6.1.

Introduction

 Conventionally, economics is divided into microeconomics and

macroeconomics.
 Microeconomics studies about the individual decision making behavior of
different economic units such as households, firms, and government at a
disaggregated level.
 Macroeconomics, studies about overall or aggregate behaviour of the
economy, such as economic growth, employment, inflation, distribution of
income, macroeconomic policies and international trade.
2
  Until now (starting from chapter one up to five), we have discussed the
major microeconomic issues.
 In this chapter we will discuss the major macroeconomic issues.
 What Macroeconomists Study
 Why have some countries experienced rapid growth in incomes over the past
century while others have stayed mired in poverty?
 Why do some countries have high rates of inflation while others maintain
stable prices?

3
  Why do all countries experience recessions and depressions—recurrent
periods of falling incomes and rising unemployment—and how can
government policy reduce the frequency and severity of these episodes?
 Macroeconomics attempts to answer these and many related questions.

 Goals and Major policy instruments in Macroeconomics

 Goals of macroeconomics
 Output:- High level and sustainable growth.
 Employment:- High level of employment and low involuntary
unemployment (to reduce unemployment). 4
 Stable price:- another goal of macroeconomics is to maintain stable price within
free market.
 International trade: - Import and export equilibrium and exchange rate stability.
 To reduce budget deficit and balance of payment (BoP) deficit.
 Resource distribution:- to ensure fair distribution of income.
 Major Policy Instruments in Macroeconomics
 Macroeconomics is policy oriented.
 It asks, to what degree can government policies affect output and
employment?
5
 Should government policy attempt to achieve a target level for foreign exchange
rates?
 A policy instrument is an economic variable under control of government that
can affect one or more macroeconomic goals.
 Fiscal policy: refers to the use of government spending and tax policies to
influence economic conditions, especially macroeconomic conditions,
including aggregate demand for goods and services, employment, inflation,
and economic growth.
 In short, fiscal policy relies on taxation, government spending, and
government borrowing. 6
 Monetary policy: Monetary policy is the macroeconomic policy laid down by the
central bank.
 Monetary policy is a modification of the supply of money, i.e. "printing"
more money, or decreasing the money supply by changing interest rates or
removing excess reserves.
 Trade policy: Trade policy refers to the regulations and agreements that control
imports and exports to foreign countries. Tariffs, subsidy are the most important
tools in trade policy.
 Income policy: Incomes policy, collective governmental effort to control the
incomes of labor and capital, usually by limiting increases in wages and prices7
 6.2. National Income Accounting

• National income is often considered as the most comprehensive measure of how

well an economy is performing.

• It is necessary and important, therefore, to measure the national income of a

country so as to have an idea of the performance of the economy.

• Measuring national income is an extremely complicated large task.

• However, economists have devised various ways of estimating national income.
In fact, national income estimates are made in every country these days.
8
 NATURE AND MEANING OF NATIONAL INCOME ACCOUNT

• National income is an essential element in the study of macroeconomics

• The national income and product accounts are designed to measure these
economic activities and the flow of income and expenditures over a given period.

• National income accounting is the science of measuring the aggregate output and
income of an economy.

• It is the measurement of flow of services and goods in economic system

• It is the measurement of production power of economic system in a given time
period. 9
 Importance of measuring National Income:
 To measure the size of the economy and level of economic performance.
 To know the composition and structure of the national income in terms of
various sectors and the periodical variations in them.
 To make projections about the future development trend of the economy.
 To help government to formulate suitable plans and policies to increase
 economic growth rate.
 To make international comparison of peoples living standards.
 Etc.
10
• National account is broadly defined as the aggregate monetary value of all
the final goods and services produced in a country during a year.
• Based on this definition, we can identify the following main features of
national income:
 National income is counted for a period of one accounting year,
  National income is a flow concept. National income is a measure of the
flow of goods and services during a year,
 We include only final goods and services in the calculation of national
income. Intermediate goods are not included in the calculation of national
income,
 National income is expressed in terms of monetary value of goods and
services 11
 Approaches to measure national income: GDP, GNP, NNP, NI, PI, PDI

• Final goods are goods that are not used up in the production of any other goods.
But, intermediate goods are completely used up in the production of other goods.

• The value of intermediate products is reflected in the prices of final goods.

• On the other hand, the value added or net output of a firm is the value of its final
output minus the value of its purchases from other firms.

12
 Gross domestic product (GDP)
• It is the total market value of all final goods and services produced in a country, during a year, by resources
located within a country whether by domestic or foreign supplied resources(regardless of their ownership).
• Three things to note about this definition of GDP:
• Total market value. We add up the monetary value of all the stuff produced in the given country. This is
because producing a car is way different that producing a haircut or a can of soup, but by converting
everything to its monetary value we have a uniform measure.
• Final goods and services. We only count final products ready to be consumed, NOT products used to make
other products. So a car will be counted in the GDP but the steel used to make the car is not counted
separately. Why? Because the value of the car already reflects the value of the steel, rubber, plastic, etc. that
goes into it.
• Produced in a country. Ethiopia’s GDP counts only those goods and services produced in the physical
borders of Ethiopia, Where the good or service is produced is important .
• GDP=C+G+I in a closed economy; and GDP = C+I+G + NE in an open economy, see more elaboration of
this formula in measuring GDP by expenditure approach part.

13
 Gross national product (GNP)
• It is the total market value of all final goods produced and services
rendered during a year by resources owned by the citizens of the
country regardless of their location.
• In another word it is the total value of all final goods and services
produced within a nation in a particular years plus income earned by
its citizens(including income of those located abroad) minus income
of non residents located in that country.
• It shows how the nations a given country are doing economically
• GNP=GDP+NFI (is the factory income received from abroad (foreign
country) minus factory income paid to abroad (foreign country).
14
• Net factory income(NFI): It is the factory income received from abroad (foreign
country) minus factory income paid to abroad (foreign country).The net
difference between income inflow and income outflow is known as net factor
income (NFI) from abroad
• GNP can be greater than, less than or equal to GDP depending on the magnitude
of the net factor income from abroad.
• If NFI > 0, then GNP > GDP;
• If NFI < 0, then GNP < GDP; and
• If NFI = 0, then GNP = GDP
• Gross domestic product (GDP) and gross national product (GNP) are the two
most important and widely used measures of the performance of an economy.
15
• In measuring the performance of an economy, various economic indicators are adopted.
• Apart from GDP and GNP, there are also other measures of the performance of the
national output such as net national product (NNP), net domestic product(NDP),
national income (NI), personal income (PI) and personal disposable income (PDI),
which can be derived as follows:
• Net National Product(NNP)
• NNP refers to the gross national product minus depreciation
• NNP= GNP-Depreciation
• More usually, capital goods such as building, equipment, machinery and what not used
in the production process lose part of their value from wear and tear during a year.
Hence, it is customary to make capital consumption allowance for the using up of
capital goods. Such allowance that indicates part of the value of the total output, which
is needed to replace obsolete and worn-out capital, is known as depreciation.
16
• Net Domestic Product(NDP)
• NDP=GDP-Depreciation
• National Income(NI)
• It is the sum of factory payment made to the owners of factors of production in the economy
• It is obtained by deduct(less) indirect business taxes(IBT) from NNI
• Personal Income(PI)
• It is the total income received by individuals and which can be derived as
• PI=NI-undistributed corporate profits-corporate income tax-social security contributions plus
transfer payments.
• Personal Disposable Income(PDI)
• PDI=PI minus personal current taxes

17
• The following table can help someone understand the six common measures of the national output:
• Gross Domestic product (GDP) Less or plus : net factor income (NFI)
• Equals : Gross National Product (GNP)
• Less : Depreciation (D)
• Equals : Net National Product (NNP)
• Less : Indirect Business Taxes (IBT)
• Equals : National Income (NI)
• Less : Undistributed corporate profits (UCP), corporate income tax (CIT), Social Security contribution (SSC)
• Plus: Transfer Payments (TP)
• Equals : Personal Income (PI)
• Less : personal Income Taxes (PIT)
• Equals : Personal Disposable Income (PDI)
•
•
•
•
•
•
•
•
•
•
•
•
•
• 18
• 7.3. Approaches to measurement of the national income
• Approaches to measurement of the national income
 There are three possible approaches to measuring of the gross domestic product (GDP)
which are based on the three different views of the national output. The GDP may be
regarded as:
 The total output of goods and services,
• The sum of the factor incomes earned by the factors of production engaged in
producing the national output, and
• The sum of expenditure on the national output. This is because the national output
must either be bought for consumption or added to stocks.
• Following these notions of the national economy, there are three ways of calculating
GDP - all of which should sum to the same amount since the following identity must
hold true:
• National Output = National Expenditure (Aggregate Demand) = National Income 19
 1. The Income approach
• One way of calculating the value of national output is to add up all the incomes accruing to all factors of
production used in producing the national output. There are four categories of factors of production: labor,
land, capital and entrepreneurial ability.
• Correspondingly, the factor payments are wages and salaries (W), rents (R), interest (I T), and profit (P).
Therefore, in the income approach,
• GDP = W + R + IT + P
• The main point to note here is that all personal incomes are not necessarily included in the national income.
• That is, all transfer payments are excluded, as these represent nothing more than redistribution of income
from taxpayers to the recipients of transfer payments.
• Transfer payments represent payment by the government to the individuals not because of their contribution
to the production of the current national output but because of the social security conventions.
We exclude from the accounts the following items:
• Transfer payments e.g. the state pension paid to retired people; income support paid to families on low
incomes; the Jobseekers’ Allowance given to the unemployed and other forms of welfare assistance including
child benefit and housing benefit.
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• Private transfers of money from one individual to another.
• Income that is not registered with the Inland Revenue or Customs and Excise. Every
year, millions of birr worth of economic activity is not declared to the tax authorities.
• This is known as the shadow economy where goods and services are exchanged but the
value of these transactions is hidden from the authorities and therefore does not show up
in the official statistics.
• It must be remarked that all the income generated in the production does not necessarily
form factor payments.
• Some part of the corporation profits may be retained and added to the reserves, and the
profit of the governmentally owned undertakings go to the government instead of forming
personal income.
• These undistributed surpluses must be added to the total incomes received by individuals.
21
• Thus, from the view point of the expenditure approach, GDP can be measured by using the
following formulae:
• GNP = C+I+G in a closed economy; and
• GDP = C+I+G + NE in an open economy.
• Personal consumption expenditure includes expenditures by households on durable consumer
goods (automobiles, refrigerators, video recorders, etc) and non-durable consumer goods
(clothes, shoes, pens, etc).
• Gross private domestic investment represents spending on producer durables (machinery,
equipment, tools), residential and non-residential construction.
• Note that gross private domestic investment differs from net private domestic investment in
that the former includes both replacement and added investment whereas the latter refers only
to added investment. Replacement means the production of all investment goods, which
replace machinery, equipment and buildings used up in the production process. In short, net
private domestic investment = Gross private domestic investment minus depreciation.
23
• Net investment is a crucial factor for economic growth of a country. That is, an increase in
net investment would help the productive capacity of the economy to boost. If net
investment is greater than zero, the economy is growing; if net investment is equal to
zero the economy is stagnant or static and if net investment is less than zero, the
economy is shrinking (contracting).
• Government purchases of goods and services include all government spending on finished
products and direct purchases of resources less government transfer payments because
transfer payments do not reflect current production although they are part of government
expenditure.
• Net exports refer to total value of exports less total value of imports. Note that net export is
different from the terms of trade in that the latter refers to the ratio of the value of exports to
the value of imports.
• Note that a closed economy is an economy which has no economic transactions with the rest
of the world (i.e. where there are no exports and imports) whereas open economy is an
economy where there is economic relationship through imports and exports with the rest of
the world 24
 3. Product Approach (value-added approach)
• The most direct way of measuring the national income or GDP is to
add up the monetary value of final goods and services or taking the
sum of the values added by all firms at different stages of
production.
• The total value added of a nation's economy is the difference
between the market value of all final products of business firms and
the market value of all intermediate products.
• Stated differently, value added is the difference between a firm's
sales and its purchases of materials and services from other firms.
25
• For illustration sake, consider a simple microeconomic example in which producing bread entails
the following different stages of production:
• Bread sales Receipts, Costs and Value-added
• Stage of Sales Cost of intermediate Value added
Production Receipts (birr) materials and (W,R,P, etc)
Services (birr)
• Wheat 300 0 300
• Flour 450 300 150
• Baked dough 570 450 120
• Delivered bread 680 570 110
• Total 680
(Sum of value added)
• Therefore, we conclude that the sum of value added measures precisely the value of the final
goods. 26
 Problems of measuring GDP
• There are many conceptual and practical problems that an economy encounters
in measuring national output, some of them are
• Double counting
• Valuation of non marketed output
• Change in the value of existing assets
• Sale of used commodities
• Valuation of self provided goods and service
• Financial transactions and transfer payments
• Change in price level and etc
27
 The following are the possible panacea(Remedial measures) to address the
problems of measuring GNP:
1. Avoid double counting:
• Double counting arises because the products of some firms are the inputs of other
firms.
• All goods and services produced in an economy over a given period of time need
to be counted only once.
• There are two possible ways of avoiding double counting:
• to consider only the value of final products.
• to take the sum of the values added by all firms at the different stages of production.
• In both cases, the value of intermediate products should be excluded in order to
avert double counting distortion. 28
 2. Exclude non-production transactions
• Some transactions during the year do not affect production and employment and are thus disregarded in the
computation of GDP. Non-production transactions include financial transactions and sales of second-hand
(used) goods.
• Pure financial transactions involve public transfer payments, private transfer payments and security
transactions.
• Public transfer payments are social security payments (example old-age pension), welfare payments (example,
unemployment benefit) and veterans' payments.
• Public transfer payments represent payments by the government to individuals not because of their
contribution to the production of the current national output but because of the social security conventions.
• Including such transfer payments in GDP would tantamount to an overstatement of the value of the current
year's production.
• Private transfer payments are transfer payments like a university monthly subsidy from home or an
occasional gift from wealthy relatives that do not entail current production but are mere transfer of funds from
one individual to another.
• Security transactions such as buying and selling of stocks and bonds do not create value and hence are excluded
29
from GDP.
• Used or second-hand sales of goods are not also included in GDP since they are counted earlier.
 3. Omit non-market output
• Most goods and services such as police, national defense, fire protection, law and order
and the like are not sold in markets but they are services rendered to the society without
charge.
• Such services have to be incorporated in the GDP in the form of government purchases of
goods and services. However, self-provided goods and services and household services
are difficult to include them in the GDP.
• Self-provided goods and services are goods and services which people provide for them.
Driving one's own car and making one's own clothes are instances of self-provided goods
and services. Household services such as the services of a housewife in cooking food for
family consumption, washing clothes, cleaning room, etc have also no market prices.
4. Change of price level
• The increase in the price of goods and services without the increase in the level of
physical output does not display the real GNP. Hence, the price changes must be adjusted
to inflation by using price index. 30
 NOMINAL GDP VS. REAL GDP

• Multiplying the volume of goods and services produced by their corresponding

market prices yields the monetary measure of a national income/ GDP.
• If the physical output produced during a given year is measured in terms of the
prices of the same year, the national output is called nominal GDP. Nominal
GDP (GDP in current dollars) is the value of final goods and services for a given
year in that year's prevailing market prices (current market price).
• It is a GDP figure which reflects current national output without taking account
of changes in the price level. Sometimes it is called GDP unadjusted for
inflation.
• GDP changes with a change in the physical output or a change in the price level
or a change in both. 31
• When the general price level changes, it is imperative to make some
adjustments to the nominal GDP/national income so that they can be
compared in real terms
• Thus, when nominal GDP is adjusted for price changes, it is called real
GDP (GDP in constant dollars).
• Since real GDP is a figure which is adjusted for price changes, it is said to
be GNP adjusted for inflation. It measures the volume of real goods and
services by avoiding the effects of changes in the general price level.
• N.B Real GDP shows what would have happened to expenditure on
output if quantities had changed, but price had not (constant).

32
• GDP Deflator: it reflects what is happening to the overall level of price in the economy.
• The simplest and most convenient method of deflating a given year's nominal GDP is to divide
the nominal GDP by the price index. Algebraically,
• Real GDP = Nominal GDP/Price index (GDP deflator)
• By way of illustration, suppose a hypothetical national income of a country as shown be
Nominal GDP Price index Real GDP
• Year (in birr) (GDP Deflator) (in birr)

• 2000 600,000,000 120 500,000,000

• 2001 700,000,000 125 560,000,000

• The above illustration shows that even though the nominal GDP has increased by 16.67 percent,
the real GDP had only increased by12% due to the increase in the general price level.
33
 GDP and Welfare (what does GDP NOT measure?)
• So GDP is an important measure of the economic power and health of a nation. But GDP does not tell
the whole story in terms of the well being of a nation. Here are a few things GDP leaves out:
• Other social indicators. These include crime, illiteracy, life expectancy, infant mortality. Although
these things are related to GDP, the connection is not perfect: The U.S. has a larger GDP per capita
than Canada or Japan, but also has a higher rate of crime, illiteracy, and infant mortality.
• Equity. A large GDP per capita does not mean that the wealth of a nation is shared equally. In some
nations, the GDP is distributed for the most part among a small elite class, leaving the rest of the nation
in poverty.
• Environmental issues. A high rate of production may have disastrous environmental consequences.
Brazil may increase its GDP by cutting down rain forests for the timber, but very few of us would say
that is a good thing.
• The underground economy. The GDP actually measured will fail to capture any goods and services
that are not reported to the government. These include illegal activities, like marijuana cultivation,
cocaine sales, and tax evasion, such as under-reporting tip income, or cash-paid babysitting.
34
• Non monetary economy. This includes transactions for which people are
not paid. When I do my family's laundry that is not counted in GDP. But if I
paid someone to do my laundry, it would count in GDP. The exclusion of
homemaking really understates the services produced in the economy.
• Wealth distribution. GDP does not take disparity in income between rich
and poor in to account. In another word it does not consider income
inequality.
• Non market transaction
• Sustainability of growth. GDP does not consider this concept.
• So while GDP is a crucial measure of the size and health of an economy,
keep in mind it is not the ONLY measure of well-being

35
 Business Cycle
• Business cycle refers to the recurrent ups and downs [fluctuations] in the level of
economic activity.
• Countries usually experience ups and downs in the level of total output and
employment through time. For some period of time, the total output level may
increase, after a while total outputs may decline.
• With this fluctuation in the overall economic activity unemployment level also
moves up and down.
• We can identify four phases in a business cycle. They are: boom or peak,
recession, trough or depression, and recovery periods.

36
• Boom or peak: is a phase in which the economy is producing the highest level
of output in a business cycle.
• It is a period of maximum output expansion. During boom period, the economy
is operating close to full capacity.
• Because of this, total output and national incomes are very high business is good,
and unemployment level is too low. This is a period of prosperity.
• Recession or contraction: during a recession phase, the level of economic
performance generally declines.
• Total output declines, national income falls, and business generally decline. As a
result unemployment problem rises.
• When the recession becomes particularly severe, we say that the economy
reaches its trough or depression phase in a business cycle
37
• Trough or depression: this is the lowest point in a business cycle. In other
words, the economy reached a low point. Total output reaches to low while
unemployment rate is too high.
• Recovery: this is a period of time in which the economy starts to grow or
recover.
• Now more and more resources are employed in the production process: output
increases, unemployment level diminishes and national income rises.
• When the expansion of the economy reaches its maximum, the economy once
again comes to another boom or peak phase.
• From one peak to the next peak or from one trough to the next trough is
considered as one business cycle. Recession and depression periods can cause
severe hardship on businesses and citizens of a country. 38
 Unemployment
• To begin with, we can classify the whole population of a country into two major groups
 Labour force and
 Outside labour force
• labour force= it refers currently active population
• The sum of the number of the population in the working age with jobs and those who are actively
seeking job but failed to find it is known as labour force. Labour force=employed
+unemployed
• Employed: Includes those who at the time of the survey worked as paid employees, worked in
their own business, out who worked as unpaid workers in a family’s business. It also includes
those who were not working but who had jobs from which they were temporarily absent because
of, for example, vacation, illness, or bad weather, etc.
39
• Unemployed: refers to group of people who are in a specified age and active,
who are without a job but are actively searching for a job.
• Out of labour force(Not in the labour force)
 This includes full-time students in the working age,

 People who choose to devote their time to keeping houses or raising

children,
 Retired people, those who are too ill to work, or simply not looking for
work. Children <14 and retired people (age above 64)
 People in mental and correctional institutions
 Very sick and disabled people, etc.
• They are neither in the labor force nor considered unemployed. 40
 Types of unemployment
• There are different types of unemployment but, the most common types are
1. Frictional unemployment
• It includes unemployment resulting from seasonality (for example bad weather in
agriculture and construction), the process of voluntarily switching jobs(individuals quit jobs
to look for better position or for more attractive occupations), entering the labor force(e.g.
college graduates), re-entering the labor force (e.g., women after delivery) etc.
• For some workers it takes time to search for a job and they become between jobs for some
time. This may be due to:
2. Structural unemployment
• It refers to unemployment resulting from mismatch between the skills or locations of job
seekers and the requirements or locations of the vacancies.
• This is unemployment which arises from a change in the pattern (structure) of demand
for goods and services in an economy. 41
• Cyclical unemployment
• This is also referred to as demand deficiency unemployment.
• It results from the fluctuation of the business cycle, i.e. It results from declines in national output in
periods of recession.
• Note that; - Frictional and structural unemployment are more or less unavoidable, and hence known
as natural level of unemployment.
Measuring unemployment
• Unemployment level in a country is measured by unemployment rate.
• TU = FU + SU + CU , Where TU = Total unemployment
FU= Fictional unemployment
SU= Structural unemployment
CU = Cyclical unemployment
Employment rate = number of employed x100 Unemployment rate= number of unemployed
x100
42
Labour force Labour force
• Example : Suppose in a country where there are 130,000,000 total population
5,000,000 people were unemployed and 85,000,000 held jobs. Calculate,
• a) National employment rate
• b) National unemployment rate
Solution
• a) Employment rate = 85,000,000  100
85,000,000 + 5,000,000 = 85,000,000  100
90,000,000
= 94.4%
• b) Unemployment rate = 5,000,000  100 = 5.6%
90,000,000
43
 Underemployment: a situation in which people are engaged in jobs but these jobs do not
measure up to their capabilities, efficiency, and qualifications.
 Involuntary Unemployment: a situation in which the workers are willing to work under
any conditions and at any wage rate but they fail to get employment.
 Voluntary Unemployment: when the economy offers employment opportunities to the
workers, but they themselves are not willing to take up jobs because employment
conditions, such as wage rate, location, promotional avenues, physical environment,
attitude of the employer, etc., do not suit them – such a situation is known as voluntary
unemployment.
 Technological Unemployment: This is generally found in the advanced countries. The
main cause of this unemployment is the introduction of a new technology which requires
changes in a labour force.
 Disguised Unemployment: When more workers are engaged in a type of work than
actually are required to do that work, it is called disguised unemployment.

44
Impact of Unemployment on Economic Growth

A. Loss of Valuable Human Resources

B. Increase in Poverty

C. Unemployment is Demoralizing

D. Exploitation of Labour

45
• Inflation
• It is also one of macroeconomic issue. Inflation refers to a sustainable or
continuous increase in the average price level of goods and services.
• Deflation, on the other hand, refers to the decrease in the average price level of
goods and service. Is inflation harmful? What are the causes of inflation? How
can we measure it?
• The inflation rate in the economy can be anticipated or unanticipated one.
Anticipated inflation is the rate of inflation expected to occur over a specified
period of time.
• Whereas unexpected inflation refers to that portion of the actual inflation that was
not expected by the society to happen.
• There is inverse relationship between unemployment and inflation in the short run
46
 In short Causes of inflation are the followings:
- Contracting supply/ particularly agricultural output per capita
- High devaluation of local currency (birr)
- rise in money supply/credit expansion,
- inflation expectation, and international food price hike.
- interest rate and inflation expectations.
- shortage of hard currency (such as Dollar, Euro, Pound and etc.)
- War or instability ( it discourages supply as production of goods and services)
- rise in the prices of factor inputs, and
- rise in the prices of final goods.

47
- Contracting export
- Contracting investment
- Contracting import (low trade oppeneness)
- High import tariff
- Growing corruption
- Low innovation
- Debt burden
- Very low real interest rate
- Increasing grievance and fractionalism.
- Etc.

48
 The Impact of Inflation on Economic Growth

 Inflation has different levels or degrees of severity, described as moderate,

galloping, and hyperinflation.
 A moderate inflation is generally believed to be a necessary condition of
economic growth.
 However, inflation may also retard economic development in a number of
ways. It may lead to lopsided development; lead to increased consumption and
have a negative effect on savings; have an adverse effect on the balance of
payments; and introduce uncertainty and instability. 49
 A. Favorable Effects (when inflation is moderate)
 Mild inflation has some favorable effects on production, capital formation, and economic
development.
B. Adverse Effects ( when inflation is galloping)
 Inflation adversely affects fixed-income groups like wage and salary earner.
 reduces the level of savings out of a given level of income.
 As wages and salaries remain more or less fixed, income of the industrial and
business classes increases relative to the income of working classes.
 Creates a vicious circle of wage and price rises.
 Adverse effect on Economic Planning
 deficit in balance of payments increases.
 Remarks: Besides these, effects rising prices encourage corruption, strikes,
social unrest, and many more problems. It is therefore necessary that inflation
should be controlled and prices stabilized or allowed to rise only within narrow
limits. 50
 Budget and Trade Deficit
• By budget, we refer to government budget, and it is planned revenue and
expenditures of a government in a given period of time, usually one year.
• At the end of the period, if government revenue exceeds government
expenditure, this is referred to as budget surplus.
• When government expenditure exceeds government revenue, the government
experiences budget deficit.
• When the two are equal, the government budget is said to be balanced.
• Most governments in the developing world experience budget deficit. If there
happens budget deficit, then the extra expenditure must be financed. And this will
usually happen through borrowing.

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• Another concern in macroeconomics is the economic interactions that exist among
nations.
• A country usually exports and imports goods and services is called as Trade. The
balance between its exports and imports in a given period is known as trade balance.
• When its export is greater than its imports the country experiences trade surplus.
• On the other hand, when its imports are greater than its exports, it experiences trade
deficit.
• IF a country experiences trade deficit, the meaning is that its export earnings could not
finance its imports of goods and services from the rest of the world. This affects its
reserves, and leads the country to borrowing or debt burden.
• Issues related to government budget and international trade also pose a number of
problems. Hence, they are investigated in macroeconomics.
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 Consumption, Saving and Investment
• Consumption, saving, and investment are crucial factors in any country’s economic performance (income,
output, employment, etc.).
• 1. Consumption
 Consumption ,may thus be defined as the expenditure by households on final goods and
services.
• The main elements of household consumption are expenditures on food, housing,
clothing, transportation, medical care, etc.
• Does consumption depend upon income? Yes, consumption is a part of income and
directly depends upon income itself.
• However, we must note that consumption is necessary for survival and thus takes place
even if income is zero. In such a case, households might be consuming from sources
such as accumulated wealth, borrowing, or begging (seeking charity). In this context,
there are two categories of consumption: 53
• Consumption when income is zero – i.e., when a minimum level of
consumption must be maintained for survival. This is called autonomous
consumption, and it is independent of income level.
• Consumption when income rises: With an increase in income, consumption also
increases, but usually less than the income increased. This part of consumption, which
varies with income, is called induced consumption.
• The major determinants of consumption expenditure at individual and national
levels are:
 Money Income: The relationship between money income and consumption expenditure is
positive and direct. The increase in income results in an increase of consumption expenditure.
This principle also acts inversely.
 Distribution of Income: Consumption expenditure per unit of income is more for
poor people than rich people. Unequal distribution of a nation’s income reduces
consumption expenditure, and equality in distribution of income increases it
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• Level of Direct Taxes: A higher level of direct taxes leads to a lower level of
personal disposable income, and thus to a decrease in consumption expenditure.
This principle also acts inversely.
• Expectation of the Future: If prices are expected to rise in the future, present
consumption will be more. This principle also acts inversely.
• Rate of Interest: Increases in the rate of interest lead to a reduction of
consumption expenditure and an increase in saving. This principle also acts
inversely.
• Level of Wealth: A higher wealth level leads to higher consumption expenditure.
This principle also acts inversely.

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• Consumption Function
• Consumption function is one of the most important tools in macroeconomics. It
shows the relationship between level of consumption and level of income. The
consumption function is also known as propensity to consume.
• The consumption function indicates how consumption responds to different levels
of income. The functional relationship between consumption and income is
generally expressed as:
• C = f (Yd) Where C = consumption expenditure, and
Yd = personal disposable income
• C = a + bYd, where a is autonomous consumption, b is percentage of income for
consumption, and bYd is induced consumption.
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• Example: Consider a consumer with a consumption function given by
• C = 110 + 0.75Yd, and disposable income of Birr 4,800. Calculate the consumer’s:
• autonomous consumption
• induced consumption
• total consumption
• saving
• Solution: Given: Consumption function C = 110 + 0.75Yd Disposable income = 4,800
• Autonomous consumption is the level of consumption when income is zero.
Thus,
• Autonomous consumption = 110 + 0.75 × 0 = 110
• Induced consumption is = Total consumption - Autonomous consumption
• Induced consumption = 0.75 × 4,800 = 3,600 57
 • Total consumption = Autonomous consumption + Induced
consumption= 110 + 3,600 = 3,710
• Saving = Yd – C = 4,800 – 3,600 = 1,200
• S = Yd – bYd
• N.B, When income is zero, consumption is always positive (i.e., there is always
some minimum level of consumption even when income is zero).
• The relationships between consumption and income (propensity to consume) are
expressed in the following ways. The next sections describe their numerical
expressions.
• Average Propensity to Consume (APC)
• Marginal Propensity to Consume (MPC)
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• Average Propensity to Consume (APC)
• APC is the ratio of total consumption expenditure (C) to total income (Yd) at a
given level of income in an economy. Symbolically, AP=C /Yd
• For example, if at a particular time, the income level in an economy is Birr 250
million, and consumption is Birr 175 million,
• APC = C = 175/250 = 0.7 or 70% Yd
• This example indicates that 70% of income was spent by way of consumption
expenditure. But if aggregate income is very low — for example, Birr 50
million and if aggregate consumption is Birr 75 million, APC = 75/50 = 1.5.
• Thus the value of APC may be greater than 1, because when income is at a very
low level, consumption exceeds income to meet the very basic necessities.
(Then saving becomes negative).
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• Marginal Propensity to Consume (MPC)
• The ratio of change in consumption (ΔC) to change in income (ΔYd) is called marginal
propensity to consume. Literally, marginal means additional (or incremental) and
propensity to consume means desire (or urge) to consume.
• Thus MPC is the ratio of additional consumption expenditure to additional income.
• It indicates the proportion of the additional income that is spent on additional
consumption. Symbolically, MPC = ΔC/ ΔYd
• For example if a country’s national income increases from Birr 200 million to Birr 250
million, and as a result consumption expenditure goes up from Birr 150 million to Birr
175 million, then MPC = ΔC/ ΔYd = 25/50 = 0.50
• Note that, with an increase in income, consumption expenditure also increases.
(i.e., MPC > 0), but the entire increase in income is not spent on consumption (i.e., MPC

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 Properties of MPC
• The following are the main properties of MPC.
• MPC is greater than zero but less than one This is because, with an increase in
income, consumption expenditure also increases. But the entire increase in income
is not spent — part of it is saved. Thus,MPC > 0, but MPC < 1.
• MPC falls with increase in income As the community becomes richer, it tends to
consume a smaller percentage of each increment to its aggregate income.
• MPC of the poor class is higher than those of other classes: In the case of poor
people, most of their basic needs remain unfulfilled. As a result, an additional
increment to income leads to greater consumption. MPC is stable in the short run:
This is because it depends upon psychological factors that do not change in the
short run. 61
 SAVING
• The part of income which is not spent on consumption is called savings. This is because
income is either consumed or saved. Thus, we may say ‘Savings is an excess of income
over consumption expenditure’. By deducting consumption expenditure (C) from income
(Yd), we get savings (S). Symbolically: S = Yd – C
• Note the following points in the context of saving:
• Just like consumption, saving depends directly upon income.
• As income increases, savings also increase, but the rate of increase in savings is more than
the rate of increase in income. This means that as income increases, the proportion of
income saved increases (and the proportion of income consumed decreases).
• At low income levels, savings is negative. In other words, when there is no income or a
very low level of income, consumption expenditure is more than income, leading to
negative saving (i.e., dissaving).
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• Determinants of Saving
The major determinants of saving at the individual and national levels are:
1. Level of Income: As stated above, as income increases, saving also increases. But the rate of increase in
saving is higher than the rate of increase in income. This is because, with an increase in income,
consumption increases but by less than the increase in income.
2. Distribution of Income: Saving increases when income inequality increases. This is because the tendency
to save is greater for rich people than poor people.
3. Expectation for Future : If prices are expected to fall in the future, present consumption is less, and
hence saving is more. This principle also acts inversely. Similarly, an expected future increase in income,
reduces present saving, and the inverse.
4 . Rate of Interest: A higher rate of interest induces greater saving. This principle also acts inversely.
5. Level of Wealth: A lower wealth level leads to a lower saving level. This principle also acts inversely.
6. Level of Direct Taxes: A higher level of direct taxes produces a lower level of personal disposable
income and hence reduced savings. This principle also acts inversely.
7. Individual Nature: Saving is directly related to the nature of the individual. For example, a miser saves
more than a spendthrift. 63
• Saving Function
• The functional relationship between saving and income is called saving function (or propensity to
save). The saving function is the proportion of income which is saved.
• Thus saving (S) is a function (f) of income (Yd). Symbolically: S = f (Yd) or S = Yd -C
• The saving function shows the tendency of households to save at given levels of income. Thus, the
saving function is a corollary or reciprocal of the consumption function.
• As in the case of the consumption function, the relationships between saving and income (propensity
to save) are expressed in the following ways. The next sections present their numerical expressions.
• Average Propensity to Save (APS)
• Marginal Propensity to Save (MPS)
• Average Propensity to Save (APS)
• Average propensity to save is the ratio of total savings (S) to total income (Y). It is the part of total
income which is saved. Symbolically: APS = S/Yd
• For example, if income (Yd) is Birr 250 million and saving(s) is Birr 75 million,
• APS = S/Yd = 75 /250=0.3 or 30% 64
• Marginal Propensity to Save (MPS)
• It is the ratio of the change in saving (ΔS) to the change in income (ΔYd).
• SymbolicallyMPS = ΔS /ΔYd
• For example, if a country’s national income increases from Birr 200 million to Birr 250 million,
and saving increases from Birr 50 million to Birr 75 million, then MPS = ΔS /ΔYd =25/50= 0.50
• INVESTMENT
• In economics, the meaning of investment is quite different from its common use by an ordinary
person who speaks of ‘investing’ when he or she purchases a piece of land, an old house, securities,
debentures, etc. In economic analysis, these transactions are simply the transfer of ownership rights
from one person to the other and, as such, result in no increase in income and employment.
• In economics, investment means an addition, during a predefined ‘current period to national
resources such as: existing stock of physical (or real) assets for example, the building of new
factories, new machines or equipment;existing stock of finished goods or raw materials.
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• Investment can be induced as well as autonomous.
• Induced Investment
• Induced investment is investment which is made with the motive of
earning a profit as in the private sector. Induced investment depends
directly upon profit expectations. It is income-elastic. If national
income goes up, induced investment also goes up – an increase in
income induces investment. This occurs because an increase in
national income leads to an increase in the demand for goods and
services, which increases investor interest in meeting that demand, and
therefore leads to investment. Thus, we can say that induced
investment takes place when levels of income and demand in the
economy go up. 66
 • Autonomous Investment
• Autonomous investment refers to investment which is made irrespective
of income level. This approach is generally taken in the government
sector. Autonomous investment is income inelastic – it is not affected by
changes in income level
• Remark: Any investment made for the purpose of compensating for
depreciation caused by production in a current year is not real investment.
Rather, it is what is sometimes known as replacement investment.

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END OF INTRODUCTION TO
ECONOMICS COURSE

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