Introduction to Agricultural Economics

Chapter six:
Macroeconomics Problems and Policies

6.1 Business Cycles

Economic performances of countries change from time to time due to different factors such as:
weather condition, political situation and economic policies followed by countries. Such
fluctuation in economic performance of a country is best depicted by almost regularly
fluctuating curve or path known as Business Cycle. Business conditions never remain
unchanged. Historical evidences show that economies of nations have stages of growth.
Economic fluctuations (boom and slump in economic activities) influence business decisions
tremendously and set the trend of future business. A period of prosperity may be followed by a
panic. The period of prosperity promotes business (opens up large opportunities for production
and employment). In contrast to this, the period of depression reduces the business
opportunities. Periodic fluctuations in economic activities which occur as the economy moves
away from its trend path are known as Business Cycle. The concept of Business Cycle was
developed in formal way only after The World Economic Crises of 1933, known as Great
Depression. One of the major concerns of macroeconomics is the upswing and downswings in
the level of real output called business cycle. Therefore, business cycle can be defined as regular
pattern of path or line fluctuating with the level of economic activity of a country or an economy
around the trend path. The total national output of a country changes from time to time
depending on different negative and positive factors.

• Negative factors like drought and civil wars leading to reduction or fall in total national
output.
• The fall in total output is represented by downward moving curve or path of the
business cycle.

• Positive factors like favorable climate conditions and political stability increase the total
national output.
• This increase in economic performance is depicted by increasing the path of the
business cycle.

Phases of the Business Cycle

These phases are stages through which an economy passes to complete the business cycle (to
complete one cycle). These phases are Peak (Boom), Contraction (Recession), Trough
(Bottom) and Expansion (Recovery). Once completed, these phases repeat themselves. That
means, the sequence of changes is recurrent (is repeating itself), but not periodic and varies in
duration. The duration depends on factors like good or bad economic policies and favorable or
unfavorable natural conditions.

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We can clearly represent this sequence of different phases of the business cycle in the following
way:
Peak (Boom) Contraction (Recession) Trough (Bottom)
Expansion (Recovery) Peak (Boom) ……

Normal business cycles vary from one year to ten or twelve years. They represent a rise and fall
of a nation’s economic activities, such as GDP or GNP, inflation, growth and unemployment.
Contraction or recession follows bad economic policy and bad natural or social factors likes
drought or conflict whereas expansion or recovery follows the opposite factors like good
economic policies or favourable natural factors. During peak, economic activities reach their
maximum after rising during a recovery. In recession or contraction, generally economy
witnesses a downturn in the business cycle during which real GDP declines. During trough
economic activities reach its minimum after falling during recession. Recovery represents an
upturn in the business cycle during which real GDP rises.

Sources of Economic Fluctuations

Over time, real GDP changes for two reasons.
 First, more resources become available which allow the economy to produce more goods
and service
 Thereby resulting in rise of the trend level of output.
 Second, factors are not fully employed all the time due to many reasons.
 Hence, economy produces below its capacity and deviates from its trend path.
Each phase of the business cycle has its own sources or factors leading the economy to take that
phase. These phases have also some characteristics. For instance, economic recessions (or
contractions) and economic troughs are the result of the following major factors:
 Natural factors such as drought caused by shortage of rainfall;
 War which diverts resources from production;
 Inappropriate economic policies;
 Underemployment of the existing economic resources or factors of production;
 And so on.
 These phases are again characterized by the following cyclical recession or cyclical
trough:
 Low output or GDP;
 High unemployment (or low employment);
 Low aggregate demand for both products and factors of production;
 Low per capita income (PCI);
 And so on.
 Economic expansion (or recovery) and peak are the result of the following major factors
which are opposite to the factors that lead to cyclical recession and cyclical trough.
 Political stability;

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 Use of appropriate economic or macroeconomic policies;

 Discovery and use of new economic resources or factors of production such as
minerals like petroleum or oil and deposits of precious metals like gold.
 Utilization of idle resources or factors of production such as labour;
 Use of improved quality workers through training and so on.
 These phases of cyclical expansion or recovery and peak are characterized by:
 
 Higher aggregate output or GDP;
 Low unemployment (or high employment) of factors of production such as labour
and capital;
 High aggregate demand for products and factors of production;
 Larger Per capita Income (PCI); and so on.

Real GDP
Growth trend
Peak
Recession
Recovery

Trough

Time
Fig 6.1 Business Cycle

6.2 Unemployment

Unemployment is a central problem in modern societies and hence macroeconomic stabilization

policies seek to minimize excessive unemployment. The sum of the number of the population in
the working age with jobs and those who are actively seeking job but failed to find it is known as
labor force. The unemployed are those in the working age who are available for work and have
actively sought for employment, but unable to get job at the existing wage.

Not everyone in the working age, without job, is considered unemployed. This includes full-time
students in the working age, people who choose to devote their time to keeping houses or raising
children, retired people, those who are too ill to work, or simply not looking for work. They are
neither in the labor force nor considered unemployed. Only those who are employed and
unemployed are in the labor force. The formulae for employment and unemployment rate are as
follows:

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Employment rate = Number of employed  100

Labor force
Unemployment rate = Number of unemployed  100
Labor force

Example Suppose in a country where there are 130,000,000 total population 5,000,000 people
were unemployed and 85,000,000 held jobs. Calculate,
a) National employment rate
b) National unemployment rate

Solution

85,000,000 85,000,000
a) Employment rate= ×100= ×100=94.4 %
85,000,000+5,000,000 90,000,000

5,000,000
b) Unemployment rate= ×100=5.6 %
90,000,000

Unemployment is of various types, depending upon the underlining causes. There are at least
four kinds of unemployment.

(a) Frictional unemployment

Unemployment resulting from people who have left jobs that didn`t work out and searching for a
new employment or people who are either entering or re-entering the labor force to search for a
job.
• In other word it is a period of unemployment experienced by people due to:
 Voluntarily switching of jobs,
 Entrance to the labor force (E.g. College graduates).
 Re-entering the labor force (e.g. women after delivery).

(b) Structural unemployment

This is unemployment which arises from a change in the pattern (structure) of demand for goods
and services in an economy. While for some goods demand increases for others it may decrease.
When demand for some goods decreases, some workers will naturally be dismissed in that
industry as production of those goods decreases. The structural unemployment also results from
changes in technology. Advances in automation, the development of word processors and other
applications of information technology are all considered to be causes for the rising
unemployment. An extensive retraining scheme or additional education for those with the
‘wrong’ skills would be a more efficient way of reducing this type of unemployment.

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(c) Cyclical unemployment

This is also referred to as demand deficiency unemployment. It results from declines in national
output in periods of recession or low economic activity. When cyclical unemployment is present,
the economy is not utilizing its labor force to the extent possible. This type of unemployment
affects the whole economy rather than particular industries. The cyclical unemployment is
viewed as controllable and it is this type of unemployment with which macroeconomic policy is
largely concerned.

The total amount of unemployment is the sum of frictional, structural and cyclical
unemployment. Frictional and structural unemployment are regarded unavoidable and known as
normal unemployment. Full employment does not mean zero unemployment. That is, when there
is full employment there may be some unemployment but that unemployment is no more than the
natural unemployment.

d) Seasonal unemployment

Unemployment caused by seasonal shift in labor demand in a year (results from seasonal
fluctuations in demand or seasonality of work).
• E.g. due to bad weather, construction workers may be laid off.

6.3 Inflation

It is one of the most serious and universal economic problem. Inflation is a situation of
continuously rising general level of prices. The important point to note is that during inflation
all prices are not necessarily rising. Even during periods of rapid inflation, some prices may be
falling while others may be relatively constant. Depending upon its sources, it is now customary
to classify inflation as demand-pull and cost-push inflation.

a) Demand-pull inflation

This is a situation where aggregate demand persistently exceeds aggregate supply at or close to
full employment. A demand-induced inflation is usually explained in terms of the conditions in
the markets for factors of production. When there is excess demand for goods and services at
full-employment, firms increase their demand for the factors of production. Since resources are
already fully employed, the prices of factors of production will rise. For instance, producers will
have to pay higher wages to attract workers away from their existing jobs. This may increase
cost of production which has an upward pressure on the prices of goods and services. Therefore,
inflation may give rise to wage claims which increase firms’ costs. The rise in wages and other

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factor incomes will result in increasing aggregate demand, so that once again we have excess
demand and so the process goes on.

PL AS

P1
Pe AD2

AD1

Ye Y1 Real GDP
Figure 4.2 Demand-pull inflation

b) Cost-push inflation

It describes a situation where the sources of upward pressure on prices are raising costs. The
wage-price spiral may be set in motion by increases in costs which are not related to conditions
of excess demand. Examples are rises in the prices of imported materials and an increase in
wages which exceeds any increase in productivity. Sometimes labor unions have considerable
market power that even with some unemployment, and some unutilized industrial capacity, the
stronger unions can achieve wage increases. If cost per unit rises, profits will become less. The
fall in profits has a discouraging effect upon producers. As a result, the aggregate supply of
goods and services will fall in the economy. The decline in supply, in turn, pushes up the price
level. PL AS2
AS1
P1

Pe
AD
Real GDP
Ye Y1
Figure 4.3 cost-push inflation

Inflation can be measured by the means of the general price level which, in turn, is measured by
the price index. A price index compares the cost of a given combination of goods and services
for two or more different years. The first step in constructing a price index is to select a group of
goods and services known as ‘market basket’. The price of the market basket goods and services,
in a particular year known as the base year, is set at 100. Then for other years, the price of the
same goods and services in the market basket are compared against the base year. If it is greater

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than 100, that means the price level in that year is higher than it was in the base year. Similarly,
if it is less than 100, the price level in that year is lower than it was in the base year. Thus,

Price index = Cost of market basket in a given year x 100

Cost of the same market basket in the base year

The rate of inflation is measured as the annual percentage change in the values of price index.
Rate of inflation = Price index in year2 – price index in year1 x 100
Price index in year1

Types of price index

A price index is a measure of the proportionate or percentage changes in a set of prices over
time. Each month, prices are collected for a group of well-defined and clearly described
products. These prices collected during a specific point in the month are compared with prices
at another point in the past. One well-known example of a price index is a Consumer Price
Index (CPI); however, there exists another important price index – the Producer Price Index
(PPI).
i) Consumer price index (CPI)
This is the most prominent price index. It aims to measure the change in the average price of a
market basket of goods and services which represents the consumption pattern of a typical
household. The CPI does not include capital goods, exports or items of government purchase.
The price of imported goods purchased by a typical consumer, however, is considered. A
primary use of the CPI is to adjust income and expenditure streams for changes in the cost of
living.

Example

Imagine that a typical consumer purchases only three consumer goods and services. We would
conduct a survey of expenditure habits in the base year (suppose it is 1999) and in the year
under consideration (say 2000).

Table: 6.1 represent the hypothetical results.

Year
1999 (base year) 2000
Market Quantity Market Cost of Market Cost of
basket of purchased price market price market
goods and basket basket
services
Shirt 3 90.00 270.00 100.00 300.00

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Meat/kg 24 2.00 48.00 2.50 60.00

Bus ticket 480 0.15 72.00 0.25 120.00

Total cost 390.00 480.00

We note that the cost of buying 3 shirts, 24 kg of meat and 480 bus tickets was birr 390.00 in
1999 and the cost of buying the same goods and services of the same quantities was 480.00 in
the year 2000. Thus,
CPI = Cost of market basket in 2000 x 100
Cost of market basket in 1999
= 480 x 100
390
= 123.08 percent, and
Rate of inflation = 123.08 – 100 x 100
100
= 23.08%

This means that CPI in 2000 stands at 123.08. The price index number can be used to find out
how much it would have cost to buy the same market basket of goods and services, back in the
base year. In our case, the price index 123.08 tells us that what cost birr 1.23 in 2000 cost birr
1.00 in 1999. This means that it is now costing the consumer birr 1.23 to get as much as goods
and services as he got for birr 1.00 in 1999.

ii) Producer price index (PPI)

The PPI measures the prices of products purchased by producers. This price index measures the
price level for products which are used to produce other goods (not for personal consumption).
Its interpretation is also similar to that of the CPI. A primary use of the PPI is to deflate revenue
streams in order to measure real growth in output.

The relationship between inflation and unemployment

There is inverse relationship between unemployment and inflation and it is generalized in the
Philips curve as shown below.

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Inflation rate

Unemployment rate

Fig 6.2 The Philips curve

The curve shows that when unemployment is low, inflation is high and when unemployment is
high, inflation is low. This inverse relationship between unemployment and inflation seemed to
have important implications because both stable prices and full employment are major
objectives of economic policy. The Philips curve presents the policy makers with a choice
between unemployment and inflation. That is, government could choose between more
unemployment and less inflation, or less unemployment and more inflation.

6.4 Instruments of policy

One of the most controversial questions in macroeconomics today is how to stabilize business
cycles. Stabilization means maintaining full-employment and a reasonably stable price without
affecting the process of economic growth. There are a number of economic policies used to
achieve economic stability. These include fiscal policy and monetary policy.

a) Fiscal policy: Fiscal Policy can be defined as the tools that the government uses to achieve its
economic objectives, these tools are government spending and taxes, and the government adjusts
its spending levels and its tax policies. Fiscal policy can achieve several objectives; the first and
the most important objective of fiscal policy is the full utilization of resources, this is will
eventually increase the employment rate and improve the standards of living in the economy.
Price stability is the second objective of fiscal policy which can be achieved through balancing
between the aggregate demand and aggregate supply to avoid prices inflation. Is the deliberate
manipulation of government expenditure and taxation so as to achieve desired economic and
social objectives. The government expenditure increases private incomes and, thereby the
private expenditure on goods and services, and transfer payments. Taxation reduces private
disposable income which, in turn, reduces the private expenditure.

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The powerfulness of fiscal policy in world with unemployed resources is that fiscal policy has a
direct impact on aggregate demand. A tax cut and rise in government expenditure aimed at
increasing aggregate demand is known as an expansionary fiscal policy. A contractionary
fiscal policy is a policy aimed at restraining aggregate demand by increasing tax and reducing
government expenditure.

Fiscal policy can influence the economic factors by adjusting government spending and taxes.

 In case of recession, the government should use expansionary fiscal policy by increasing
government spending, decreasing taxes, or a mixture of both. Increasing government
spending will create more money in the economy and will help in creating more jobs and
more economic growth rate. Decreasing taxes will increase the purchasing power of
people which in return will increase the aggregate demand in the economy. By applying
this policy, aggregate demand and employment will increase thus the government will
achieve higher economic growth.

 In case of inflation, the government may use contractionary fiscal policy by increasing
taxes, decreasing government spending, or both. Increasing taxes will decrease the
purchasing power of individuals which will result in lower demand. Decreasing
government spending will decrease aggregate spending in the economy which will
decrease the inflationary gap.

b) Monetary policy: Monetary policy is basically used by central banks and governments to
encourage the economic growth or to discourage the growth rate to avoid economic issues such
as inflation. By facilitating borrowing and spending to people and businesses, monetary policy
will help the economy to grow faster, while limiting spending will make the economy grow
slower.

 In case of recession, the government may use expansionary monetary policy by buying
government bonds, lowering the interest rate, or lowering the reserve ratio. Thus, the
money supply will increase in the economy, unemployment will decrease, and borrowing
and spending will be stimulated.

 In developed countries, governments may want to decrease the money supply by using
contractionary monetary policy in which governments sell government bonds, raise the
interest rate, or raise the reserve ratio. This can help in dealing with economic issues
such as inflation.

It refers to actions taken by national bank to manipulate either the supply of money or interest
rate to bring about desired changes in the economy. The following are the traditional monetary
instruments through which a national bank carries out the monetary policies.

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i, Open market operation: These operations mean sales and purchases of treasury securities
(e.g. government bonds) at the free money market between the central bank and commercial
banks. If the central bank sells government securities to commercial banks, it reduces the money
supply. If the central bank buys government securities from commercial banks, it increases the
money supply in circulation.

ii, Changes in discount rate: It is also called the bank rate policy. Commercial banks and other
financial institutions can borrow from the central banks of a country at discount rate. The
amount that these banks and institution borrow from central bank affects the monetary base. The
important thing about the bank rate or discount rate is that it is lower than bank lending rate;
therefore banks have an incentive to borrow from the central bank at discount rate and lend
those funds at higher interest rates. Discount rate policy, which primarily involves changes in
the discount rate, affects the money supply by affecting the volume of discount loans and the
monetary base. A rise in discount loans adds to the monetary base and expands the money
supply; a fall in discount loans reduces the monetary base and shrinks the money supply.

iii, Changes in the required reserve ratio: Every bank is required by law to keep a certain
percentage of its total deposits in the form of a reserve fund in its vaults and also a certain
percentage with the central bank. When prices are rising, the central bank raises the reserve
ratio. Banks are required to keep more with the central bank. Their reserves are reduced and
they lend less. The volume of investment, output and employment are adversely affected. In the
opposite case, when the reserve ratio in lowered, the reserves of commercial banks are raised.
They lend more and the economic activity is favorably affected. Changes in reserve requirements
affect the money supply by causing the money supply multiplier to change. A rise in reserve
requirements reduces the amount of the deposits that can be supported by a given level of the
monetary base and will lead to a contraction of the money supply. Conversely, a decline in
reserve requirements leads to an expansion of the money supply because more multiple deposits
creation can take place.

A tight monetary policy involves a reduction in the growth of the supply of money and/or an
increase in the interest rate. This has a demand decreasing effect. An easy monetary policy is a
policy when the national bank acts to increase the growth of money supply and/or to reduce the
interest rate. This policy has a demand increasing effect.

Fiscal policy and monetary policy together:

Both policies can be used at the same time in order to achieve economic stability. In case of
recession, the government will use expansionary fiscal policy by which it increases its spending
or reduces its taxes, and at the same time it can use expansionary monetary policy which leads
to a decrease in the interest rate and stimulation of investments.

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But if the economy suffers from inflation, contractionary fiscal policy will be used by decreasing
the government spending or increasing taxes which leads to a lower aggregate demand, at the
same time, contractionary monetary policy can be used which leads to an increase in the interest
rate and thus a decrease in investments and aggregate demand will occur.

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