Chapter Six

Fundamental concepts of
macroeconomics
 Introduction
• Conventionally, economics is divided into
microeconomics and macroeconomics.
• Microeconomics studies about the individual
decision making behaviour of different economic
units such as households, firms, and government
at a disaggregated level.
• Whereas, macroeconomics, studies about overall
or aggregate behaviour of the economy, such as
economic growth, employment, inflation,
distribution of income, macroeconomic policies
and international trade.
 6.1. Goals of macroeconomics
• Macroeconomics studies the working of an
economy in aggregation or as a whole. And it
aimed at how;
• To achieve high economic growth
• To reduce unemployment
• To attain stable prices
• To reduce budget deficit and balance of payment
(BoP) deficit
• To ensure fair distribution of income
In other words, the goals of macroeconomics can
be given as ways towards full employment, price
 6.2. The National Income Accounting
• National Income Accounting (NIA) is an
accounting record of the level of economic
activities of an economy. It is a measure of
an aggregate output, income and
expenditure in an economy.
Why do we need to study NIA?
• It enables us to measure the level of total
output in a given period of time, and to
explain the causes for such level of
performance.
• It enables us to observe the long run trend
 6.2.1. Approaches to measure national
income (GDP/GNP)
• Before discussing different approaches of
national income, it is important to
understand about the measure of the
economic performance of a given country
at large. Generally it is named as GDP or
GNP.
• Gross Domestic Product (GDP): it is the total
value of currently produced final goods and
services that are produced within a
country‘s boundary during a given period of
time, usually one year.
From this definition, we can infer that:
• It measures the current production only.
• It takes in to account final goods and services only
(only the end products of various production
processes) or we do not include the intermediate
products in our GDP calculations. Intermediate goods
are goods that are completely used up in the
production of other products in the same period that
they themselves are produced.
• It measures the values of final goods and services
produced within the boundary/territory of a country
irrespective of who owns that output. In measuring
GDP, we take the market values of goods and services
GDP = where:
• Pi = series of prices of outputs produced in different
• Gross National Product (GNP): is the
total value of final goods and services
currently produced by domestically owned
factors of production in a given period of
time, usually one year, irrespective of their
geographical locations. GDP and GNP are
related as follows:
GNP=GDP + NFI
• NFI denotes Net Factor Income received from
abroad which is equal to factor income received
from abroad by a country‘s citizens less factor
income paid for foreigners to abroad. Thus, NFI
could be negative, positive or zero depending on
the amount of factor income received by the two
parties.
• If NFI >0, then GNP > GDP
• If NFI<0, then GNP < GDP
• If NFI =0, then GNP =GDP
• Basically, there are three approaches to
measure GDP/GNP. These are:
I. Product/value added approach,
II. Expenditure approach and
III.Income approach
• Product Approach: In this approach, GDP is
calculated by adding the market value of
goods and services currently produced by
each sector of the economy. In this case,
GDP includes only the values of final goods
and services in order to avoid double
counting.
• Double counting will arise when the output
of some firms are used as intermediate
inputs of other firms.
• For example, we would not include the full
price of an automobile in GDP and then also
include as part of GDP the value of the tires
that were sold to the automobile producer.
• The components of the car that are sold to
the manufacturers are called intermediate
goods, and their value is not included in
GDP.
There are two possible ways of avoiding
double counting.
Taking only the value of final goods and
services
Taking the sum of the valued added by all
firms at each stage of production. We can
illustrate the two scenarios using some
hypothetical examples as follows.
• Expenditure Approach: Here GDP is
measured by adding all expenditures on
final goods and services produced in the
country by all sectors of the economy.
• Thus, GDP can be estimated by summing
up personal consumption of households (C),
gross private domestic investment (I),
government purchases of goods and
services (G) and net exports (NE).
• Personal consumption expenditure includes
expenditures by households on durable consumer
goods (automobiles, refrigerators, video recorders,
etc), non-durable consumer goods (clothes, shoes,
pens, etc) and services.
• Gross private domestic investment is defined as the
sum of all spending of firms on plants, equipment,
and inventories, and the spending of households on
new houses.
• Investment is broken down into three categories:
residential investment (the spending of households
on the construction of new houses), business fixed
investment (the spending of firms on buildings and
equipment for business use), and inventory
investment (the change in inventories of firms).
• Note that gross private domestic investment
differs from net private domestic investment
in that the former includes both
replacement and added investment whereas
the latter refers only to added investment.
• Replacement means the production of all
investment goods, which replace
machinery, equipment and buildings used
up in the production process.
• In short, net private domestic investment =
gross private domestic investment minus
depreciation.
• Government purchases of goods and
services include all government spending
on finished products and direct purchases
of resources less government transfer
payments because transfer payments do
not reflect current production although they
are part of government expenditure.
• Net exports refer to total value of exports
less total value of imports. Note that net
export is different from the terms of trade in
that the latter refers to the ratio of the
value of exports to the value of imports.
• Income approach: in this approach, GDP is calculated
by adding all the incomes accruing to all factors of
production used in producing the national output.
• It is crucial, however, to note that some forms of
personal incomes are not incorporated in the national
income.
• For instance, transfer payments (payments which are
made to the recipients who have not contributed to the
production of current goods and services in exchange
for these payments) are excluded from national income,
as these are mere redistribution of income from
taxpayers to the recipients of transfer payments.
• Transfer payments may take the form of old age
pension, unemployment benefit, subsidies, etc.
• According to the income approach, GDP is the sum
incomes to owners of factors of production plus some
other claims on the value of output (depreciation and
indirect business tax) less subsidies and transfer
payments.
• GDP = Compensation of employees (wages & salaries )
+ Rental income +
+ Interest income
+ Profits (proprietors‘ profit plus corporate profit)
+ Indirect business taxes
+ Depreciation
- Subsidies
- Transfer payments
 Limitation of GDP measurement
The calculation of national income is not an easy
task. We face a number of problems in the
estimation of national income, especially in under-
developed countries like Ethiopia.
• Definition of a nation: while calculating
national income, nation does not mean only the
political or geographical boundaries of a country
for calculating the value of final goods and
services produced in the country. It includes
income earned by the nationals abroad.
• Stages of economic activities: it is also difficult
to determine the stages of economic activity at
which the national income is determined i.e.
whether the income should be calculated at the
stage of production or distribution or consumption.
• It has, therefore, been agreed that the stage of
economic activity may be decided by the objective
for which the national income is being calculated.
• If the objective is to measure economic progress,
then the production stage can be considered.
• To measure the welfare of the people, then the
consumption stage should be taken into
consideration.
• Transfer payments: this also creates a
great difficulty in calculating the national
income. It has generally been agreed that
the best way is to consider only the disposal
income of the individuals of groups.
• Underground economy: no imputation is
made for the value of goods and services
sold in the illegal market. The underground
economy is the part of the economy that
people hide from the government either
because they wish to evade taxation or
because the activity is illegal. The parallel
exchange rate market is one example.
• Inadequate data: in all most all the
countries, difficulty has been faced in the
calculation of national income due to lack of
adequate data. Sometimes, the data are
not reliable.
• Non-monetized sector: this difficulty is
special to developing countries where a
substantial portion of the total produce is
not brought to the market for sale. It is
either retained for self-consumption or
exchanged for other goods and services.
• Valuation of depreciation: the value of
depreciation is deducted from the gross
• Changes in price levels: since the
national income is in terms of money
whose value itself keeps on changing,
it is difficult to make a stable
calculation which is assessed in terms
of prices of the base year.
• No focus on quality: it is difficult to
account correctly for improvements in
the quality of goods. This has been the
case for computers, whose quality has
improved dramatically while their price
 6.2.2. Other income accounts
• Apart from GDP and GNP, there are also
other social accounts which have equal
importance in macroeconomic analysis.
These are:
Net National Product (NNP)
National Income (NI)
Personal Income (PI)
Personal Disposable Income (PDI)
• Net National product (NNP) : GNP
as a measure of the economy‘s annual
output may have defect because it fails
to take into account capital
consumption allowance, which is
necessary to replace the capital goods
used up in that year‘s production.
• Hence, net national product is a more
accurate measure of economy‘s annual
output than gross national product and
it is given as:
• National income (NI): National income is the
income earned by economic resource (input)
suppliers for their contributions of land, labour,
capital and entrepreneurial ability, which are
involved in the given year‘s production activity.
• However, from the components of NNP, indirect
business tax, which is collected by the
government, does not reflect the productive
contributions of economic resources because
government contributes nothing directly to the
production in return to the indirect business tax.
• Hence, to get the national income, we must
subtract indirect business tax from net national
product.
• Personal Income (PI): refers to income earned
by persons or households. Persons in the
economy may not earn all the income earned as
national income.

• Personal Disposable Income: it is personal

income less personal tax payments.
DI = PI – Personal taxes
DI = C + S where, C = personal consumption
expenditure, S = Personal savings
 6.3. Nominal versus Real GDP
• Nominal GDP: is the value of all final goods
and services produced in a given year when
valued at the prices of that year.
• That is, nominal GDP = where, P is the general
price level and Q is the quantity of final goods
and services produced. Therefore, any change
that can happen in the country‘s GDP is due to
changes in price, quantity or both.
• For example, if prices are doubled over one
year, then GDP will also double even though
exactly the same goods and services are
produced as the year before.
• Real GDP : is the value of final goods and
services produced in a given year when
valued at the prices of a reference base
year.
• By comparing the value of production in the
two years at the same prices, we reveal the
change in output.
• Hence, to be able to make reasonable
comparisons of GDP overtime we must
adjust for inflation.
Given the above information, we can
calculate the real and nominal GDP in
both years as follows:
 6.4. The GDP Deflator and the Consumer Price Index(CPI)

• The GDP Deflator: The calculation of real

GDP gives us a useful measure of inflation
known as the GDP deflator. The GDP
deflator is the ratio of nominal GDP in a
given year to real GDP of that year. It
reflects what‘s happening to the overall
level of prices in the economy.
• The Consumer Price Index: The Consumer
Price Index (CPI) is an indicator that measures
the average change in prices paid by consumers
for a representative basket of goods and
services. It compares the current and base year
cost of a basket of goods of fixed composition.
• If we denote the base year quantities of the
various goods by q'0 and their base year prices by
р'0, the cost of the basket in the base year is
∑р'0*q'0, where the summation is over all the
goods in the basket.
• The cost of a basket of the same quantities but at
today's prices is ∑p't,q'0, where pt is today's price.
• The CPI is the ratio of today's cost to the base
• The CPI versus the GDP Deflator
• The GDP deflator and the CPI give somewhat
different information about what‘s happening
to the overall level of prices in the economy.
There are three key differences between the
two measures.
1) GDP deflator measures the prices of all
goods and services produced, whereas the
CPI measures the prices of only the goods and
services bought by consumers. Thus, an
increase in the price of goods bought by firms
or the government will show up in the GDP
deflator but not in the CPI.
2) GDP deflator includes only those goods
produced domestically. Imported goods are
not part of GDP and do not show up in the
GDP deflator.
3) The CPI assigns fixed weights to the
prices of different goods, whereas the GDP
deflator assigns changing weights. In other
words, the CPI is computed using a fixed
basket of goods, whereas the GDP deflator
allows the basket of goods to change over
time as the composition of GDP changes.
 6.5. The Business Cycle
• Business cycle refers to the recurrent ups
and downs in the level of economic activity.
• Countries usually experience ups and downs
in the level of total output and employment
over time.
• For some period of time the total output level
may increase and other times it may decline.
• With the fluctuation in the overall economic
activity, the level of unemployment also
moves up and down.
• A business cycle is a fluctuation in overall
economic activity, which is characterized by the
simultaneous expansion or contraction of output in
most sectors. We can identify four phases in the
business cycle.
• Boom/peak: it is a phase in which the economy is
producing the highest level of output in the
business cycle. It is the point which marks the end
of economic expansion and the beginning of
recession. In this phase, the economy‘s output is
growing faster than its long-term (potential) trend
and is therefore unsustainable. Due to very high
degree of utilization of resources, unemployment
level is low; business is good; and it is a period of
prosperity.
• Recession/contraction: during a
recession phase, the level of economic
performance generally declines. Total
output declines, national income falls,
and business generally decline. As a
result, unemployment problem rises.
When the recession becomes
particularly severe, we say the
economy reaches depression or trough.
This period can cause hardship on
business and citizens.
• Trough/Depression: - this phase is the lowest
point in a business cycle. It marks the end of a
recession and the beginning of economic
recovery/expansion. During this period, there is
an excessive amount of unemployment and idle
productive capacity.
• Recovery/Expansion: - during this phase, the
economy starts to grow or recover, i.e. there is
an option of economic activity between a trough
and a peak. In this phase, more and more
resources are employed in the production
process; output increases, unemployment level
diminishes and national income rises. When this
expansion of the economy reaches its maximum,
Note that:
One business cycle includes the point from
one peak to the next peak or from one
trough to the next.
A business cycle is a short-term fluctuation
in economic activities.
The trend path of GDP is the path GDP
would take if factors of production were
fully employed.
Business cycles may vary in duration and
intensity.
 6.6. Macroeconomic Problems
6.6.1. Unemployment

Can we say that every person who

does not have a job is unemployed?
• Problem of unemployment is one of the major
issues dealt in macroeconomics.
• Unemployment refers to group of people who
are in a specified age (labour force), who are
without a job but are actively searching for a job.
• In the Ethiopia context, the specified age is
between 14 and 60 which are normally named
as productive population.
• To better understand what unemployment is, it
is important to begin with classifying the whole
population of a country into two major groups:
those in the labour force and those outside the
labour force.
• Labor force includes group of people within a
specified age (for instance, people whose
ages are greater than 14 are considered as job
seekers though formal employment requires a
minimum of 18 years of age bracket) who are
actually employed and those who are without
a job but are actively searching for a job,
according to the Ethiopian labour law.
• Therefore, the labour force does not include:
Children <14 and retired people age >60, and
also people in mental and correctional
institutions, and very sick and disabled people
etc.
• A person in the labour force is said to be
unemployed if he/she is without a job but is
actively searching for a job.
Labour force = Employed + Unemployed
Types of unemployment
1. Frictional unemployment: refers to a brief
period of unemployment experienced due to.
• Seasonality of work E.g. Construction workers
• Voluntary switching of jobs in search of better
jobs
• Entrance to the labor force E.g. A student
immediately after graduation
• Re-entering to the labor force
2. Structural unemployment: results from
mismatch between the skills or locations of
job seekers and the requirements or locations
of the vacancies. E.g. An agricultural
graduate looking for a job at ―Piassa‖. The
causes could be change in demand pattern or
technological change.
3. Cyclical unemployment: results due to
absence of vacancies. This usually happens
due to deficiency in demand for commodities/
the low performance of the economy to
create jobs. E.g. During recession
• Note: Frictional and structural
unemployment are more or less unavoidable;
hence, they are known as natural level of
unemployment.
Measurement of rates of unemployment
• When the unemployment rate is
equal to the natural rate of
unemployment, we say the
economy is at full employment.
• Therefore, full employment does
not mean zero unemployment.
 6.6.2. Inflation
• It is the sustainable increase in the general
or average price levels commodities. Price
index serves to measure inflation. Two
points about this definition need emphasis.
First, the increase price must be a sustained
one, and it is not simply once time increase
in prices. Second, it must be the general
level of prices, which is rising; increase in
individual prices, which can be offset by fall
in prices of other goods is not considered as
inflation.
• Causes of inflation The causes of inflation are
generally classified into two major groups:
demand pull and cost push inflation.
A.Demand pull inflation: according to demand
pull theory of inflation, inflation results from a
rapid increase in demand for goods and
services than supply of goods and services. This
is a situation where ―too much money chases
too few goods.‖
B. Cost push or supply side inflation: it arises
due to continuous decline in aggregate supply.
This may be due to bad weather, increase in
wage, or the prices of other inputs.
 Economic effects of inflation
1. Generally inflation reduces real money balance or
purchasing power of money. This will in turn reduce the
welfare of individuals.
2. Banks charge their customers nominal interest rate for
their loans. Nominal interest rate however is
determined based on inflation rate as it is represented
by Fisher‘s equation. I= r+П where, I is nominal interest
rate, r is real interest rate and П is inflation rate.
• Increase in inflation rate will raise the nominal interest
rate and the opportunity cost of holding money. If people
are to hold lower money balances on average, they must
make more frequent trips to the bank to withdraw
money. This is metaphorically called the shoe-leather
cost of inflation.
3. Inflation reduces investment by increasing
nominal interest rate and creating uncertainty
about macroeconomic policies.
4. Inflation redistributes wealth among individuals.
Most loan agreements specify a nominal interest
rate, which is based on the rate of inflation
expected at the time of the agreement.
If inflation turns out to be higher than expected,
the debtor wins and the creditor loses because the
debtor repays the loan with less valuable dollars.
If inflation turns out to be lower than expected, the
creditor wins and the debtor loses because the
repayment is worth more than the two parties
anticipated.
5. Unanticipated inflation hurts
individuals with fixed income and
pension.
6. High inflation is always associated
with variability of prices which induces
firms to change their price list more
frequently and requires printing and
distributing new catalogue. This is
known as menu cost of inflation.
 6.6.3. Trade deficit and budget deficit
Budget deficit
• The overriding objectives of the government‘s
fiscal policy are building prudent( careful) public
financial management, financing the required
expenditure with available resource and refrain
from possibility of unsustainable fiscal deficit.
• The government receives revenue from taxes
and uses it to pay for government purchases.
Any excess of tax revenue over government
spending is called public saving, which can be
either positive (a budget surplus) or negative (a
budget deficit).
• When a government spends more than
it collects in taxes, it faces a budget
deficit, which it finances by borrowing
from internal and external borrowing.
• The accumulation of past borrowing is
the government debt.
• Debate about the appropriate amount
of government debt in the United
States is as old as the country itself.
• Alexander Hamilton believed that “a
national debt, if it is not excessive, will
• When we see Ethiopian case, to augment available
domestic financing options, the government opted to
finance its fiscal deficit from external sources on
concessional terms.
• In particular, the Government of Ethiopia finances its budget
by accessing external loans on concessional terms.
• As a rule of thumb, non-concessional loans cannot be used
to finance the budgetary activities.
• On the other hand, external non-concessional loans are
used to finance projects that are run by State Owned
Enterprises.
• In recent years, the government accessed loans from
international market on non-concessional terms to finance
feasible and profitable projects managed by State Owned
Enterprises (SOEs).
• The country‘s total public debt contains central government,
government guaranteed and public enterprises.
 Trade deficit
• The national income accounts identity
shows that net capital outflow always
equals the trade balance. Mathematically,
S − I = NX.
• Net Capital Outflow = Trade Balance
• Net cash out flow is Saving(S) – Investment
(I)
• Balance of Trade = Merchandize Exports –
Merchandize Imports
• If this balance between S − I and NX is
positive, we have a trade surplus, so we say
that there is a surplus in the current account.
In this case, we are net lenders in world
financial markets, and we are exporting more
goods than we are importing.
• If the balance between S − I and NX is
negative, we have a trade deficit then we say
that there is a deficit in the current account. In
this case, we are net borrowers in world
financial markets, and we are importing more
goods than we are exporting.
• If S − I and NX are exactly zero, we are said to
 6.7. Macroeconomic policy instruments
• The ultimate policy objective of any
country in general is to have sustainable
economic growth and development.
• Policy measures are geared at achieving
moderate inflation rate, keeping
unemployment rate low, balancing
foreign trade, stabilizing exchange and
interest rates, etc and in general
attaining stable and well-functioning
macroeconomic environment.
 6.7.1. Monetary policy
• Monetary policy refers to the adoption of
suitable policy regarding the control of
money supply and the management of
credit which is important measure for
adjusting aggregate demand to control
inflation.
• It is concerned with the money supply,
lending rates and interest rates and is often
administered by a central bank.
• Monetary policy is a highly flexible
stabilization policy tool.
• For instance, during economic recession where
output falls with a fall in aggregate demand,
monetary policy aims at increasing demand
and hence production as well as employment
will follow the same pattern of demand.
• In contrast, at the time of economic boom
where demand exceeds production and treat
to create inflation, the monetary policy
instruments are utilized that could offset the
condition and achieve price stability by
counter cyclical action upon money supply.
• Government monetary policy regulation is
under responsibilities of Central Banks.
• Central Bank controls the money supply to
control nominal interest rates.
• Investment and saving decisions are based
on the real interest rate.
• When government lowers interest rate,
firms borrow more and invest more. Higher
interest rates mean less investment.
 6.7.2. Fiscal policy
• Fiscal policy involves the use of government spending,
taxation and borrowing to influence both the pattern of
economic activity and also the level and growth of aggregate
demand, output and employment.
• It is important to realize that changes in fiscal policy affect
both aggregate demand (AD) and aggregate supply (AS).
• Most governments use fiscal policy to promote stable and
sustainable growth while pursuing its income redistribution
effect to reduce poverty.
• Fiscal policy therefore plays an important role in influencing
the behaviour of the economy as monetary policy does.
• The choice of the government fiscal policy can have both short
and long term influences.
• The most important tools of implementing the government
fiscal policy are taxes, expenditure and public debt.
•Traditionally fiscal policy has been
seen as an instrument of demand
management.
•This means that changes in
government spending, direct and
indirect taxation and the budget
balance can be used to help
smooth out some of the volatility of
real national output particularly
when the economy has experienced
• Fiscal policy decisions have a widespread
effect on the everyday decisions and behaviour
of individual households and businesses.
• Thus, it is mainly used to achieve internal
balance, by adjusting aggregate demand to
available supply. It also promotes external
balance by ensuring sustainable current
account balance and by reducing risk of
external crisis.
• In general, it helps promote economic growth
through more and better education and health
care.
 Major functions of fiscal policy
• Allocation: The first major function of fiscal
policy is to determine exactly how funds will be
allocated.
• This is closely related to the issues of taxation
and spending, because the allocation of funds
depends upon the collection of taxes and the
government using that revenue for specific
purposes.
• The national budget determines how funds are
allocated. This means that a specific amount of
funds is set aside for purposes specifically laid
out by the government.
• Distribution: The distribution functions of the
fiscal policy are implemented mainly through
progressive taxation and targeted budget
subsidy.
• Virtually allocation determines how much will
be set aside and for what purpose, the
distribution function of fiscal policy is to
determine more specifically how those funds
will be distributed throughout each segment of
the economy.
• For instance, the government might apportion a
share of its budget toward social welfare
programs, such as food security and asset
building for the most vulnerable and
• Stabilization: Stabilization is another
important function of fiscal policy in that the
purpose of budgeting is to provide stable
economic growth.
• Government expenditure needs particularly in
developing countries such as Ethiopia are
unlimited. But its source of financing is limited.
• Thus without some restraints on spending or
limiting the level of expenditure with available
financial resources the economic growth of the
nation could become unstable, creating
imbalances in external sector as well as
resulting in high prices.
• Development: The fourth and most important
function of fiscal policy is that of promoting
development.
• Development seems to indicate economic growth,
and that is, in fact, its overall purpose.
• However, fiscal policy is far more complicated than
determining how much the government will tax
citizens in a given year and then determining how
that money will be spent.
• True economic growth occurs when various projects
are financed and carried out using budgetary
finance.
• This stems from the belief that the private sector
cannot grow the economy by itself.
The underlying principles of the tax policies in
Ethiopia are as follows:
• To introduce taxes that enhance economic growth,
broaden the tax base and increase government
revenue;
• To introduce taxes that are helpful to implement
social policies that discourage consumption of
substances that are hazardous to health and social
problems;
• To introduce tax system that accelerate industrial
growth and achieve transformation of the country
and to improve foreign exchange earnings, as well as
create conducive environment for domestic products
to become competitive in the international
commodity markets;
• To ensure modern and efficient tax system that
supports the economic development;
• To make the tax system fair and equitable;
• To minimize the damage that may be caused by
avoidance and evasion of tax; and
• To promote a tax system that enhances saving
and investment.
END OF THE COURSE