ECON 302-Intermediate Macroeconomic Theory

KENYA METHODIST UNIVERSITY
Department of Economics and Statistics
ECON 302
Intermediate Macroeconomic Theory
Dr. Levi Mbugua (PhD) – 2014
Open and Distance Learning Instructional
Material
Published by Kenya Methodist University
P.O. Box 267 – 60200, Meru
Tel: 254 – 064 – 30301, 31146
1
TABLE OF CONTENTS
TABLE OF CONTENTS ............................................................................. 2
COURSE OVERVIEW ............................................................................... 3
COURSE OBJECTIVES ............................................................................. 4
COURSE OUTLINE ................................................................................... 6
LECTURE 1 ................................................................................................ 7
INTRODUCTION ....................................................................................... 7
LECTURE 2 ...............................................................................................15
MACROECONOMIC MARKETS .............................................................15
LECTURE 3 and 4 ......................................................................................26
THE DEMAND FOR GOODS AND SERVICES ......................................26
LECTURE 5 and 6 ......................................................................................40
FINANCIAL MARKET .............................................................................40
LECTURE 7 and 8 ......................................................................................57
MACROECONOMIC MODELS ................................................................57
LECTURE 9 ...............................................................................................64
STABALIZATION POLICY AND ISSUES ..............................................65
LECTURE 10 .............................................................................................72
UNEMPLOYMENT ...................................................................................72
LECTURE 11 .............................................................................................84
ECONOMIC GROWTH THEORIES .........................................................84
LECTURE 12 .............................................................................................90
MACROECONOMIC ISSUES AND POLICIES IN RELATION TO
DEVELOPMENT .......................................................................................90
2
COURSE OVERVIEW
I welcome you to the study of Intermediate Macroeconomic Analysis. In this course we
shall study important issues in macroeconomics. Macroeconomics is important since it
facilitates the estimation of the economy’s performance. Also, the macro economy affects
individuals well being, societies well being and affects politics and current events.
This course will help us understand the importance of policy formulation by government,
understand how aggregate variables like Gross National Product, wage rate,
consumption, saving, investments, interest rates will be affected by change in government
expenditure, tax policy, foreign exchange rates among others. Macroeconomics deals
with aggregates which shall be regarded as homogeneous. Generalizations are made
about the whole economy based on small samples of which an assumption is made that
aggregates may be functionally related. This course shall assume that aggregate models
that may be derived to explain the behavior of the economy may end up conforming to
the real world.
Since economics is an empirical science, the economic environment which affects human
daily lives will be discussed. Also the behavior of economic systems from the national
and international perspectives will be analyzed. The goals of macroeconomic policy are
among others; full employment, national income growth, price stability and external
balance. Four criterions are frequently applied in understanding macroeconomics
outcome and these are efficiency, equity, growth and stability. In macroeconomics, the
government plays a major role in terms of policy making.
In this course we shall try to answer questions like;
 Why does the cost of living keep on rising?
 Why are millions of people unemployed even when the economy is booming?
 Why are there recessions? Can the government do something to combat
recession? Why should it?
 What is the government budget deficit? How does if affect the economy?
 Why are so many countries poor? What policies might help them grow out of
poverty?
3
The topics are arranged in 12 weeks and each week has one or more lectures depending
on the topics depth. There are 12 lectures and each lecture has its own objectives which
you should achieve. At the end of each lecture you will find a series of practice questions
that are meant to help you to evaluate your understanding of the concepts presented. You
are advised to attempt all the questions once you have finished studying the relevant
work. A summary of each lecture is also provided at the end with a list of further
resources that you are expected to read and make notes from.
Kindly, make sure that:
 You complete each lecture at a time, before proceeding to the next Lecture.
 You attempt all the questions provided at the end of each Lecture.
Once again welcome and let us begin. Good luck!!!!
COURSE OBJECTIVES
By the end of this course, you should be able to:-

i. Define measurements of macroeconomic variables.
ii. Explain the methodology of economics as a social and empirical science.
iii. Analyze current economic events and public policies.
iv. Formulate models that will help in understanding the macroeconomic
environment in the short-run and in the long-run.
v. Explain how the economic environment affects people and societies in their daily
lives.
vi. Identify the processes involved in formulating insights on the macro economy and
translate these insights into policies
4
REFERENCES AND SUPPLEMENTARY MATERIALS
Branson, W. H. (1972). Macroeconomics Theory and Policy, Haper & Row

Publishers
Gregory, N. Mankiw (2012). Macroeconomics ISBN-10: 1429240024
Richard, G. L. and Chrystal, K. A. (1995) An Introduction to Positive Economics, Oxford
University Press ISBN-10: 0198774259
Weinstein, M. (2005). Globalization, What’s New? Columbia University Press
Columbia
Other Instructional materials/Equipment:

Newspapers publications,
Journals,
Case studies & Government reports,
The internet will also be a strong source of literature and knowledge
Course Assessment Weighted %

Continuous assessment Tests 30%
End of semester Exam (3hrs) 70%
Total 100%
Prerequisite: ECON 102 (Principles of Macroeconomics)
5
COURSE OUTLINE
Week Lecture TOPICS Sub-Topics

1 1 Introduction to i. The science of macroeconomics
Intermediate ii. The data of macroeconomics.
Macroeconomics iii. National income
iv. Introduction to the circular flow of income.
2 2 Macroeconomic Markets i. Equilibrium in the goods and service

market.
ii. Equilibrium in the resource market.
iii. Equilibrium in the Loan able funds market
iv. Equilibrium in the foreign exchange market
3 3&4 Demand for goods and i. Demand for goods model

services. ii. Introduction to saving
iii. Saving is investment identity.
4 and 5 5&6 Financial Market i. Money market equilibrium and the LM

identity
ii. The IS-LM Identity
iii. The open economy.
6&7 7 Macroeconomic models i. Introduction to the Business Cycle Theory

(Short run) ii. The Real Business Cycle model
iii. The Keynesian Business Cycle model
8&9 8 Stabilization Policy and i. Definition of stabilization policies

issues ii. The classical economist school of thought
iii. The Keynesians school of thought
iv. The monetarist school of thought
v. The new classical economist
10 9 & 10 Unemployment and i. Types of unemployment

Inflation ii. Stagflation and the Philips curve.
iii. Okuns Law
11 11 Economic Growth i. Determinants of economic growth

Theories ii. The Solow model (Neoclassical)
iii. The Endogenous growth Theory.
12 12 Macroeconomic Issues i. Fundamental structural drivers of growth.

and Policies in relation to ii. Potential spoilers and risks
Development iii. Potential areas of macroeconomic concern
6
LECTURE 1
INTRODUCTION
Lecture Overview
In this Lecture 1, we start by revisiting the data of macroeconomics. We begin by

justifying the rational for studying macroeconomics and basically how macroeconomics
is studied. A few key terms will also be defined.
Objectives of the Lecture
By the end of this lecture, you should be able to

i. Justify why we learn macroeconomics.
ii. Describe the data of macroeconomics.
iii. Explain where national income comes from and where it goes.
Why learn Macroeconomics?

We learn macroeconomics because of several reasons. These reasons include;
1 The macro economy affects your well being. For example, unemployment is
related to earnings and growth. Also interest rates affect mortgage payments.
2 The macro economy affects society’s well-being. For example unemployment
compared to social problems.
3 The macro economy affects politics and current events. For example inflation and
unemployment in election years.
7
In understanding macroeconomics, we normally make use of models. Models are
simplified versions of a complex reality. It is like a road map. In a model irrelevant
details are stripped away. Models are used to:-
 show the relationships between economic variables,
 explain the economy’s behavior,
 device policies to improve economic performance
At this point you should note that, models have assumptions on which they are based on.
Example of a model is the model for the supply and demand for new cars.
The supply and demand of new cars model

This model
 explains the factors that determine the price of cars and the quantity sold
 assumes that the market is competitive: buyers and sellers are too small to affect
market price
The variables in this model are;
Quantity of cars that buyers demand, which will be denoted by ( ), Quantity
that producers supply, denoted by ( ), Price of new cars ( ), aggregate income
( ), and price of an input ( )
The demand for cars can be given by the demand equation as;
= ( , ). This equation shows that the quantity of cars consumers demand is
related to the price of cars and aggregate income ( ) and ( ) are the lists of variables that
affect ( ).
A specific functional form shows the precise quantitative relationship. For example
1. = ( , )=60 − 10 + 2
.
2. = ( , )=
The demand equation can be represented graphically as;
8
The demand curve shows the
relationship between quantity
demanded and price, other
things equal.
On the other hand, the supply equation will be given by; = ( , )
Supply curve (S)
9
Equilibrium
An increase in income increases the quantity of cars consumers demand at each price,
which increases the equilibrium price and quantity.
An increase in the price of an input ( ) reduces the quantity of cars producers supply at
each price; which increases the market price and reduces the quantity.
In the model of supply and demand for cars, , , are endogenous variables, while
the variables , are exogenous.
Note:
 The values of endogenous variables are determined in the model.
 The values of exogenous variables are determined outside the model: the model
takes their values and behavior as given
10
THE DATA OF MACROECONOMICS
Gross Domestic Product (GDP)

We shall begin by defining Gross Domestic Product (GDP) in two ways:-
i. Total expenditure of domestically produced final goods and services
ii. Total income earned by domestically-located factors of production.
Since in every transaction, the buyer’s expenditure becomes the seller’s income then
expenditure equals income. GDP can also be computed using value added approach. A
firm’s value added is the value of its output minus the value of the intermediate goods the
firm used to produce that output.
Activity
A farmer grows a bushel of wheat and sells it to a miller for $ 1.00. The
miller turns the wheat into flour and sells it to a baker for $ 3.00. The baker uses the flour
to make a loaf of bread and sell it to an engineer for $6.00. The engineer eats the bread.
Calculate the value added at each stage of production and the GDP.
Gross Domestic Product (GDP) variables

The expenditure components of GDP are; consumption, investment, government
spending and net exports.
Consumption (C)
These are the value of goods and services bought by households. They include
i. Durable goods. These are goods which last a long time, for example cars and
home appliances
11
ii. Non-durable goods. These are goods which last for a short time. For example,
food and clothing
iii. Services. This is work done for consumers. For example dry cleaning, air travel,
teaching.
Investment (I)
Investment is spending on goods bought for future use. They include:-
 Business fixed investment. This is spending on plant and equipment by firms
 Residential fixed investment. This is spending on housing units by consumers
 Inventory investment. This is the change in the value of all firms inventories
The difference between investment and capital is that capital is one of the factors of
production. At any given moment, the economy has a certain overall stock of capital.
While investment, is spending on new capital.
Government spending (G)

These are all government spending on goods and services. It excludes transfer payments
(example, unemployment insurance payments), because they do not represent spending
on goods and services
Net exports (NX)
Net exports are the value of total exports (EX) minus the value of total imports (IM).
That is (NX = EX - IM)
If we sum up the four components, we get the identity
= + + +
Where
= = Value of total output
+ + + = Aggregate expenditure
From these calculations, we can define GDP as the value of all final goods and services
produced.
Nominal GDP measures these values using current prices, while Real GDP measures
these values using the prices of a base year.
12
Changes in nominal GDP can be due to;
 Changes in prices
 changes in quantities of output produced
The inflation rate is the percentage increase in the overall level of prices.
One measure of price level is the GDP Deflator, defined as

= 100 ×

Over time, relative prices change, so the base year should be updated periodically. In
essence, “chain-weighted Real GDP” updates the base year every year.
A measure of the overall level of prices is the ; Consumer Price Index (CPI). CPI may
overstate inflation, due to the following reasons
 Substitution bias: The CPI uses fixed weights, so it cannot reflect consumers’
ability to substitute toward goods whose relative prices have fallen.
 Introduction of new goods. The introduction of new goods makes consumers
better off and, in effect increases the real value of the shilling. But it does not
reduce the CPI because the CPI uses fixed weights
 Unmeasured changes in quality. Quality improvements increase the value of the
dollar, but are often not fully measured
SUMMARY OF LECTURE 1
In this lecture we have learnt that
i. We learn macroeconomics because it affects the well being of individuals, society
and affects politics and current events.
ii. In understanding macroeconomics we normally make use of models.
iii. There are two main measures of inflation; GDP deflator and CPI.
13
Self Assessment Questions
Attempt all the questions that follow

(1) Study the table below
2001 2002 2003

Price Quantity Price Quantity Price Quantity
Good A $30 900 $31 1000 $36 1050
Good B $100 192 $102 200 $100 205
i. Compute nominal GDP for each year. (Hint: multiply Ps & Qs from same
year, i.e. for 2001,GDP will be 30 × 900 + 100 × 192 = 46,200)
ii. Compute real GDP for each year using 2001 as the base year.(multiply
each years Qs by 2001 Ps)
(2) Compute the GDP inflator and inflation rate in each year
Nom. GDP Real GDP GDP Inflation

deflator rate
2001 46,200 46,200 n.a.
2002 51,400 50,000
2003 58,300 52,000
Further Reading
14
LECTURE 2
MACROECONOMIC MARKETS
Lecture overview
In any given economy, income does circulate from one market to another a concept
referred to as circular flow of income. This flow is coordinated by four key markets. In
this Lecture 2, we shall discuss these key macroeconomic markets.

i. Describe the goods and service market.
ii. Explain the resource market.
iii. Discuss the loanable funds market.
iv. Explain the foreign exchange market.
v. Draw and describe the circular flow of income diagram
Introduction
In macroeconomics, four key markets coordinate the circular flow of income. These
markets are:
 goods and service market
 resource market
 loanable funds market and
 foreign exchange market
15
Goods and services market
Businesses supply goods and services in exchange to sales revenue. Households,
investors, governments and foreigner’s (net exports) will demand these goods. The goods
and services market coordinates the demand and the supply of domestic production
(GDP).
Aggregate demand for goods and services

Aggregate demand (AD) curve indicates the various quantities of domestically produced
goods and services that purchasers are willing to buy at different price levels. The
aggregate demand curve slopes downwards to the right, indicating an inverse relationship
between the amount of goods and services demanded and the price level.
Other things constant, a lower price level will increase the wealth of people holding the
fixed quantity of money, leading to lower interest rates which make domestically made
goods cheaper relative to foreign goods. Each of these factors tends to increase the
quantity of goods and services purchased at the lower price level.
Why does the aggregate demand curve slope downwards?

 A lower price level increases the purchasing power of the fixed quantity of
money.
 A lower price level will reduce the demand for money and lower the real interest
rate which then stimulates additional purchases during the current period. This
effect is referred to as the interest rate effect.
 Other things constant, a lower price level will make domestically produced goods
cheaper (less expensive) relative to foreign goods.
Aggregate supply of goods and services

When considering the aggregate supply curve, it is important to distinguish between the
short-run and the long-run
Short run
It’s a period of time during which some prices particularly those in the resource market
are set by prior agreements (contract). Therefore in the short run households and
16
businesses are unable to adjust these prices when unexpected change occurs including
unexpected changes in price level.
Long run
It is a period of time of sufficient duration that people have the opportunity to modify
their behavior in response to price changes.
Short-Run Aggregate Supply (SRAS) indicates the various quantities of goods and
services that domestic firms will supply in response to changing demand conditions that
alter the level of prices in the goods and services market.
Short run aggregate supply curve (SRAS) slopes upwards to the right. The upward slope
reflects the fact that in the short run, increase in the price level will improve the
profitability of firms. Firms respond to this increase in the price level with an expansion
in out put. This is because higher prices improve profit margins, since many components
of costs will be temporarily fixed as a result of prior long term commitments.
Long Run Aggregate Supply (LRAS) indicates the relationship between the price level
and quantity of output after decision makers have had sufficient time to adjust their prior
commitments where possible. (LRAS) is related to the economy’s production
possibilities constraint. A higher price level does not loosen the constraints imposed by
the economy’s resource base, level of technology and the efficiency of its institutional
arrangements. Therefore an increase in the price level will not lead to a sustainable
expansion in out put. Thus the (LRAS) curve is vertical.
Once people have time to adjust their long-term commitments, resource market (and
costs) will adjust to the higher levels of prices and thereby remove the incentive of firms
to continue to supply at larger out put. Thus an economy’s full employment rate of
output( ), which is the maximum output rate that is sustainable, is determined by the
supply of resources, level of technology and the structure of the institutions, which are
factors that are insensitive to changes in the price level.
Equilibrium in the goods and services market

Short run equilibrium is present in the goods and services market at the price level (P)
where the aggregate quantity demand is equal to aggregate quantity supplied. This occurs
17
graphically at the output rate where the aggregate demand (AD) and short run aggregate
supply (SRAS) curve intersect.
If the price level were lower than (P) general excess demand of goods and services would
push the prices upwards conversely if the price level were higher than (P) excess supply
would result in falling prices.
When long run equilibrium is present,

 Potential GDP is equal to the economy’s maximum sustainable output consistent
with its resource base, current technology and institutional structure.
 The economy is operating at full employment.
 Actual rate of unemployment equals to natural rate of unemployment.
 It occurs graphically at the output rate where the aggregate demand (AD),
SRAS, and LRAS curves intersect.
Disequilibrium, are adjustments that occur when the output differs from long run
potential. You should note that
 An unexpected change in the price level (rate of inflation) will alter the rate of
output in the short run. This increase will improve the profit margins of firms
and therefore induce them to expand output and employment in the short run.
 An unexpected decline in the price level, will reduce profitability, which will
cause firms to cut back on output and employment.
Activity
Draw the aggregate demand curve, the SRAS curve and the LRAS
curves. Identify the equilibrium point.
18
Resource market
It is a highly aggregated market where business firms demand resources and households
supply labour and other resources in exchange for income.
Business firms demand resources because they contribute to the production of goods the
firm expects to sell at a profit. The demand curve for resources slopes down and to the
right. Households supply resources in exchange for income. Higher prices increase the
incentive to supply resources thus the supply curve slopes up and to the right.
As resource prices increase the amount demanded by producers decrease and the amount
supplied by the resource owners expands. In equilibrium the resource price brings the
quantity demanded by firms into balance with those supplied by the resource owners.
The labour market is a large part of the resource market.
Loanable funds market

Loanable funds market coordinates the action of borrowers and lenders. This market
brings net household saving and the net inflow of foreign capital into balance with the
borrowing of businesses and government.
19
The interest rate coordinates the action of borrowers and lenders. From the borrowers
point, interest is the cost paid for earlier availability. From the lenders point interest is a
premium received for waiting, for delayed possible expenditure into the future.
The money interest rate is the nominal price of loanable funds. When inflation is
anticipated lenders will demand (and borrower’s pay) a higher money interest rate to
compensate for the expected decline in the purchasing power of the shilling.
The real interest rate is a real price of loanable funds. The difference between the money
interest rate and real interest rate is the inflationary premium. This premium reflects the
expected decline in the purchasing power of the shilling during the period that the loan is
outstanding.
= −
Suppose that when people expect the general level of prices to remain stable (zero
inflation), a 6% interest rate brings equilibrium in the loanable funds market.
Under these conditions the money and real interest rates will be equal (here 6%).
When people expect prices to rise by a 5% rate, the money interest rate ( ) will rise to
11% even though the real interest ( ) remains constant at 6%. This is illustrated by the
figure that follows, which shows the relationship between interest rate and quantity.
20
Activity
Suppose that you purchased a five hundred thousand Kenyan

shilling bond that pays 6% interest annually and matures in 5 years. If the inflation in
the recent years has been steady at 3% annually what is the estimate real rate of
interest? If the inflation rate during the next 5 years rose to 8%, what is the real rate
of return will you earn?
Capital Flows
When demand for loanable funds is strong (D2) real interest rates will be high (r2) and
there will be an inflow of capital. In contrast weak demand (D1) and low interest rates
(r1) will lead to capital outflow.
21
Foreign exchange market
This market coordinates the action of Kenyans (local) who demand foreign currency (in
order to buy things abroad) and foreigners who supply foreign currencies in exchange for
cash (so that they can buy things from Kenya). The foreign exchange market brings the
purchases (imports) from the foreigners into balance with the sales (exports plus net
inflow of capital) to them.
Kenyans demand foreign currency to import goods and services and make investments
abroad. Foreigners supply their currency in exchange for Kenyan shillings, to purchase
Kenya’s exports and undertake investments in Kenya.
The exchange rate brings quantity demand into balance with quantity supplied and will
bring (imports plus capital outflow) into equality with (exports + capital inflow).
When equilibrium is present the foreign exchange market the following relation exists.
Imports + capital outflow = exports + capital inflow
Imports – exports = capital inflow – capital outflow
since capital inflow minus capital outflow is the net capital inflow, then we have:
Imports-exports = Net capital inflow
Net capital inflow may be positive reflecting a net inflow of capital, or negative,
reflecting a net outflow of capital. Imports minus exports are called the trade balance.
Thus
Trade balance is equal to net capital inflow
When;
i. Imports is greater than exports, we have trade deficit
ii. Exports are greater than imports, then we have trade surplus
Trade deficits will be closely linked with a net inflow of capital when the exchange rate is
determined by market forces; conversely trade surplus will be closely linked with a net
outflow of capital.
The next question we need to ask ourselves is,
?
“Are trade deficits bad?”
22
If investors both domestic and foreign weren’t optimistic about an economy’s future,
there wouldn’t be a net inflow of capital into the economy thus trade deficits are often a
reflection of something positive. A net inflow of capital that results is because investors
have substantial confidence in the future strength of the domestic economy.
Activity
Using the arrow provided in the diagram below, indicate what moves
where in the circular flow diagram.
The Circular Flow Diagram
23
Equilibrium in the foreign exchange market implies:
Net saving + net capital inflow = investments + budget deficit
Net saving + (imports – exports) = investment + budget deficit
As budget deficit = (government purchases - taxes), we have
Net saving + imports – exports = investment + government purchases – tax purchases
Net savings + imports + Taxes = Investments + government expenditure + exports
The left hand side of the equation represents leakages in the circular flow of income,
while the right hand side of the equation, (Investments + government purchases +
exports) represents injections into it.
Therefore when the loanable funds and foreign exchange markets are in equilibrium
leakages from the circular flow of income are equals to injections.
In this lecture we have learnt that;
i. There are four key markets that coordinate the circular flow of income.
ii. Equilibrium in the goods market is either short-run equilibrium or the long run
equilibrium.
iii. Real interest rate is given by money interest rate minus inflationary premium.
iv. Imports minus exports give us the trade balance which is equal to capital inflow.
v. When loanable funds and foreign exchange markets are in equilibrium, leakages
are equal to injections.

1. Define circular flow of income. Hence list the four key markets of the circular flow
model.
24
2. Discuss why aggregate demand curve for goods and services is inversely related to
the price level. What does this inverse relationship indicate?
3. State the major factors that influence the quantity of goods and services groups of
people can produce in the long run. Why is the Long Run Aggregate Supply (LRAS)
curve vertical? What does this vertical shape indicate?
4. Discuss why the Short Run Aggregate Supply curve (SRAS) curve slopes upward to
the right? What does the upward slope indicate?
5. If the prices of both (a) resources and (b) goods and services increase proportionally,
will business firms have a greater incentive to expand output? Why or why not?
6. If the price level in the current period is higher than what buyers and sellers
anticipated, state what will tend to happen to real wages and the level of employment.
How will the profit margins of the business firms be affected? How will the actual
rate of unemployment be compared with the natural rate of unemployment? Will the
current rate of output be sustainable in the future?
7. Discuss why unanticipated increase in the price level is likely to expand output in the
short run but not in the long run.
8. If the inflation rate increases and the higher rate is sustained over an extended period
of time. Discuss what will happen to the nominal interest rate. What will happen to
the real interest rate?
9. When the Kenyan shilling appreciates against the dollar, few Kenyan shillings will be
required to purchase a dollar. Is this true? If the Kenyan shilling appreciates how will
this affect net exports?
10. Can output rates beyond the economy’s long-run potential be achieved? Can they be
sustained? Why or Why not?
Further Reading
25
LECTURE 3 and 4
THE DEMAND FOR GOODS AND SERVICES
Lecture overview
In this Lecture 3 and 4, we introduce the demand for goods model. We shall discuss the
relationship among production, demand and income. We shall also examine the
implication of saving in the short run and also in the long run. Finally a relationship
between saving and investment will be derived.
By the end of this lecture, you should be able to:-

i. Come up with the demand for goods model.
ii. Compute the marginal propensity to consume and interpret it.
iii. Calculate the fiscal multiplier in the demand for goods model and interpret the
results.
iv. Prove the identity, savings is equals to investment.
Introduction
Let the total demand for goods be denoted by . Using the decomposition of GDP, we
have
= = + + + +
This equation is an identity which defines the demand for goods as the sum of
consumption plus investment plus government spending plus exports and imports.
The assumption of the determinant of are,
 It assumes that all firms produce same goods. These goods can then be used by
consumers for consumption, by firms for investments or by the government. With
26
this assumption, we need to look at only one market, the market for goods, and
think about what determines supply and demand in that market.
 It also assumes that firms are willing to supply any amount of goods at price " ".
This assumption allows us to focus on the law of demand in the determination of
output. This assumption is valid only on short-run.
 We shall start first by assuming that the economy is closed in that it does not trade
with the rest of the world and therefore exports and imports are zero. Under this
assumption, − =0
 Thus the demand for goods will simplify to;
= + +
Consumption (C)
Consumption decision depends on many factors, the main factor being income( ). More
precisely, disposable income, which shall be denote it by ( ). This is the income that
remains after consumers have received transfers from the government and after they have
paid taxes.
When the disposable income goes up, people buy more goods. When it goes down,
people buy fewer goods.
House holds consume out of their disposable income, so we write
= ( )+ , where = −
are taxes paid minus government transfers received by consumers. This is a formal way
of stating that consumption is a function of disposable income. The (+) sign reflects the
fact that when disposable income rises consumption goes up. It is therefore reasonable to
assume that the relationship between consumption and disposable income is a linear
specification. The relationship between consumption and disposable income is
characterized by two parameters; and and is given by;
= + ( )
This equation is known as the KEYNES consumption function.
is called the autonomous consumption, and is the sum of all expenditures of all
households that is necessary for their survival. It is what people could consume if there
disposable income in the current year was equal to zero. is called the marginal
27
propensity to consume (MPC) and it describes, by how much consumption rises if
households receives an increase in their income. If for example = 0.6, this means that
an additional shilling of disposable income will increase consumption by (1 × 0.6 =
60 ).
The natural restriction of is that it must be positive and it must be less than 1. On the
other hand, a natural restriction of is that it is positive. This means that; with or
without income, people have to eat; they do this by dis saving or borrowing. The Keynes
consumption function can be re written as
= +
is the average propensity to consume (APC) and answers the question; how much out
of the total income is consumed not out of the marginal income.

Because = + is a linear relation it is represented by a straight line. Its
intersection with the vertical axis is and its slope is . Because is less than 1, the
slope of the line is also less than 1.
28
Equivalently, the line is flatter than 450 line. This implies that consumption rises with
disposable income but by less than one. Rising up by one implies that there is no saving.
If we replace with ( − ), we have
= + = + ( − )
Opening the brackets, we have
= + −
This equation tells us that consumption is a function of income and taxes.
Higher income increases consumption but by less than 1. Also higher taxes decrease
consumption by less than 1.
Investments
Investors react to two different variables;
i. Expected sales. The level of sales should affect the investment plans. These are not
known, but observed output (Y) should be a good indicator of expected sales.
ii. Interest rate. This determines the cost of loans required to execute investment plans.
Thus we can write investment as;

= ( , )
Since ( ) is an exogenous variable we shall express it as ( )̅
Government Spending (G)

Government spending (G) describes the fiscal policy which is the choice of taxes and
spending by the government. Again we take Taxes (T) and (G) as exogenous, that is ( )
and ( ̅ ) . The reason we assume (I) and (G) as exogenous is different from the reason we
assume investment as exogenous. This is based on two arguments;
 Government doesn’t behave with same regularity as consumers or firms, so there
is no reliable value we could write T or G.
 One of the tasks of macroeconomics is to think about implication of alternative
spending and tax decisions. We want to be able to say “If the government were to
choose those values for G and T, this is what could happen”
29
We typically treat T and G as variables chosen by the government and not explained
within the model.
Determination of equilibrium Output

We assume exports and imports are but zero. The demand for goods is the sum of
consumption, investment and government spending. Thus
= + +
Replacing C and I, we have
= + ( − )+ ̅+ ̅
= + − + ̅+ ̅
From this equation, the demand for goods depends on income , taxes ,
investments and government spending .
Equilibrium in the goods market requires that production be equal to demand for
goods . This equation is called equilibrium condition. Replacing , we get
= + − + ̅+ ̅
In equilibrium, Production ( ) which is the left side of the equation is equal to
demand the right hand side of the equation. Demand in turn depends on income, and
income is equal to production. The reason as to why we are using the symbol Y for
production and income is that we can look at GDP either from production or income
side.
Since production and income are identically equal, having constructed our model we
can solve it and look at what determines the level of output with changes in respond
to a change in government spending. Solving a model means not only solving it
algebraically but also understanding why results are the way they are. Solving a
model also means characterizing the results using graphs.
Macroeconomics always uses 3 tools in describing a model. These tools are;

i. Algebra, which is used to make sure that the logic, is correct.
ii. Graphs, which are used to build the intuition and
iii. Words, which are used to explain the results.
30
For algebra, we have
= + − + ̅+ ̅
− = − + ̅+ ̅
(1 − ) = + ̅+ ̅ −
1
= [ + ̅+ ̅ − ]
1−
The above equation characterizes equilibrium level of output such that production equals
demand.
The term[ + ̅+ ̅ − ] is that part of demand for goods that does not depend on
output. For this reason, it is called the autonomous spending.
? The question we need to ask ourselves is “can we be sure that autonomous spending
is positive (+)”?
The answer is, we can’t but it’s very likely to be. The first two terms and ̅ are
positive. What about ̅ − ?
Suppose the government is running a balanced budget, = , Taxes is equal to
government spending, and which is marginal propensity to consume is less than one,
then ̅ − is positive and so its autonomous spending. Only if the government were
running a very large budget surplus could autonomous spending be negative.
Again, because (MPC) is between zero and one the term should be greater than
one. For this reason since , multiplies autonomous spending, it is called the
multiplier. The closer is to 1, the larger the multiplier.
? What does the multiplier imply?

Suppose that for a given level of income, consumer decides to consume more. Assume
that increases by Kenya shillings I billion. Let = 0.6 (MPC). The multiplier is
31
1 1 1 1
= = = = 2.5
1− 1− 1 − 0.6 0.4
Output in this case will increase by 2.5 × 1 which is equal to 2.5 billion.
If we increase government expenditure (G) by 1, this increases national income by
Likewise, the same will happen if we increase investments and autonomous consumption
by one. If we increase taxes by one, Y will fall by .
This multiplier effect is caused by the following mechanism:-

Additional consumer demand leads to an increase in total aggregate demand (Z) which is
satisfied by the firms immediately whereby Y increases ones more since income is equal
to production (Y = Z).
Production depends on demand which depends on income. An increase in demand such
as government expenditure, leads to an increase in production and corresponding increase
in income.
Illustration
Assume that the marginal propensity to consume is around 0.8 in other words an
additional Kenyan shilling on income leads on average to an increase in consumption of
80 cents. This implies that the multiplier is equal to
1
=5
1 − 0.8
Example:
Suppose the economy is characterized by the following behavioral equations
C = 160 + 0.6
I = 150
G = 150
T = 100
Solve the following variables

a) Equilibrium GDP (Y)
b) Disposable income
c) Consumption
d) Equilibrium output and show that total demand = production
32
Solution
(a)
= + +
= 160 + 0.6 − ) + 150 + 15 − 150
(
= 460 + 0.6( − 100)
− 0.6 = 400
0.4 = 400
= 1000
(b) = − , = 1000 − 100 = 900
(c) = + = 160 + 0.6 × 900 = 700
(d) = + + = 700 + 150 + 150 = 1000
Saving
So far we have been thinking of equilibrium in the goods market in terms of equality of
production and demand for goods. An alternative but equivalent way of thinking about
equilibrium focuses on investment and saving.
The supply of loanable funds comes from saving. Households use their saving to make
bank deposits, purchase bonds and other assets. These funds become available to firms to
borrow to finance investment spending. The government may also contribute to saving if
it does not spend all of the tax revenue it receives.
There are two types of saving;
Private saving= ( − ) − and
Public saving = −
If we add the two we have, national saving,
= +
=( − )− + −
= − −
When > we have budget surplus = − = public saving
When < we have budget deficit = − and public saving is negative
When = budget is balanced and public saving = 0
Thus the loanable funds supply curve is vertical
33
From the diagram, national saving does not depend on , so the supply curve is vertical.
For saving, the following “assets” can be used;
 Narrow sense money (cash, currency). Liquidity is maximal but the interest rate is
zero
 Checking account (demand deposits). These are short run assets at bank like debit
card. Liquidity is high but very low interest nearly zero.
 Saving account : these are longer run assets at banks and they must be exchanged
for money to enable transactions (limited liquidity) but bear interest
 Bonds : These are risk free securities with fixed interest
 Shares : These are certificates of shared ownership at corporations
 Real estate, stamps: They have low liquidity and have uncertain interest
Saving propensity and multiplier:

If − (disposable income minus consumption), is interpreted as household savings
then:
= −
= −( + )
= − −
=− + (1 − )
34
We define 1 − as the marginal saving propensity of households.
The bigger the saving propensity the smaller the propensity to consume and the smaller is
the multiplier.
The saving of households is that part of income that is not consumed

= −
= − −
Since = + + , substituting , we obtain;
= + + − −
If the government runs a balanced budget then its expenditure (G) equals taxes (T),
= , This implies that = . This relationship is referred to as saving is investment
identity, denoted as ( ) identity
? Is saving good or bad?
In the short run saving has a contractionary effect and a negative effect on output. If one
saves there will be lower (autonomous consumption). Lower decreases aggregate
income by ( )
. Lower has even stronger negative effect. Because of a
contractionary effect of saving, this appears to be a “paradox”. This is sometimes called

the saving paradox. It can also be shown that, in the model a decrease of or implies
such a strong decrease in national income ( ) that (Which depends on Y) does not
change at all.
In the long run the saving paradox disappears, as saving increases the growth potential of
the economy. This causes interest rate to fall thereby increasing investments.
Note that directly affects aggregate income, while only affects the disposable income
and household consumption, whereby saving annihilates a part of (1 − )
Thus the general mathematical definition of curve is
= ( − )+ ( , )+
35
But ( ) which is the nominal interest rate was previously given as real interest rate plus
inflationary expectation. Mathematically we can write; = +
Thus our equation becomes: = ( − )+ ( , + )+
Deriving the curve

Suppose that in Figure (A) the demand curve is given by ZZ and the initial equilibrium is
at point A. Suppose that interest rate increases from (i) to (i’). We noted previously that at
any level of output, the higher interest rate the lower the investment and the lower the
demand. The demand curve therefore shift from ZZ down to Z’Z’, whereby at a given
level of out put demand is lower. The new equilibrium is at intersection at a lower
demand. This can be summarized as: the increase in interest rate decreases investments
and the decrease in investments leads to a decrease in demand which together decreases
output
36
Shift of the curve
Changes in either or or will shift the curve. An increase in taxes from T to T’ at
a given interest rate say , disposable income decreases, leading to a decrease in
consumption. This in turn leads to a decrease in demand for goods and a decrease in
equilibrium out put. The equilibrium level of out put decreases from Y to Y’ hence the
curve shifts to the left.
In general, any factor that decreases equilibrium output causes curve to shift to the left.
The same will hold for a decrease in government spending or a decrease in consumer
confidence. Systematically, any factor that increases equilibrium level of out put like
decrease in taxes or increase in government spending and increase in consumer
confidence, causes the curve to shift to the right
37
SUMMARY OF LECTURE 3 and 4
i. Total consumption is a sum of autonomous consumption and a proportion of
disposable income.
ii. Marginal propensity to consume, describes how much consumption rises if
household receives an increase in their income.
iii. Investors react due to two different variables; expected sales and interest rate.
iv. Increase in Investments and government spending, increases national income,
while an increase in taxes, national income falls.
v. In the short run, savings has a contractionary effect. But in the Long-run, savings
increases the growth potential of the economy.

1. Suppose the structure model of an economy is given as
C = 100 + 0.8
I = 100
G = 100
T = 100
Find the following:
(a) fiscal multiplier
(b) change in if the change in G = 50
(c) Compute the national income equilibrium.
2. Suppose
= 100 + 0.8
= ℎ. 200
Calculate .
38
3. Suppose investment and saving functions in an economy are given as;
= 200 − 10
= −200 + 0.2
respectively, derive the equation and interpret your answer.
4. Suppose the behavioral and structural equation for an economy is as follows;
= 50 + 0.8
= 50
= 50
= 50
(a) Name the endogenous and the exogenous variables.
(b) Derive the reduced form of the combination of the endogenous variables.
(c) Find the equilibrium values for each endogenous value.
5. A certain economy is characterized by the following characteristics
GDP 6000
Gross investment 800
Net Investment 200
Consumption 4000
Government purchases of goods and services 1100
Government budget surplus 300
Compute;
(a) Net domestic product (NDP)
(b) Net Exports
(c) Net taxes and disposable personal income
6. Consider the following economy
= 100 + 0.8( − )
= 100 + 0.1
= 50 − 0.2
= 200
= 200
(a) Solve for real GDP.
(b) What is the multiplier?
(c) Calculate the National savings.
(d) What is the marginal propensity to consume?
Further reading

Branson, W.H. (1972) Macroeconomic Theory and Policy, Harpe & Row publisher
39
LECTURE 5 and 6
FINANCIAL MARKET
Lecture overview
In this Lecture 5 & 6, you will learn the characteristics of the financial market. We shall
discuss the connection between money and prices. In this Lecture, The identity shall
be introduced. Later on we shall put together the identity and the identity
discussed in Lecture 3 & 4 to determine equilibrium in the goods and in the money
market. At the end of this Lecture we shall bring on board the international trade in form
of net export, hence our economy will be an open economy.

i. Define Money and its characteristics.
ii. Derive the money demand and money supply function
iii. Solve for equilibrium in the − model.
iv. Discuss the characteristics of an open economy
Introduction
To understand the financial market we need to define a number of terms. They include:-
i. Inflation rate is the percentage increase in the average level of prices.
ii. Price is the amount of money required to buy a good. Because prices are defined
in terms of money, we need to consider the nature of money, the supply of money
and how it is controlled.
40
iii. Money can be defined as the stock of assets that can readily be used to make
transactions. The functions of money include:-
 Medium of exchange. We use it to buy stuff
 Store of value. Transfers purchasing power from the present to the future
 Unit of account; the common unit by which everyone measures prices and
values.
There are two types of money; Flat money (which has no intrinsic value for
example the paper currency we use) and commodity money (has intrinsic
value, example is gold coins).
iv. Monetary policy also referred to as monetary policy control over the money
supply. This is controlled by a country’s central bank. In Kenya it is managed by
Central Bank.
A simple theory linking the inflation rate to the growth rate of the money supply begins
with a concept called “velocity”.
v. Velocity is the rate at which money circulates. If for example, in a certain year,
money supply was 100 billion and 500 billion was in transactions. Thus on
average a shilling is used in five transactions, so velocity is equals to 5.
We use nominal GDP as a proxy for total transactions. Thus we can write
×
=
where = price of out put (GDP deflator)

= quantity of out put (real GDP)
× = value of out put (nominal GDP)
= money supply
It follows that from the preceding, the quantity equation will be
× = ×
If we assume that is constant and exogenous; that is = the quantity equation can be
written × = × . With constant, the money supply determines nominal GDP
( × ). On the other hand, real GDP is determined by the economy’s supplies of capital
( ) and labour ( ) and the production function.
The price level will be given by = ( ⁄( )).
41
Given that the growth rate of a product equals to the sum of the growth rates, then
+ = +
Where denotes change. Since the quantity theory of money assumes to be a constant,
then change in divided by , that is = 0.
Let = denote the inflation rate, thus solving for , we get
= −
Normal economic growth requires a certain amount of money supply growth to facilitate
the growth in transactions. Money growth in excess of this amount leads to inflation.
Hence the Quantity Theory of Money predicts a one-for-one relation between changes
in the money growth rate and changes in the inflation rate.
To spend more without raising taxes or selling bonds, the government can print money.
The revenue raised from printing money is called seigniorage (pronounced SEEN-your-
ige). Printing money to raise revenue causes inflation. Inflation is like a tax on people
who hold money.
The nominal interest rate is given by ( ) after adjusting for inflation we have real interest
rate where: = −
We saw in Lecture 3 & 4 that = determines , hence an increase in causes an equal
increase in . This one for one relationship is called the Fisher effect. You should note
that
i. = actual inflation rate (not known until it occurs)
ii. = expected inflation rate
iii. − real interest rate; what people expect at the time they buy a bond or take
out a loan
iv. − real interest rate; what people actually end up earning on their bond or
paying on their loan
The quantity theory of money assumes that the demand for real money balances depends
only on real income .
We now consider another determinant of money demand, which is the nominal interest
rate. The nominal interest rate is the opportunity cost of holding money, Instead of
42
bonds or other interest earning assets. Hence, increase in will result to a decrease in
money demand. This leads us to the money demand equation given by:-
= ( , )
we read this as real money demand, depends negatively on where is the opportunity
cost of holding money and positively on . This means that higher implies more
spending and so need more money. is used for the money demand function because
money is the most liquid asset.
When people are deciding whether to hold money or bonds, they don’t know, what
inflation will turn out to be. Hence the nominal interest rate relevant for money demand
is + . Thus,
= ( + , )
At equilibrium, the supply of real money balances with real money demand.
What determines what?

Variable How it is determined in the long-run
Exogenous
Adjusts to make =
= ( , ).
Adjust to make = (, )
For given values of , , a change in causes to change by the same

percentage, just like in the Quantity Theory of Money.
Over the long-run, people don’t consistently over-or-under-forecast inflation, so =
on average. In the short run, may change when people get new information. For
example if the government announces it will increase money supply ( ) next year,
people will expect next years to be higher, so rises. This will affect now even
though hasn’t change yet.
43
Assumption:
Let us assume that we have a closed economy and that there are only money and bonds.
The problem of the households is the distribution of wealth optimally between money
and bonds.
Bonds
They pay a positive interest rate but cannot be used for transactions. Therefore there is
need to hold both money and bonds.
? But in what proportion!
This depends on two variables:

(a) Level of transaction: You will want to have enough money in hand to avoid
selling the bonds to often.
(b) Interest rates on bonds. The only reason to hold any money in bonds is that they
pay interest.
Interest rate has a negative effect on money demand. An increase in interest rate
decreases the demand for money as people put more of their wealth in bonds. The
demand for money increases in proportion to nominal income. If the nominal income
doubles then the demand for money also doubles. The relation between demand for
money and interest rate for a given level of nominal income is represented by money
demand ( ) curve. The curve is downward sloping, meaning that the lower the interest
rate the higher the amount people want to hold.
Suppose the central bank decides to supply an amount of money equals to =
(money supply). Equilibrium in the financial market requires that money supply be equal
to money demand, that is, =
This equation is called the relation (“Liquidity means money” identity).
This supply of money which is independent of interest rate is equal to money demand
which depends on interest rate. An increase in nominal income leads to an increase in
interest rate. An increase in nominal income increases the level of transaction which
44
increases the demand for money at any interest rate. An increase in money supply leads
to a decrease in interest rate
Note: the assets of central bank are the bonds it holds in its portfolio. The liability is the
stock of money in the economy.
In an open market operation the central bank buys bonds and issues money, increasing
both the assets and liabilities by the same amount. If the central bank buys one million
shillings worth of bonds both the amount of bonds held by the central bank and the
amount of money in the economy will be lower by one million. Such an operation is
called a contractionary open market operation. because central bank decreases (contract)
the supply of money.
Equilibrium in the financial market implies that increase in income leads to increase in
interest rate, therefore, the curve is upward sloping.
Consider an increase in income from to which leads to people to increase their
demand for money at any given interest rate.
An increase in money causes the curve to shift down. An increase in money supply
from to given the fixed price level , the real money supply increases from to
Then for any income say , interest rate consistent with equilibrium in financial market is
lower going down from to , the curve shifts down from to
45
By the same reasoning, at any level of income, a decrease in money supply leads to a
decrease in interest rate. This causes the curve to shift up.
Putting and curves together

The − curve developed by John Hincks is used to determine a unique equilibrium
income and interest rate combination. Such a combination occurs when planned saving
( ) equals planned investments ( ) and the demand for money ( ) or “Liquidity
preference” equals to the supply of money ( ). Putting and curves together, we
have, , curve: = + ( − )+ ( , + )+ , , curve: = ( )
46
Example
The following equations describe an economy product market model;
Consumption function: = 100 + 0.75
Investment function: = 200 − 2000
Tax function: = 0.20
Government expenditure: = 100
(a) From the product market model, derive the equation for curve.
The Financial market model is given by;
Transaction and precautionary demand for money: = 0.5
Speculative demand for money: = 100 − 2000
Real money supply: = 200
(b) From the financial model derive the equation for LM curve.
(c) Determine the equilibrium value of and .
Solution
equation: = + +
= 100 + 0.75 + 200 − 2000 + 100
= 100 + 0.75( − 0.20 ) + 200 − 2000 + 100
= 400 + 0.6 − 2000
− 0.6 = 400 − 2000
0.4 = 400 − 2000
= 1000 − 5000 ( )
equation: = ()
200 = 0.5 + 100 − 2000

0.5 = 200 − 100 + 2000
0.5 = 100 + 2000
= 200 + 4000 ( )
47
For equilibrium value of and .
= 1000 − 5000 = 200 + 4000
800 = 9000
= 0.0889
= 200 + 4000
= 200 + 4000(0.0889) = 555.55
Example
Suppose that the macro model of an economy is given as follows;
Government spending: = 150
Tax function: = 40 + 0.20
Transfer payment: = 40
Transaction/precaution of money: = 0.25
Speculative demand for money: = −20
Nominal supply of money: = 1000
Price level: =5
(a) Derive the curve and the curve.
(b) Compute the equilibrium and .
Solution
curve : = + ( − )+ ( , + )+
= 100 + 0.75( − (40 + 0.20 ) + 40) + 250 − 4 + 150
= 100 + 0.6 + 400 − 4
0.4 = 500 − 4
= 1250 − 10
equation: = ( )
1000
= 0.25 − 20
5
200 = 0.25 − 20
0.25 = 200 + 20
48
= 800 + 80
Equilibrium: 1250 − 10 = 800 + 80
1250 − 800 = 80 + 10
450 = 90
= 5%
We’ve seen that = 800 + 80 , this implies that = 800 + 80(5) = 1200
The Open Economy

In an open economy, spending need not equal out put and saving need not equal
investment.
Let the superscripts, , denote spending on domestic goods and superscript denote
spending on foreign goods, then in an open economy the identity for consumption,
investment and government spending will be;
= +
= +
= +
Let, denote exports (foreign spending on domestic goods) and denote imports,
thus imports can be expressed as + + which is spending on foreign goods.
The GDP expenditure on domestically produced goods and services in this case will be
= + + +
=( − )+( − )+( − )+
= + + + −( + + )
= + + + −
= + + +
The national income identity in an open economy is therefore
= + + +
or,
= −( + + )
Where stands for net export, Y are the output and ( + + ) is the domestic saving.
= − ( + + ) Can be re-written as =( − − )− = − (trade
balance is equal to net capital out flows). Thus for a country with a trade deficit
49
( < 0) . When is greater than ( > ) the country is a net
lender, and when ( < ) the country is a net borrower.
An open economy version of the loanable funds model includes many of the same
elements:
Production function: = = ( , )
Consumption function: = ( − )
Investment function: = ( )
Exogenous policy variables: = ̅ , =
Since the economy is small, it cannot affect the world interest rate, so we shall denote
interest rate by ∗ .
Investment is still a downward-sloping function of the interest rate, but the exogenous
world interest rate determines the country’s level of investment.
But in a small open economy, the exogenous world interest rate determines investment
and the difference between saving and investment determines net capital outflows and net
exports.
50
Fiscal Policy at home and abroad
An increase in government spending or decrease in taxes reduces saving resulting to a
zero change in investments, with a net export equal to change in saving which is less than
zero. On the other hand, expansionary fiscal policy abroad raises the world interest rate
resulting to change in investment being less than zero and a change in net export being
equal to negative investment.
Fiscal policy abroad
An increase in investment demand will lead to a positive change in investment and a zero
change in saving. Net capital outflows and net exports fall by the same amount as change
in investment.
We shall denote the nominal exchange rate by ( ).
Nominal exchange rate is the relative price of domestic currency in terms of foreign
currency. For example, Kenya shilling per dollar
The real exchange rate is the relative price of domestic goods in terms of foreign goods.
For example Kenyan price of a plate of rice per U.S plate of rice. The real exchange rate
is denoted by ( ).
51
The real exchange rate is computed as
×
= ∗
( ℎ $) × ($ . . )
ℎ =
ℎ
ℎ . .
=
ℎ
= . .
∗
For example, Let the price of a plate of rice in Kenya be = 200 Kenya shillings. Ley
the same plate of rice in USA cost = $2.50. Let the nominal exchange rate be =
110 ℎ /$, therefore;
×
= ∗
110 × $2.50
= = 1.375
200
Thus, to buy a U.S. plate of rice, someone from Kenya would have to pay an amount that
could buy 1.375 Kenyan plates of rice. In the real world, we can think of as the relative
price of a basket of domestic goods in terms of a basket of foreign goods.
In our macro model, there is only one good, “Output.” So is the relative price of one
country’s output in terms of the other country’s output.
Increase in the real exchange rate implies that Kenyan goods become more expensive
relative to foreign goods, thus exports decreases and imports increases leading to a
decrease in net export. The net exports function, reflects this inverse relationship between
Net exports ( ) and the relative price ( )
= ( )
52
At high values of Kenyan goods become so expensive that we export less than we
import. The accounting identity says;
= −
We saw earlier how identity is determined: depends on domestic factors (output,
fiscal policy variables, e.t.c.) and is determined by the world interest rate ∗ . So must
adjust to ensure
( ) = ̅ − ( ∗)
Thus from the demand side, foreigners need Kenya shillings to by Kenyan net exports,
while from the supply side, the net capital outflow ( − ) is the supply of Kenya
shillings to be invested abroad.
A fiscal expansion in three models

A fiscal expansion causes national saving to fall. The effects of this depend on the degree
of openness:
53
Closed economy Large open Small open
economy economy
rises Rises, but not as No change
much as in closed
economy
falls Falls, but not as No change
much as in closed
economy
No change Falls, but not as falls
much as in small
open economy
SUMMARY OF LECTURE 5 & 6

i. There is a connection between money and prices
ii. The quantity theory of money predicts a one-for-one relation between changes in
money growth rate and changes in the inflation rate.
iii. The − model, determines a unique equilibrium income and interest rate
combination.
iv. Net export increases if policies causes saving to rise or investment to fall, while it
does not change if policy affects neither saving nor investment
v. The relative price of domestic currency in terms of another country’s currency is
the nominal exchange rate, while real exchange rate is the price of a country’s
goods relative to the price of another country’s goods.
vi. The real exchange rate equals the nominal rate times the ratio of prices of the two
countries
54

(1) Using illustrations, explain three motives of holding cash balances according to
Keynesian theory of money demand.
(2) Suppose that a persons wealth is 50,000 and yearly income of 60,000. Let the
demand for money be given by = (0.35 − )
i. Derive the demand for bonds. Suppose interest rate increases by 10%,
what is the effect on the demand for bonds?
ii. What is the effect of an increase in wealth on demand for money and
demand for bonds?
iii. Explain the effect of an increase in income on the demand for money and
demand for bonds.
(3) Suppose the money demand is given by:
= (0.25 − )
where = 100. Also suppose that the supply of money is 20,
i. Calculate the equilibrium interest rate.
ii. If the Central bank wants to increase by 10 percentage points, example
from 2% to 12% at what level should it set the supply of money?
(4) What happens to the curve when
i. There is an increase in the demand for money at a given interest rate.
ii. The interest elasticity of the demand for money rises.
iii. As interest rate get very close to zero.
iv. When central bank increases the supply for money.
Can an expansionary Monetary Policy increase output when the interest rate is
already very close to zero?
55
(5) Suppose that the macroeconomic-model of an economy is given as follows
Government spending: = 160
Tax function: = 60 + 0.2
Transfer Payments: = 40
Transactions and precautionary demand for money: = = 0.4
Speculative demand for money: = = 300 − 200
Nominal supply of money: = 2380
Price level: =5
i. What is the general mathematical definition of the curve?

ii. Derive the equation that describes the curve.
iii. What is the general mathematical definition of the curve?
iv. Derive the equation that describes the curve
v. What are the equilibrium levels of income and interest rate?
(6) Suppose the government of Kenya increases spending from to , while
simultaneously raising taxes in such a way that, the initial level of output and the
budget remains balanced:
i. Show the effect of this change on the aggregate demand schedule
ii. How does this affect output and the price level in the Keynesian case?
iii. How does this affect output and price level in the classical case?
Further reading
Barro, R. and Gordon, D. (1983)”A Positive Theory of Monetary Policy in a Natural

Rate Model”, Journal of Political Economy, 91 (4)
56
LECTURE 7
MACROECONOMIC MODELS
Lecture overview
This Lecture provides an introductory look at trends of real GDP growth and the
macroeconomic problems of business cycles that are unemployment and inflation. At the
end of the Lecture we shall discuss some business cycle models.

i. Define business cycle and its phases.
ii. Describe the Real business cycle model.
iii. Describe the Keynesian business cycle model.
Introduction
If we examine time series of economic data, what we tend to observe are cyclical
fluctuations in unemployment, real annual output, interest rates and other macroeconomic
variables. These fluctuations are referred to as trade cycle or business cycle.
Thus business cycles are sequential expansions and contractions in the aggregate level of
economic activity like real GDP.
57
Phases of a business cycle
As an economy moves through time it passes from slump through recovery and boom
into recession. The difference between the actual level of output and the potential level of
output gives an index of unemployment. The greater the difference, the higher the
unemployment
Four phases of the business cycle are identified over a several year period. These are:-
i. A peak (boom) is when business activity reaches a temporary maximum with full
employment and near-capacity output.
ii. A recession is a decline in total output, income, employment, and trade lasting six
months or more.
iii. The trough is the bottom of the recession period
iv. Recovery is when output and employment are expanding toward full-employnent
level.
There are several theories about causation
58
(1) Major innovations may trigger new investments and /or consumption spending
(2) Changes in productivity may be a related cause.
(3) Most agree that the level of aggregate spending is important, especially changes on
capital goods and consumer durables.
(4) For cyclical fluctuations, durable goods output is more unstable than non-durables
and services because spending on latter usually can not be postponed
Explanation
If business persons expectations are that the recession will continue, they reduce (cut
back) on investment plans, cut back on output and cut back on employment. Profits fall
and because the demand for borrowing for investment has declined, the rate of interest
falls. Interest rate might reach such a low level that it becomes worthwhile investing
again. The new investment stimulates demand and so the economy begins to pick up
slowly. More new investments take place and the economy comes out of the recession
and moves into the recovery phase.
At the recovery phase the level of output increase and unemployment falls. Profits
improve. At the top of the bloom everybody is competing for loanable funds. Therefore
interest rate rise which choke off investment. As investment spending fall the economy
moves into the deflation phase and so the business cycle is set up. Also in the boom
phase, because the economy is reaching its capacity limit everyone is competing for
scarce resources and prices rise. Labour becomes more expensive as money wages chase
rapidly rising prices. The boom withers out into inflation.
Note:
i. Rapid increases in the prices of imported raw materials can cause a recession by
reducing aggregate supply, a process referred to as supply shocks.
ii. Creation of an excessive amount of capital leads to the upper turning point.
iii. The end of the boom can be attributed to the exhaustion of loanable funds.
iv. A portion of business fluctuations are derived from poor institutional policies for
example, erratic changes in money supply.
v. When investment opportunities decline, the economy experiences a recession and
ultimately a depression.
59
vi. Major innovations like rail road generates longer cycles
The role of money in business cycles

The variability in the growth of money supply is a major cause of business cycles. The
changes in the money supply always/often accompany change in investment. According
to the monetary disequilibrium theory of the business cycle, recessions are as a result of
excess demand for money at full employment. This excess is due to instability in the
growth of money supply
The excess demand for money will lead to a fall in output rather than in prices because
wages and prices are established on a decentralized basis
Note:
 The condition in which expected aggregated demand exceeds actual aggregate
demand is the primary cause of recession. Cuts backs in the rate of growth of the
money supply and declines in investment opportunities are among the reasons for
this condition.
 Output rather than prices will initially fall because of:
i. Misperception by businesses and labour.
ii. The existence of long term contracts and
iii. Decentralized decision making.
 investment is volatile because:
i. Innovations don’t take place smoothly over time.
ii. Firms respond to fluctuations in demand with output change.
iii. Investments have long gestation period.
iv. business cycles cannot be eliminated in a free market economy
The real business cycle model

This model explains the co movements in the fluctuations of aggregate economic variable
around their trend. It is a competitive model with perfect markets. The market is
characterized by;
 No externalities
 systematic information
60
 complete markets
 No other imperfection
The two ingredients are;

i. Shocks to the economies technology (change in the production function from
period to period). Another possible source of shock is the unexpected changes in
government purchases
ii. An optimizing households who decides how much to consume and to work. The
cost of work is the loss of leisure time.
In this model, the economy is populated by:
(a) A large number of identical price taking firms.
(b) A large number of identical price taking households
(c) A government which each period purchases an amount of goods ( ) and
finances itself using lump sum taxes.
Since all agents are identical and price taking we can aggregate and consider an economy
with one representative firm and one representative house hold.
The firm:
In each period the firm produces output , using capital and labour . The units of
labour are multiplier by the labour augmented technology . Therefore, is the
effective labour input.
The production function is a Cobb Douglas function, that is
= ( ) , 0 < <1
Capital depreciates at a rate , whereby:
= +
Where is investment.
The firm observes some disturbances and chooses and in order to maximize the
profits at time .
Labour ( ), is paid with the wage ( ), while the opportunity cost of capital is ( + )
where , is the real interest rate.
61
The household
The representative household is infinitely lived. It is endowed with a certain amount of
time each period (normalized to one unit), which can be used either to work or as leisure
time. Labour supply is endogenous and is the labour income of the household.
We consume at the beginning of period . You can consume more than your salary if
> then you reduce your net wealth.
Real business cycle

Real businesses cycle begin by pointing out that an increase in government purchases
increases the demand for goods. To achieve equilibrium in the goods market the real
interest rate must rise which reduces consumption and investments. Increase in the real
interest rate also causes individuals to re-allocate leisure across time. With higher real
interest rate, working days become relatively more attractive than working in future.
Today’s labour supply therefore increases. This increase in labour supply causes
equilibrium employment and output to rise.
The Keynesian business cycle

The new Keynesian theory of the business cycle asserts that contractual arrangements
prevent wages and prices from rapidly adjusting to reductions in aggregate demand.
If aggregate demand fails to grow as predicted, prices will be higher than their market
clearing levels. Inventories will rise and real GNP and number of man hours of labour
employed will decline.
The new Keynesians feel that changes in Investments, Government spending and taxes or
money supply can cause fluctuations in aggregate demand.
While Keynesian theory also predicts and also increase in the real interest rate in
response to temporary increase in government purchases, the effect of the real interest
rate in labour supply, it does not play a crucial role. Instead, the increase in employment
and output is due to a reduction in the amount of labour employed or underutilized.
62
In Keynesian theory, the labour market is characterized as often in a state of excess
supply. In contrast, the real business cycle theory which doesn’t allow for the possibility
of involuntary unemployment.
Both real business cycle theory and Keynesian theory conclude that an increase in
government purchases increases output and employment. In Real business cycle model
most attention has focused on technological disturbances. Consumption and leisure move
in the opposite direction.
Keynesian theory explains the reduction in welfare by failure in economic coordination:
because wages and price do not adjust instantaneously to equate supply and demand in all
markets, some gains from trade go unrealized in a recession. In contrast, real business
cycle theory allows no unrealized gains from trade. The reason welfare is low in
recession is that the technological capabilities of a society have declined.
In this lecture we have learnt that
i. There are four phases of a business cycle which can be identified over a several-
year period
ii. Money supply plays a very big role in business cycles.
iii. Increases in government purchases increases output and employment.
63
(1) Define a business cycle.

(2) Differentiate between real business cycles and Keynesian business cycle model?
Further reading

64
LECTURE 8
STABALIZATION POLICY AND ISSUES
Lecture overview
Individuals make economic decisions on the basis of rational expectations formed by
using information and their familiarity with the way the economy functions. Changes in
rational expectations of future inflation can shift aggregate supply and cause changes in
macroeconomics equilibrium. This Lecture discusses ways in which fluctuations in
business cycles can be stabilized.

i. Define stabilization policy and issues.
ii. Describe the policy implications of various school of thoughts in macroeconomics
Introduction
Stabilization policy describes both monetary and fiscal policies, the goals of which are to
smooth out fluctuations in output and employment and to keep prices as stable as possible
65
Two possible paths for GDP
Path A is less stable. It varies more over time. Other things being equal, societies prefer
path B to path A. according to an economist, Milton Friedman the government is
constantly stimulating or contracting the economy at the wrong time. From the figure
below;
An expansion policy that should have begun to take effect at point doesn’t actually
begin to have an impact until point , when the economy is already on an upswing.
66
′ ′
Hence the policy pushes the economy to points and instead of and . Income
varies more widely than it would have if no policy has been implemented.
According to the theory of rational expectations, an anticipated increase in aggregate
demand will decrease aggregate supply if it increases expectations of inflation. As
expectations of inflation are revised, the labour supply shifts, resulting in an increase in
nominal wages. The increase in nominal wages decreases aggregate supply. The theory of
rational expectation hypothesizes that when the changes in aggregate demand are
anticipated, a change in aggregate demand will change the equilibrium price level but has
no effect on equilibrium real GDP.
A summary of the views of the major schools of thought in macroeconomics in regard to

stabilization policies are as follows;
The classical economist

Basic assumptions
i. The economy is basically stable with equilibrium real GDP equal to potential real
GDP over the long run
ii. Flexible wages and prices
iii. Households are forward looking
iv. In the long run the price level is proportional to the money stock.
v. Supply creates own demand
Thus the economy has a self-correction mechanism.
When aggregate demand fluctuates so that equilibrium real GDP is less than the potential
GDP and unemployment exceeds that natural rate of unemployment there is a downward
pressure of wages and prices. As nominal wages fall, aggregate supply curves shifts out
until macroeconomic equilibrium is retained at full employment
Policy implications
 Because the economy is viewed as having good self-correction mechanism
through flexibility of nominal wages and other prices. There is no need for
discretionary changes in monetary and fiscal policy.
67
 Monetary policy should limit the rate of growth of the money stock to the rate of
Growth of potential real GDP. Inflation is caused only by excessive growth in the
money stock.
 Tax finance and deficit finance are equivalent and an increase in the deficit has no
effect on real interest rate or capital accumulation.
 Fiscal policy cannot increase real GDP in the long run it merely changes the
government and private purchases.
The Keynesians
Basic assumptions
i. Nominal wages and other prices are inflexible in the downward direction
ii. The economy is unstable subject to unpredictable shifts in the aggregate demand
iii. Changes in the real interest do not increase investments in deep recession because
there is little demand for new capital and much of the existing stock of capital is
idle.
iv. There is a large multiplier effect for changes in government spending and changes
in tax rates.
The economy is prone to periodic recessions. The economy will stagnate in equilibrium
unless expansionary fiscal policy is used to increase aggregate demand. Inflation can be
kept under control with either contractionary fiscal or monetary policy.
Policy implications
 Fiscal policy should be used to manage aggregate demand
 Monetary policy is useful in the long run to keep inflation under control, however
in deep recession monetary policy becomes useless because increase in money
stock do not lower interest rates and do not increase investments.
The Monetarist
Basic assumption
i. The velocity of circulation of money is reasonably stable or varies in predictable
manner
68
ii. Investment purchases are sensitive to changes in the real interest rate in the short run
iii. Inflation is a monetary phenomenon and is caused by excessive money growth
relative to the growth in potential real GDP and money demand
iv. Nominal GDP depends on the money stock after adjustment for any possible changes
in velocity.
Discretionary stabilization policies are more likely to cause recessions and inflation than
are policies that provide clear and predictable rules for monetary growth and fiscal policy
Policy implications
 Fiscal policy primarily affects the mix between private and government use of
resources, expansionary fiscal policy can lead to inflation when accommodated by
monetary authorities with increased money growth
 High marginal tax rates can reduce potential real GDP by hamming incentives to
work and save
 To stabilize the economy, policies should be based on clear and credible rules that
will reduce uncertainty in the economy.
 The rate of growth of the money stock over the long run should equal the rate of
growth of potential real GDP.
The New Classical Economist: Rational expectationist and supply-siders

Basic assumptions
i. Rational expectations households and businesses make forecast about the future
and the effect of changes in economic policies based on the information available
to them and some basic idea about how an economy operates.
ii. Aggregate supply is responsive to changes in expectations about inflation.
iii. Changes in stabilization policy are anticipated by households and businesses who
respond by adjusting their expectation of inflation.
iv. Incentives to produce, work and save are affected by government policies that
influence marginal tax rates and subsidize households and businesses.
69
Adjustment mechanism for the economy:
Self correction is based on shifts in aggregate supply caused by changes in expectation of
inflation. Once potential real GDP is attained, it can be maintained, but the price level can
be affected by economic policies that shift aggregate demand.
Policy implications
 Expansionary policies tend to raise the price level
 Attempts by stabilization to expand the economy beyond potential real GDP, will
raise inflationary expectation, the price level and nominal interest rates
 Fiscal policies will mainly affect the mix between private and government use of
resources in the short-run.
 In the long-run, high marginal tax rates and government policies that adversely
affect incentives to work will lower the rate of growth of potential real GDP
 Fiscal policies that encourage saving and work effort can improve future living
standards.
 Clear and credible policies that keep monetary growth close to the rate of growth
of potential real GDP can prevent inflation.
In this lecture we have learnt that:-
i. Stabilization policies are both monetary and fiscal policies
ii. The classical economists assumes that the economy has a self correction
mechanism
iii. The Keynesians views the economy as prone to periodic recessions so fiscal
policy should not be used to manage aggregate demand.
iv. The monetarist view that the rate of growth of money stock over the long-run
should equal the rate of growth of potential real GDP.
70
v. For the Neo-classical economist, self correction is based on shifts in aggregate
supply caused by changes in expectation of inflation.
Attempt all the questions that follow.
(1) Define stabilization policies.

(2) Discuss the consequences of each stabilization policy.
(3) In your country, which stabilization policies will you advocate for? Why?
Further reading

71
LECTURE 9 and10
UNEMPLOYMENT AND INFLATION
Lecture overview
The natural rate of unemployment is not fixed but depends on the demographic makeup
of the labour force and the laws and customs of the nations. In this Lecture we shall
discuss how the rate of unemployment can be calculated, what causes unemployment and
the different types of unemployment. We shall also discuss inflation and the effects of
inflation

i. Define unemployment.
ii. Describe why there is unemployment
iii. Discuss the different types of unemployment and inflation
iv. Justify the relationship between inflation and unemployment.
Introduction
The average rate of unemployment around which the economy fluctuates is called the
Natural rate of unemployment. In a recession, the actual unemployment rate rises
above the natural rate. In a boom, the actual unemployment rate falls below the
natural rate.
A simple model of the natural rate of unemployment is hereby discussed.
Let denote the number of workers in a labour force.
Let denote the number of employed workers and
72
Let be the number of unemployed. It follows that the unemployment rate is given

by
Assumptions
i. is exogenously fixed.
ii. During any given month, is the fraction of employed workers that become
separated from their jobs, and is the fraction of unemployed workers that
find jobs. This can be expressed as;
= rate of job separation
= rate of job finding (both exogenous)
The transition between employment and unemployment can be illustrated as
Definition: The labour market is in steady state, or long run equilibrium, if the
unemployment rate is constant. The steady state condition is:
× = ×
That is the number of employed people who lose or leave their jobs is equal to the
number of employed people who find jobs. Solving for the “equilibrium” U rate, we have
× = ×
= ×( − )
= × − ×
Solving for , we have;
73
( + )× = ×
So
=
+
Example
Each month, 1% of employed workers lose their jobs ( = 0.01).
Each month, 19% of unemployed workers find jobs ( = 0.19)
Find the natural rate of unemployment.
Solution
0.01
= = = 0.05, 5%
+ 0.01 + 0.19
Thus the unemployment rate is 5%.
A policy that aims at reducing the natural rate of unemployment will succeed only if it
lowers or increases . If job finding were instantaneous( = 1), then all spells of
unemployment would be brief, and the natural rate would be near zero.
There are two reasons as to why the rate of job finding is less than 1. ( < 1). These are;
i. job search
ii. wage rigidity
Job search is related to Frictional unemployment. It can be explained by the time it takes
workers to search for job. It occurs even when wages are flexible and there are enough
jobs to go around. It occurs because
 workers have different abilities, preferences
 jobs have different skill requirements
 geographic mobility of workers not instantaneous
 flow of information about vacancies and job candidates is imperfect.
74
Change in the composition of demand among industries or regions leads to sectoral shifts.
For example, technological change increases demand for computer repair persons and
decreases demand for typewriter repair persons.
It takes time for workers to change sectors, so sectoral shifts cause frictional
unemployment.
The government programs affecting unemployment includes;
 Government employment agencies; disseminate information about job openings
to better match workers and jobs.
 Public job training programs: help workers displaced from declining industries get
skills needed for jobs in growing industries
Unemployment from real wage rigidity

If the real wage is stuck above the equilibrium level, then there aren’t enough jobs to go
around.
The unemployment resulting from real wage rigidity and job rationing is called
structural unemployment. The reasons for wage rigidity and structural unemployment
includes
75
 Minimum wage laws
 Labour unions
 Efficiency wages
The minimum wage is well below the equilibrium wage for most workers, so it can not
explain the majority of natural rate unemployment.
However the minimum wage may exceed the equilibrium wage of unskilled workers,
especially teenagers.
For labour unions, unions exercise monopoly power to secure higher wages for their
members. When the union wages exceed the equilibrium wage, unemployment results
Employed union workers are insiders whose interest is to keep wages high.
Unemployed non-union workers are outsiders, who would prefer wages to be lower (so
that labour demand would be high enough for them to get jobs).
For the efficiency wage theory, high wages increase worker productivity. This is because
it attracts higher quality job applicants, increase worker effort and reduce “shirking”,
reduce turn over which is costly and improve health of workers (in developing countries).
The increased productivity justifies the cost of paying above-equilibrium wages. The
result is unemployment.
More spells of unemployment are short-term than medium-term or long-term. Yet most
of the total time spent unemployed is attributable to the long-term unemployed.
This long-term unemployment is probably structural and/or due to sectoral shifts among
vastly different industries.
Knowing this is important because it can help us craft policies that are more likely to
succeed.
Examples of Structural unemployment includes,
 Oil field workers displaced when oil demand falls
 Airline mergers displacing air line workers
 Foreign competition leading to loss of jobs
 Military cutbacks leading to displacement of workers in military-related industries
Apart from Frictional unemployment and structural unemployment, we have Cyclical
unemployment. This is caused by recession phase of the business cycle, which is
sometimes called deficient demand unemployment.
76
Full Employment
i. Full employment does not mean zero unemployment.
ii. The full-employment unemployment rate is equal to the total frictional and
structural unemployment.
iii. The full-employment rate of unemployment is also referred to as natural rate of
unemployment.
iv. The natural rate is achieved when labour markets are in balance; the number of
job seekers equals to the number of job vacancies. At this point the economy’s
potential output is being achieved. The natural rate of unemployment of
unemployment is not fixed, but depends on the demographic makeup of the
labour force and the laws and customs of the nations.
Economic cost of unemployment

To understand the economic cost of unemployment we need to define GDP gap and
Okun’s Law.
GDP gap is the difference between potential and actual GDP.
Economist Okun quantified the relationship between unemployment and GDP as follows:
For every 1 percent of unemployment above the natural rate, a 2 percent GDP gap occurs.
This has been referred to as “Okun’s Law”.
Because of Okun’s Law, we do not have to separately keep track of what is happening to
real GDP (relative to potential output) and so the unemployment rate. Using Okun’s Law,
you can easily go back and forth from one to the other. It is usually more convenient to
work with the unemployment than with the output gap-real GDP relative to potential
output- if only because the unemployment rate is easier to measure.
As we saw in Lecture 1, inflation is the rising general level of prices (not all prices rise at
the same rate, and some may fall). Also in Lecture 1 we learnt that to measure inflation,
subtract last year’s price index from this year’s price index and divide by last year’s
index; then multiply by 100 to express as a percentage.
There are several causes and theories of inflation:
(1) Demand-pull inflation: spending increases faster than production
77
(2) Cost-push or supply-side inflation: Prices rise because of rise in per-unit
production costs (Unit cost=total cost/units of output)
(a) Wage-push can occur as a result of union strength
(b) Supply shocks may occur with unexpected increases in the price of raw
materials
(3) Complexities: it is difficult to distinguish between demand-pull and cost-push
causes of inflation, although cost-push will die out in a recession if spending does
not also rise
?
Why is inflation bad?
Inflation reduces real wages (Common misperception). This is true only in the short run,
when nominal wages are fixed by contracts. In the long-run, the real wage is determined
by labour supply and the marginal product of labour, not the price level or inflation rate.
Thus the cost of inflation includes;
 Same monthly spending but lower average money holdings means more frequent
trips to the bank.
 The higher is inflation, the more frequently firms must change their prices and
incur these costs.
 Different firms change their prices at different times, leading to relative price
distortions, which cause microeconomic inefficiencies in the allocation of
resources.
 Some taxes are not adjusted to account for inflation, such as the capital gains tax.
for example, in the beginning of the year you bought stocks worth 10,000 at the
end of the year you sold the stock for 11,000, so your nominal capital gain was
1,000 (10%). Suppose within that year = 10%, then real capital gain is 0. but
the government requires you to pay taxes on your 1000 nominal gain!!!
78
 Inflation makes it harder to compare nominal values from different time periods.
This complicates long range financial planning.
 If turns out different from then some gain at others expense. For example;
borrowers and lenders
If > , then the purchasing power is transferred from lenders to borrowers,
If < then the purchasing power is transferred from borrowers to lenders.
One benefit of inflation is that inflation allows equilibrium real wages to fall without
nominal wage cuts. Therefore, moderate inflation improves the functioning of labour
markets.
When > 50% per month, this is termed as Hyperinflation. All the costs of moderate
inflation described above become huge under hyperinflation. Money ceases to function as
a store of value; people may conduct transactions with barter or a stable foreign currency.
Hyperinflation is caused by excessive money supply growth like when the central bank
prints money, the price level rises. If it prints money rapidly enough, the result is
hyperinflation.
Why governments create hyperinflation
 When a government cannot raise taxes or sell bonds,
 it must finance spending increases by printing money,
 In theory, the solution to hyperinflation is simple: stop printing money.
 In the real world, this requires drastic and painful fiscal restraint.
? Do changes in stock prices and stock market wealth cause instability?
The answer is yes but usually the effect is weak. This is because
i. There is a wealth effect: Consumer spending rises as asset values rise and vice
versa if stock prices decline substantially.
ii. Also there is an investment effect: Rising share prices lead to more capital goods
investment and the reverse is true for falling share prices.
79
? How if at all, do changes in stock prices relate to macroeconomic stability?
Stock market “bubbles” can hurt the economy by encouraging reckless speculation with
borrowed funds or savings needed for other purposes. A “crush” can cause unwarranted
pessimism about the underlying economy.
A related question concerns forecasting value of stock market averages. Stock price
averages are included as one of the leading indicators used to forecast the future direction
of the economy. However, by themselves, stock values are not a reliable predictor of
economic conditions.
The Phillips Curve

The Phillips curve illustrates the trade-off between inflation and unemployment. The
Phillips curve is based on the assumption of stable aggregate supply, with economic
fluctuations caused by shifts in aggregate demand.
When inflation is higher than expected inflation and production is higher than potential
output, the unemployment rate will be lower than the natural rate of unemployment.
There is an inverse relationship in the short run between inflation and unemployment.
80
The slope of the Phillips curve depends on how sticky wages and prices are. The sticker
is wages and prices, the smaller is the gradient and the flatter is the Phillips curve. The
slope of Phillips curve varies widely from country to country and era to era.
Shifts in the Phillips Curve
When expected inflation changes, the position of the Phillips curve changes too
81
When wages and prices are less sticky, the Phillips curve is nearly vertical. Then even
small movements in the unemployment rate have the potential to cause large changes in
the price level.
Whenever unemployment is equal to its natural rate, inflation is equal to expected
inflation. Thus we can determine the position of the Phillips if we know the natural rate
of unemployment and the expected rate of inflation. A higher natural rate moves the
Phillips curve right. Higher expected inflation moves the Phillips curve up.
Stagflation exists when annual decreases in aggregate supply are stronger than the annual
increases in aggregate demand. With stagflation caused by decreases in aggregate supply,
both inflation and unemployment increase.
SUMMARY OF LECTURE 9 and 10

i. The average rate of unemployment around which the economy fluctuates is called
the Natural rate of unemployment.
ii. There are two reasons as to why the rate of job finding is less than 1. These are;
Job search and wage rigidity.
iii. Full employment does not mean zero unemployment.
iv. Okun’s Law, quantifies the relationship between unemployment and GDP.
v. The Phillips curve illustrates the trade-off between inflation and unemployment.
82
(1) Discuss the theory of employment/labour as postulated by the classical school of

thought. Compare and contrast this with the Keynesian and Neo-classical views.
(2) Describe the Phillips curve, stating its assumption and factors which will shift it.
(3) What is stagflation?
(4) Briefly discuss Okum’s Law and its significance in the study of macroeconomics.
Identify the various variables found in the Okun’s equation.
Further reading
Ben, S. Bernanke and Frederic, S. Mishkin (1997)”Inflation Targeting: A New Frame

work for Monetary Policy”, Journal of Economic Perspective
Robert, E. Lucas, J.r (1976)”Economic Policy Evaluation: A Critique” In Carl
Brunner and Allan Meltzer (Eds). The Phillips Curve and Labor Markets,
Conference on Public Policy, 1, Amsterdam 19-46
83
LECTURE 11
ECONOMIC GROWTH THEORIES
Lecture overview
Growth is an important economic goal because it means more material abundance and
ability to meet the economizing problem. Growth also, growth lessens the burden of
scarcity. In this Lecture we shall discuss the determinants of economic growth and the
different models of economic growth.

i. Define economic growth.
ii. State the determinants of economic growth.
iii. Discuss the Solow growth model
iv. Differentiate between the exogenous and endogenous growth models.
Introduction
Growth is basically determined by the ability to produce goods and services. Goods and
services are produced by two important inputs, i.e. labour and capital and we combines
them with know how (technology) to produce output.
Some important determinants of economic growth includes
 Capital
 Human capital
 Corruption
84
 Trade
 Institutions
 Technology
 Labour
 Geography
 Infrastructure
We can write down a production function that describes how labour ( ), capital ( ) and
technology ( ) get transformed into output ( ). That is;
= ( , , )
An economy can start producing more output if it has more workers, more machines or
better ways of putting together machines or workers. A good model should enable us to
understand the importance of most if not all of these variables for economic growth. It
should help us understand whether an economy would invest in more capital when it has
better technology or whether it will continue to use the same amount of capital and make
better use of it.
The Solow model

It consist of two equations: a production function and a capital accumulation equation
The production function
Assumptions
a) There are only two inputs which are capital and labour and one output good.
b) The production function exhibits constant returns to scale i.e. doubling K and L
doubles Y
c) The production functions exhibits the diminishing returns to labour and capital
(increase in one input holding the other constant yield fewer and fewer additional
units of output)
d) The growth rate of labour force is exogenously (from outside the model).
A production function that works well is of the Cobb-Douglas form, that is

=
85
Where is a positive number less than one. For example ∝= 0.3 implies that 30% of the
output is produced by capital and 70% by labour.
In order to understand the growth rate of output we need to understand the growth rate of
capital. This leads us to the second equation in the Solow’s model;
The capital accumulation equation

The second equation is,
= −
Where is the saving rate. A fraction of every unit of output is saved and
is the depreciation rate, a fraction of every unit of capital is worn out. Both and are
exogenous to the model
= Total savings=Gross investments
= Replacement investment which is the worn-out portion
− = Net investments
When total savings exceeds replacement investment > , the capital stock increases
( > 0).
When total saving is less than replacement investment, < the capital stock
decreases, ( < 0).
When total saving equals replacement investment ( = ) the capital stock does not
change ( = 0)
The theory of economic growth considers how models different but related explanations
of the process or group. The major questions include;-
i. Why do countries grow faster than others?
ii. What are the most important components of output growth?
Several theoretical models explain the growth rate of a countries real GDP per capita.
The main determinants of economic growth includes: fiscal capital accumulation and
Total Factor Productivity.
Solow (1956) presents a simplified model of economic growth. The model specifies a
neoclassical production function, where physical capital, labour accumulation and
exogenous technology influence the level of output.
86
The major criticism of neoclassical models comes from failure to explain cross countries
differences in per capita growth rates. This has led to focus on analyzing the sources of
total factor productivity growth, so called endogenous growth models. The main
contribution for endogenous growth model consists of including not only human capital
but also international trade in goods and adoption and implementation of foreign
technology.
Most studies considers factor accumulation, total factor productivity growth and
production efficiency improvement can be used to explain economic growth.
Because of data limitation in developing countries, most growth studies consider
developed countries.
Recent growth models looks at the diffusion of technology and assimilation.
Productivity of capital depends on the average age of the capital stock, while the
productivity of labour depends on the average level of education of the population. The
quality of labour possesses a positive and significant effect on output growth.
Solow model assumes an exogenous and homogenous technology across countries. As
countries accumulate technology at the same rate, cross country differences in output
growth rates represents differences in capital accumulation. The model also implies that a
countries real GDP per capita growth negatively correlates with its initial level of income.
Solow model assumes a steady-state growth.
Endogenous growth theory departs from neoclassical theory and focuses on explaining
the Solow residual (unexplained part of the model). The theory considers the effects of
variables such as trade, human capital and endogenous technology on output growth, and
the different mechanisms of technology diffusion. Technological change becomes
endogenous to the model and output growth becomes the outcome of forces that belong
to the model.
Developed countries devote natural resources and human capital to invent new
technology while developing countries invest in human capital and their political and
economic institutions to foster the diffusions and absorption of foreign technologies.
Technological innovation provides the main source of total factor productivity (TFP)
growth in advanced countries. Developing countries face the challenge of acquiring and
87
absorbing foreign technology. Thus innovation and absorption determines cross-country
differences in per capita income growth rates.
i. Economic growth is the increase in the real GDP which occurs over time. It can
also be defined as the increase in real GDP per capita which occurs over time.
ii. The main sources of growth are increasing inputs or increasing productivity of
existing inputs.
iii. Growth doesn’t measure quality improvement, neither does it measure increased
leisure time.
iv. Endogenous growth models depart from neo-classical theory and focuses on
explaining Total factor productivity.
88
(1) Discuss the assumptions of Solow model.

(2) Analyze relevant macroeconomic policies and issues that relates to developing
countries.
(3) Explain how the policies taken by one country can have global effects in an
increasingly open world economy.
Further reading
Ben, S. Bernanke and Frederic, S. Mishkin (1997)”Inflation Targeting: A New Frame

work for Monetary Policy”, Journal of Economic Perspective
89
LECTURE 12
MACROECONOMIC ISSUES AND POLICIES IN RELATION TO

DEVELOPMENT
Lecture overview
In our previous lecture we have seen that, economic performance is measured by GDP
growth. This includes consumption, investment, inflation, market imperfections among
others. In this lecture we shall discuss the drivers of growth.

i. Define fundamental drivers to growth
ii. Discuss potential spoilers and risks to development.
iii. Explain the potential areas of macroeconomic concern
Fundamental, structural drivers of growth

i) Attractive demographics: falling dependency ratio, rising labour force
ii) High saving rates: should be above the emerging markets average
iii) High infrastructure investments: In ports, power, roads, railways is likely to
provide investment opportunities, productivity improvements, through small
policy changes
iv) Consumption: penetration levels for most goods and services, including
finance are relatively low in developing countries implying room for high
growth investment ideas.
v) Global drivers: expanding tradable sectors
90
vi) Transition dynamics: an economy moving from agricultural activities to
manufacturing activities then to IT activities
vii) Empowerment of the rural segment: we need diffusion and dispersion, top to
bottom, center to periphery.
Potential spoiler’s risks

i) Political shortcoming, including bureaucratic restrictions and regulations
ii) Poor state of infrastructure
iii) Education skills and literacy gaps
iv) Raising energy dependency
In summary the potential areas of macroeconomics concern include: State of national

balance sheet: fiscal deficits persistent and structural current account deficit stands out for
its vulnerability to short-term, volatile financing. Areas to focus are among others;
i) Reviving growth e.g. ,capital labour and technology

ii) Fiscal consolidation
iii) Inflation
iv) Current account
v) Reversing weakening savings/investments rates
vi) Meeting the infrastructure deficit
vii) International oil prices
viii) Managing capital flows
i. There are some fundamentals structures which can facilitate growth in an
economy.
91
ii. There are potential risks which do affect some economy as they gear up towards
growth
iii. Reviving growth, fiscal consolidation, reversing weakening savings and
investments, international prices are some of the potential areas of
macroeconomic concerns.
1. Explain why some countries grow faster than others

2. How is wage determined in your country? Explain
3. Discuss five factors which tend to hinder economic growth in your country.
Further Reading
92

ECON 302-Intermediate Macroeconomic Theory

Uploaded by

Copyright:

Available Formats

You might also like

ECON 302-Intermediate Macroeconomic Theory

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

ECON 302-Intermediate Macroeconomic Theory

Uploaded by

Copyright:

Available Formats

KENYA METHODIST UNIVERSITY

Department of Economics and Statistics

Intermediate Macroeconomic Theory

Dr. Levi Mbugua (PhD) – 2014

Open and Distance Learning Instructional

By the end of this course, you should be able to:-

Branson, W. H. (1972). Macroeconomics Theory and Policy, Haper & Row

Other Instructional materials/Equipment:

Course Assessment Weighted %

Prerequisite: ECON 102 (Principles of Macroeconomics)

Week Lecture TOPICS Sub-Topics

2 2 Macroeconomic Markets i. Equilibrium in the goods and service

3 3&4 Demand for goods and i. Demand for goods model

4 and 5 5&6 Financial Market i. Money market equilibrium and the LM

6&7 7 Macroeconomic models i. Introduction to the Business Cycle Theory

8&9 8 Stabilization Policy and i. Definition of stabilization policies

10 9 & 10 Unemployment and i. Types of unemployment

11 11 Economic Growth i. Determinants of economic growth

12 12 Macroeconomic Issues i. Fundamental structural drivers of growth.

In this Lecture 1, we start by revisiting the data of macroeconomics. We begin by

Objectives of the Lecture

By the end of this lecture, you should be able to

Why learn Macroeconomics?

The supply and demand of new cars model

The demand equation can be represented graphically as;

On the other hand, the supply equation will be given by; = ( , )

Supply curve (S)

Gross Domestic Product (GDP)

Gross Domestic Product (GDP) variables

Government spending (G)

Attempt all the questions that follow

2001 2002 2003

Nom. GDP Real GDP GDP Inflation

Gregory, N. Mankiw (2012). Macroeconomics ISBN-10: 1429240024

Objectives of the Lecture

By the end of this lecture, you should be able to

Aggregate demand for goods and services

Why does the aggregate demand curve slope downwards?

Aggregate supply of goods and services

Equilibrium in the goods and services market

When long run equilibrium is present,

Loanable funds market

Suppose that you purchased a five hundred thousand Kenyan

The Circular Flow Diagram

Attempt all the questions that follow

Gregory, N. Mankiw (2012). Macroeconomics ISBN-10: 1429240024

THE DEMAND FOR GOODS AND SERVICES

Objectives of the Lecture

By the end of this lecture, you should be able to:-

of the total income is consumed not out of the marginal income.

Thus we can write investment as;

Government Spending (G)

Determination of equilibrium Output

Macroeconomics always uses 3 tools in describing a model. These tools are;

multiplier. The closer is to 1, the larger the multiplier.

? What does the multiplier imply?

If we increase government expenditure (G) by 1, this increases national income by

by one. If we increase taxes by one, Y will fall by .