INFOLINK UNIVERSITY COLLEGE
Department of Business Management
Course: Macro Economics
Section II
Name ID
1. Simon Esayas…….754645-15
2. Yeabsra Asnake….865541-15
3. Nahom Cheru……830327-15
4. Sara Bedru……….4844-16
5. Ayda Jemal……….759534-15
6. Samiya Reshid……887827-15
7. Biruktawit Dessalegn…. 260166-15
Submitted to Mr. Tekalign
Submission date 21 December 2025
Instruction: Answer the following questions on a separate
sheet of paper and attach it with this assignment question
paper while you sent it back.
1. How does a negative supply shock lead to stagflation?
2. Explain the Quantity Theory of Money and how it relates money growth to inflation.
3. Distinguish between nominal and real interest rates and explain the Fisher Equation.
4. Why is seigniorage considered an inflation tax?
5. Discuss the major social costs of expected and unexpected inflation.
6. What causes hyperinflation?
7. Discuss Pros and cons of floating and fixed exchange rate systems?
8. Which exchange rate system does Ethiopia follow currently (is it floating, fixed or any
other)? How does the exchange rate determined under that system?
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1. A negative supply shock occurs when an unexpected event reduces an economy’s ability to
produce goods and services, shifting the aggregate supply (AS) curve leftward. Common
examples include sharp increases in oil prices, natural disasters, pandemics, or disruptions to
global supply chains. Such shocks are a key explanation for stagflation, a situation characterized
by simultaneously high inflation and stagnant or falling economic output, often accompanied by
rising unemployment.
When a negative supply shock hits, production costs rise. For example, if energy prices increase
suddenly, firms must pay more for fuel, transportation, and electricity. Because these inputs are
used throughout the economy, higher costs affect a wide range of industries. To maintain
profitability, firms raise the prices of their goods and services. This cost-push effect leads
directly to inflation, even though demand has not increased.
At the same time, higher production costs reduce firms’ willingness and ability to produce. Some
firms cut back output, delay investment, or shut down entirely. As production declines, real GDP
falls and unemployment rises. Consumers also suffer from higher prices, which reduce real
purchasing power and further weaken spending. Thus, economic growth slows or turns negative,
leading to stagnation.
The combination of these two effects—higher prices and lower output—is what creates
stagflation. In aggregate demand–aggregate supply (AD–AS) terms, the leftward shift of the
short-run aggregate supply curve results in a higher price level and a lower level of real output.
Unlike demand-driven inflation, policymakers face a dilemma: policies that reduce inflation
(such as tighter monetary policy) can worsen unemployment, while policies that stimulate
growth (such as expansionary fiscal or monetary policy) can intensify inflation.
Historically, the 1970s oil shocks illustrate this mechanism clearly. Sharp increases in oil prices
raised production costs across many economies, leading to high inflation alongside rising
unemployment and slow growth. This experience showed that inflation can originate from the
supply side, not just excessive demand.
In summary, a negative supply shock leads to stagflation by raising production costs, which
pushes prices up, while simultaneously reducing output and employment. The resulting
coexistence of inflation and economic stagnation makes stagflation particularly difficult to
manage and highlights the central role of supply conditions in macroeconomic performance.
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[Link] Quantity Theory of Money (QTM) is a classical economic theory that explains the
relationship between the supply of money in an economy and the overall price level. At its core,
the theory argues that changes in the quantity of money primarily determine inflation, especially
in the long run..
This equation is an identity, meaning it must always hold. The Quantity Theory of Money
becomes a theory when economists make assumptions about how these variables behave. In
particular, classical and monetarist economists assume that velocity (V) is relatively stable in the
short to medium run and that real output (Y) is determined by real factors such as technology,
labor, and capital, rather than by the money supply. Under these assumptions, changes in the
money supply mainly affect the price level.
If velocity is constant and real output grows at a steady rate, then an increase in the money
supply leads to a proportional increase in the price level. In other words, money growth
translates directly into inflation. For example, if the money supply grows by 10 percent while
real output grows by 3 percent, the remaining 7 percent increase will be reflected as inflation.
This relationship can be summarized as:
The intuition behind this result is straightforward. When there is more money in the economy but
no corresponding increase in the quantity of goods and services, people have more money to
spend relative to available output. This excess money demand pushes prices upward. Thus,
inflation is seen as a monetary phenomenon, a view famously emphasized by economist Milton
Friedman.
The Quantity Theory of Money also highlights the difference between the short run and the long
run. In the short run, velocity may fluctuate and output may respond to monetary changes due to
price rigidities. As a result, money growth does not translate perfectly into inflation. However, in
the long run, when prices and wages adjust fully, changes in the money supply are reflected
mainly in changes in the price level rather than real output.
In conclusion, the Quantity Theory of Money provides a clear framework linking money growth
to inflation. By emphasizing the long-run proportional relationship between the money supply
and the price level, it explains why sustained high inflation is typically associated with excessive
growth in the money supply.
[Link] and real interest rates differ in whether they account for inflation, and this distinction
is essential for understanding borrowing, saving, and investment decisions.
The nominal interest rate is the interest rate quoted on financial contracts such as bank loans,
bonds, or savings accounts. It measures the return in money terms, that is, how many more
dollars a lender receives or a borrower repays in the future compared to today. However, the
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nominal interest rate does not indicate how much purchasing power those future dollars will
have.
The real interest rate, by contrast, measures the return in purchasing power. It adjusts the
nominal interest rate for inflation and shows how many more goods and services a lender can
buy in the future compared to today. Because inflation erodes the value of money, the real
interest rate is the relevant rate for economic decision-making, especially when individuals and
firms consider saving, consumption, or investment.
The relationship between nominal and real interest rates is captured by the Fisher Equation,
named after economist Irving Fisher. The exact form of the Fisher Equation is:
1 + i = (1 + r)(1 + π)
where
i = nominal interest rate,
r = real interest rate,
π= expected inflation rate.
For most practical purposes, especially when inflation is relatively low, this equation is
approximated as:
i \approx r + \π
This approximation shows that the nominal interest rate consists of two components: the real
interest rate and expected inflation. Lenders require compensation both for postponing
consumption (the real return) and for the anticipated loss of purchasing power due to inflation.
The Fisher Equation explains how inflation affects interest rates. If expected inflation rises while
the real interest rate remains unchanged, the nominal interest rate will increase one-for-one with
inflation. This is known as the Fisher effect. For example, if lenders desire a real return of 3
percent and expected inflation is 5 percent, the nominal interest rate will be approximately 8
percent. In this way, nominal interest rates adjust to protect lenders from inflation, while
borrowers face higher borrowing costs in nominal terms.
The distinction between nominal and real interest rates also has important policy implications.
Central banks often set or target nominal interest rates, but what matters for economic activity is
the real interest rate. If inflation rises unexpectedly, the real interest rate may fall even if the
nominal rate remains unchanged, potentially stimulating spending and investment.
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In summary, the nominal interest rate reflects returns in money terms, while the real interest rate
reflects returns in purchasing power. The Fisher Equation links the two by showing that nominal
interest rates equal real interest rates plus expected inflation, providing a fundamental
explanation of how inflation influences interest rates in the economy.
[Link] refers to the revenue a government earns by issuing new money. It arises because
the government, typically through the central bank, can create money at a very low cost and use
it to purchase goods, services, or pay off debt. Seigniorage is often described as an inflation tax
because its economic effect is similar to that of a tax imposed on holders of money.
Money serves as a store of value, but inflation reduces its purchasing power. When the
government increases the money supply, the price level eventually rises. As prices increase, the
real value of existing money balances held by the public falls. In effect, people holding cash or
non-interest-bearing money experience a loss in real wealth. This loss represents a transfer of
resources from the public to the government, just like a tax.
The mechanism works as follows. When new money is created, the government can spend it
before prices fully adjust. During this period, the government obtains goods and services at
current prices. Once prices rise in response to the higher money supply, the purchasing power of
previously issued money declines. The public “pays” for the government’s spending through this
erosion of real money balances. Unlike explicit taxes, this payment is indirect and often less
visible, which is why it is sometimes called a hidden tax.
Seigniorage revenue can be expressed in real terms as the growth rate of the money supply
multiplied by the real money balances held by the public. This shows clearly why inflation
functions like a tax rate: higher inflation increases the rate at which real money balances are
taxed, while the amount of money people hold determines the tax base. As inflation rises,
individuals try to reduce their money holdings to avoid the loss of purchasing power, which can
limit how much revenue the government can raise through seigniorage.
Historically, governments facing fiscal constraints—such as during wars or periods of weak tax
collection—have relied heavily on seigniorage. In extreme cases, excessive money creation leads
to high inflation or hyperinflation, where the inflation tax becomes very large and economically
destructive, severely discouraging money holding and disrupting normal economic activity.
Seigniorage is considered an inflation tax because money creation finances government spending
by reducing the real value of the public’s money holdings. Inflation acts like a tax rate that
erodes purchasing power, transferring resources from money holders to the government without
explicit taxation.
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[Link] imposes social costs on an economy, but the nature and severity of these costs depend
on whether inflation is expected or unexpected. While expected inflation allows individuals and
firms to adjust their behavior, unexpected inflation creates additional distortions and redistributes
income in arbitrary ways.
Social costs of expected inflation
When inflation is anticipated, economic agents can build it into contracts, wages, interest rates,
and prices. Even so, expected inflation is not costless. One major cost is the shoe-leather cost. As
inflation rises, holding money becomes more expensive because its purchasing power erodes
more quickly. People respond by reducing their real money balances, making more frequent trips
to banks or managing cash more actively, which wastes time and resources.
Another cost is menu costs. Firms must frequently update price lists, catalogs, labels, and
accounting systems to reflect rising prices. Although individually small, these costs add up
across the economy, especially in periods of sustained inflation.
Expected inflation also leads to distortions caused by the tax system. Many tax codes are written
in nominal terms. Inflation can push individuals into higher tax brackets (bracket creep), increase
the taxation of nominal interest income and capital gains, and distort saving and investment
decisions, even when real incomes have not increased.
In addition, expected inflation can reduce the usefulness of money as a unit of account. When
prices change rapidly, comparing values over time becomes more difficult, increasing
uncertainty and reducing economic efficiency.
Social costs of unexpected inflation
Unexpected inflation tends to be more harmful because it redistributes income and wealth
arbitrarily. It benefits borrowers at the expense of lenders, since loans are repaid in money that is
worth less than expected. Conversely, unexpected disinflation or deflation harms borrowers and
benefits lenders. These redistributions are not based on productivity or effort, which is socially
inefficient and often viewed as unfair.
Unexpected inflation also distorts relative prices and wages. Because not all prices and wages
adjust at the same time, inflation can send misleading signals about scarcity and demand. Firms
and workers may make poor production, consumption, or labor supply decisions based on
temporarily distorted prices.
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Another major cost is increased uncertainty, which discourages long-term planning, saving, and
investment. When inflation is unpredictable, firms are less willing to undertake long-term
projects, and households may find it harder to plan for retirement or major purchases. This
uncertainty can slow economic growth.
Finally, unexpected inflation can undermine trust in monetary institutions. If people lose
confidence in the central bank’s ability to maintain price stability, inflation expectations may
become unanchored, making inflation more volatile and costly in the future.
[Link] is an extreme and rapid increase in the general price level, typically defined as
inflation exceeding 50 percent per month. It is a rare but devastating economic phenomenon.
Although specific historical episodes differ, hyperinflation is usually caused by a combination of
fiscal collapse and excessive money creation, reinforced by a loss of confidence in the currency.
The primary cause of hyperinflation is large and persistent government budget deficits that
cannot be financed through normal means such as taxation or borrowing. When governments
face weak tax systems, high spending pressures (often due to wars, political instability, or
economic collapse), and limited access to credit markets, they often resort to printing money to
finance expenditures. This leads to explosive growth in the money supply, which rapidly pushes
prices upward.
As inflation accelerates, real tax revenues fall, a phenomenon known as the Tanzi effect.
Because taxes are collected with a lag, rising prices reduce their real value by the time the
government receives them. This worsens fiscal deficits, forcing the government to print even
more money, creating a vicious cycle of money creation and inflation.
Another crucial factor is the collapse of confidence in the currency. When people expect prices
to rise rapidly, they try to spend money as quickly as possible and avoid holding cash. This
sharply increases the velocity of money, meaning money circulates faster through the economy.
Even if money growth remains unchanged, a surge in velocity can dramatically raise inflation. In
practice, both money supply growth and velocity tend to rise together during hyperinflation.
Hyperinflation is often triggered or intensified by economic and political shocks, such as wars,
regime changes, loss of productive capacity, or the breakdown of institutions. These shocks
reduce real output and undermine the government’s ability to raise revenue, making reliance on
money creation more likely.
Historical examples such as Weimar Germany in the early 1920s, Zimbabwe in the 2000s, and
Venezuela in the 2010s illustrate these mechanisms. In each case, massive fiscal deficits
financed by money creation, combined with declining output and loss of confidence in the
currency, led to runaway inflation.
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In summary, hyperinflation is caused by unchecked money creation to finance large fiscal
deficits, reinforced by falling real revenues, rising velocity of money, and a collapse in
confidence in monetary institutions. It is fundamentally a monetary phenomenon rooted in fiscal
and institutional failure.
7. Exchange rate systems determine how a country’s currency value is set relative to others. The
two main systems are floating exchange rates, where the currency value is determined by market
forces, and fixed (or pegged) exchange rates, where the currency is tied to another currency or a
basket of currencies. Each system has advantages and disadvantages.
Floating exchange rate system
Pros
Monetary policy independence
Under a floating exchange rate, a central bank can use monetary policy to pursue domestic goals
such as controlling inflation or reducing unemployment, without having to defend a particular
exchange rate.
Automatic adjustment mechanism
Floating rates help correct balance of payments imbalances automatically. A trade deficit tends
to cause currency depreciation, making exports cheaper and imports more expensive, which
helps restore equilibrium.
No need for large foreign reserves
Since the exchange rate is not defended at a fixed level, governments do not need to hold large
amounts of foreign currency reserves.
Resilience to external shocks
Exchange rate movements can absorb shocks from changes in global demand, commodity prices,
or capital flows, reducing the need for painful domestic adjustments.
Cons
Exchange rate volatility
Floating rates can fluctuate significantly, creating uncertainty for exporters, importers, and
investors, and potentially discouraging international trade and investment.
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Risk of overshooting and speculation
Exchange rates may overreact to news or capital flows in the short run, leading to misalignment
from economic fundamentals.
Inflation pass-through
Currency depreciation can raise import prices and contribute to inflation, especially in economies
heavily dependent on imports.
Fixed exchange rate system
Pros
Exchange rate stability
Fixed exchange rates reduce uncertainty in international transactions, encouraging trade,
investment, and economic integration.
Credibility and inflation control
Pegging a currency to a low-inflation country can help anchor inflation expectations and impose
monetary discipline on the domestic economy.
Reduced transaction costs
Stable exchange rates lower hedging costs and simplify pricing in international trade.
Useful for small open economies
For countries with strong trade links to a major partner, a fixed rate can provide stability and
predictability.
Cons
Loss of monetary policy autonomy
To maintain the peg, the central bank must adjust interest rates and money supply in line with the
anchor currency, limiting its ability to respond to domestic economic conditions.
Vulnerability to speculative attacks
If markets doubt the sustainability of the peg, speculative attacks can force costly interventions
or abrupt devaluations.
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Need for large foreign reserves
Defending a fixed exchange rate requires substantial foreign currency reserves, which can be
expensive to maintain.
Difficulty adjusting to shocks
Fixed exchange rates prevent currency adjustment, so external imbalances must be corrected
through changes in output, employment, or wages, often causing recessions.
Conclusion
Floating exchange rate systems offer flexibility, policy independence, and automatic adjustment
but at the cost of higher volatility and uncertainty. Fixed exchange rate systems provide stability
and credibility but reduce monetary autonomy and can be fragile in the face of shocks. The
choice between the two depends on a country’s economic structure, institutional strength, and
policy priorities.
[Link] exchange rate system in Ethiopia
Ethiopia’s official exchange rate regime has shifted in recent years from tight controls toward a
more market-based, floating system, but it is not a simple “pure float” like those in advanced
economies. According to the International Monetary Fund (IMF), Ethiopia’s de jure (officially
declared) exchange rate arrangement is considered floating, while the de facto arrangement is
best described as “other managed”, meaning the central bank still influences the rate and imposes
some restrictions.
This shift reflects ongoing reforms: in July 2024, the National Bank of Ethiopia (NBE)
liberalized the foreign exchange regime as part of an IMF-backed program, allowing banks to
**buy and sell foreign currencies at freely negotiated market rates with only limited central bank
intervention.
However, despite this official move toward a floating regime, practical features of management
remain. Some controls on access to forex persist, and the official rate often differs from parallel
(black) market rates, indicating that the exchange rate is not purely market-driven in practice.
Ethiopian Policy Institute +1
In some Ethiopian central bank documents and economic descriptions, the regime is still referred
to as a managed float (or previously as a crawling peg), where the rate is influenced both by
market forces and periodic central bank adjustments. [Link]
How the exchange rate is determined under the current system
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Under Ethiopia’s more flexible (market-based) exchange rate regime, the birr’s value against
other currencies is determined mainly by supply and demand dynamics in the foreign exchange
market. Commercial banks and licensed foreign exchange bureaus trade foreign currency with
clients and among themselves, and these transactions help set the daily exchange rate.
The National Bank of Ethiopia may intervene occasionally by buying or selling foreign currency
to smooth extreme volatility or disorderly movements, but it no longer fixes the rate at a set level
or rigid band. This means that rates can adjust more frequently in response to changes in
international capital flows, export receipts, remittances, import demand, inflation expectations,
and macroeconomic conditions.
In practice, because access to foreign currency can still be restricted and shortages may occur, a
parallel foreign exchange market operates outside official channels. The rate in this parallel
market often differs from the official weighted average rate, reflecting real supply and demand
pressures that are not fully captured in the official market.
Summary
Ethiopia’s de jure regime is a floating exchange rate, transitioning from earlier managed or
crawling-peg systems. In practice, it functions as a managed or regulated float, with the central
bank intervening to mitigate volatility and maintain some controls.
The exchange rate is primarily determined by market forces of supply and demand, with central
bank interventions when necessary and continued presence of a parallel market reflecting
ongoing distortions.
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