change in the consumer price index
(CPI) or inflation rate. The general price level is measured by means of price index. A price index

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 Macroeconomics Lecture Note for Accounting dep’t 2nd year students (R- 2019)

compares the cost of a given combination of goods and service for two or more different years. The first
step in constructing a price index is to select a group of goods and service known as “market basket”.

CPI: - the device used to estimate the percent change in the prices of a particular bundle of consumption
goods.
❑
CPI t =∑ ¿¿ )*100
❑

Where ’Qi,o’ represents the quantity of the ith good consumed in the base time period
’Pi,o’ represents the price of the ith good in the base time period, and
’Pi,t’represents the price of the same good in the current time period ’t’.
A measure of inflation is then developed by computing the percentage change in the CPI from one time
period to the next which measuring the cost of living of the society.
%Δ.CPI or R.I. = CPI in a given year – CPI in the base year X 100
CPI in the base year
Generally the relationship b/n inflation rate and CPI for different year given by:

inflation rate

consumer price index (CPI) of this year

consumer price index (CPI) of last year

Fisher Equation - Real Interest Rate

real interest rate
nominal interest rate
inflation rate
Where n= is nominal interest rate
r= real interest rate
i= inflation rate
Numerical example: Consider three goods consumed by consumer: 100 units of A, 100 units of Good B,
and 100 units of Good C. In the base year, Good A sold at a price of $1, Good B sold at a price of $1, and
Good C sold at a price of $1. In the current year, Good A sold at a price of $3, Good B sold at a price of
$5, and Good C sold at a price of $10. Using 2016 as the base year the CPI is = 300. Then determine
consumer Price Index (CPI) and rate of inflation for the current year
❑
Answer: Current yearCPI =CPI t =∑ ¿¿ )*100
❑

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 Macroeconomics Lecture Note for Accounting dep’t 2nd year students (R- 2019)

❑
CPI t =∑ ¿ ¿*100
❑

1800
CPI t = ∗100
300
Current yearCPI (CPIt )=600
Rate of inflation = CPI in a given year – CPI in the base year X 100
CPI in the base year
600−300
Rate of inflation = ∗100
300
300
Rate of inflation = ∗100
300
Rate of inflation = 100%

Real Income vs Consumer Price Index

Real income is a person’s nominal income (or money income) adjusted for any change in prices.
As real income measures the purchasing power of an individual's wages, analysts often compare it to the
Consumer Price Index (CPI). Real income is computed as follows:

Types and Causes of Inflation

a. Demand pull inflation: it is inflation resulting from an increase in aggregate demand for goods and
services while the economy is producing at or close to full employment. At full employment income
is rises, this result in AD>AS→shortage→P↑. Graphically

Demand pull inflation rises due to:

 Growing of aggregate demand at an unsustainable rate leading to increased pressure on scarce
resources and a positive output gap (i.e Actual output > potential output)

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 Macroeconomics Lecture Note for Accounting dep’t 2nd year students (R- 2019)

 Excess demand for products: at this time producers can raise their prices and achieve bigger profit
margins.
 Full employment of resources and aggregate supply is inelastic
 A depreciation of the exchange rate: increases the price of imports and reduces the foreign price of
a country's exports. If consumers buy fewer imports, while exports grow, AD in will rise and there
may be a multiplier effect on the level of demand and output
 Expansionary monetary or fiscal policy which results in increase in nominal money supply: This
enables people to hold excess cash balances.
b. Cost push or supply side inflation: occurs when firms respond to rising costs by increasing prices
in order to protect their profit margins or occur due to supply shocks.

Cost push or supply side inflation arises due to:

 Component costs: e.g. an increase in the prices of raw materials, labour cost and other components.
This might be because of a rise in commodity prices such as oil, copper and agricultural products
used in food processing.
 Expectations of inflation: are important in shaping what actually happens to inflation. When people
see prices are rising for everyday items they get concerned about the effects of inflation on their real
standard of living.
 Higher indirect taxes: for example a rise in the duty on alcohol, fuels and cigarettes, or a rise in
Value Added Tax. Depending on the price elasticity of demand and supply for their products,
suppliers may choose to pass on the burden of the tax onto consumers.
 A fall in the exchange rate: this can cause cost push inflation because it leads to an increase in the
prices of imported products such as essential raw materials, components and finished products
 Monopoly employers/profit-push inflation: where dominants firms in a market use their market
power (at whatever level of demand) to increase prices well above costs
c. Currency inflation: This type of inflation is caused by the printing of currency notes. Seigniorage: the
revenue from printing money results in hyperinflations. When the central bank prints money, the price level
rises. When it prints money rapidly enough, the result is hyperinflation.

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 Macroeconomics Lecture Note for Accounting dep’t 2nd year students (R- 2019)

Effects/ consequences of Inflation

Inflation affects different people differently. This is because when the value of money falls, some group
of the society gain, some lose and some stand in between. The reason is that the price movements in the
case of different goods and services are not the same.
1. Inflation, and consumer and producer: High living costs to consumer, higher wage rates and excess
nominal money supply over the real products. Shortage of goods and services supplied by producer due to
high cost of production.
2. Inflation and people who hold money: During inflation, the purchasing power of money declines.
Therefore, people who hold money /their asset in a liquid form will face a decrease in the purchasing
power of their money during the period of inflation.
3. Inflation and savers: Inflation may also decrease the value of money set. To offset inflation effects,
interest rates are adjusted for the expected rate of inflation so that the actual interest rate paid (the
nominal interest rate) equal to the real interest plus expected inflation rate.
4. Inflation, and lenders and borrowers: During inflation, borrowers will gain purchasing power at the
expense of lenders since they will be paying back the loan with money that is worthless than the money
they borrowed.
5. Inflation and international competitiveness: Due to inflation in one country, that country will be less
competitive than the other country. Compared to foreign currencies the value of domestic currency
becomes very low and becomes subject to be changed to smaller amount of foreign currency. Thus, when
one purchases smaller amount of foreign commodity or imports becomes expensive.
Benefit of Moderate Inflation
Good for the growth of economy: A mild or moderate inflation (up to 2% per year) is good for the
growth of economy because if there is no rise in price of goods or services than it can lead to deflation
which presents different set of problems for the economy like recession or depression for the economy,
vicious cycle of lower consumption and lower production due to fall in price of goods and services,
unemployment and so on. Perhaps that is the reason why countries all over the world if given a choice
between inflation and deflation would prefer inflation because inflation if kept under control can boost the
growth of the economy.
Increases productivity: Inflation though indirectly can result in more productivity because when
inflation rises companies tend to increase their production so as to earn more money and workers also
work overtime because their real wage has fallen due to inflation and to counter inflation they have to
increase their wages which can be done either through overtime work or doing side job after work.
In addition some individuals which hold their wealth in the form of asset, borrowing cash and change to
non-liquid asset reap the rewards of inflation. Investors also enjoy a boost if they hold assets in the
markets that are affected by inflation.
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 Macroeconomics Lecture Note for Accounting dep’t 2nd year students (R- 2019)

3.4. Trade-offs Between Inflation and Unemployment

Two goals of economic policymakers are low inflation and low unemployment, but often these goals
conflict. Normally, there is negative relationship between inflation rate and unemployment rate. When
unemployment rate is very low, then workers have the market power to push up wages. Higher wage rate
means that the cost of production is high and so sellers change higher prices implying higher inflation
rate. When unemployment rate is very high, then workers do not have much bargaining power; rather,
they would be ready to accept lower wage to get job. Therefore the pressure on prices also remains low.
This relation can be described by Phillips curve shown below.
The Phillips curve is used to analyze the relationship between inflation and unemployment. The Phillips
curve describes the empirical relationship between inflation and unemployment: the higher the rate of
unemployment, the lower the rate of inflation. The Phillips curve argues that unemployment and inflation
are inversely related: as levels of unemployment decrease, inflation increases. Graphically, the short-run
Phillips curve traces an L-shape when the unemployment rate is on the x-axis and the inflation rate is on
the y-axis.

The Phillips curve has been used for macroeconomic policy analyses which suggest that policymakers
could choose different combinations of unemployment and inflation rates. The curve suggests that less
unemployment can always be attained by incurring more inflation and that the inflation rate can always
be reduced by incurring the costs of more unemployment. In other words, the curve implies that there is a
trade- off between policies to reduce inflation and that intended to reduce unemployment. The Phillips
curve suggests that society can make a choice between various combinations of inflation rate and
unemployment level. So in the short run policy maker need to choose moderate level of inflation and
unemployment. In addition increase lobar force productivity and improve structural rigidity.

3.2. Macroeconomic Policies Instruments

Macroeconomic policy aims to provide a stable economic environment that is conducive to achieve
macroeconomic goals such as high and stable economic growth, low unemployment and inflation,
Achieve Balance of Payments Equilibrium and stable exchange rate. Macroeconomic Policies
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Instruments are an economic variable under the control of government that can affect one or more of the
macroeconomic goals.Macroeconomic policy instruments are categorized into:
 Fiscal Policy
 Monetary Policy
 International Economic Policy
 Incomes Policy
3.2.1. Fiscal Policy, its Instruments and Effects
Fiscal Policy: deals with changes in government expenditures and/or taxes to achieve particular economic
goals, such as low unemployment, stable prices, and economic growth.Fiscal policy is the use of
government expenditures and taxes to affect aggregate demand and aggregate supply.Fiscal policy can be
either contractionary or expansionary fiscal policy.
Contractionary fiscal policy: is undertaken by reducing government expenditure and increasing
taxation. This policy used to slow down spending, economic growth as well as high inflation.
Expansionary fiscal policy: is undertaken by increasing government expenditure and reducing taxation.
And it is used to combat unemployment and increasing output.
Government expenditure: includes government spending on goods and services. It determines the
relative size of the public and private sectors.
Tax: Taxation affects the overall economy in two ways:
 Taxes tend to reduce the amount people spend on goods and services
 Taxes affect market prices, thereby influencing incentives and behaviour
Note: The taxation and public expenditure policies are also jointly called as ‘budgetary policy.’
3.2.2. Monetary Policy, its Instruments and Effects
Monetary Policy: is a deliberate manipulation or change in money supply and interest rate to bring about
desirable change in the economy. Monetary policy determines the money supply as well as interest rates,
in order to achieve desired economic objectives.
Generally there are three tools of monetary policy
i) Open market operations (OMOs): is selling and buying of bonds, treasury bills, securities
by the national bank to increase or decrease money supply in the economy.
ii) Change in discount rate (r): is changing the discount rate (the interest rate commercial
banks pay to borrow money from the central bank (national bank) to affect the money supply
and interest rate.
iii) Change in reserve requirement (RR): is changing the reserve rate required by national
bank. Required reserve ratio- is the portion of commercial banks total deposit that are
required to put in the national bank.

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 Macroeconomics Lecture Note for Accounting dep’t 2nd year students (R- 2019)

Similar to fiscal policy, monetary policy also classified in to two, namely expansionary and
contractionary.
Expansionary monetary policy: the policy intends to increase the money supply and decrease in interest
rate. Includes:
 Purchasing bonds and treasury bills
 Decreasing discount rate and decreasing the required reserve.
Contractionary monetary policy: the policy intends to decrease the money supply and increase interest
rate. It includes
 Selling bonds and treasury bills,
 Increasing discount rate and increasing the required reserve rate.
Easy (Expansionary) Vs Tight (Contractionary) monetary policy
MONETARY POLICY: MAINSTREAM INTERPRETATION
(1) (2)
Easy money policy Tight money policy
Problem: Unemployment and Recession Problem: Inflation
Federal reserve buys bonds, lowers reserve ratio, Federal reserve sells bonds, increases reserves
or lowers the discount rate ratio, or increases the discount rate

Money supply rises Money supply falls

Interest rate falls Interest rate rises

Investment spending increases Investment spending decreases

Aggregate demand increases Aggregate demand decreases

Real GDP rises and UE decreases Inflation declines

3.2.3. International Economic Policy
Consists of two sets of policies:
 Trade policies: which consist of tariff, quotas, and other devices that restrict or encourage
imports and exports
 Exchange-rate setting: Exchange rate represents the price of one currency in terms of the
currencies of the other nations. There are different systems to regulate foreign exchange
market. Such as currency devaluation, currency revaluation, etc.
3.2.4. Incomes Policy
 Measures through which a government attempts to control rise in incomes (wages, salaries,
dividends, rents) to restrain rise in prices (inflation) without increasing unemployment.
 Incomes policies are government attempts to moderate inflation by direct steps (legislated
wage, price controls).

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