CHAPTER ONE

1. THE STATE OF MACROECONOMICS - INTRODUCTION

1.1. Macroeconomics: Definition and Objectives
The question here is “What macroeconomics is about?” Before defining Macroeconomics, let’s
deal first with basic definitions of Economics.

What is Economics? The fundamental factors that build up economics as a discipline are the
problem of unlimited human wants and the principle of economic resources (natural resources,
human resources, physical capital resources and entrepreneurship) scarcity. Therefore,
“Economics is a consequential social science discipline that deals with efficient allocation of
the available economic resources so as to satisfy the unlimited human wants.” This means
economics is needed because of the problem of unlimited human want and the principle of
scarcity. In general, “Economics is the study of the economy and the behavior of people in the
economy”.

The Economics discipline has two major areas of study: Microeconomics and Macroeconomics.
Microeconomics is a branch of economics that studies the economic decision making of
households, firms and individual industry in a market. Microeconomics concerns with the
specific economic units and a detailed consideration of the behavior of these individual units.
However, Macroeconomics is branch of economics deals with the economy at large or as a
whole. It is also concerned with the sub-aggregates (sub-divisions) of the economy such as the
government, total households in the economy, the whole industry, and business sector, which
make up the economy. In short, here is the distinction summarized below:

Microeconomics Macroeconomics
Deals with the behavior of individual economic Concerned with the economy as a whole and with
units and decision makers sub-aggregates of an economy.
Concerned with output, consumption, price, & Entails with total output, total income, total
employment determination at household or firm employment and general price level in the economy
level. at large.
Is with the objective of efficient resource Is with the objective of maintaining high
allocation and price determination & etc employment, maintaining stability of an economy,
facilitating growth & etc.

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 Macroeconomics is part of the scope of economics which deals with the economy as a whole. It
studies the aggregate behavior, structure, and performance of national economy.
Macroeconomics examines aggregate economic units like national output, income, employment,
general price level, saving and investment, exchange rate, interest rate, balance of payment,
economic growth etc rather than individual units of the economy. In short, the overall
performance of the economy with regard to the above variables and that is why it sometimes
refers to aggregate economics.

Macroeconomics is concerned with the behaviour of the economy as a whole- with booms and
recessions, the economy’s total output of goods and services and the growth of output, the rate of
inflation and unemployment, the balance of payments, and exchange rates. Macroeconomics
focuses on the economic behaviour and policies that affect consumption and investment, trade
balance, the determinants of changes in wages and prices, monetary and fiscal policies, the
money stock, government budget, interest rate, and national debt.

1.2. Basic Concepts and Methods of Macroeconomic Analysis

A. Measuring the Value of Economic Activity: Gross Domestic Product
The single most important measure of overall economic performance is Gross Domestic Product
(GDP). The GDP is an attempt to summarize all economic activity over a period of time in terms
of a single number; it is a measure of the economy’s total output and of total income. In other
words GDP is the value of all final goods and services produced in the economy in a given time
period (not that GDP is a flow not a stock).
 Real GDP versus Nominal GDP

Valuing goods at their market price allows us to add different goods into a composite measure,
but also means we might be misled into thinking we are producing more if prices are rising.
Thus, it is important to correct for changes in prices. To do this, economists value goods at the
prices at which they sold at in some given year. For example, in Ethiopia, we mostly measure
GDP at 1980/81 prices. This is known as real GDP. GDP measured at current prices is known as
nominal GDP.
 The GDP Deflator
Nominal GDP
The GDP deflator is the ratio of nominal to real GDP: GDP Deflator 
Real GDP
The GDP deflator is a measure of the general price level.

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 GDP and GNP

There is a distinction between GDP and gross national product (GNP). GNP is the value of final
goods and services produced by domestically owned factors of production within a given period.
The difference between GDP and GNP corresponds to the net income earned by foreigners.
When GDP exceeds GNP residents of a given country are earning less abroad than foreigners are
earning in that country. In Ethiopia, GDP has exceeded GNP since 1981 (based on the data
available in World Development Indicators CD-ROM, 2000) but the gap is well below 1%
(0.75% to be exact) during 1981 – 1998.
 In simple words, GDP is territorial while GNP is national.

 Gross and Net Domestic Product

Capital wears out, or depreciates while it is being used to produce output. Net domestic product
(NDP) is equal to GDP minus the capital consumption allowance, a measure of depreciation.

The Business Cycle and the Output Gap

Inflation, growth, and unemployment are related through the business cycle. The business cycle
is the more or less regular pattern of expansion (recovery) and contraction (recession) in
economic activity around the path of trend growth. At a cyclical peak, economic activity is high
relative to trend; and at a cyclical trough, the low point in economic activity is reached. Inflation,
growth, and unemployment all have clear cyclical patterns.

Figure 1: Business cycle

Output Peak
Trend

Trough

Time

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The trend path of GDP is the path GDP would take if factors of production were fully employed.
Over time, real GDP changes for the two reasons. First, more resources become available which
allows the economy to produce more goods and services, resulting in a rising trend level of
output. Second, factors are not fully employed all the time. Thus, output can be increased by
increasing capacity utilization.

Output is not always at its trend level, that is, the level corresponding to full employment of the
factors of production. Rather output fluctuates around the trend level. During expansion (or
recovery) the employment of factors of production increased, and that is a source of increased
production. Conversely, during a recession unemployment increases and less output is produced
than can in fact be produced with the existing resources and technology. Deviations of output
from trend are referred to as the output gap.

The output gap measures the gap between actual output and the output the economy could
produce at full employment given the existing resources. Full employment output is also called
potential output.
Output gap  potential output – actual output
When looking at the business cycle fluctuation, one question that naturally arises is whether
expansions give way inevitably to old age, or whether they are instead brought to an end by
policy mistakes. Often a long expansion reduces unemployment too much, causes
inflationary pressures, and therefore triggers policies to fight inflation- and such policies
usually create recessions.
Okun’s Law
A relationship between real growth and changes in the unemployment rate is known as Okun’s
law, named after its discoverer, Arthur Okun. Okun’s law says that the unemployment rate
declines when growth is above the trend rate.
u = -x(ya – yt)
where u is change in unemployment, x the magnitude in which unemployment declines due to
a percentage point growth, ya actual growth rate of output, and yt is trend output growth rate.
The figure below shows the Okun’s law relationship between unemployment and growth in
output.

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 Grow th and U nemploy ment Dy namics

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Percentage change in real GDP

0
-3 -2 -1 0 1 2 3

-3
C hange in unemploy ment rate

Inflation –Unemployment Dynamics

The Phillips curve describes the empirical relationship between inflation and unemployment: the
higher the rate of unemployment, the lower the rate of inflation. The curve suggests that less
unemployment can always be attained by incurring more inflation and that the inflation rate can
always be reduced by incurring the costs of more unemployment. In other words the curve
suggests there is a trade-off between inflation and unemployment.

Phillips curve
Inflation
Rate

0
Unemployment rate

1.3. Macroeconomic Goals and Instruments

The objective of macroeconomic policies is to maximize the level of national income, providing
economic growth to raise the utility and standard of living of participants in the economy. There
are also a number of secondary objectives which are held to lead to the maximization of income
over the long run. While there are variations between the objectives of different national and
international entities, most follow the ones detailed below:

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1. Economic growth – the process of increasing real output of goods and services thereby
bringing economic growth. In other words, it is the way of increasing (quantity) and improving
(quality) the goods and services produced in a nation. In addition, this also includes increasing
productivity, more output per unit of labor per hour. The various economics resources are also
too.
2. Full employment – macroeconomics seeks to create job opportunities for those who are able
and willing to have a job. When it says full employment it doesn’t means that the unemployment
rate should be zero but it means that the rate should be approximately equal to the natural rate of
unemployment (acceptable and justifiable rate is 7 percent). Thus, the economy should provide
adequate job opportunities for those who are active workers and interested groups.
3. Price stability - when prices remain largely stable, and there is not rapid inflation or deflation.
Price stability is not necessarily the same as zero inflation, but instead steady levels of low-
moderate inflation are often regarded as ideal. It is worth noting that prices of some goods and
services often fall as a result of productivity improvements during periods of inflation, as
inflation is only a measure of general price levels. However, inflation is a good measure of 'price
stability'. Zero inflation is often undesirable in an economy.
4. Equitable distribution of income and wealth (raise standard of living) – a fair share of the
national 'cake', more equitable than would be in the case of an entirely free market. To make it
clear, macroeconomics also seeks to fairly distribute the total output (income) produced among
the members of society. By fairly (evenly) distributing income (output), macroeconomics tries to
maintain good standard living of citizens of a nation.
5. External balance - equilibrium in the balance of payments without the use of artificial
constraints. That is, exports roughly equal to imports over the long run. It also strives to have
fewer ups and downs in the economic activities of a nation plus prosperous world economy and
smooth relationship with rest of the world.
6. Sustainability - a rate of growth which allows an increase in living standards without undue
structural and environmental difficulties.

1.4. The State of Macroeconomics: Historical Evolution and Recent

Developments of Macroeconomics

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The origin of macroeconomics dates back to 1730’s when economic statisticians began to collect
and publish the great body of statistical data used to describe aggregate economic behavior,
especially during the classical period, particularly by Adam Smith. The writing of a book on
“The general theory of unemployment, interest and money” by John Maynard Keynes as an
attack on classical economists’ theory on the operation of the whole economy and the world
depression that began in 1929 has also added urgency to the study of macroeconomics. In this
chapter, we briefly distinguish:

I. The Classical School (1776 – 1870) - Classical economics is widely regarded as the
first modern school of economic thought. Its major developers include Adam Smith (Wealth of
Nations, 1776), David Ricardo (Principles of Political Economy, 1817), John Stuart Mill
(Principles of Political Economy, 1848) and Irving Fischer (The Purchasing Power of Money,
1922). They emerged as an attack on an earlier orthodoxy, the mercantilist who believed in stock
of precious metals as determinant of wealth of a nation and strong role of the state action in the
development of the capitalist state.

The Classical view regarding the operation of the economy is characterized by a strong belief in
the market and the efficacy of the price mechanism. Their doctrine was that, in the aggregate,
production of a given quantity of output will generate sufficient demand for that output. As a
result, they gave little explicit attention to factors that determine the overall demand for
commodities or to policies that regulate aggregate demand (i.e. fiscal or monetary policies).

A central relationship in classical model is the short run aggregate production function which
shows output variation in terms of labor employment variation as stock of capital, and state of
technology is assumed to be fixed. This in turn has made the classical to the belief that a change
in equilibrium output is only possible by factors that determine the position of the labor supply,
labor demand, and the position of the aggregate production function. For them; changes in
technology, shocks that affect capital formation, labor productivity, as well as disturbances that
influence the availability and prices of natural resource are the main factors that can explain
changes in output and employment.

However, these variables are constant in the short run which in turn has led the classical
economists to conclude the short run aggregate supply curve as vertical. An aggregate demand
curve could be added to the picture, but whatever the shape or position of this curve; it would

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clearly not affect output. In other words, the aggregate demand curve in the short run is
downward sloping as usual.

The classical economists thus believed in a dichotomy: Demand side policies merely affect the
interest rate/ or the price level, while supply side policies affect the real wage, employment and
output. It is this view that Keynes attacked. The traditional view was that these supply side
variables only change slowly overtime. But, according to Keynes, if output is determined by
factors that changes only slowly overtime, how can the classical model explain the sharp cyclical
movement in output? It was the apparent failure of the classical model to explain cyclical
movement of output that led to neoclassical and Keynesian revolution.

II. The Neo-Classicists Era (1870 – 1936) - The most prominent neo-classicist
economists were William Stanley Jevons, Léon Walras, Alfred Marshall and Karl Menger.
Concentrating on the utility or satisfaction rendered by the last or marginal unit purchased, neo-
classicists explained market prices not by reference to the differing quantities of human labor
needed to produce assorted items but rather according to the intensity of consumer preference for
one more unit of any given commodity.

They explained demand by the principle of marginal utility, and supply by the rule of marginal
productivity (the cost of producing the last item of a given quantity). In competitive markets,
consumer preferences for low prices of goods and seller preferences for high prices were
adjusted to some mutually agreeable level. At any actual price, then, buyers were willing to
purchase precisely the quantity of goods that sellers were prepared to offer.

The same application supply and demand occurred in markets for money and human labor. In
money markets, the interest rate matched borrowers with lenders. The borrowers expected to use
their loans to earn profits larger than the interest they had to pay. Savers demanded a price for
postponing the enjoyment of their own money. In competitive labor markets, wages actually paid
represented at least the value to the employer of the output attributed to hour’s worked and at
least acceptable compensation to the employee for the tedium and fatigue of the work.

The main distinction for neo-classical is the tool of analysis, such as the marginal analysis. They
assumed the real money supply rather than nominal and no liquidity trap hence any depression
and unemployment can be solved automatically by adjusting prices and quantities as long as the

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market is competitive. The school, however, faces a big problem from 1929 to 1933, which was
beyond the theory’s capacity i.e., the Great Depression. Since the neoclassical model couldn’t
solve the problem and come up with new theory, another school of economics is necessitates.

III. Keynesian period (1936 – 1970) - The Great Depression bewildered economists and
politicians. The existing economic policies simply did not work. New explanations and fresh
policies were urgently required; this was precisely what Keynes supplied. The main thesis of the
Keynesian stream is that the economy is subjected to failure so that it may not achieve full
employment level. Thus, government intervention is inevitable. In a very simplified form we can
present Keynes’s theory of recessions. Imagine an economy that is chugging along happily at full
employment. Alongside the smoothly functioning ‘real’ economy there will be a smooth
financial flows, as firms earn money from their sales, pay out their earnings in wages and
dividends, and household spend these receipts on new purchases from the firms.

But now suppose that for some reason each household and firm in this economy decides that it
would like to hold a little more cash. Keynes argued, in particular, this happens when
businessmen lose confidence and start to think of potential investments as risky, leading them to
hesitate and accumulate cash instead; today we might add the problem of nervous households
who worry about their jobs and cut back on purchases of big-ticket consumer items. Either way,
each individual firm or household tries to increase its holdings of cash by cutting its spending so
that its receipts exceed its outlays.

But as Keynes pointed out, what works for an individual does not work for the economy as a
whole, because the amount of cash in the economy is fixed. An individual can increase his cash
holding by spending less, but he does so only by taking away cash that other people had been
holding. Obviously, not everybody can do this at the same time. So what happens when everyone
tries to accumulate cash simultaneously?

The answer is that income falls along with spending. I try to accumulate cash by reducing my
purchases from you, and you try to accumulate cash by reducing your purchases from me; the
result is that both of our incomes fall along with our spending, and neither of us succeeds in
increasing our cash holdings. If we remain determined to hold more cash, we will react to this
disappointment by cutting our spending still further, with the same disappointing result; and so
on. Looking at the economy as a whole, you will see factories closing, workers laid off, stores

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empty, as firms and households throughout the economy cut back on spending in a collectively
vain effort to accumulate more cash. The process only reaches a limit when incomes are so
shrunken that the demand for cash falls to equal the available supply.

To solve the problem which was occurred during the neo classical, Keynes proposed two
alternative economic policies. For Keynes to do about recessions, the first and most obvious
thing to do is to make it possible for people to satisfy their demand for more cash without cutting
their spending, preventing the downward spiral of shrinking spending and shrinking income. The
way to do this is simple to print more money, and somehow get it into circulation.

So the usual and basic Keynesian answer to recessions is a monetary expansion. But Keynes
worried that even this might sometimes not be enough, particularly if a recession had been
allowed to get out of hand and become a true depression. Once the economy is deeply depressed,
households and especially firms may be unwilling to increase spending no matter how much cash
they have; they may simply add any monetary expansion to their hoarding. Such a situation, in
which monetary policy has become ineffective, has come to be known as a “liquidity trap”. In
such a case, the government has to do what the private sector will not spend. When monetary
expansion is ineffective, fiscal expansion must take its place. Such a fiscal expansion can break
the vicious circle of low spending and low incomes and getting the economy moving again. Here
are the summaries for Keynes’ economic policy:
1. Monetary Policy - print more money to increase supply of money results in interest rate
reduction, which, in turn, increases investment, and then increase aggregate demand thereby
increases gross output level of the economy. Here, the problem of liquidity trap-monetary policy
has become ineffective if household and firms hold their money whatever cash they have.
2. Fiscal Policy - expansionary fiscal policy results, on the one hand, an increment of
government expenditure. This also leads to an increasing aggregate demand, which in return, to
an increasing of national output. On the other hand, to tax rate reduction, this leads to an
increasing of household income. This, in turn, results in household spending thereby an
increment to national income.

Hence, government intervention is essential to improve the operation of the market and break the
vicious cycle of low spending and low income. In 1968 and 1973, two problems were occurred;

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increase oil price due to supply shock and problem of stagflation. The school couldn’t provide
and suggest a remedy for those problems and a new school of thought is required.

IV. Monetarism doctrine (1970-19801) - Monetarism, as advocates of free market,

started challenging Keynes’s theory in the 1970s. Milton Friedman, the founder of monetarism,
attacked Keynes idea of smoothing business cycle on the ground that such active policy is not
only unnecessary but actually harmful, worsening the very economic instability that it is
supposed to correct, and should be replaced by simple, mechanical monetary rules. This is the
doctrine that came to be known as “monetarism”.

Friedman began with a factual claim: most recessions, including the huge slump that initiated the
Great Depression, did not follow Keynes’s script. That is, they did not arise because the private
sector was trying to increase its holdings of a fixed amount of money. Rather, they occurred
because of a fall in the quantity of money in circulation.

If economic slumps begin when people spontaneously decide to increase their money holdings
(quantity of money fall), then the monetary authority must monitor the economy and pump
money in when it finds a slump is imminent. If such slumps are always created by a fall in the
quantity of money, then the monetary authority need not monitor the economy; it need only
make sure that the quantity of money doesn’t slump.

In other words, keep the money supply steady is good enough, so that there is no need for a
“discretionary” policy of the form, “Pump money in when your economic advisers think a
recession is imminent.” In all, if economic slumps begin when people spontaneously decide to
increase their money holdings, then the monetary authority must monitor the economy and pump
money in when it finds a slump is imminent.

If such slumps are always created by a fall in the quantity of money, then the monetary authority
need not monitor the economy; it need only make sure that the quantity of money doesn’t slump.
In other words, a straightforward rule- “Keep the money supply steady”- is good enough, so that
there is no need for a “discretionary” policy of the form, “Pump money in when your economic
advisers think a recession is imminent.”

1
Source: Paul Krugman (1995) Peddling Prosperity, WW Norton & Company, New York and London. (Page 34-40)

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V. The New Classical School (1980’s-19932) - The new classical macroeconomics
remained influential in the 1980s. Among the most famous leaders were Robert Lucas, Thomas
Sargent, Robert Barro, and Edward Prescott and Neil Wallace. This school of macroeconomics
shares many policy views with Friedman. It sees the world as one in which individuals act
rationally in their self-interest in markets that adjust rapidly to changing conditions. The
government, it is claimed, is likely only to make things worse by intervening.

In general, this school introduced rational expectation and market equilibrium. They believed
recession and demand problem are not problems as they are rational outcome. Thus the only
problem is the supply side and called supply –side economy. The essence of the new classical
approach is therefore the assumption that markets are continuously in equilibrium. The central
working assumptions of the new classical school are three:
 Economic agents maximize utility/profit. Households and firms make optimal decisions
given all available information in reaching decisions and that those decisions are the best
possible in the circumstances in which they find themselves.
 Expectations are rational, which means they are statistically the best predictions of the future
that can be made using the available information. Rational expectations imply that people
will eventually come to understand whatever government policy used, and thus that it is not
possible to fool most of the people all the time or even most of the time.
 Markets clear. There is no reason why firms or workers would not adjust wages or prices if
that would make them better off. Accordingly prices and wages adjust in order to equate
supply and demand; in other words, market clear. For instance, any unemployed person who
really wants a job will offer to cut this or her wage until the wage is low enough to attract an
offer from some employer. Similarly, anyone with an excess supply of goods on the shelf
will cut prices so as to sell.

VI. The New Keynesians school (1993 onwards3) - The new classical group remains
highly influential in today’s macroeconomics. But a new generation of scholars, the new
Keynesians, mostly trained in the Keynesian tradition but moving beyond it, emerged in the

2
Source: Dornbusch and Fischer, 1994. pp. 6-7.

3 Source: Dornbusch and Fischer, 1994, Page 7.

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1990s. They do not believe that markets clear all the time but seek to understand and explain
exactly why markets fail.

The new Keynesians argue that markets sometimes do not clear even when individuals are
looking out for their own interests. Both information problems and costs of changing prices lead
to some price rigidities, which help cause macroeconomic fluctuations in output and
employment. For example, in the labor market, firms that cut waged not only reduce the cost of
labor but are likely to wind up with a poorer quality labor. Thus they will be reluctant to cut
wages.

Associated with the New Keynesian economic principles, the World Bank and International
Monetary Fund follow two essential argumentative views: debt cancellation policy, and poverty
reduction strategy. In all, all school of macroeconomics agree on the purpose of macro policy but
they disagree on how to achieve the macro objectives of higher output, lower level of
unemployment and inflation rate.
1.5. Macroeconomics: Problems and Policies
The rational behind this sub chapter is to examine the different national problems that the
economy as whole faces and identify the various national policies that the economy uses to solve
the macro problems.

It is known that, macroeconomics focuses on the economic behavior and policies that affect
consumption and investment, trade balance, the determinants of changes in wages and prices,
monetary and fiscal policies, the balance of payments, exchange rates, the money stock,
government budget, interest rate, and national debt.

The behavior of the whole economy can be failed or instable because of environmental, human,
political, cultural or nature changes. These changes directly or indirectly results in recessions,
unemployment, stagnation and inflation, which are known as macroeconomic problems (in detail
see chapter three). Government policies that related to national economy in aiming at facilitating
the achievement of the macroeconomics objectives and minimizing (if possible avoiding) the
macroeconomics problems are called macroeconomics policy. Some of the policies are listed
below:

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  Fiscal policy - government decision about taxes and government spending on goods and
services. In this case, the government can minimize the macro problems that the economy
faces using either the government purchasing or tax/subsidy instruments.
 Monetary policy - government decision about money supply and interest rate. When the
economy faces macroeconomic problems, the decision maker can at least minimize the
extent of the problem using money supply or interest rates.
 Income policy - policy about wages and salaries. It also includes other fringe benefits,
which are given to employees.
 Foreign policy – another name is trade policy. This policy focuses on the interaction of
the domestic economy with the ROW. It includes exchange rate, tariff policy, non-tariff
policy and so on.
1.6. Importance of Macroeconomics
The purpose of the lesson is to introduce students about the importance of macroeconomics.
Here below are identified the various advantages of macroeconomics.

In macroeconomics, we do two things. First, we seek to understand the economic functioning of

the world we live in; and, second, we ask if we can do anything to improve the performance of
the economy. That is, we are concerned with both explanation and policy prescriptions.
Explanation involves an attempt to understand the behavior of economic variables, both at a
moment in time and as time passes. Modern macroeconomics recognizes that it is important to
focus on more than just short period of time, and so has an explicitly dynamic focus. We thus try
to explain the behavior of economic variables over time, otherwise.

Hence, the social, cultural, political, military, and economic fate of nations is greatly dependant
on their macroeconomic performance. No area of economics is today more vital or controversial
than macroeconomics. Unemployment, inflation, business cycle, economic growth affects the
day-to-day lives of people. It is macroeconomics that examines all these aggregate economic
variables (units). Thus, making them as smooth as possible is making the society of a nation to
be better off.

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