CHAPTER-FIVE

MACROECONOMIC
PROBLEMS

1
 5.1. Definition of Unemployment
 Unemployment is the macroeconomic problem
that affects people most directly and severely.
Unemployment refers to groups of people who
are in a specified age ( labor age ), who are
without a job but are actively searching for a job .
 in Ethiopia context, the specified age is between
15 and 60 which are normally named as
productive population.
 Unemployment is a frequent topic of political
debate and that politicians often claim that their
proposed policies would help create jobs. 2
 5.1. Measurement of Unemployment
 The problem of unemployment and its
intensity is usually measured in terms of
unemployment rate.
 Unemployment rate is The number of
unemployed people divided by the labor force.
 Labor force (L):The total number of employed
and unemployed people in the economy.
L=E+U
 People who are employed may be either full
time or part time employees.
3
 Employed labor: are those who worked full-
time or part-time during the past week.
 Unemployed labor: are those who did not work
during the preceding week but made some effort to find
work in the past 4 weeks.
 Unemployed; are those who are able, available and
willing to work but cannot find a job.
 Worker unemployed for 6 months or more is called
long-term unemployed.

4
 Out of the labor force: are those who did not
work in the past week and did not look for work
in the past 4 weeks. Examples
Full-time student who do not work
 Unpaid homemakers
 Retirees
Disabled unable to get work
Armed forces
Institutionalized/hospitalized, prisoners
5
 5.2. Types of Unemployment
1. Frictional unemployment
2. Seasonal Unemployment
3. Structural unemployment
4. Cyclical Unemployment

6
 1. Frictional unemployment
 Fractional unemployment refers to a brief period of
unemployment experienced due to,
 Voluntary switching of jobs in search of better jobs .
 Entrance to the labour force E.g. A student
immediately after graduation.
 Re- entering to the labour force.
 This occurs in the period between leaving one job and
finding another
 Governments reduce this by improving information
about vacancies, job centres, financial incentives,
retraining schemes etc.
7
 2. Seasonal Unemployment
 Unemployment due to the seasonal nature of
some occupations and industries.
 Unemployment that occurs because of the need
for workers falls at certain times during the year.
 Examples are Construction, Tourism and
Agriculture.
 Unemployment due to the seasonal changes.

8
 3. Structural unemployment
 It is long term unemployment because workers do
not have the wright skills/lack of skills/ they can
not move to new job.
 It is when workers do not have transferable skills
and these jobs will never come back.
 Unemployment do you to technology change and
advancement.
 Unemployment do you to workers are not willing
to move to other places to get work.

9
 Con…
 It is the unemployment that results because the
number of jobs available in some labor markets is
insufficient to provide a job for everyone who
wants one.
 Changes in the structure of the labor force make
some skills obsolete.
 In this respect one of the policy options used to
reduce such unemployment is training workers
and improving labour mobility.

10
 4. Cyclical Unemployment
 Unemployment that rises and falls as a result of
business cycle.
 Unemployment that occurs as a result of poor
economy .
 Unemployment that results from economic
downturns (recessions).
 Unemployment that occur when there is demand
deficient/ lack of AD/ in the economy.
 As demand for goods and services falls, demand
for labor falls and workers are fired.
 Full employment: is the Level of employment
that occurs when the unemployment rate is at NRU.
11
When National rate of unemployment equal to un
employment rate it is known as full employment,
full employment does not mean zero
unemployment .
 It is nearly every one who wants a job has a job.
 If cyclical unemployment is zero because we
have unemployment that is unavoidable (frictional
and structural) we are at full employment. It is
generally thought to be between 94%-96%
employment.
 There will always be unemployment.
The policy instrument to solve this problem is
fiscal policy (for instance increasing government
expenditure and reducing tax rates) and/or monetary
12
 Consequence of unemployment
 Loss of income
 Fall in real living standards
 Increased health risks (Stress, Reduction in
quality of diet and Social exclusion).
 Loss of marketable skills and motivation.
 A rise in government borrowing (i.e. a budget
deficit)
 Lost output (real GDP) from people being out of
work
 Increase in the inequality – rise in relative poverty
 Fall in revenue from income tax and taxes on
consumer spending 13
 5.1.3. Relationship between unemployment
and output
 When the economy is in recession unemployment
rate rises and when the economy rises
unemployment rate will go down.
 Fluctuations in unemployment rate is strongly
correlated with the overall GDP of the economy.
 Okuns law states an inverse relationship between
unemployment and GDP.

14
 Con…
 The relationship that Okun found between
changes in the unemployment rate and change in
output is called okun’s law.
 Okun’s law: states that for every percentage point
increase in the unemployment rate there is a 2.5
percent drop in real GDP.
 Okun’s law measures the short-run losses of
output due to a cyclical increase in the
unemployment rate above the natural rate.

15
 5.1.4. Labor Market equilibrium
 The equilibrium wage rates and employment is
determined by the intersection of demand for
labor and supply of labor.
 Equilibrium in the labor market requires that the
marginal revenue product of labor (MRPL) is
equal to the wage rate.
 Firms determine their demand for labor through
a lens of profit maximization, ultimately seeking
to produce the optimum level of output and the
lowest possible cost.
16
  The marginal revenue product of labor (MRPL)
is the amount of revenue that each additional
workers earned a firm which is determined by
MPL multiplied by the price of output.
 The MRPL represents the additional revenue that
a firm can expect to gain from employing one
additional unit of labor-it is the marginal benefit to
the firm from labor.
 MRPL is decreasing as the quantity of labor
increases, and firms can increase profit by hiring
more labor if the MRPL is greater than the
marginal cost of that additional unit of labor- the
wage rate 17
 Con…
 The wage rates and number of workers/quantity
of labor demanded by firms are inversely related.
At higher wage rates fewer workers are
demanded in labor market.
 At lower wage rates more workers are
demanded in labor market.
If the wage rate is high there will be excess
supply of labor/unemployment/ in the
market.
18
 5.1.5. Labor supply and Business cycle
 The business cycle affect personal labor supply
decisions.
The labor supply is the number of hours people
are willing and able to supply at a given wage.
The labor force participation rate are cyclical,
falling during recessions and rising during
expansions.
The labour supply curve for any industry or
occupation wage be upward sloping.
19
 Con…
 As wages rises, other workers enter this industry
attracted by the incentive of higher rewards.
The extent to which a rise in the prevailing wage
or salary in an occupation leads to an expansion
in the supply of labor depends on the elasticity of
labor supply.

20
  The demand for labor is one determinant of the
equilibrium wage and equilibrium quantity of
labor in a perfectly competitive market.
 Economists think of the supply of labor as a
problem in which individuals weigh the
opportunity cost of various activities that can fill
an available amount of time and choose how to
allocate it.
 A change in attitudes toward work and leisure can
shift the supply curve for labor.

21
 Con…
Two factors that influence a workers supply of
labor;
1. Substitution effect of arise in wage: With
higher wages, workers will give greater value to
working than leisure. With work more profitable,
there is a higher opportunity cost of not working. The
substitution effect causes more hours to be worked as
wage rise.
2. Income effect of a rise in wages: This occurs
when an increase in wages causes workers to work
fewer hours. This is because workers can get a higher
income by working fewer hours.
22
 Con…
Market supply of labor for a particular vocation
depends upon:
The number of qualified people
 Difficulty of getting qualifications
 The non-wage benefits of a job
 The wages and conditions of other jobs
 Demographic changes and immigration

23
 5.2. Inflation
5.2.1. Concepts and Definition of inflation
 Inflation is increase in the overall level of prices.
 Inflation is the sustained increase in the general
price level of goods and services in an economy
over a period of time.
 A birr today doesn't buy as much as it did ten
years ago.
 It is the primary concerns of economists and
policymakers.

24
 Inflation rate measures how fast prices are
rising.
 Inflation reflects a reduction in the purchasing
power per unit of money-a loss of real value in
the medium of exchange and unit of account
within the economy.
 Inflation occurs due to an
 Imbalance between aggregate demand and
supply.
 Changes in production and distribution cost.
 Increase in taxes on products. 25
 High prices of day-to-day goods make it difficult
for consumers to afford even the basic
commodities in life.
 Price inflation is measured by the inflation rate,
which is calculated year on year basis.

 Inflation defined as a decline in the value or

purchasing power of money.
 An increase in money supply can be a reason of
inflation. 26
 Types of inflation
There are four different types of inflation.
1) Demand-pull inflation
2) Cost-push inflation
3) Pricing power inflation
4) Sectorial inflation

27
 Demand-pull inflation
 It occurs when demand greater than
production.
 It occurs when the total demand for goods and
services in an economy exceeds the available
supply, so the prices for them rise in the
market economy.
 Every war produces this type of inflation
because demand for war materials and man
power grows rapidly without comparable
shrinkage elsewhere.

28
 2) Cost-push inflation
 It is supply side inflation.
 It occurs when the cost of productions (raw
material) s rise, for one reason or another, and
force up the prices of finished goods and
services.
 When cost increases supply will decrease
which lead a rise in price.
 Often a rise in wages in excess of any gains in
labor productivity is what raises unit costs of
production and thus raises prices.
29
 3) Pricing power inflation
 It is also called administrated price
inflation or oligopolistic inflation.
 It occurs whenever businesses in general
decide to boost their prices to increase their
profit margins.
 It might be called oligopolistic inflation,
because it is oligopolies that have the power to
set their own prices and raise them when they
decide the time is ripe.
30
 4) Sectorial inflation
 The term applies whenever any of the other
three factors hits a basic industry causing
inflation.
 Since the industry in which inflation has
occurred is a major supplier to many other
industries, the price of their products also
increases and hence inflation occurs in that
industry.
 So it can be said that though inflation was
started in one sector, it has been propagated to
other sectors.
31
 5.2.2. Price Indexes
 Economists measure the price level by
constructing price indexes.
 Price Indexes measures changes in the cost of
living.
 There are three types of price indexes.
1. CPI
3. GDP deflator
2. PPI
32
 A. Consumer price index
 Consumer price index (CPI) is a measure of
the overall cost of the goods and services
bought by a typical consumer.
 CPI is calculated from sampling of thousands
of households and businesses.
 It is used to monitor changes in the cost of
living over time.

33
 CPI measures the average changes in the
prices for a market basket of goods/services.
 Steps to calculate Consumer Price Index
1. Fix the basket.
2. Find the prices of each good
3. Compute the basket’s cost.
4.Choose a base year and compute the index
5. Compute the inflation rate.

34
 Con…
 Calculating the Consumer Price Index and the Inflation
Rate: An Example

35
Con…

36
 Inflation rate measures how fast prices are rising.
 The inflation rate is the percentage change in the
price index from the preceding period.

 Example of calculating inflation rate

CPI in 1999 was 168.9
CPI in 2000 was 174.6
 Calculate the inflation rate in year 2000 ?

37
 B. GDP deflator
 GDP deflator measures price changes for all goods
and services produced in the economy and weights
them in terms of the economy’s total output (GDP).
 GDP deflator reflects prices of all goods/services
produced domestically.

C. Producer price index (PPI)

 It is measures the cost of a basket of goods and
services bought by firms rather than consumers.

38
 Causes of Inflation
1. Unfavorable agricultural production
2. Deficit financing
3. Population and Black money
4. Increase in indirect taxes
5. Increase in wage rates

39
 Consequences of Inflation
 With high inflation, it is hard to predict the
future.
 The dollar loses value and one cannot buy as
much.
 If prices increase but wages do not, one’s
disposable income decreases.
 If inflation increase faster than interest rates,
my savings and investments may lose money.
 Inequality (it hurts low income household)
 Increased cost of living
40
 5.3. Relationship between Unemployment and
Inflation Rates
 The two goals of economic policymakers are
low inflation and low unemployment.
 Higher output means lower unemployment,
because firms need more workers when they
produce more.
 A higher price level, given the previous years
price level, means higher inflation.

41
 High AD causes the demand for labor to
increase and lead to fall in cyclical
unemployment and also it leads to demand
pull inflation.
 If price of wages increases it causes cost push
inflation.
 Phillips presented the r/sip of unemployment
and inflation on curve and that curve is known
as Phillips curve.

42
 Con…
 Phillips curve is the graphical
representation of unemployment and
inflation in the short run.
 Phillips showed inverse r/sip b/n inflation
and unemployment-the year with high
unemployment showed low inflation, and
the years with low unemployment
experienced high inflation.

43
Con…

44
 Con…
 The Phillips curve illustrates the short-run
relationship between inflation and unemployment.
 Phillips curve shows in the short run inflation and
unemployment have an inverse r/ship b/c the cause
that increase inflation is also the same thing that
lower unemployment and vise versa.
 In the short run inflation reduces unemployment
because When prices are rising that leads to increase
in profit margins of the firms since there is motive to
maximize profit so if the tendency of profit increase
investment increases and so unemployment go down.

45
 5.4. Business cycle fluctuation
 Business cycle fluctuation is the fluctuation of
RGDP around its long term trend or normal
growth rate.
 Economy fluctuates b/n periods of expansion
and contraction.
 Business cycles are intervals of expansion
followed by recession in economic activity.
 Business cycles are measured by examining
trends in a broad economic indicator such as
real gross domestic production.
46
 Business cycle fluctuations are usually
characterized by general upswings and
downturns in a span of macroeconomic
variables.
 Unemployment increases during business
cycle recessions and decreases during
expansion.
 Inflation decreases during recessions and
increase during expansion.

47
 Con…
 In expansion phase of the business cycle there
is an increase in positive economic indicators
such as employment, income, output, demand
and supply of goods and services, high
money supply and increase in spending and
investment.
 In recession economic indicators such as
income, output wages start to fall.

48
CHAPTER SIX

Macroeconomic
Policies 49
 Macroeconomic Policies
What are the major goals of Ma policies?
Macroeconomic policies affect the overall
performance of the economy.
The two main macroeconomics policies are:
Monetary (financial) policy and fiscal policy.
These policies will be used to achieve
macroeconomics objectives, such as full
employment, price stability and satisfactory
economic growth

50
 6.1.Monetary Policy
 Monetary/financial/ policy is the process by which the
monetary authority of a country controls the supply of money,
often targeting a rate of interest to attain a set of objectives
oriented towards the growth and stability of the economy.
 It is controlled by the Central Bank which acts as a
government agency.
 Monetary policy is the changes in interest rates and money
supply to expand or contract aggregate demand.
 In a recession, expansionary monetary policy-"easy money"
involves lowering interest rates and increasing the money
supply.
51
 Money is anything that is generally acceptable to
sellers in exchange for goods and services.
 Money is the most liquid asset, an asset that can
be easily exchanged for goods and services.
 The three functions of Money are: (1) a medium
of exchange (2) a unit of account (3) a store of value.
 A medium of exchange: It is an efficient way to
allocate resources.

52
 Con…
 Economies have goods and services that need to
be allocated to people.
 The best way to do this is to establish a currency
because it establishes structure.
 If we didn’t have currencies, people would likely
be bartering (or stealing!) their way through life.

53
 A unit of account: Money helps us understand
relative values of goods and services.
Money allows us to determine how valuable labor
and wages are relative to goods and services.
 A store of value: We can exchange money for a
good or service at any time without worrying about
our money expiring.
 Our currency does not rot, wither, or melt away.
It can be kept for long periods without a loss of
exterior value.
54
 Con…
Responsibilities of the Federal Reserve
1. Issuing currency
2. Setting the reserve requirements
3. Lending money
4. Supervising banks
5. Securities intermediary
6. Controlling the money supply

55
 Con…
 The Fed issues the money that is printed. It
decides just how much of the printed money
should be released into the economy.
 The Fed sets the reserve requirement for banks
in the nation.
 The Federal Reserve occasionally lends money
to other banks and charges them an interest rate
on this money called the discount rate.
 When banks’ reserves are running low, the Fed
lends them money to replenish their vaults.
56
 Con…
 The reserve requirement is the fraction or
percentage of a checking account balance that
must be maintained in banks’ reserves.
 The Fed examines other banks to make sure that
they are adhering to the standards and regulations
that the Fed has set for appropriate monetary
policy.

57
 Con…
 It is in the Fed’s best interest to see that banks
carry out these policies.
 The government’s collection of taxes, spending
of revenue, and the buying and selling of open
market securities is done through the Federal
Reserve.
 It regulates how much money is made available
to the general public. The careful regulation of
the money supply is a task the Fed is most
associated with because of its economic impact.
58
 Monetary Policy tools
 Monetary policy tools are used by the Federal
Reserve to aid the economy in times of
macroeconomic instability. These are
1. Reserve Requirement
2. Discount Rate
3. Open Market Operations

59
 Con…
 Reserve Requirement: The Fed requires
banks to hold a fraction of their transaction
deposits in their vaults.
 Banks are required to hold a certain percentage
of their deposits in reserve in order to ensure
that they always have enough cash to meet
withdrawal requests of their depositors. Not all
depositors are likely to withdraw their money
simultaneously.

60
 Con…
 Discount rate is the interest rate on the loans that
the central bank makes to banks.
 The discount rate is changed periodically by the
Fed to control the money supply.
 When the Fed raises the discount rate, it is trying
to discourage other banks from borrowing money
and thereby restricts the money supply.
 When the Fed lowers the discount rate, the
expansion of the money supply is made easier for
banks because the Fed is encouraging banks to
borrow. 61
 Con…
 Open Market Operations: Open market
operations consist of buying and selling of
government securities/ bonds by the central bank.
 This tool is the most effective way in which the
Federal Reserve controls the money supply.
 To increase the money supply, the central bank
buys government bonds from the public in the
nation’s bond markets.

62
 Con…
 The cash the central bank pays for the bonds
increase the number of dollars in circulation.
 To reduce the money supply, the Central bank
sells government bonds to the public in the
nation’s bond markets.
 When the Fed decides to buy, it gives money to
banks (or the economy), and this expands the
supply of money. When the Fed decides to sell,
it takes money from banks (or the economy) and
contracts the supply of money.
63
 During a contractionary period, the Fed may want
to implement expansionary monetary policy.
 During an expansionary phase of the business
cycle, the Fed may want to slow down growth to
avoid inflation.
 The main purpose of expansionary monetary
policy is to increase the money supply and help
the economy climb out of a contractionary
period.
 To achieve this, the Fed can decrease the money
supply (contractionary monetary policy) by
raising the reserve requirement, raising the
discount rate, or selling government bonds. 64
 Monetary policy and aggregate demand
 The aggregate-demand curve shows the total
quantity of goods and services demanded in the
economy for any price level.
 The aggregate-demand curve slopes downward
for three reasons: 1)The wealth effect
2)The interest-rate effect
3)The exchange-rate effect

65
 Con…
 The wealth effect: A lower price level raises the
real value of households money holdings, and higher
real wealth stimulates consumer spending.
 The interest rate effect: A lower price level lowers
the interest rate as people try to lend out their excess money
holdings, and the lower interest rate stimulates investment
spending.
 The exchange-rate effect: When a lower price level
lowers the interest rate, investors move some of their funds
overseas and cause the domestic currency to depreciate relative
to foreign currencies. This depreciation makes domestic goods
cheaper compared to foreign goods and, therefore, stimulates
spending on net exports. 66
 6.2. Fiscal Policy
 Fiscal policy shows change in the taxing and
spending of the government for purposes of
expanding or contracting the level of aggregate
demand thereby achieving economic objectives of
price stability, full employment, and economic
growth.
 Fiscal Policy is Using taxes and spending to
help the economy grow.
 Fiscal policy is when the government uses the
federal budget to influence the economy
outcome.
67
 Fiscal policy influences saving, investment, and
growth in the long run.
There are two basic types of fiscal policy:
discretionary and nondiscretionary fiscal policies.
 Discretionary fiscal policy is “active”
government involvement in the economy. Tax
changes and changes in government spending are
both considered discretionary fiscal policy.
 Non-discretionary fiscal policy: is when the
government decides to take a “non-active” role in
the economy.
68
 Expansionary Fiscal Policy
 The federal government can implement
decreasing taxes and or increasing government
spending, during a period of contraction.
 Its aim is to stimulate the economy and steer it in
the direction of economic growth.
 Increase AD
 Aiming to fight a recession (increase output and
decrease unemployment).
 Increase inflation ( demand-pull inflation) and
Reduce unemployment ( Cyclical unemployment) 69
 CON…
 The total level of government spending can be
changed to help increase or decrease the output of
the economy.
 When the government increases its spending, it
uses tax revenue to increase aggregate demand.
 The government spends money on national
defense, roads, education, and other parts of the
economy.
 Increased tax revenue and borrowing are two main
ways the government can fill deficits.
70
 Contractionary Fiscal Policy
 Decrease government spending or increased
taxes aiming to fight inflation.
 These tools are used to offset the increasing
demand in the economy and to cool the economy
down (Decrease AD).
 Sometimes too much demand is not good for the
economy; it erodes purchasing power and creates
a rise in the price level.

71
 The government attempts to strengthen
purchasing power by limiting the ability of
consumers to spend.
 When the government makes it more difficult for
consumers to demand products, the price level and
the value of the dollar stabilize.
 The spending multiplier is used by the
government to determine the impact of the
government’s dollar on the economy.

72
 6.2.1. Changes in government purchases
 Government purchases are one component of
expenditure, high government purchases imply,
for any given level of income, higher planned
aggregate demand.
 An increase in government purchases leads to an
even greater increase in income.
 An increase in government purchases have a
multiplied effect on income because an increase
in gov’t purchases raises income, it also raises
consumption, which further raises income, which
further raises consumption. 73
 Con…
 Government purchase multiplier: tells how
much income rises in response to a one-unit
increase in government purchases.
 Government purchase multiplier is the ratio of

 Government purchase multiplier is calculated by

using marginal propensity to consume

74
 Con…
 Government purchase multiplier =
 This is overall effect of change in government purchase
on income
 Example: Calculate government purchase
multiplier if mpc equals = 0.8
 = == 5, An increase in government purchases
causes an income to increase 5 times as much.

75
 Con…
 MPC is the amount of additional consumption
resulting from the change in consumers
income.
 MPC is the change in consumption divided
by the change in income. MPC=

76
 6.2.2. Changes in Taxes
 A decrease in taxes of ΔT immediately raises
disposable income.
 An increase in government purchases has a
multiplied effect on income, so does a decrease in
taxes.
 Tax multiplier is the amount income changes in
response to a $1 change in taxes.
 It has a negative effect because tax increase
reduces consumption which reduces income.

77
 Con…
 Tax multiplier = = , this is overall effect of
changes in taxes on income.
 Tax multiplier is the value that tells how a tax
percentage change would change GDP.
 The tax multiplier is a negative effect b/c tax
increase reduces consumption which reduces
income.

78
 Con…
 Example; Calculate tax multiplier if mpc equals
0.6?
 Tax multiplier = = = = -1.5
A $1 cut in taxes raises equilibrium income by
$1.50.
The tax multiplier is a negative effect because tax
increase reduces consumption which reduces
income.

79
 6.3. Stabilization policy
Stabilization policy refers to a strategy
implemented by the government of a nation to
ensure that the economy is steady.
The main goal of stabilization policy are to
close output gap, to reduce unemployment and to
stable price level.
 This policy reduces price fluctuations in an
economy through the implementation of certain
measures and monitoring the economic cycle.
80
 CON…
Stabilization policy is a remedy that central
banks or governments use to prevent irregular
and unpredictable changes in price which affects
the gross domestic product (GDP) and output of
an economy.
Stabilization policy is using fiscal or monitory
policy to offset shocks.
It is adjustment mechanisms used to adjust the
economy in order to avoid high cost of inflation
and high cost of unemployment.
81
 Con…
 John Maynard Keynes was the first economist who
introduced the stabilization policy as a key process to
stop or prevent erratic movements and surges in the
prices of goods in an economy.
Central to the stabilization policy is the control
of aggregate demand in an economy.
 Fiscal and monetary policies will continuously
be used by central banks and governments of
nations that keep the economy in a healthy state.
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End for the
course!!
Thanks 83