MACRO ECONOMICS ECO2214

Introduction

Macroeconomics is concerned with the behavior of the economy as a whole. It

is concerned with booms and recessions, the economy’s total output of goods
and services and the growth of output, the rate of inflation and unemployment,
the balance of payment, the level of savings (savings rate), level of investment
(investment rate), level of government revenue/ government expenditure,
private consumption and exchange rates. Macroeconomics deals with long-run
economic growth and short-run run fluctuations that constitute the business
cycle. It concentrates on the general consequences of the individual actions of
households, businesses, consumers, government, and foreign sectors. Hence it
is the study of the whole economy.

Macroeconomics also focuses on the economic behavior and policies that affect
current issues such as; consumption and investment, trade balance, changes
in wages and prices, monetary and fiscal policies, money stock, interest rate,
and national debt. In brief, macroeconomics tries to deal with major economic
issues of the day. Therefore, we have to understand these issues as they lie in
the interactions among the goods, labour, assets, and markets of the economy
and the interaction among the national economies whose residents trade with
each other. In dealing with these essentials we go beyond details of the
behavior of individual economic units such as households and firms and the
determination of prices in particular markets which are subjects of micro
economics. The major difference between micro and macro is primarily one of
emphasis and exposition. For example, in studying price determination in an
industry in micro economics we assumed prices in other industries are
constant whereas in macroeconomics where we assume average price level it is
more sensible to consider changes in prices in other industries.

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The behavior of each individual representative should be identified before
aggregating for example the Marginal propensity to save for an individual is
more than 0 so we can assume the aggregate MPS to be greater than zero.
Therefore 0 ¿ MPS<1. after developing a theory of aggregating then there is a
need of empirical analysis with the purpose of

1. Validation of empirical data (hypothesis testing)

2. Measurement of data that the theoretical analysis has identified
3. Explaining an economic theory
4. Providing the basis for predictability of the likely future trend of the
economy.

ISSUES IN MACRO ECONOMICS

Macroeconomic analysis is interested in the determination of the variables and

the factors affecting them at a particular moment of time. Therefore, macro-
economic is a time dimension analysis.

1. GDP/ GNP (New economic activity (growth) (How do we determine

economic growth)

The most important measure in macro-economics is the measure of economic

activity (GDP). It is the total monetary value of all economic activities which are
undertaken within the territory boundary of the economy regardless of the
citizenship. A similar measure GNP measure the monetary value of all
economic activities under taken by all nationals of a country irrespective of
geographical location.

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 B
Trend
GDP
GNP
D
A

Time

The upward long run time trend is referred to a growth. But within the long
run there are short run points A & B are called peaks C & D are called troughs.
The movement from point A to B is called the business cycle.

2. UN-EMPLOYMENT (Level of unemployment (UNE) (how do we

explaining the high level and persistent unemployment)

This refers to the number of people out of jobs and are actively in search for
jobs as a proportion in labor force. Un employment is closely related to
business cycle. This because short run moments of unemployment are often
observed to be linked with short term activities in the level of economic activity.
In Uganda unemployment rate stands at 12% which translate to over 1million
people. Macroeconomic research focuses on persistent unemployment as a
central question. There are many theories why persistent high unemployment
is possible. There is a policy question of what need to be done about this

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unemployment. Some say not much can be done and advocate a hands-off
policy. Others view an active fiscal policy like cutting taxes. Or raising
government expenditure when unemployment is high so as to create demand
and hence jobs.

3. INFLATION (How do we explain inflation)

This is the measure of % change in average level of prices it is measured using

C.P.I. C.P.I measures the average price for the market of goods and services for
consumption.

CPI t−CPI t−1

π= X 100
CPI t−1

4. External position of the economy (B.O.P)

Controversies in macroeconomic thought (Schools of Thought)

There are two major schools of thought namely the classical under Adam Smith
and the Keynesian under J. KEYNES. The fundamental difference between the
two that the Classicals believe that markets work when left on their own. (no
government intervention). The Keynes argues that government intervention can
significantly improve the operation of the economy.

CLASSICALS

The classical believe in the existence in the automatic mechanism in the

system. They believe that market forces work best when left on their own. They
believe that there is no unemployment. This school was built on inter related
behaviors which include;

1. SAY’S LAWS, which states that supply creates its own demand that is
whatever is supplied/produced will be demanded. This means that the
income derived from producing certain goods by some people, allows
them to purchase goods produced by others. Since all people have a need

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 to purchase goods, they will seek to produce some goods to derive
income and buy whatever they want. Therefore, there is no
unemployment. Thus the product markets will always necessarily be in
equilibrium.
2. Quantity theory of money: QTM states
MV = PQ where M = money supply, v = velocity of money, P = Price level
and Q = real output.
3. Real theory of interests (Saving =investment)
This states that factors which determine interest rates are basically those
which affect real productivity of capital but not real monetary factors.
The real theory of interest by Fisher argues that real economic variables
determine the real interest rate. The theory says that the real interest
rate
r adjusts so desired saving S equals desired investment
4. Wage and price flexibility

If prices and wages are flexible both in the upward and downward direction the
economy will be at full employment. The classical theory proposes that all
markets equilibrate because of adjustments in prices and wages which are
flexible. For instance, if an excess in the labor force or products exist, the wageSL2
or price of these will adjust to absorb the excess.

P
W SL1
Wage w2

w1 w2

w1
DL2

DL1
D2

L2 L1 L2 Labour
L1

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KEYNESSIAN SCHOOL OF THOUGHT

This school of thought or model concentrates on the aggregate demand side of

the economy. Keynesian argues that unemployment was a consequence of
insufficient spending of government on goods and services and capital
demanded by the business sector.

e2
DD

DS DD2
AD1

e1

Yf Output
ye

When ye ¿ y f then we have a recession, Keyness maintains that the only way to
reduce unemployment is by increasing output to y f by increasing aggregate
demand.

The new Keynesian

They don’t believe that markets clear all the time but they seek to understand
why markets can fail. They argue that markets sometimes do not clear even
when individuals are looking for their self-interest. Both information problems
and cost of changing prices lead to some price rigidities which may cause to
some economic fluctuation of output and unemployment. For example, in the
labour market if you decide to cut wages not only reduce the cost of labour but
also may attract low quality workers. Therefore, firms may remain reluctant in
cutting wages.

MONERERIST

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This school was developed in 1960’s under the leadership of Milton
‘FREIDMAN’. These economists advocated for monetary policy and stressed the
work of money markets in the economy. Higher interest rate lower money
demand since money supply is assumed to be fixed. they believe that
controlling the supply of money directly influences inflation and that by
fighting inflation with the supply of money, they can influence interest rates in
the future.

AD1
ms
i1
i
i2 md

md md

Monetarists believe that velocity (V) is constant and changes to money

supply (M) is the sole determinant of economic growth, a view that serves
as a bone of contention to Keynesians.

NEW/ NEOCLASSICALS/ RATIONAL EXPECTATION

This school developed in 1970’s under the leadership of ROBERT LUCAS and
others. These shared many policy views with Friedman. This school sees the
world as one in which individuals act rationally in their self-interest in markets
that adjusts rapidly to changing conditions. They claim that the government
slightly worsen the situation by intervening. The school is based on these
major assumptions.

1. Economic agents aim at maximization. Households and firms make

optimal decisions. This means that they use all available information in
making best decisions.

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 2. Decisions expectations are rational which means that they are
statistically the best prediction of the future that can be made using the
available information.
3. Markets clear. There is no reason why firms or workers would not adjust
wages or prices in the market if that would make them better off. This
will result into market supply equal to market demand.

Therefore, there is no involuntary unemployment. Any unemployed person who

really wants to a job will offer to cut his or her wage until the wage is low
enough to attract an offer from some employer. The major assumption of new
classical is that markets are continuously in equilibrium.

KEY MACRO ECONOMIC CONCEPTS

GDP. Recall that the primary measure we use is the GDP, it can be considered
both income and output. GDP is the measure of the monetary value of goods
and services provided in an economy in given period of time. It can also be the
measure of all final goods and services produced in an economy in a given
period of time (quarter or year). There are three important distinctions that
need to be made

a) Nominal V’s Real GDP

b) Level of GDP (Nominal or real) vs the growth of GDP
c) GDP VS GDP per capita.

Normal GDP (current shilling GDP) measures the value of economy’s total
output at the prices prevailing in particular period. On the other hand, Real
GDP measures total output produced in any one period at the prices of some
base year. Real GDP values output produced in different years at the same
price implies an estimate of a change in real or physical production between
different years. Uganda’s current GDP per capita $878 (Shs3.2m) annually.

GDP DEFLATOR

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Is the ratio of nominal GDP to real GDP?

N GDP
GDP def =
R GDP

GDP Per Capita: Is the ratio of total GDP to total population of a country =
GDP
Total Popn

PRICE LEVELS & INFLATION

Price level is the overall level of prices in the country as usually measured
empirically by a price index. There are many indices of the price level but the
commonly sighted is the CPI: CPI is a price index measuring the value of a
basket of goods bought by consumers in a particular country. For example,
consider the following table below CPI =Cost of market basket of goods in a
given year/cost of market basket of goods in a base year *100%. CPI Measures
inflation over time.

Good Mkt v.2018 Mkt v. 2019 Mkt v.2020

Beans 400 450 300
Maize 1000 1050 900
Juice 200 200 300
Total value 1600 1700 1500
CPI 100 106.25 93.75

= x 100 II=¿ (CPIt – CPIt-1)*100/ CPIt-1

For example, inflation rate in year 2019 was 6.25%.

GDP DEFLATOR Vs CPI

Prices of capital goods are included in the GDP deflator when are produced
domestically however they are excluded when calculating CPI domestically.

Prices of imported goods

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There are included in CPI but excluded in GDP deflator calculations

The basket of goods is fixed under CPI but changes every year under GDP
INFLATION AND UN EMPLOYMENT & GROWTH

Macro-economic performance is judged by three broad measures we have

introduced i.e. inflation rate, the growth rate of output and the rate of
unemployment. The high growth rates indicate that the production of goods &
services has increased and hence increased standard of living. The growth rate
of real GDP is the most important of all indicators of the performance of the
economy in the long run. Therefore, it is associated with lower unemployment
levels. However, there is a tradeoff between inflation and unemployment in the
short run as shown by the Philips curve.

inflation

o Unemployment

The curve suggests that lesser/ lower unemployment can always be obtained
by allowing more inflation and vise-vasa.

An increase in the demand for labour as government spending generates

growth. The pool of unemployed will fall, Firms must compete for fewer workers
by raising nominal wages. Workers have greater bargaining power to seek out
increases in nominal wages. Wage costs will rise. Faced with rising wage costs,
firms pass on these cost increases in higher prices

STOCKs Vs FLOWs

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A flow is can economic magnitude measured at a rate per unit of time such as
production of milk per week, consumption of wine per year, and total output of
the economy in a particular year. Stock on the other hand is a magnitude
measured at a point in time such as total number of buildings in Kampala.
Most of the previous concepts such as capital in the economy is a stock. The
capital of an economy is accumulated stock of residential buildings, factories
and equipment etc. investment spending is a flow of output in any given period
and is the difference in capital stock between two different periods. Wealth and
Saving and also represent stock-flow relationship where difference in wealth
represent saving.

NATIONAL INCOME ACCOUNTING

National income. This is the amount of goods and services expressed in

monetary terms within a given accounting period basically one year.

There are three approaches of measuring national income namely:

a) Income approach which consider income received by all factors of

production
b) Expenditure approach. This divides GNP/ GDP according to who bought
the goods and services
c) Product/output approach which considers value added.

PRODUCT APPROACH

In this approach we measure GDP by measuring the value added in the

production of goods and services in different industries.

GDP = TR – TC. TC = Costs of intermediate inputs

Expenditure approach

We measure GDP by measuring total expenditure on final goods and services

by different groups. i.e households’ business, foreign sector and government

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GDP = Y = C + I + G + EX ------(1)
Y = Cd + Id + Gd + EX ------- (2)
Y = (C – Cf) + (I – If) + (G – Gd) + EX
Y = C + I + G + EX – IM
Y = C + I + G + CA
CA = Current a/c
Y – (C + I + G) = CA  =

S = Y – (C + G) = CA + I

The way the above equation is written (1) is not the usual way it should be
written. The more convectional way is writing it in two steps.

Y = (C – Cf) + (I – If) + G -Gf) + EX.

C = Cd + Cf I = Id + If + If, G = Gd + Gf
IM = Cf + If + Gf
Stage (2). Y = C + I + G + CA
CA = EX - IM

INCOME APPROACH

This is by measuring total income by different groups producing goods and

services. The incomes are in form of wage, rent, profit and interest. These are
pre-taxed income. They don’t include tax. It should be noted that

1) For the only goods and services that goes through organized markets
are included in GDP calculation.
2) Only final goods and services count in GDP.
3) Production within the geographical boundary of the country is
considered.
4) GDP for a particular year includes only goods and services produced
within that particular year.

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All the above three approaches should give the same measure of GDP as it can
be explained by circular flow of income.

MEASURING GDP THROUGH PRODUCTION

GDP is the value of the final goods and services produced in country within a
given year by both citizens and non-citizen’s. Emphasis is put on the word final
to avoid double counting. Value added = R – C=revenue earned by the firm
minus the amount it pays for products from other firms used as intermediate
output. In measuring GDP, we use the value of the market price of the goods
and services.

Y = C + I + G + CA
S=Y–C–G
S = I + CA
S – I = CA
S = (Y – T) – C + (T – G)
Private public

Alternatively

National saving can be thought of as the amount of remaining income that is

not consumed, or spent by government. In a simple model of a closed economy,
anything that is not spent is assumed to be invested:

National Saving=Y-C-G=I

National saving can be split into private saving and public saving. Denoting T
for taxes paid by consumers that go directly to the government and TR for
transfers paid by the government to the consumers as shown here:

Y-T+TR-C)+(T-G-TR)=I

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(Y − T + TR) is disposable income whereas (Y − T + TR − C) is private saving.
Public saving, also known as the budget surplus, is the term (T − G − TR),
which is government revenue through taxes, minus government expenditures
on goods and services, minus transfers. Thus we have that private plus public
saving equals investment.

The market prices of goods and services include indirect taxes such as sales
and exercise tax. The amount is greater than the amount licensed by factors of
production that produce the goods. The mount received by fop is net and
indirect tax and is called factor cost.

GDPFC = GDPmp - Indirect taxes

Some useful identities

National income accounting is just a series of identities. Consider these two

useful identities

Y=C+I+G+X ……………………..1

Y=C+S+T+M……………………….2

The first identity mean that final output is is either consumed, invested,
purchased by government or exported. The second identity implies that
individuals may spend their income on either consumption consumed, saving,
paying taxes or on imports. Combining the two equations we get the following

X-M= S-I+T-G

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EXAMPLE

Total spending on goods and services produced in a country during any given
period can be broken down as
C + I + G + NX = GDP where,
Y = 5950.7
I = 770.4
G = 1114.9
EX = 636.3
IM = 666.7
T = 837.9

C = 4095.9

Find (i) CA and comment on it value

(ii) Level of National Saving
(iii) Level of Disposable income

CA = EX – IM = 636.3 – 666.7

= -29.6

(ii) S = (Y – T) – C + (C – G)
S=Y–C–G
5950.7-
S= CA + I

MEASURING GDP THROUGH INCOME

Residents of a country who produce GDP receive income for their work. The
value added in production which is the different between revenue and the cost
of intermediate output must be some body’s income in form of wages, interest

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profit and rent but part of GDP goes as depreciation and thus cannot be
counted as part of part of income. Also GDP is valued at market prices which
include indirect tax. However, the income accruing to the producers doesn’t
include indirect taxes. This holds for defining net domestic income.

NDI = Wages +profits +rent + interest.

From the net domestic income, we can obtain personal income received by
household and incorporated business. We have to subtract corporation profit,
transfers, dividends and interest on government debt from NDI. Subtracting
taxes (indirect) from personal income and adding transfers gives disposable
income.

Yd = PI – Indirect taxes + TR

EQUILIBRIUM OUTPUT DETERMINATION USING KEYNESSIAN APPROACH

According to Keynesian the level of national income is determined by the

aggregate demand for goods and services in the economy. He argued that the
major variables that determines of national income are those variables that are
exogenous (Government taxes and government expenditure). Therefore, fiscal
policy is the basis of the Keynesian approach to national income determination.
In the AD / AS model equilibrium output is determined when AD = AS

According to Keynesian Aggregate expenditure determines demand for goods

and services and AS measures total output produced by all sectors in the
economy. If AD ¿ AS the economy experiences an inflation gap.

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 AS
recession

AS  AD AD = C+I+G+NX

00
AS
45⁰
ye O/P
The Keynesian believed that it is possible to be in equilibrium at less than full
employment level. This is because firms usually operate at less than optimal
capacity such that if there is any increase in AD, they can increase output
without undertaking any new investment. This was explained by Keynesian
multiplier concept in that a change in AD due to an autonomous change that
affects AD leads to a more proportionate change in output.

BASIC ASSUMPTIONS UNDERLYING MULTIPLIER

1) Basic domestic prices and exchange rates are fixed

2) Economy is operating at less than full employment so that an increase in
demand result in the expansion of output and employment.
3) The authorities adjust money supply to changes in money demand by
pegging/fixing domestic interest rate.
4) There is no inflation resulting from money supply expansion because it is
just a response to increase in money demand.

Basic assumption of the Keynesian model includes

1) Government expenditure (G), exports are assumed to be exogenous. G is

determined independently by politician and X is determined by foreign
Expenditure decision and foreign income.

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 2) Domestic consumption is partly Autonomous and partly endogenous and
a linear function of national income.
C= Co + bYd. Yd = (Y – T) + TR
0<b<1
3. Import expenditure is assumed to be endogenously determined and
depends on level of national income.
M = Mo + MY O<MPM ¿ 1
4. Investment expenditure is partly autonomous and partly depend on
income
I = Io + iY
0< i¿ 1
5. Government tax is partly autonomous and positively related to national
income T = T – X + Y, 0 ¿ t ¿1, t= tax rate.

2- SECTOR MODEL

Y=C+I
C = CO + bY
I = Io
Y – bY = Co + Io
Co + I o
Ye =
1−b
Co + I = M = autonomous spending
1 – b = mps
DY 1 1
= = >0
DI 0 1−b mps

3- SECTOR MODEL

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Y = C + I + G …………………. (1)
C = Co + bYd
Yd = Y – T + TR
I = To, G = Go
bTR−bT o + I o +Go+Co
Ye =
I +bt + b
Co+ I o +Go+ bTR−bT o
Y=
I + b+bt
A=Co+ Io +Go +bTY −bTo
A
Y =¿
I −b+bt
dγ 1 dy dy
dI o
= = n = ¿ 0
1−b+ bt dCo dGo
dY −b dY b
dT
= 1−b+ bt
<0 =
dTR 1−b+ bt
>0

Example:
C = 300 + 0.8Yd, T = 200 + 0.25Y, TR = 100, I = 400, G = 500
Find (i) Y e (ii) A (iii) G’ Revenue (iv) G Budget position (v) equation
Consumption (vi) = APS (vii) APC

300+200+300−0.8 X 200+ 0.8 X 100

Ye =
1−0.8+ 0.25 X 0.8

1120
Ye= = 2800
0.4
A = 1120
R = T = 200 + 0.25 x 2800 = 900
(iv) R – E = 900 – (500 + 100) = 300
= 300 + 0.8(2800-900+100)
C= 1900

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 1900
APC = = 0.68 ≂ 0.7
2800
TS
APS = = 0.32 ≂ 0.3
X

4- SECTOR MODEL

Y=C+I+G+X–M
C = Co + bYd
Yd = Y – T + TR
T = T o +tY
M = Mo + MY
I = Io + iY
Y = Co + b(Y – T + TR) + Io + iY + Go + Xo – (Mo + MY)
Y = Co + bY – b(To + XY) + bTR + Io + iY + Go + X0 – M0 –MY
(1 – b + bt – i + m) Y = Co – bTo + bTR + Io + Go + xo – Mo
Co +G o+ x o −bT −M o +bTR
Y =
1−b+bt−i+m
A
Y -
1+ m−b(1 – t )– i
1 + m ¿ b(1-t)
dy −1
1–b¿0 =
dm 1−m−b ( 1−t )−l
Qn. C = 400 + 0.75yd

T = 200 + 0.2Y I = 600, G = 500, TR= 100 M = 200 + 0.1 Y, X = 500

d Y dY
Find (a) Y , b)= A , (c) C (d) APC & APS (e)T, (f) d , (f) (GBP) d CA
d G o dT −0

(e) If there is a change in government expenditure by 100, what is the new

government budget position

(f) What will be new of Y if i = 0.2

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Explain the concept BDM and show that it is equal = 1 when I, G, T are
exogenous

National Income and The Foreign Trade Multiplier

In a closed economy equilibrium level of national income is determined at the

level where intended saving equals intended investment . Equilibrium

level of national income in an open economy is determined at the level at which

total leakage, that is, savings plus imports equal total injection, that is,

domestic investment plus exports into the income stream. Thus, in an

open economy, national income is in equilibrium at the level at which

When a change in any of the above four variables occurs, then the change on
the left side of the above equation must equal the change on the right side if
the new equilibrium is to be achieved.

Hence ……………………………………(1)

Now, change in saving,

Where s = marginal propensity to save and

change in national income.

Likewise, change in imports,

where m = marginal propensity to import.

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Thus, rewriting equation (l) we have

or

----------------------------------------------- (2)

It will be known from equation (2) that change in either investment or exports

will cause income to increase by the multiple, .Thus is the foreign

trade multiplier which is generally denoted by . Thus, if exports increase by

, the national income will rise by

Hence,

When there is increase in exports, it will cause the increase in income of the
exporters and those employed in the export industries. They will save some of
the increase in their incomes and will spend a good part of the increases in
their incomes on consumer goods, both domestic and imported ones. While
savings do not generate further income and represent leakage from the income
stream, expenditure on imports leads to the increase in the incomes of the
foreign countries from which goods are imported.

TAX RATE MULTIPLIER.

decrease in tax rate leaves the consumer with large proportion of income
earned. This will increase consumption which results into increase in national
income.

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N.B.

Government spending all taxes affect the level of income. Therefore, fiscal
policy can be used to stabilize the economy. When the economy has a
recession, this should be cut or government spending should be increased and
vise versa.

BALANCED BUDGET MULTIPLIER

Balanced budget multiplier occurs when a given increase in government

expenditure is financed through an equal increase in the tax level. The
question therefore is whether there will be an impact on the economy when an
increase in taxes and increase in government expenditures are balanced.
According to the classical, balanced budget, neutral. According to the
monetarist view balanced budget has a net expansionary effect because a fall
in AD due to an increase in taxes is less than an increase in AD due to an
increase in government expenditure. Therefore, consumption will not decrease
by the full amount of the tax increase.

DERIVING BALANCED BUDGET MULTIPLIER

Consider a closed economy

Y=C+I+G
C = Co + b(Y – T)
T = To, I = Io, G = Go

Balanced budget implies that taxes – Government expenditure equals zero.

BB → T – G = 0

Assuming a change in government expenditure leads to a change in National

Income holding Consumption and investment expenditures constant. Then

Y = C o +b ( Y −T o ) + I o +Go

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ΔY = ΔCo + b(ΔY – ΔTo) + ΔIo + ΔGo

ΔY = b(ΔY – ΔTo) + ΔGo

ΔT – ΔG = 0

ΔY = bDY – b DT0 + DG0

ΔY = b ΔY – bΔT0 + ΔT0 + ΔGo
DY
ΔY = b ΔY – ΔT0(b-1) =1
DT 0
DT0(b-1) = b ΔY – ΔY
ΔT0(b-1) = (b – 1) ΔY ΔY = ΔT0 = ΔG

BDM = 1 implies than an increase in government spending is combined with a

simple increase in tax revenue such that budget position is unchanged.
suppose government tax revenue is endogenous show that the impact of
balanced budget multiplier on the level of national income is less than one.

Y=C+I+G
C = C0 + bYd
Yd = Y-T+TR0 0 ¿ bt ¿ 1
T = To + tY
I = Io, G = Go
DGo → DY
Y = C+I+G
Y = Co + b(Y-To-tY) + Io + Go
DY = DCo + b(DY – DTo-tDV) + DI0 + DG0
DY = b(DY – DG0 – tDY) + DG0
DY = bDY + btDY = -bDG0 + DG0
(1-b+bt) DY = (1-b) DG0
DY (1−b )
<1
DGo 1−b+bt

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If BBM is less than one, it means that if government tries to raise the
expenditure by financing it with a further increase in the tax, the change in
N/Y will be less than the initial change in government expenditure.

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