Chapter Four

Macroeconomic Stabilization

Kassa T. (PhD)
Department of Development Economics
Ethiopian Civil Service University
Email: ktshager@yahoo.com
Telephone: +251911346214
Concepts of macroeconomics
• Economics is a social science concerned with
the factors that determine the production,
distribution, and consumption of goods and
services
• It focuses on the behavior and interactions of
economic agents and how economies work
• Economics is divided into two:
microeconomics and macroeconomics
• Microeconomics is a branch of economics that
examines the market behavior of individual
consumers and organizations.
• It examines how entities, forming a market
structure, interact within a market to create a
market system.
• It focuses on the demand and supply, pricing,
and output of individual organizations.
• Macroeconomics is the branch of economics
that study the aggregate economic variables.
• It is the study of the entire economy as a whole
(aggregates) or with basic sub-divisions such as
sectors and sub-sectors.
• An aggregate is a collection of specific
economic units treated as if they were one unit.
• Example, aggregate consumption is the sum
total of consumption by all consumers in the
economy.
• Other aggregate variables include aggregate
savings, aggregate investment, aggregate output,
aggregate unemployment, aggregate price level,
etc.
• Sectors and sub-sectors refer to sub-divisions with
in the economy such as agriculture, industry,
services, etc. and the sub-sectors under each
sector such as crop production, construction, hotel
and tourism, etc.
• In general, macroeconomics deals with issues
related to national income, employment pattern,
inflation, recession, and economic growth
• Macroeconomics answer the following key question:

– How do different economy grow at different rate?

– What is the cause of inflation?

– How does the economy fluctuate?

– How does government policy affect the economy?

– How does international trade affect the economy?

• By answering the above questions macroeconomics provide an

overview of the structure and performance of the economy and
• It suggest the possible macroeconomic policy to solve the
problems of the economy.
Objectives of macroeconomics

The following are the major four objectives of macroeconomics:

– Stable growth of gross national product

– Stable level of prices

– High employment level

– Stable (equal) balance of payment

Macroeconomic Stability
• Macroeconomic stability describes a policy prescription that prepares national
economy for growth by safeguarding it against shocks and in turn increases its
prospects for sustained growth.
• Stability is often measured by five variables:
1. Low and stable inflation indicates healthy demand in the marketplace;
however, high or unstable inflation threaten growth.
2. Low long-term interest rates reflect stable future inflation expectations.
3. Low national debt relative to GDP indicates that the government will
have the flexibility to use its tax revenue to address domestic needs instead
of paying foreign creditors.
4. Low deficits prevent growth in the national debt.
5. Currency stability allows importers and exporters to develop long-term
growth strategies and in reduces investors' needs to manage exchange-rate
risk.
Importance of macroeconomic stability
• Large fluctuation in output, employment and inflation add
uncertainty for firms, consumers and public sectors and can
reduce the growth potential of the economy in the long run.
• Stability allow:

– Business individuals and the government plan more

effectively for the long term
– Improving the quality of investment in physical and human
aspects
– Helping to raise productivity
Macroeconomic policy instruments
• What can a country do to reduce inflation or
unemployment, to speed economic growth, or to
correct a trade deficit?
• Government has certain instruments that can use
to affect macroeconomic performance and
reduce macroeconomic problems of inflation,
unemployment, Poverty, etc. through
macroeconomic policy instrument.
• A macroeconomic policy instrument –is an
economic variable under the control of the
government that can affect one or more of the
macroeconomic goals (objectives).
• The four most important macroeconomic policy
instruments are:
– Fiscal policy
– Monetary policy
– Income and price policy
– Foreign trade policy
Fiscal Policy
• Fiscal policy refers to the deliberate manipulation of
government income and expenditure (budget) to influence
income, output, employment, and prices.
• It consists of taxation (revenue) and government expenditure
• Fiscal policy can be used to stabilize the economy over the
course of the business cycle.
• Keynesian economics suggests that increasing government
spending and decreasing tax rates are the best ways to stimulate
aggregate demand, and decreasing spending & increasing taxes
after the economic boom begins.
Fiscal Policy
• Government expenditure is divided in to two categories:
I. Government purchases – spending on goods and services.
e.g. purchase of such goods as weapons, computers,
machines, tools, stationary materials, etc, and
– such services as electricity, telephone, postal, internet, the
labor service of the police/defense force, the parliament,
public servants , judges, etc.
– When the government makes such expenditures, it gets in
return either a good or a service.
– Using these expenditures, the government in turn produces
different goods (public goods) and services.
II. Transfer payments and subsidies:-transfer payments to a
targeted group of households to boost their income (i.e.
pension payments, unemployment benefits, payments to
support the elderly, etc).
 • Subsidies - targeted private businesses to help them under
conditions of loss & uncertainty or to help consumers indirectly.
• Taxation affects the overall economy into the following ways :
– It reduces households’ spend able (disposable) income & reduce
their spending on goods and services
– Lowers the demand for goods and services and reduce output,
income and employment
– Taxes affect prices of inputs (factors) and output and thereby
influence the behavior of producers and the incentive to produce.
– An increase in tax on business profits discourages production and a
decrease in tax gives the incentive to produce by increasing profit
after tax .
Types of Fiscal Policy: two types of fiscal policy
1)Expansionary Fiscal Policy – used when the
government uses its budgeting tools to provided
consumers and businesses with more money
– The government either spends more, cuts taxes, or does
both if it can. The idea is to put more money into
consumers' hands, so they spend more

2) Contractionary Fiscal Policy: used when the

government either cuts spending or raises taxes.
– Its purpose is to slow growth to a healthy economic
level.
Advantages of fiscal policy instruments
• In addition to the stabilization effects discussed above, they have the
following two additional importance:
1. They may be used in discriminatory manner to alter the geographical and
sectoral distribution of resources.
• For example: tax burdens may be reduced for firms working in
development areas (strategic industries).
• the government may impose high tax burdens on firms engaged in less
desirable areas.
2. They may also be used to reduce income inequalities and wealth by:
• Applying progressive taxes which increase with income and wealth.
Accordingly, the burden will be high on high-income people.
• Redistribute revenues in the form of social security benefits.
Difficulties in the use of fiscal policies
• The following are the major difficulties to use fiscal policy:
1. Government expenditures may become inflexible in a
downward direction. Any reduction in the expenditures on
education, health services, pensions and other social security
measures will be very strongly resisted (opposed). Unless the
situation is very critical, the best the government can do is to
postpone the implementation of certain programs.
2. Major changes in taxation also take a considerable time to
implement since they usually involve an immense amount of
tax administration work.
3. While tax reductions will certainly increase
demand, their effectiveness as stimulant to private
investment is more uncertain.
• Much depends upon the climate of business
expectations. Increase in tax aimed at reducing
aggregate demand may also affect aggregate
supply if they have unfavorable effects on the
incentive to work and invest.
4. The use of indirect taxes to restrict demand may
certainly provoke a reaction by organized labor.
Monetary Policy
• Monetary policy refers to policy that control money supply and
regulate financial institution. The following are the major
instruments of monetary policy.
– Open market operation

– Reserve requirement

– Bank rate and discounting rate

• Open Market Operation (OMO): This refers to the purchase and
sale of government bonds by the national bank.
• Changes in the required reserve ratio: reserve ratio also known as
Cash Reserve Ratio, it is the percentage of deposits which
commercial banks are required to keep as cash according to the
directions of the central bank.
• By changing the legal reserve ratio, the national bank can change the
amount of bank loans and thus the amount of money in the
economy.
• When the central bank wants to increase money supply in the
economy, it lowers the reserve ratio.
Bank rate and Discount rate
• The bank rate is the interest rate that the NB charges on the
credit it gives to commercial banks.
• The discount rate is the interest rate that the NB charges the
commercial banks when they take money by offering
(discounting) bonds and import/export bills at the discount
window that the NB opens for commercial banks.
• In general there are two types of monetary policy

– Expansionary monetary policy

– Contractionary monetary policy

Expansionary monetary policy
• Expansionary monetary policy is appropriate when the
economy is in recession and unemployment is a
problem.
• The goal of expansionary monetary policy is to reduce
unemployment. Therefore, the tools would be an
increase in the money supply.
• To increase the money supply the federal government
can:
– buy government bonds (open market purchase)
– Lower the interest rate
– Lower the reserve ratio
Contractionary monetary policy
• Contractionary monetary policy is appropriate when
the economy is in expansion and inflation is a
problem.
• The goal of contractionary monetary policy is to
reduce inflation. Therefore, the tools would be a
decrease in the money supply.
• To decrease the money supply the federal reserve can:
– sell government bonds (open market sell)
– raise the interest rate
– raise the reserve ratio
Income and price Policy
• Income and price policies are polices that control wages
and prices. Example: the price ceilings and price floors
• A government policy to curb inflation by directly imposing
wage restraint and price controls
• When inflation tends to be uncontrollable, the traditional
ways of slowing inflation by taking fiscal or monetary
policy steps may be ineffective and costly.
• In such cases, governments have often searched for other
methods of controlling inflation.
• These alternatives range from Wage and price
controls to Wage and price guidelines
• Income policies are the most controversial of
all the macroeconomic policies.
• Many proponents of the market system believe
that they are ineffective and interfere with free
markets. Most high income countries resort to
income policies only in periods of emergency.
Foreign Trade Policy
• The government affects its imports and exports through its
trade policy.
• To reduce/remove trade deficit, achieve a balanced trade or
even a trade surplus, the following are the major elements of
foreign trade policy:
– Subsidy - subsidies on exports are any payments, direct or
indirect, to producers resulting in export prices that are below
domestic prices
– Tariff - taxes on imports usually called tariffs or customs duties, though
sometimes other terms, such as import surcharges or equalizing duties
– Tariffs produce customs revenue, protect domestic output, and reduce imports,

– Quota - quantitative trade restrictions imposed on both exports and

imports
– Administrative requirement
• The government may use such trade policies:
– To discourage the import and consumption of unwanted
goods
– To protect domestic infant industries
– To encourage the production of some goods those are
expected to earn higher foreign currency.
• The government may increase exports by:

– Reducing export tariffs:- Other factors remaining constant,

the lower the tariff, the lower the price of the product(s)
abroad, the higher the demand for the product(s) by foreign
buyers and the higher the exports.
– Improve the investment codes, investment licensing and
renewing procedures (improving customer service delivery)
– providing credit facilities to producers/exporters in the export
sector at lower interest rate,
– Providing land for export purposes freely or at lower lease
rates.
Types and purpose of financial sector in Ethiopia

• There are a number of financial institutions which operate in the

country.
• Financial institutions currently operating in the Ethiopian
financial system comprise:
– The central Bank (NBE)
– Commercial banks
– Specialized banks(Development bank and CBB)
– Insurance companies
– Pension fund, savings and credit cooperatives (SACCs) and;
– Micro-finance institutions (MFIs).
Purpose of the National Bank of Ethiopia

• The following are the major purposes of the national bank:

– print and issue legal tender currency;

– regulate the supply, availability of money and credit and

applicable interest and charges.

– implement exchange rate policy.

– license, supervise and regulate banks Insurance and other

financial institutions.
– set limits on gold and foreign exchange assets which banks
and other finical institutions authorize to deal in foreign
exchange can hold in deposits.
– Set limits on the net foreign exchange and on the terms and
the amount of internal indebtedness of banks and other
financial institutions.
– make short and long tern financing facilities available to
banks and other financial institutions.
– make short and long tern financing facilities available to
banks and other financial institutions.
The purpose of commercial bank in Ethiopia

• The following are the purposes/roles of commercial bank in Ethiopia:

– To accept saving demand and time deposits

• Time deposit is money deposit at a banking institution that cannot be
withdrawn for a specific term or period of time

– To dual, accept discount, buy and sell bills of exchange, drafts and
promissory note payable within or outside Ethiopia.
– To issue letters of credits.

– To provide short and medium loans

– To buy and sell foreign exchange.

– To buy and sell negotiable instruction and security issued by
governments private organization or any other persons.
– To accept and keep in states securities, jewels and other
valuables.
– To issues cheques and traveler cheques and generally deal in
cheques.
– To participate in equity investment
Financial reform
• The financial systems prevailing in most countries in the early 1970s
were characterized by important restrictions on market forces which
included controls on the prices or quantities of business conducted by
financial institutions, restrictions on market access and controls on the
allocation of finance among competing borrowers.
• These regulatory systems had evolved to serve a number of social and
economic policy objectives of governments.
– Direct controls were used in many countries to allocate finance to
preferred industries during the post-war reconstruction period;
– restrictions on market access and competition were partly
motivated by a concern for financial stability; and
– controls on banks and financial institutions were frequently used as
instruments of macroeconomic management.
• The substantial shift to more market-oriented financial
systems during the past two decades was driven by a
number of interrelated factors which made direct controls
increasingly ineffective in achieving their intended
purposes. Few of them are:
– Financial innovation and rapid technological
development, which progressively increased the ease
with which regulations could be avoided
– Macroeconomic developments, particularly the
increases in fiscal deficits and emergence of inflationary
problems in the 1970s, which increased the need for
interest rate flexibility.
• What is financial reform or liberalization? Financial
liberalization refers to measures directed at reducing or
dismantling regulatory control over the institutional
structures, instruments and activities of agents in
different segments of the financial sector. These
measures can relate to internal or external regulations.
• The main rational for financial reform are: to meet
resource allocation objectives; to provide instruments
of monetary control; and to correct perceived market
failures and systemic externalities in the financial
• In details, the key components of financial liberalization are the
following:
 deregulation of interest rates;
 removal of credit control;
 privatization of government banks and financial institutions;
 liberalization of restrictions on the entry of private sector
and/or foreign banks and financial institution into domestic
financial markets;
 introduction of market based instruments of monetary
control; and
 capital account liberalization
Table 4.1 Prototypical Conditions of Pre-and Post-Financial
Reforms
Dimension of Financial Reforms Pre-Financial Reforms Post-Financial Reforms

Privatization of Banks Most banks are state owned All banks are privately owned
Enhancement of Banking Lack of comprehensive legal Comprehensive legal framework,
Supervision framework, and/or lack of strict enforcement of banking
enforcement of banking supervision and prudential
supervision and prudent regulations
regulations
Capital Account Liberalization Many restrictions on capital Free movement of capital
account transactions without restrictions

Interest Rate Liberalization Interests rates set by the central Interests rates determined at
bank market rates

Elimination of Credit Controls Credit allocation determined by Credit allocation determined by

the central bank, preferential banks, no preferential credit
credit allocation at subsidized allocation
interest rates

Elimination of Entry Barriers on No entry of new banks allowed, Free entry of new banks, no
Banks no new branches allowed, branching restrictions, banks'
restrictions on banks' activities wide range of activities permitted
Ethiopia’s financial reform
• As an important instrument of stabilization, the monetary policies of
the reform have aimed at maintaining the sustainable macroeconomic
stability in the country. The reform includes:
– The removal of discriminatory credit and interest rates

– the introduction of a competitive financial sector which included

the establishment of private banking and insurance companies.
– Modernizing the financial sector

– Adjusting interest rates and introduction of open market

operations for government securities (Treasury Bills).
– The establishment of microfinance
 Effect of Financial Reform
• There are three broad effects that the process of financial
liberalization has:
 it opens the country to new forms and larger volumes of
international financial flows, in order to attract a part of the
substantially increased flows of financial capital to the so-
called “emerging markets” since the late-1970s;
 to facilitate these inflows it liberalizes to differing degree
the terms governing outflows of foreign exchange; and
 it transforms the structure of the financial sector and the
nature and operations of financial firms in a manner that
makes the financial system resemble that in countries like
the US and the UK.
Table 4.2 : The structure of financial institution in Ethiopia

S.N Indicators 200809 2012/13

1 Saving rate

Minimum 4 5.00

Maximum 5 5.75

2 Lending rate
Minimum 8 7.5

Maximum 16 16.25

3 Number of public bank branch 273 866

Number of private bank branch 363 858

4 Insurance Companies Branches 194 275

5 Microfinance institution
Total capital 1,737,402 4,536,577

Saving deposit 2,098,742 7,611,397

6 Deposit Mobilization

Private 7,670 16,906

Public 7,524 32,949

Total 15.195 49,855

Problems of the Financial Sector in Ethiopia
• The following factors may be cited as the main problems of the
financial sector in Ethiopia.
– The policies pursued by the Derg regime following the
revolution of 1974 have played a principal role in arresting
the financial sector development:
– The financial sector was opened up for private participation
only recently.
– Competition is not yet strong both in the banking and
insurance segments.
– There are no capital markets in the country that could have
competed with banks.
– Some types of non-bank financial institutions such as mutual
funds, finance houses, investment companies, etc. are
historically unknown in Ethiopia.
– The absence of foreign banks and insurance companies from
the financial sector has also contributed to the lack of
dynamism in the financial system
Fiscal policy reform in Ethiopia
• As mentioned before fiscal policy refers to the management of
government spending and taxation in the economy.
• Ethiopia, like most countries in Africa, has been making
considerable efforts in recent years to restructure its tax and
expenditure system with a view to increase tax revenue as well as
reduce distortions in the economy.
• The impact these reforms have had on the poor is of considerable
importance to policymakers, given that the poor and the vulnerable
constitute a significant majority of the population in Ethiopia.
• The reforms also contribute for fast development of private sector in
the country.
 Recent Developments in Government Revenue
Policy
• Since 1991/92 a number of amendments on existing tax
structures (e.g. personal income tax, corporate tax, and sales
and excise tax) and new tax laws (e.g. mining income tax,
capital gains tax, and rental tax) have been introduced.
• In general terms all these measures basically aim at:
– rationalizing the tax structure;
– broadening the tax base;
– reducing the marginal tax rates ;
– stimulate economic growth;
– overcome fiscal imbalance; and
– avoid economic inefficiencies
• The following are the major changes undertaken in taxation

– the income brackets were reduced from 16 to 9, from 9 to 7. An

important rationalization worth nothing is, starting from the second
income bracket up to the eighth bracket, the marginal tax rate
increased by 5%
– Third, the maximum marginal tax rate was reduced to 35% from a
previous high level of 85%.
– the level of monthly income free from taxation rose from Birr 50 to
300 and now to Birr 600.
– The profit tax (business income tax) rate for any organization
except mining has been reduced from 59% to 35% on annual profit.
New tax rate
– With the view to broadening the tax base and increasing its
revenue, the government has also issued new tax laws
namely:
• mining income tax;

• capital gains tax; and

• tax on rental income.

• Implement the Tax Identification Number (TIN) system

throughout the country;
• Some institutional reforms aimed at enhancing the
government’s capacity to raise tax revenue have also been
made.
– The government scaled up the previous revenue
commission to the level of a ministry.
– This ministry (now renamed agency) controls the three
revenue collection institutions:
• Federal Inland Revenue (FIR);
• Ethiopian Custom Authority (ECA); and
• The National Lottery Administration (NLA).
• The other reform measures include
– the establishment of additional branch offices,
– training and recruitment of qualified personnel,
– introduction of performance and accountability measures,
– setting up a taxpayer education program and similar
initiatives aimed at implementing the new taxes.
– Modernization of tax collection system. Use of biological
data for tax collection(finger printing)
Challenges of taxes reform
• Difficult to implements the reform
• Owing to the predominance of small and informal operators in
the country,
• Its history of tax evasion and corruption,
• Lack of standard record keeping systems as well as the lack of
knowledge about VAT and a tax base for its computation.
 Recent Developments in Government
Expenditure Policy
• One way to minimize the government fiscal gap (i.e. reducing
the gap between domestic revenue and expenditure) is
expenditure reduction.
• This together with the effort to boost revenue was the
approach followed by the Ethiopian government since the
structural Adjustment Program.
• The purposes of expenditure reforms are;
– To shift resources from defense to social sectors (like education and
health) and economic infrastructure
– to improve expenditure allocation and efficiency.
– to reduce unproductive spending; and
– rationalize the budget - reducing costs or introducing modern
methods
• In order to rationalize government expenditure, fiscal
federalism introduced by Proclamation 33/1992. Such move
enhance revenue sharing between federal and regional
governmenthe objectives of revenue sharing are explained as:
– to enable the central government and national/regional
governments efficiently carry out their respective duties and
responsibilities,
– to assist national/regional governments develop their regions on
their own initiatives,
– to narrow the existing gap in development and economic growth
between regions, and
– to encourage activities that have common interest to regions.
Deficit financing
• Fiscal deficit (the excess of expenditure over domestic
revenue) and its financing has always been the core of public
finance.
• Some blame that fiscal deficit have been result on economic
distortion for developing countries. The debt crisis facing
developing countries are high inflation, poor investment
performance and low level of economic growth in general.
• Some other people say that fiscal deficit provides capital
inflow that helps the economic development of a country.
• The government may cover this deficit either by running
down its accumulated balances or by borrowing from the
banking system
Impacts of fiscal reform in Ethiopia
• The wide range fiscal policy reform affected government
revenue and expenditure.
• Government expenditure increased from 8551.6 thousand in
1994/95 to 58534.4 thousand in 2008/09. In increased by 584
percent.
– Capital expenditure increased by 909 percent
– Recurrent expenditure by 406 percent
• In the same period, government revenue increased from
7044.6 in 1994/95 to 57258. During this period revenue
increased by 880
– Internal government revenue increased by 650%
– External source of revenue increased by 1087%
• Between 1996/97 and 2008/09, expenditure to GDP declined
from 24.2 to 17.2 and revenue to GDP ratio increased from 19
to 16.2.
• The Total debt outstanding reduced from $ 6186 to $ 4151
from 2002/03 to 2008/09 respectively. It declined by -33
• Debt to GDP declined from 29.8 percent in 1996/97 to 14.8
percent in 2008/09.
 Table 4. 4: The change in structure and trends of government
revenue and expenditure

Government expenditure 1994/95 1999/00 2008/09 2013/14

Total government expenditure 8551.6 17172.9 58534.4 185,471
Capital expenditure 3032.7 3425.6 30598 107,364
% share of total expenditure 35 20 52 58
Recurrent expenditure 5518.7 13747.3 27935.7 78,086
% share total expenditure 65 80 48 42
Government revenue(in Million Birr) 1994/95 1999/00 2008/09 2013/14

Total government revenue 7044.6 11808.2 57258 158076

Internal source 5841.7 10084.1 43821 146,172
% share of total revenue 82.9 85.4 76.5 92
External source 1131.7 1724.1 13437 11,903
% share of total revenue 16.1 14.6 23.5 7.5
Tax revenue 3878.7 6482.8 32382 133,118
% share of total revenue 55.1 54.9 56.5 84
Non-tax revenue 2034.2 3665.1 11439 13,054
% share of total revenue 28.9 31.0 20.0 8
Source: Compiled from CSA abstracts and NBE
Thank You!!

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 Assignment Topics
1. Agricultural development and its major constraints in Ethiopia
2. Industrial development and its main constraints in Ethiopia
3. Social development and its main constraints in Ethiopia
4. Economic growth and its main constraints in Ethiopia
5. Performance and challenges of financial sector in Ethiopia
6. Performance and challenges of international trade in Ethiopia
7. Climate change and development in Ethiopia
8. Gender and development in Ethiopia

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