Chapter 6

MACROECONOMICS
6.1. Definition of macroeconomics
 macroeconomics is the study of the behaviour of the economy
as a whole.
 An economy that has successful macroeconomic
management experiences low inflation and
unemployment as well as steady and sustainable growth.
 In contrast, in a country where there is macroeconomic
mismanagement, it has adverse impact on the living
standards and employment opportunities of the citizens
of that country.

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 6.2 NATIONAL INCOME ACCOUNTING

 National income accounting is

accounting system that is used to measure
aggregate economic activities.
 It is an official measurement of the flow of
income and product in a given economy.
Aggregate economic activity or total
output (income) of an economy for given
period of time can be represented by GDP/
GNP

2
 Cont.………………………………………
 Gross Domestic Product (GDP) is the market
value of all final goods and services produced
in a country in a given year.
 On the other hand Gross National Product
(GNP) is the total market value of goods and
services produced by the nationality of a
given country for a given period of time
 GNP would includes some output produced by
a citizen of a country living abroad and
excludes the output produced by the
nationality of other country under taking
production in that country
3
Cont.…………………………………………….
 GNP =GDP+ Net factor payment (NFP).
Where net factor payment or income is the difference between
factor payment from abroad.
In other words payment of factor income to the rest of the
world subtracted from receipts of factor income (wage, profit
and rent) from the rest of the world.
 For example Ethiopians who own apartments in New York earn
rental income for their building. This income earned included
in GDP calculation of US but not part of GNP of USA but it is
included in GNP of Ethiopia.
4
 6.3.Measuring GDP
 How can we measure GDP/GNP of an
economy?
 Approaches of measuring GDP
There are three methods result in the same
value of GDP since the expenditure of one
agent becomes the income for others.

5
 Cont…………………………………………..
I. Income approach
 In case of income approach the returns (income) to
factors of input such as labour, entrepreneur skill, Land
and capital sum up together to arrive at the amount of
output produced in a given economy per unit of time.
 Employment compensations payment made for labour in
the form of wages and salaries.
 Rents payments for use of land, building and other
capital input.
 Interest income received by households on their saving
deposit.
 Profit payments made to the owner of firms in return to
the output produced
6
 Cont.………………………………………………
The following table represents an example of GDP computation for hypothetical economy using
income approach.
Table 1.1. GDP of hypothetical economy in billions of dollars
Component of GDP Values in dollars
Wages and salaries $6,657.4
Rents $153.8
Interest rate $ 546.7
Profit $2,020.9
Plus depreciation $ 1,479.9
Plus Indirect business tax $885.9
Plus statistical discrepancy $90.4
GDP $11,835.00

7
 II. Expenditure approach

 Alternative to income approach, the value

of total output in the economy can be
measured by aggregating expenditure
made on final goods and services in the
product market.
 Such approach of measuring GDP is known
as expenditure approach.
 This demand (expenditure) for domestically
produced goods comprise of four main
components depending up on who makes
the expenditure.
8
 These are

I. consumer expenditure (C)

II. Business investment (I)
III. Government expenditure (G)
IV. Foreign expenditure or net
export (NX)

9
Cont.……………………………………………
I. Consumption spending (C) : is the spending
made on domestically produced final goods and
services by household
II. Business investment spending (I) :is
spending made on goods and services which
are used for production of other goods.
III. Government purchase or spending (G): is
spending made on domestic goods and services
by federal, state and local government.
IV. Net export (NX) :represents the value of
goods and services exported minus value of
other countries produces and supply to us.
GDP=C +I +G + NX. 10
 Table 1-2 GDP and it components, in $ billions in 1987 for USA

Component of GDP Amount of spending

 Personal consumption expand………………………………………….$4527.00

o Durable goods……………………………………… $3012.00
o Non durable goods…………………………………… $422.00
o Services goods…………………………………………$998.00
 Business investment………………………………………………………$713.00
o Business fixed investment ……………………………$713.00
o Structures………………………………………………$447.00
o Producers durables……………………………………. $140.00
o Residential Structure………………… ………………. $307.00
 Net export…………………………………………………………………$123.00
o Exports……………………………………………….…$482.00
o Import…………………………………………………..$551.00
 Government spending…………………………………………………....$925.00
Federal Gov’t spending…………………………………..$382.00
National defence……………………………………$295.00
Others………………………………………………. $ 87.00
State and local………………………………………$543.00

11
III. Product or value added approach

Production of goods and services typically involves

a sense of distinct stage.
Each stage involves separate market transaction

and flow of income.

For example as indicated in table below,
there are four different stages having their
own market transaction in production of
bread.
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Table 1.3. Production of bread involving four different stages.

Stage of production Value of transaction Value added

1. Farmer grows wheat and sell
And sell to miller ……………….$0.12……………… $0.12
1. Miller converts wheat to
Flour and sell to baker………………$0.28………………. $0.16
2. The baker bake bread and
Sell to store owner…………………. $0.60……………….. $0.32
3. The store sells bread to the ……… $0.75………………… $0.15
$1.75 $0.75
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 Cont.………………………………………
 we add up separate value of each market
transaction we would come to the conclusion
that the value of output produced in production
process equal to $1.75 even though the output
produced is equal to $0.75
 This example show that there is a problem of
double count if we uses intermediate goods for
calculation of GDP rather than using final goods
and services or the value added in production.
 Therefore to measure GDP more accurately we
must distinguish between intermediate and final
goods and services before we start aggregating
together the value of output produced.
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 Cont.……………………………………………..

 The value of most goods and services

during GDP accounting computed at
market prices. However some goods
have no market price and don’t have
market where they sold.
 So to include such goods in GDP, their
values are estimated (Imputed) using
different proxy measures.
 For example the services of own house,
police officer and fire fighter have no
market price. Their value should be
15
estimated using some proxies to add to
 Cont.………………………………………..
 Lastly, there are goods and services
produced but hidden from government
such section of the economy is said to be
the underground economy (informal
economy).
 In case of under developed countries there
is output/income creation in billions of
dollars in the underground economy. Such
good however have no market value and
cannot be imputed.
 As a result output produced in
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underground economy left from
 6.4. Other measures of
output/income
 Alternative to GDP, there are other
measures that are used to represent the
total output produced in an economy. Let
us identify how to determine these
measures based on GDP.
I. Net domestic product (NDP)
II. Net national product (NNP)-
III. National Income (NI)
IV. Personal income
V. Disposable personal
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 Cont.……………………………………………..
I. Net domestic product (NDP) – It
represent the value of total output of an
economy after net out depreciation.
 NDP=GDP - depreciation.
 Net national product (NNP)-measures
the value of total output produced by a
citizen of a given country within a specified
time period after subtracting the
consumption of fixed capital (depreciation).
 NNP=GNP – Depreciation
18
 Cont.……………………………………………….
II. National Income (NI) – It is the
total income earned by resource owner
from current production. Can be
determined in two ways
 NI= NNP-Indirect business tax (e.g.
sales tax)
 NI= GNP - Depreciation – Indirect
business tax

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 Cont.………………………………………….
 NI=wages and salaries + proprietors
income + Rental income +corporate profit
+Interest income.
III. Personal income is the amount of
income that households and non corporate
businesses receive.
 Personal income (PI) =National Income-
corporate profit -Social -Insurance
contributions-Net interest + Dividend +
Government transfer + Personal interest
income
20
 Cont.…………………………………………
IV. Disposable personal income-
Households non corporate business
income that is really to spend after tax
and non tax payments.
 Disposable income (DI) = personal
income -Personal tax and non-tax
payments
 DI = consumption + saving

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 6.5. Nominal and real GDP

 The aggregate that is obtained by measuring economic

activity at current market price is termed as nominal
GDP.
 Consider for example an economy producing only two
goods banana and coffee. To find a nominal GDP of
such economy, simply sum up the total value of
banana and coffee at current market prices.
 That is, nominal GDP = (Price of banana x Quantity of
banana) + (price of coffee x Quantity of coffee).
 The problem with such type of valuation of goods and
services is that it could not reflect the cause for
change in GDP resulted from change in price or change
in quantity of output overtime.
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Table , the total amount of output of two goods economy with their market
prices of hypothetical economy.

Year Price of Quantity Price Quantity of

banana/kg of of coffee(tone)
banana(to coffee/
ne) kg
2004 2.00 10,000.00 5.00 20,000.00

2005 2.50 10,500.00 8.00 20,500.00

2006 3.00 10,600.00 10.00

20,600.00
2007 5.00 10,600.00 30.00
20,600.00
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 Cont.……………………………………………..
 Let us compute the nominal GDP of the
economy for 2006 and 2007 to see the
impact of price on the value of total
output (GDP).
 Nominal GDP of 2006 = (2006 price of
banana x 2006 amount of banana) +
(2006 price of Coffeex2006 amount of
coffee). = (3x10, 600) + (10x20, 600) =
31,800+206,000
• =237,800
24
Cont.……………………………………………
Nominal GDP in 2007 = (2007 Price of banana x
2007 amount of banana) + (2007 price of banana
x amount of coffee in 2007) = (5x10, 600) +
(30x20, 600) =53,000+618,000
=671,000
 This example show that the nominal GDP in
2007 increases without an increase in the
amount of output produced because of increase
in price
25
 Cont.………………………………………….

 A better way of measuring the state of an

economy is measuring the economy’s total
output by avoiding the impact of price.
 This can be possible by using real GDP.
Real GDP is the value of goods and
services measured using constant or base
year price.
 It is computed after adjusting for change
in price from year to year.

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 For instance, let us set a base year price for the above
hypothetical economy to be 2004, then the real GDP of 2006
and 2007 can be computed as follows.
 Real GDP= (2004 price of banana) (2006 Quantity of
banana) + (2004 price of coffee) +(2006 Quantity of coffee) =
(2x10, 600) + (5x20, 600)= 21,200+103000=124,200
Real GDP= (2004 price of banana) (2007 quantity of banana)
+ (2004 price of coffee) (2007 ) (Quantity of coffee) = (2x10,
600) + (5x20, 600) =21,200+103,000= 124,200
 When price held constant, the real GDP varies
from year to year only when the quantities
produced vary.
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 6.6. GDP Deflator and Other Measures of
General prices
Economist and policy makers use change in general level of price to measure the performance of
an economy in combination with the level of GDP. To measure the general price of an economy
they use GDP deflator and consumers and producer price index.
GDP deflator
GDP deflator also called the implicit price deflator for GDP is defined as the ratio of nominal
GDP to real GDP.
No
mi
nald
GDPP
QP
GDP deflator = R 
e
alGD
P PQ
b P
b

Where P-current price of goods, Pb-base year price and Q-Quantity of good produced.
GDP deflator measures the price of output (goods) relative to its price in the base year. It shows
whether the price of goods increase or decreases in reference to the base year price. 28
 Cont.……………………………………………
For the hypothetical economy represented by table 1.3, GDP deflator for year 2006 computed as:
No
min
alG
DPo
f20
06
GDP Deflator of 2006 = Rea
lGD
Po
f2
006

237,800
= 1.915
124,200
This means there is an increase general level of price by 191.5 percent in 2006 relative to
general price of 2004.
As the name indicates it also used to deflate nominal GDP to get real GDP.
NGDP
Real GDP=
GDP deflator
29
 Cont.…………………………………………
Consumer price index (CPI)
CPI is the most commonly used price index to measure the general price level of an economy. It
represents price of a fixed basket of goods and services purchased by a typical consumer relative
to the same basket of goods and services in some base year. For example if a typical consumer
buy 10 unit of Banana and 3 unit of coffee then the CPI for the two consumption good can be
computed as:

10 current price of Banana 3current price of coffee

CPI= 
10 baseyear price of Banana 3base year priceof coffee

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 Cont.…………………………………………
Alternative to consumer price index, cost of producer goods would be
measured by an index called producer price index. Producer price index
measures the price of typical basket of goods bought by firms.
Short comings of GDP/GNP as a measure of social welfare
Both nominal and real GDP/GNP cannot serve as a good instrument for
measuring the welfare changes of a society.
I. They both lack in indicating the composition of output in the current
production year.
II. Improvements in the relative quality of the goods produced in the
currents year are not indicated in the GDP.
III. GDP/GNP does not show the income distribution in the economy, the
measurements simply indicate the total output.
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 6.2. Inflation and unemployment
. Inflation
In a broad sense, inflation is defined as a sustained rise in the general level of prices. Two
points about this definition need emphasis. First, the increase price must be a sustained one, and
it is not simply a once for all increase in prices. Second, it must be the general level of prices,
which is rising; increase in individual prices, which can be offset by falling in prices of other
goods is not considered as inflation. Thus we define inflation rate (Πt) as:
Pt  Pt  1
Πt = x100
Pt  1
Where Pt is overall price index (CPI, GDP deflator) for time –t
Pt-1 is over all price index for time t-1

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 Cont.………………………………………………

Cause of inflation
 Theories that deal with the causes of inflation generally classified into
two major groups: Demand pull and cost push factors.
i. Demand pulls factors.
According to demand pull theory of inflation, inflation is the resulted from
a rapid increase in demand for goods and services than supply of goods
and services (fixed level of goods and services supplied).
i. Cost push (supply side) factors
There are non-demand factors that cause inflation. Cost push inflation
occurs when different factors which increases cost of production
(increases price of input) and other structural bottle neck cause firms to
reduce the supply of goods and services below existing demand

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 Cont.…………
Effects of inflation
1. Generally inflation reduces real money balance or
purchasing power of money.
2. Inflation increases uncertainties about macroeconomic
policy and adversely affects the public decision making
ability.
3. Inflation is an indicator of the overall inability of
government to manage the economy.
4. Unanticipated inflation hurts individuals with fixed income
(pension).
5. The case of debtors and creditors: inflation is a friend of
debtors and an enemy of creditors. 34
 Cont.……………………………………………
 Moderate inflation reduces real wage (w/p) and then
increase level of employment (decreases unemployment).
 Therefore to increase labour supply cutting of nominal
wage is not possible to decreases real wage.
 The only way to decrease real wage is to allow inflation to
do the job.
 Increase in nominal wage will be taken as an increase in
their real wage and hence increase labour supply and then
output.

35
 Cont.………………………………………………

 Such relationship between nominal wage and level of

unemployment can be represented by a curve known as
Philips curve as indicated by figure below

Wage infaltion Price

Unemployment

Figure 1-4 the Philips curve

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 Unemployment

Unemployment is a situation in which able bodied persons willing

to work at prevailing wage rate do not able to find job. People
who are not in the work force include
 Young people who are below some legally established age limit
 Full time students
 Retired people
 People who are hospitalized (i.e., only for the period in which
they are hospitalized)
 People held in prison and mental institutions
Unemployment is measured by rate of unemployment, which
represents the percentage of those people who wants to work but
cannot get any job.
Noofu
ne
mplo
ye
d
Unemployment rate = ( la
bo
rfo
rc
e
)1
00
37
 Types of unemployment
1. Frictional unemployment.
 The reason behind frictional unemployment is
that it takes time to match workers with jobs.
 Besides, the flow of information about job
candidates and job vacancies is imperfect.
Geographical motilities of workers are not
instantaneous, in addition workers difference in
preference and jobs have different attributes.
 For all these reasons, searching for an
appropriate job takes time and effort. Such
type of unemployment which created due to

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 The time to get job is known frictional unemployment.
2. Structural unemployment
 Structural unemployment arises due to structural change in
dynamic economy and wage rigidity.
 Such structural change includes change in the structure or
sectoral composition of the economy due to technological
change.
 That is gradual decline of some kind of industries production
and the emergence of new industries.
 Some skills become obsolete and less efficient resulting
mismatch between labor demand and supply.
 The second reason for structural unemployment is wage
rigidity. Workers are unemployed sometimes not because of
the skill gap at ongoing wage rate but, the supply of labour
exceeds the demand.
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 3. Seasonal unemployment: arises at least for two reasons
I. In the first case, industrial production slows down
anticipating for example seasonal weather changes.
II. In the second case, the concentration of graduating
students at the end of the year accounts for high number
of unemployed people.
4. Cyclic unemployment
 Cyclic unemployment is unemployment created associated
with short run fluctuation of the economy.
 Workers become unemployed for some period when job
evaporates due to recession and returns to job when there
is expansion in economic activities.
 It is avoidable type of unemployment, since a set of
macroeconomic policies geared towards promoting
aggregate demand can avoid it.

40
 Cont……………………………………………
 Some of inflation controlling measures we seen previously
results in increase in unemployment. This kind of situation
creates a dilemma for policy makers as to whether or not to
control inflation. Therefore, the cost of inflation should be
identified and compared with the cost of unemployment to
choose optimal policy that used to manage the economy.

 Employed workers produce goods and services where as

unemployed workers do not. Thus an increase in the
unemployment rate decreases the real GDP of an economy.

 The other cost of unemployment is that it reduces living

standard and causes psychological distress. Unemployment has
also income distribution effect. It causes inequality among
employed and unemployment workers.

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 5. Natural rate of unemployment
 As we said, only cyclical unemployment is a direct result of the
economy’s weak performance. The other forms of
unemployment, however involve other variables outside of the
economy. Such a contention led economists to the conclusion
that at any point in time there may be some people in the work
force who remain unemployed even if the economy is
functioning without difficulty. This is what we mean by natural
rate of unemployment.
Mathematically,
 Natural rate of unemployment=
No. of unemployed – No. of cyclically
unemployed
Total work force
= No of frictionally, seasonally, and structurally unemployed
Total work force
Cost of unemployment
42
 Business cycle

 The ups and downs of the economy, in the

short run are known as business cycle.
 It is a regular pattern of expansion and
contraction in economic activity around trend
growth.
 All industrialized societies are subject to recurrent
fluctuations in economic activity.
 Even though the fluctuation characterizes all
macro variables, in most case business cycle
primarily represents fluctuation of output or GDP
along the trend.

43
44
 Peak or boom refers to the highest level of
aggregate output or GNP over a period of time.
 Peaks imply that at these points the economy
performs at or close to full capacity and that it
opens up greater job opportunities
 Recession are often result of over heated
economy in times of boom, too much activity,
too much money chasing increasingly too few
goods lead to decline in GDP. Business persons
lose confidence, and cut production.
Unemployment rises and income falls, prices
decline.
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 The point in which a recession ends and recovery
begins is called a trough.
 Although employment and incomes are still too
low, everybody begins to rebuild hope believing
that the economy cannot get any worse.
 Recovery (expansion) is a prolonged journey.
 It is built on the revival of business confidence
from which everything else springs.
 In this phase, production, the number of jobs,
incomes and demand gradually increase.

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 The line from the origin shows the trend
growth, long run change in the level of
output over time when full employment of
resources is achieved.
 The deviation of output from the trend
level (Output gap) shows the change in
level of employment of resources from full
employment level.
 Positive output gap shows over
employment of resources and utilization of
improved method of production.
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
Int S E
ro R
du O U
cti C
o n
H E
T to
F Ec
O on
D Peace for our o mi
E N country!!! cs
 48