Cha-1 Macroeconomics I

CHAPTER ONE-MACROECONOMICS I
CHAPTER ONE
CONCEPTS, DEFINITIONS, HISTORICAL DEVELOPMENT OF

MACROECONOMICS & CIRCULAR FLOWS
1.1. Introduction
1.2. Basic Concepts and Definitions
The basic concept of economics are:-.
Economics is a science that explains how society makes decisions about

consumption,
production and
the exchange of G+S.
The 3 basic and wider economic undertakings:-
production,
distribution and
consumption.
Economics is also the study how people allocate scarce resources that have alternative uses
among virtually competing ends.
Resources are of two types, Scare and abundant resources.
Abundant resources:
Resources found in large amount and their use doesn’t require payment.
Air could be an example for such type of resource.
Scarce resources: -
Resources found scarcely or in a limited amount
The use of this resources also requires payment.
This includes Land, labor, capital and technology.
Land can be classified as:
fertile and marginal or
located close and far away from the center.
Labor which is further classified as:
skilled and
unskilled labor.
Capital which can be classified as:-
physical capital that refers to the physical structure possessed and
financial capital which is associated with money.
Technology is also among the resources which can be classified as
Labor intensive technology;
uses more of labor and less of capital
developing countries like ours use this technology
Capital intensive technology
uses more machines and machineries than labor to produce G+S
mostly practiced in the developed countries
why? no adequate labor resource.
All the mentioned resources are directly affecting production.
Economics is further defined as the study of how society decides what gets produced, how and
for whom.
The 3 major problems and questions of economics.
What gets and how much to produce,
How to produce
To whom to produce
Different economic systems to find the best answers/solutions for the questions.
These are:
a. Prior to 1989:- 3 d/t economic systems to provide an answer
I. Capitalist economy: this is characterized by
free market economy-
USA, England, Canada, etc
private ownership-dominated economy
II. Socialist economy:-
public ownership-dominated,
planned or
centralized economy.
Mao’s China, former USSR, former Yugoslavia can be cited as examples.
The socialist economic system ceased to exist since the fall of the Berlin Wall,
1989, except in North Korea.
Ethiopia:- practiced this economic ideology during the Derg regime.
III. Mixed economy:-
Comprises a mixture of the above two systems’ characteristics
Private ownership and public ownership coexist in this system
Most North European countries like Sweden, Norway etc, exercise this system
What to produce and decided based on the
How much to produce available resource
As the available resource increases the level of production also increases
The question how to produce is answered in relation with:-
the available resource and
the technology used
Adam Smith regarded economics as the study of material welfare.
Welfare can be divided into two:-
1. Spiritual welfare: - divine activities and is studied by theology.
2. Material welfare: - the increasing of material welfare
the worldly activities that are encouraged in economics.
Nowadays several branches of economics are existing
1. Labor economics 9. Industrial economics
2. Land economics 10. Agricultural economics
3. Monetary economics 11. Trade economics
4. Resource economics 12. Defense economics
5. Urban economics 13. Health economics
6. Rural economics 14. Development economics
7. Energy economics 15. Environmental economics
8. Transition economics 16. managerial economics …etc.
All economic issues however fall into two categories
1. Microeconomics and
2. Macroeconomics
The words Micro and Macro are derived from the Greek words
‘Micros’ meaning small
‘Macros’ means large
1. Microeconomics:-
The study of issues that do not encompass the entire economy
And are in this sense “small”
It examines the economic behavior of:-
individuals households, businesses and industries
relatively small groups of them like
people operating in a teff market or
firms producing garments
In microeconomics one analyzes a small sector of the economy on the assumption that changes
in that factor are too small to affect the rest of the economy
Thus can be assumed “ceteris paribus”
“Ceteris paribus”
Latin word
Meaning’ let all other factors remain constant’
2. Macroeconomics:
The study of issues that are economy-wide or “large”
It examines the economy as a whole
Concerned with the combined, aggregate effects of millions of individual choices on such
variables
National output
The overall level of employment
The general level of prices
Because these aggregates are large in relation to the national economy, a change in one macro
variable tends to affect all other variables.
Therefore it is wrong to assume ceteris paribus in macro-analysis
Indeed the main purpose of macroeconomics study is to analyze how other things change in
relation to each other
For example if total demand increases then total supply or price will increase
In either case income rises meaning that there is a continuous flow of causation among the
various macro variables:
Level of employment
Demand Supply/or prices income demand
What Makes Macroeconomics Interesting?
Macroeconomics is interesting because

a) It deals with important economic issues and problems of the day
b) Studied as:
why have some countries experienced rapid growth in incomes over the past century
while others stay mired in poverty?
Why do some countries high rates of unemployment or inflation while others maintain
stable economy?
c) Macroeconomics considers many of the world’s most pressing economic problems
persistent unemployment,
soaring inflation,
balance of payment difficulties,
economic stagnation and
unequal distributions of income and wealth.
In order to analyze these problems economists must first:-
identify,
the determinants of the main
measure and
aggregates in the economy
consider
The most important aggregates are:
1. The economy’s total output of G+S

2. The total demand for this output
3. Total employment and unemployment
4. The general price level
5. The balance of payments
6. The rate of economic growth
All aggregates are made up of their constituent parts
Example: total demand for a country’s output consists of the sum of individual demands
This can be written as follows:-
AD = C + I + G + X – M
Where,
AD - aggregate demand (Total demand for domestically-produced G+S = GDP)

C - the sum of all individual consumers’ demands for G+S
I - the sum of all individual firm’s demands for investment goods (investment
spending)
G - the governments demand for G+S (government spending)
X - the total foreign demand for the country’s exports (export of G+S)
M - the demand for imports (import of G+S)
Having an understanding of the behavior of the individual economic agents is a prerequisite to
analyze the main determinants of the above aggregates
Aware of the microeconomic theories of:-
− consumer behavior or the firm
− public sector activity and
− distribution
Because Microeconomics and Macroeconomics are intimately linked
College of Business, Economics, and Social Sciences; Department of Common and Supportive
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1.3. Historical Development of Macroeconomics Theory

1.3.1. Civilization period (400 B.C. - 5th century A.D.)
1.3.2. The Medieval Period (5th century A.D. - 15th century A.D.)
1.3.3. Pre-classical era (early 17th century – late 18th century)
- Mercantilism:
- Pysiocracy:-
1.3.4. Classical Era (last quarter of 18th century A.D. - late 19th century A.D.)
- Capitalist system Advocators
- Capitalist system Opponents
1.3.5. Neo classical era (Late 19th – Depression period)
1.3.6. The Keynesian Macroeconomics School (Great Depression - 1970s)
and Monetarism (1970s and 1980s)
a) The Keynesian school
b) The Monetarist School (From 1970s onwards)
1.3.7. The new Classical macroeconomics (1970s plus)
o Rational expectationists
1.3.8. The Neo-Keynesian School of Thought (1980s)
- Do not believe markets clear all the time - markets fail.
- Information problems and cost of changing prices
Course Title: Macroeconomics I 8

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1.3.1. Civilization period (400 B.C. - 5th century A.D.)

During this period people started to settle down.
The demand for goods and services and private property grew and expanded
The formation of government administration
The cities Athens, Mesopotamia, and Rome, Axum
Land tends to become private property
The era that architecture, literature, ship building, construction of roads and sewages, paintings,
invention of money…etc were flourished
1.3.2. The Medieval Period (5th century A.D. - 15th century A.D.)
Major contributors theologians (Clergy, church men)
Advocated the principle of fairness
The society was classified as landlords and peasants
Theologians contributed in the area of religion, ethics and moral
Worldly activities and material welfare were not applauded and encouraged.
1.3.3. Pre-classical era (early 17th century – late 18th century)
Merchants became economically strong and were able to accumulate wealth
Owing to this merchant capitalism emerged
The influential merchant capitalists were
the merchants of England ….Mercantilists
the merchants of France…..physiocrats
They were the founders of mercantilism and pysiocracy.
Mercantilism:
A set of economic ideas & polices established in England during 17thc

The mercantilists stressed the importance of trade & commerce as source of nation’s wealth
They advocated three policies
1. Protectionism: protecting domestic economy from foreign imports
2. state interventionism: participation of government in economic activities
3. monopoly: protecting different trade routes
These policies were implemented through:

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through peaceful means (trade) and

by colonizing those countries opposing this idea
Great Britain accumulated wealth at the expense of other nations
And become one of the strong economies in the world.
Pysiocracy:-
French economists and philosophers school of thought

Land was the single source of income, wealth and to producing a ‘net product’
Wealth lay in Agriculture and this Wealth consisted of real product
Industry and trade were considered to be sterile or producing only their subsistence.
Strong proponents of individual liberty & strong opponents of gov’t intervention in society
This policy was known as laissez faire; french words meaning “hands-off”.
Quesnay, Francois (1694-1774):
− a French economist laid the basis for the physiocratic school of thought
− agriculture was the source of wealth
− net product- creating an economic surplus
− This “net product” is then available to meet the needs of landowners and the cultivators of
the land, the artisans and merchants
− Quesnay wrote TABLEAU ECONOMIQUE (1758)
to show how the product is produced and circulates between farmers, land
lords and merchants
an INPUT-OUT-PUT) table
This era is regarded as the transition period from feudalism to industrial capitalism
1.3.4. Classical Era (last quarter of 18th century A.D. - late 19th century A.D.)
Fundamental (Basic) goals were:-
produce full employment
a maximum GNP
price stability
Fulflaged Capitalist system era - mainly focused on industrial capitalism
Prior to this period a means of production (land, labor and capital) were not converted into
commodity (a good which can be bought or sold in the market)
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During this period:-

− the means of productions were commercialized.
− Following this:-
industrial capitalism emerged
land, labor and capital were freed from the yoke of feudalism
− there was no more landlord and tenants
− rather the society was divided as capitalist and working class or proletariat.
− The working class was further divided into two
1. agricultural working class- those who were working in the agriculture
2. industrial working class- those engaged on industrial activities
Improvements observed during the classical era were:-
− cities flourished,
− supply increased and price decreased
− people tend to move from rural to urban areas in search of a job
− following this people tend to concentrate in some cities
− then problems which were not seen before emerged
− the system was exploitative at the beginning
− people used to work longer (16) hrs a day with low pay
− two groups of intellectuals emerged
− each forwarding their own ideology in order to deal with the problems
1. who advocate the system of capitalism
2. those who oppose the system
Capitalist system Advocators
Adam Smith, David Ricardo and Robert Malthus…etc were prominent figures
They favored the system
Capitalist system Opponents
Karl Marx and followers were opposing the capitalist system

Karl Marx
suggested for radical change of capitalist system

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wanted to take the system into new dimension

establish the socialist system
England was the first country to establish the capitalist system through industrial revolution
in 1750.
England’s ruling class was considered to be enlightened as it was able to quickly adapt to the
change that took place in its period.
As a result the ruling class changed the system from absolute monarchy to constitutional
monarchy.
All which was in the hands of the kings/queens and exercised absolute power
After the transformation just changed and remained symbols in the new system of government
administration
In the meantime parliamentary system (liberal democracy) emerged
For this matter it could be said that the transformation that took place in England was not
violent and achieved peacefully through technical and technological revolution.
Later in 1789 French revolution took place.
But this was d/t from the transformation of England.
French Monarchy was arrogant and not willing to cope up with changes.
Thus the transition from feudalism to industrial capitalism occurred through bloodshed or class
struggle or violent means.
Economic ideas started to be discussed as a science
Why?
Because of the contribution of Adam smith and
Publication of his famous book The Wealth of Nations (1776)
General economics emerged as a science of wealth during this period
The ruling principle was the invisible hand coined by Adam smith
The rule placed great faith in the natural self-adjustment mechanism of market
as a means of maintaining full employment equilibrium

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With regards to macroeconomic thought:-

there was no single unified or formalized theory of
aggregate employment, and
substantial differences existed between economists on the nature and origin
of business cycle prior to the publication of the General Theory of
Employment, Interest and Money (Keynes, 1936)
Hence the structure of classical macroeconomics mainly emerged:
after 1936
did so largely in response to Keynes’s own theory.
Classical Economics Assumptions:-
three basic assumptions of Classical Economics theorizes:
1) Flexible Prices:
The prices of everything, the commodities, labor (wages), land (rent), etc. must be both
upwardly and downwardly mobile.
2) Say's Law:
Supply creates its own demand'
The aggregate production in an economy must generate an income enough to purchase all
of the economy's output
If a good is produced, it has to be bought.
3) Savings - Investment Equality:
The household savings to equal the capital investment expenditures.
Classical economists were well aware that a capitalist market economy could deviate from its
equilibrium level of output and employment
they believed that such disturbances would be temporary and very short-lived
The market mechanism would operate relatively quickly and efficiently to restore full
employment equilibrium
With regard to the labor market:-
labor demand and labor supply are brought into equilibrium by the real wage
as a result there is no involuntary unemployment
With regard to the financial market:-

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saving and investment are brought into equilibrium by the interest rate and investments
respond to the interest rate
In the money market:-
money demand is simply a transaction demand
money has no any effect on the real economy
Hence raising money supply simply pushes up prices (i.e. inflationary).
The implication is that, the government has no role in the economy through its monetary
policy.
the classical are proponents of laissez-faire and government intervention
stabilization policies, would be neither necessary nor desirable.
1.3.5. Neo classical era (Late 19th – Depression period)
This school of thought is basically not that much different from the classical school
Neo-classical economics developed in the late 19th and early 20thc-largely in England
It grew out of the blending of marginal concepts (e.g. marginal utility)
Marginal utility- a body of thought developed by 1 st and 2nd generation of marginalists
(Wickcel, Pareto, Goosen, Menger, Fisher, Marshal …etc.
This school developed the 1st branch of economics namely microeconomics theory
Has been very influential in macroeconomic theory
Providing a basis for the later monetarist and New Classical schools
Its methodology is:
strongly microeconomic
it pioneered the use of graphical and algebraic tools to explain economic
relationships
It uses inductive analysis
building generalized theories from basic assumptions
The theory is a deliberate abstraction from reality
Neo-classical economists always tried to check its predictions against historical
experience

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The assumptions of the neo-classical theory

man was a rational utility-maximizer
Markets were competitive and
prices were flexible to clear markets in the long-run
perfect information about all present and future relative prices
their main analytical technique was comparative statics/comparing equilibrium states
Neoclassicists were also concerned with dynamic adjustment processes, trying to
demonstrate that markets tended to equilibrium
Like classical economists, Neo classical schools gave little attention to either the factors
which determine
aggregate demand or
the policies, which could be used to stabilize aggregate demand in order to promote full
employment
Full employment was the normal state of affairs for them
1.3.6. The Keynesian Macroeconomics School (Great Depression - 1970s)
and Monetarism (1970s and 1980s)
A). The Keynesian school
During the depression period (1929-1933):-
Great depression
GDP decreases by 27%
Cyclical unemployment emerged-unemployment increased from 3% to 27%
The problem of high unemployment sustained until 1948
Prices fell but wage was not flexible
The principle of laissez faire was no more functional
Invisible hand of the Adam smith principle failed
John Maynard Keynes wrote a book called:-
the “General theory of Employment, Interest and Money” in 1936
He called for government intervention by suggesting fiscal policy

His ideas was not accepted until 1948
In 1948 the British government accepted his idea and implemented fiscal policy
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Following this in 1950s and 1960s unemployment problem was resolved in England
Owing to this the Keynesian economics become popular
Fiscal policy has two instruments:-
1. Tax:- it is the major government revenue
2. Government spending: defence and non-defence spending
As a result the 2nd branch of economics, Macroeconomics emerged during the period of
depression
The originator of it was John Maynard Keynes
whose idea was influential until 1970s
In 1970s another problem emerged that is inflation and became a serious problem.
Economy started to decline
Economists tried to solve the problem using the previous principles
B). The Monetarist School (From 1970s onwards)
Milton Friedman understood that the problem worsened due to government intervention
He suggested markets to regulate economic activities by opposing government intervention
Milton’s idea led to the development of a monetarist school of thought
Emphasized regulation of the economy from money side rather than the demand side of the
economy
Monetarism advocated to influence the money side of the economy indirectly through central
banks by manipulating the policy instruments of money supply and interest rate rather than
activist demand management policy (Fiscal policy).
During the early 1970s there was a significant renaissance of the belief that a market economy
is capable of achieving macroeconomic stability
The ‘Great Inflation’ of the 1970s:-
Stagflation (inflation with unemployment) was a challenge for Keynes
provided increasing credibility and influence to those economists
warned that Keynesian activism was both over ambitious
predicated on theories that were fundamentally flawed
1.3.7. The new Classical macroeconomics (1970s plus)

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o During the 1970s, another group of economists provided a much more damaging
critique of Keynesian economics
o Their main argument against Keynes and the Keynesians was that:-
they had failed to explore the full implications of endogenously formed expectations on
the behavior of economic agents.
o Only expectations accepted to incorporate into macroeconomic models-
They adopted some variant of John Muth’s (1961) ‘rational expectations hypothesis.’
o Following Thomas Sargent’s (1979) contribution, rational expectationists, who also
adhered to the principle of equilibrium theorizing, became known collectively as the
new classical school.
o The new classical school aim:-
restore classical modes of equilibrium analysis
by assuming continuous market clearing within a framework of competitive markets
o The assumption of market clearing:-
perfectly and instantaneously flexible prices
flexibility is the most controversial aspect of new classical theorizing
the incorporation of this assumption represents the classical element in their thinking
namely a firm conviction ‘that the economy should be modeled as an economic
equilibrium’
o Thus, to new classical theorists, ‘the ultimate macroeconomics is a fully specified
general equilibrium microeconomics.’
o This approach implies the revival of classical modes of thought.
o This school of macroeconomics sees the world as one
Why?
B/s individuals act rationally in their self-interest in markets that adjust rapidly to
changing conditions
o The government is likely only to make things worse by intervening.
o Their approach is a challenge to traditional macroeconomics
o Who are the traditional macroeconomics?
School thought advocating the usefulness of government action in an economy
a. adjusting sluggishly
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b. with slowly responding prices

c. poor information and
d. social customs
traditional macroeconomics do believe that all those (a to d) impeding the rapid clearing
of markets
o The central working assumptions of the new classical school are three:
1. Economic agents maximize:-
Households and firms make optimal decisions
They use all available information in reaching decisions and
Those decisions are the best possible in the circumstances in which they find
themselves
2. Expectations are rational:-
They (HHs & Firms) are statistically the best predictions of the future that can be made
using the available information
The new classical school is sometimes described as the rational expectations school
Though rational expectations is the only one part of the theoretical approach of the
new classical economists
What does Rational expectations mean?
a. people will eventually come to understand whatever government policy is being
used
b. thus that it is not possible to fool most of the people all the time or even most of
the time
3. Markets clear:-
There is no reason why firms or workers would not adjust wages and prices if that
would make them better off
Accordingly, prices and wages adjust in order to equate supply and demand;
Thus markets clear
o One dramatic implication of these assumptions which seem so reasonable individually is
that:
there is no possibility for involuntary unemployment assumption
Their justifications:
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any unemployed person who really wants a job will offer to cut his or her
wage until the wage is low enough to attract an offer from some employer
Similarly, anyone with an excess supply of goods on the shelf will cut prices
so as to sell
o Flexible adjustment of wages and prices leaves all individuals all the time in a situation
in which they work as much as they want and firms produce as much as they want.
o The essence of the new classical approach is the assumption that markets are
continuously in equilibrium.
1.3.8. The Neo-Keynesian School of Thought
New Keynesian economics is the school of thought in modern macroeconomics that evolved
from ideas of John Maynard Keynes
Keynes wrote The General Theory of Employment, Interest and Money in the 30s, and his
influence among the academics and policy makers increased through the 60s
In the 70s the new classical economists called into question many of the perceptions of the
Keynesian revolution.
The new classical group remains highly influential in today’s macroeconomics
But a new generation of scholars, the Neo Keynesians, mostly trained in the Keynesian
tradition but moving beyond it, emerged in the 1980s
Argument of the New Keynesians
They do not believe that markets clear all the time but seek to understand and explain exactly
why markets fail.
The new Keynesians argue that markets sometimes do not clear even when individuals are
looking out for their own interests
There are information problems and cost of changing prices
lead to some price rigidities
price rigidities help cause macroeconomic fluctuations in output and employment
Example:- in the labor market:
firms that cut wage not only reduce the cost of labor
but are likely to wind up with a poorer quality labor
they will thus be reluctant to cut wages
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The primary disagreement between new classical and new Keynesian economists is over how
quickly wages and prices adjust
New classical economists
New classical economists build their macroeconomic theories on the assumption that wages
and prices are flexible.
They believe that prices “clear” market by adjusting quickly
New Keynesians economists
New Keynesians economists, however, believe that market-models cannot explain short-run
economic fluctuations
So they advocate models with “sticky” wages and prices
New Keynesian theories rely on this stickiness of wages and prices to explain why involuntary
unemployment exists and why monetary policy has such a strong influence on economic
activity.
A long tradition in macroeconomics emphasizes that:-
monetary policy affects employment and production in the short run
This is b/s prices respond sluggishly to changes in the money supply.
According to this view: -
If the money
supply falls
layoffs of people spend

workers less money
Production the demand

drops for goods fall
Why and how the fall of demand for goods causes drop in production and layoffs of workers?
Because prices and wages are inflexible and do not fall immediately

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If they are sticky or inflexible then the decreased spending causes a drop in production and
layoffs of workers.
New classical economist criticized this tradition: - How?
Because they believe that this theory lacked a coherent theoretical explanation for the
sluggish behavior of prices
Much new Keynesian research attempts to remedy this omission.
In New Keynesian economics, among the reasons causing price not to adjust immediately to
clear markets (elements of New Keynesian economics) are:-
1. menu costs-the cost to a firm resulting from changing its prices
2. staggered prices,
3. coordination failures, and
4. efficiency wages.
These elements represent substantial departure from the assumptions of classical economics,
which provides the intellectual basis for economists’ usual justification of laissez-faire.
Thus, new Keynesian economics provides:
a rationale for government intervention in the economy
such as countercyclical monetary or fiscal policy
Whether policymakers should intervene in practice, however, a more difficult question is that
entails various political as well as economic judgments.

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1.4. Circular flow of macro economy

The circular flow shows how an economy works
Using it the interaction existing among sectors in the economy can be illustrated
The working of an economy explained either sectors or economy aspects
1. Sector approach
2. Economy ways
1. Sector Approach:
There are three variations in this approach
Production by firms generates factor incomes
The injections-leakages model comes in 3 common variations

Each based on a d/t combination of the 4 macroeconomic sectors
1. Households-HHs
2. Business firms
3. Government and
4. Foreign Trade
a) Two-Sector Model:
The simplest injections-leakages model includes the household and business sectors
Also termed the saving-investment model
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This variation is often used to illustrate the basic operation of the model including
adjustment to equilibrium and the multiplier process.
The two-sector model captures the role of induced activity through household saving and
the role of autonomous expenditures through business investment.
Saving is the only leakage and investment is the only injection.
b) Three-Sector Model:
The second variation of the injections-leakages model adds the government (or public)
sector to the household and business sectors contained in the two-sector model
This variation is used to analyze government stabilization policies
Especially how fiscal policy changes in government purchases and taxes can be used to
close recessionary gaps and inflationary gaps.
Saving and taxes are the two leakages.
Investment and government purchases are the two injections.
c) Four-Sector Model:
All 4 macroeconomic sectors--household, business, government & foreign are included in
the four-sector Keynesian model
This model is not only used to capture the interaction between the domestic economic and
the foreign sector, but also provides the foundation for detailed, empirically estimated
models of the macro-economy.
Saving, taxes, and imports are the three leakages.
Investment, government purchases, and exports are the three injections.
2. The working of an economy can also be explained into two ways
a) Closed economy:
b) Open economy:
A. Closed economy:
Characterized by absence of international trade.
Can be expressed as either
Y= C+I or Y= C+I+G ………..two and three sector model respectively.
B. Open economy:
Characterized by the presence of international trade.
Can be expressed as
Y = C+ I+ G+ NX………..four sector model.
Where,

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C – Household,
I - firms,
G-government,
NX - foreign sector or trade balance which the difference of total export(X) and import (M). I.e.
NX= (X-M).
C and I are major sectors that highly contribute in the creation of county’s wealth (GNP)
And thus economists tend to analyze C and I so as to conclude for the general economy as the
two sectors
C and I contribute for more than 80% of the total wealth

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Figure 1.1. A circular flow of closed macro Economy
Business
expenses Income
Factor Markets
Labor Labor
Gross Domestic Product
Firms Households
Goods / Goods /
Services Services
Product Markets
Revenue Consumer
spending
Factors of production:
land,
labor,
are owned by HHs or individuals under free
capital and market economy
technology
It’s the households that supply the factors of production.
Firms produce final goods and services (G+S) combing the factors of production that are
offered by the households.
Once the final G+S have been produced then the firms will again supply these G+S to the HHs
Firms will pay for the factors of production they have used in the form of income while the
households make payment to the firms in the form of spending.

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Figure 1.2. The circular flow of open economy
The Circular Flow
Wages, rents,
interest, profits
Factor services
Goods
Household Firms
(production)
Government
Financial markets
Personal consumption
Other countries
All sectors including the foreign sector is involved and that’s why it is called open economy.
Households supply factors of production to firms and firms will have to pay for the use of the
factors of production.
If the government is considered the whole income will not go to the pocket of a household
rather some part of the income will have to be pass to the government in the form of tax.
The remaining part after tax has been deducted is personal disposable income, Yd.
This is the amount that gets into the hands of households.
The personal disposable (Yd) income will then be broken down into 2 major parts
1. Saving (S): the amount that flows out of the system and transferred to banks.
2. Consumption (C): the amount which will be used to purchase different G+S
Under normal condition:
the total amount of personal Yd will be the sum of the consumption and saving
Under abnormal condition:
personal Yd could be equal or below consumption.

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Part of the personal Yd which is used to purchase foreign G+S will leak from the system in the
form of import (M)
Again the one which is leaked as Tax injected into the system as G
Foreigners also purchase goods
exporting will be conducted
and cash will be obtained in the exchange
Exporting will be injected in the form of X.
The money leaked as S will also be injected in the form of investment (I).
Symbolically the above flow forms the aggregate demand that can be expressed as:
AD = C + I + G + (X – M)
At equilibrium aggregate demand and aggregate supply are equal.
Aggregate supply = Aggregate demand
M + Y = C+I+G+X
M= Foreign produced goods
Y= Domestic produced goods
Rearranging the above equation
Y= C + I + G + (X-M) ………… (Spending outlays) ………………..…………… (1)
Aggregate demand (Y) are the sum of consumption (C), investment (I), government purchases (G),
and net exports (X - M).
Y= Yd+T,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,, (income receipt)
As Yd = C+ S, thus rewriting the above
Y= C+S+T-------……………………………………………………………..………..……… (2)
This is the income generated by aggregate production (Y) is used by the household sector for
consumption (C), saving (S), and taxes (T)
At equilibrium: Equation (1), Expenditure = Equation (2), Income

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C+I+G+X-M = C+S+T
Or the other way of calculating the Injection-Leakage Balance is given as below:
The Injections-Leakages Balance
A balance between injections and leakages generates the same equilibrium as a balance between
aggregate expenditures and aggregate production.
A little manipulation of the Y = AE equilibrium condition illustrates why.
Aggregate expenditures (AE) are the sum of consumption (C), investment (I), government
purchases (G), and net exports (X - M).
AE = C + I + G + (X - M)
The income generated by aggregate production (Y) is used by the household sector for
consumption (C), saving (S), and taxes (T).
Y=C+S+T
Substituting each of these equations into the Y = AE equilibrium condition gives us:
C + S + T = C + I + G + (X - M)
Because consumption (C) is on both sides, it cancels out.
S + T = I + G + (X - M)
For reasons that will be apparent later, let's move imports (M) to the left-hand side.
S+T+M=I+G+X
This last equation indicates that equilibrium can be achieved by equating injections I + G + X with
leakages S + T + M.
Most importantly, when aggregate expenditures equal aggregate production (Y = AE), then
injections are necessarily equal to leakages S + T + M = I + G + X.
I+G+X = S+T+M
↓ ↓
Injection Leakage
This implies that at equilibrium total injections (I+G+X) = total leakages (S+T+M)
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Remember:
Injection into economy include investment, government purchases and exports

Whereas leakages (withdrawals) from the economy include savings, taxes and imports
An economy is thus in equilibrium when the rate of injections = the rate of leakages
/withdrawals from the circular flow
The Graphical Model

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Refer the table to an open economy with government sector. In which situation is the economy in
disequilibrium?
C I S G T X M
A 400 150 80 150 200 120 100
B 450 150 100 150 230 120 90
C 480 150 110 150 210 120 100
D 520 150 120 150 210 120 90
Answer:
Check the situation where I+G+X is not equal to S+T+M

It is in A where the economy in disequilibrium
So the answer is A
The economy is in equilibrium in the remaining situations since I+G+X = S+T+M
I+G+X = S+T+M
A 420 380
B 420 420
C 420 420
D 420 420

Cha-1 Macroeconomics I

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Cha-1 Macroeconomics I

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CHAPTER ONE-MACROECONOMICS I

CONCEPTS, DEFINITIONS, HISTORICAL DEVELOPMENT OF

The basic concept of economics are:-.

Economics is a science that explains how society makes decisions about

Demand Supply/or prices income demand

What Makes Macroeconomics Interesting?

Macroeconomics is interesting because

1. The economy’s total output of G+S

AD - aggregate demand (Total demand for domestically-produced G+S = GDP)

1.3. Historical Development of Macroeconomics Theory

1.3.3. Pre-classical era (early 17th century – late 18th century)

- Capitalist system Advocators

- Capitalist system Opponents

1.3.5. Neo classical era (Late 19th – Depression period)

1.3.6. The Keynesian Macroeconomics School (Great Depression - 1970s)

and Monetarism (1970s and 1980s)

a) The Keynesian school

b) The Monetarist School (From 1970s onwards)

1.3.7. The new Classical macroeconomics (1970s plus)

1.3.8. The Neo-Keynesian School of Thought (1980s)

- Do not believe markets clear all the time - markets fail.

- Information problems and cost of changing prices

Course Title: Macroeconomics I 8

1.3.1. Civilization period (400 B.C. - 5th century A.D.)

A set of economic ideas & polices established in England during 17thc

Course Title: Macroeconomics I 9

through peaceful means (trade) and

French economists and philosophers school of thought

During this period:-

Capitalist system Advocators

Capitalist system Opponents

Karl Marx and followers were opposing the capitalist system

Course Title: Macroeconomics I 11

wanted to take the system into new dimension

Course Title: Macroeconomics I 12

With regards to macroeconomic thought:-

Course Title: Macroeconomics I 13

Course Title: Macroeconomics I 14

The assumptions of the neo-classical theory

the “General theory of Employment, Interest and Money” in 1936

He called for government intervention by suggesting fiscal policy

B). The Monetarist School (From 1970s onwards)

Course Title: Macroeconomics I 16

b. with slowly responding prices

Argument of the New Keynesians

New classical economists

New Keynesians economists

layoffs of people spend

Production the demand

Course Title: Macroeconomics I 20

Course Title: Macroeconomics I 21

1.4. Circular flow of macro economy

Production by firms generates factor incomes

The injections-leakages model comes in 3 common variations

Y= C+I or Y= C+I+G ………..two and three sector model respectively.

Y = C+ I+ G+ NX………..four sector model.

Course Title: Macroeconomics I 23

Course Title: Macroeconomics I 24

Figure 1.1. A circular flow of closed macro Economy

Course Title: Macroeconomics I 25

Figure 1.2. The circular flow of open economy

The Circular Flow

Under normal condition: