MACROECONOMICS

ECON2031/1061
OUTLINE
Digression
• Why Economics
• Choice opportunity cost
• Method
• Agents who act in the economy
• Economic system
• Branch
• What Macroeconomics is about?
• Goals and Instruments of Macroeconomic Policy
• Schools of Thought in Macroeconomics
The subject matter of economics:
 Economics is one of the most exciting disciplines in social
sciences. There are two facts that provide the foundation for
the field of economics:
 Human or society’s material wants are unlimited and

 Economic resources are scarce or limited in supply

 Economics is a social science, which studies how societies

allocate scarce resources in the production, distribution,

exchange and consumption of goods and services so as to
attain the maximum fulfillment of society’s material wants.
 Why We Study Economics?

The knowledge of economics is important in;

• Wisely allocating scarce resources to satisfy the unlimited
human wants
• Efficiently managing your business , since it deals about price
,cost ,profit ,market, production, saving ,investment etc
• A better understanding of the economic problems of
societies ,such as rising unemployment, inflation, budget
deficit, external debt, economic growth etc
• Formulating different policies.
 Stakeholders in Economics
The economy is made up of four sectors sometimes called
economic agents:

I. Households: -
They are owners of resources (land, labor, capital and entrepreneurship)

They make decisions on how to sell their resources to firms and governments.

They make decisions on what and how much of the commodities they can buy from

business firms.

II. Business firms: -

a production unit that uses resources to produce goods and services

They make decision on buying resources from households.

They make decision on selling their products to households and

governments.
Cont’d…

III. Government (also known as the public or state sector):

organization that has a legal and political power to exert control over
individuals, business firms and markets.

Provides social services such as defense, education, public health and

infrastructural facilities.

Tax from households and business firms is the main source of

government revenue.

IV. International/ the Foreign Sector: These flows include

exports, imports, and borrowing from other countries
Cont’d…
Figure: Decision making units and circular flow of economic activities
Scope of Economics:

 Taking the scope of the subject matter, economics can be

divided into two main branches:-microeconomics and
macroeconomics.
 Thus, economics is divided into macroeconomics and
microeconomics largely for the sake of pedagogical
clarity: We can’t teach you everything at once.
i. Microeconomics studies the economic behaviour of individual
economic decision makers (consumers, firms, workers, individual
households, managers...)
 It studies the behavior of economic agents (consumers, firms and

government) and variables (prices, quantities and the like) at a

disaggregated level.
 It is concerned with the decisions taken by individual consumers

and firms
 It address questions like how does a particular person or
household maximize satisfaction, how does a particular firm
maximize profit?
Examples
 How much a consumer is willing and able to offer for a

kilo of sugar?
 How will cigarette industry be affected by the new

government tax increment?

 How price of teff is determined? Etc…..
ii. Macroeconomics analyses how an entire ‘economy’ or
economic system performs, on a national, regional or
global level.
 It is the study of behavior of the economy as a whole.
 It deals with magnitudes such as the total output level in
an economy, national income of a country, the overall
level of prices of goods and services, total employment
in the economy, economic growth, trade balance and
balance of payments, foreign economic relations, fiscal
and monetary policies of the government etc.
 It does not deal with single household, firm, or industry.
 Macro economics examines the economy as a whole and
concerned with the combined or aggregate effects of
choices/decisions of economic agents at economy or macro
level.
Example:
 Is there a rise in general price level in the economy?
 What is the unemployment rate of the economy?
 What is the total output of the Ethiopia in 2022? (GDP)
 Etc…
 How do the two branches of the discipline differ?

In microeconomics:
 The focus is on the decisions of individual units, no

matter how large the unit is.

 The spotlight is on how individual decision-making

units like dairy farmer and consumer behave.

 We generally ignore inflation, unemployment, and

growth, focusing instead on how individual markets

allocate resources and distribute income.
In macroeconomics:
 The concentrates is on the behavior of entire
economies, no matter how small the economies is.
 We study the overall price level, unemployment rate,
and other things that we call economic aggregates like
total output, aggregate price level, employment and
unemployment, interest rates, wage rates and foreign
exchange rates and how the variables are change over
time.
Macroeconomics tries to address diverse
questions such as:
 Why is average income high in some countries
while it is low in others?
 What causes long run and short run economic
fluctuations?
 What causes inflation?
 Why is the unemployment rate sometimes high and
sometimes low?
 Why do some national economies grow faster than
other national economies?
 How do changes in the money supply, government
spending and taxes affect the economy?
Focus areas of macroeconomics
 Macroeconomics is a policy-oriented part of

economics which deals with central issues like

• economic growth,
• inflation,
• unemployment, and
• open economy market policies
 Major policy used in macro-economics:
 fiscal,
 monetary, and
 trade policy instruments.
 Macroeconomics is concerned with the behavior of
the economy as a whole
• Macroeconomics: is the study of the behavior of the
economy as a whole & the policy measures that the
government uses to influence it.
• It is concerned with:
 The economy’s total output of goods & services
and the growth of output,
 Booms & recessions,
 The rates of inflation and unemployment,
 Balance of payments & exchange rates.
 In macroeconomics, we do two things:
1. we seek to understand the economic functioning of
the world we live in; and
2. we ask if we can do anything to improve the
performance of the economy.
 That is, we are concerned with both explanation and
policy prescriptions.
 Macroeconomics makes use of:
 algebraic & geometric tools of analysis like
differentiation & graphs;
 models like AD-AS model & IS-LM model.
1.2 Goals and Instruments of Macroeconomic Policy

1.2.1. Goals of macroeconomic policy

 Economists evaluate the success of an
economy’s overall performance by how well it
attains the following listed macroeconomic
policy goals.
i. a high and growing level of national output,
ii. low unemployment and high employment
iii. Price-level stability (or lower inflation).
iv. Foreign economic relations marked by a
stable foreign exchange rate and export more
or less balancing imports.
1.2.2. Instruments of macroeconomic policy
 Today, there are numerous instruments with which

the government can steer the economy. Policy

instruments are the economic variables under the
control of government that can affect one or more
of the macroeconomic goals.
 A nation has two major kinds of policies that can

be used to pursue its macroeconomic goals: fiscal

policy and monetary policy.
i. Fiscal policy: Consists of government
expenditure and taxation.
A. Government expenditure influences the relative
size of collective spending and private
consumption. It comes in to two distinct forms.
• As government purchases: which comprise

spending on goods and services purchased by

government.
• As government transfer payments: which boost

the incomes of target groups such as the elderly

or the unemployed so as to sustain their life.
B. The other part of fiscal policy is taxation. It affects the
overall economy in two ways.
 First, it affects people’s incomes. By leaving

households with more or less disposable income.

 Second taxation affects the price of goods and factors

of production and thereby affects incentives and

behavior
 Conducted by the MOFED
 Monetary policy,
ii.

 Determines the money supply and financial conditions.

 It is conducted through managing the nation’s money, credit, and

banking system.
 Conducted by the central bank,

 By changing the money supply, the central bank can influence many

financial and economic variables.

For instance,
 Restricting the money supply leads to higher interest rates and

reduced investment, which, in turn, causes a decline in GDP and

lower inflation.
 If the central bank is faced with a business downturn, it can increase

money supply and lower interest rates to stimulate economic

activity.
1.3. The School of Thoughts in Macroeconomics

 Economists vary considerably regarding their view

of how macroeconomic variables change over time.
Hence, economists are often divided on how they
view an economy reacting to any given shock.
 Thus, there are many different schools of thought
that are distinguished by which shocks they choose
to emphasize and/or in their explanation of how the
economy reacts to any given shock.
Major school of thoughts:
 Classical 1776 – 1870.
 Keynesian 1936 – 1960s.
 New Classical 1970s
 Monetarists 1970s
 1980s – present. There is no dominant school of
thought of macroeconomics.
 Prior to great depression (1930), macroeconomics did not
emerge as distinct discipline of economics. Nonetheless,
under various thought macroeconomic issue had been
raised (the classical school and neoclassical school).
 Following the great depression, modern macroeconomics
emerged with the writings of John Maynard Keynes
(1936), the General theory of unemployment, interest and
money.
 C
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1930

Ke
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1960

Mo
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RECENT DEVELOPMENTS

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1970 1980

New Class
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New Keyne als
G ro sian
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Th e
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THE STATE OF MACROECONOMICS: EVOLUTION &
Two Basic Questions & Two Broad Answers in
Macroeconomics
1) Can Governments influence the Economy?
No Yes
Classicals & Keynesians
Neo-Classicals Monetarists (?)
New Keynesians
2) Should Governments Intervene?
No Yes
Classicals & Neoclassicals Keynesians
Monetarists
New Classicals (?) New Keynesians
 Classical & Neo-classical Macroeconomics
Names of some economists in this group: Adam Smith (1723-1790), David Hume

(1711-1776), David Ricardo (1772-1823), John Stuart Mill (1806-1873), Knut

Wicksell (1851-1926), Irving Fisher (1867-1947).

Classical 1776 -1870. In this period the distinction between micro and macro was not

clear. The ruling principle was the invisible hands lead the market (i.e. coined by

Alfred Marshall). The classical have made an ample contribution to the

development of economic science.

With regard to the labor market, they contend that labor demand and labor supply

are brought into equilibrium by the real wage. As a result there is no involuntary

unemployment.

With regard to the financial market, for classical saving and investment are brought

into equilibrium by the interest rate and investment respond to the interest rate.
 Basic Assumptions:
 Flexible wages and prices.
 Supply creates its own demand, Say’s Law.
 Forward-looking economic agents with perfect
foresight(optimistic).
 The price level is proportional to the money stock in the
long run.
Main argument:
 No need for government intervention as the economy has a
self-correction mechanism.
 Inflation is caused by excessive growth in money stock.
 No distinction b/n macro- & micro-economics.
Cont’d…
In the money market, money demand is simply a transaction demand and
money has no any effect on the real economy and hence raising the money
supply simply pushes up prices (i.e. inflationary).

The implication is that, government has no any role in the economy

through its monetary policy. To this end, the classical are the proponents of
laissez-faire (no government role). In general, for this school markets (be
it, commodity, factor, and money) works best if left to themselves.
 Keynesian Macroeconomics

Names of some economists in this group: too many interpreters to mention

The rise of Keynesian economics created a place for macroeconomics as a

second main branch of economic theory.

The Great Depression, of course, had a dramatic effect upon thought about such
matters. The birth of modern macroeconomics can be traced back to 1930s, and
in particular the publication of John Maynard Keynes’ (1936) his book General
Theory of Employment, Interest and Money had a profound intellectual impact,
essentially creating the subject of macroeconomics as it is now understood.

Prior to 1930 view of macroeconomics is the classical approach the market

mechanism operate quickly and efficiently to restore full employment
equilibrium.
 The birth of modern macroeconomics is linked to the
Great Depression (period of high unemp’t & stagnant
production) & Keynes.
 The market adjustment concept of classicals &
neoclassicals didn’t work during 1929-1933.
 Basic Assumptions:
 Economy alone is unstable due to shifts in AD.
 Nominal wages & prices are inflexible, esp.
downwards.
 Large multiplier effect for changes in government
spending & tax rates to create demand.
 Keynes emphasized on creating “effective demand” or
AD, and proposed expansionary policies(G or T).
Cont’d…

Neo-classical 1870 - 1936. The main distinction is the tool of

analysis, such as the marginal analysis. Pick best elements of
Classical and Keynesian approaches
Economy is “Keynesian” in the short run but “Classical” in the long
run.

Long-run AS curve vertical, short-run AS curve upward sloping

nominal wage,W, sticky downward in the short run

expected price level, Pe, sticky in the short run (adaptive expectations)

Both monetary and fiscal policy can affect the economy

 1.2 THE STATE OF MACROECONOMICS:
EVOLUTION & RECENT DEVELOPMENTS

These Policies are fiscal & monetary:

1. Increasing government expenditure (G):
G  AD  Y (production).
Y (output/income)  C (Consumption) 
AD  Y ... – the multiplier effect.

2. Increasing money supply (M):

M  r (interest rate)  I (investment) 
AD  Y ... – the multiplier effect.

 Keynes preferred fiscal policy to monetary policy.

 Keynes focused primarily on short-term: cure for
immediate problem almost regardless of long-term
results of the cure b/c in the long run we all are dead!
 But, An AD:
 (given supply) may  inflation, and
 may  long-term growth rate (by ring
saving/investment if firms/people decide not to
accumulate wealth in fear of future increase in
taxes). With lower long-term growth rate, the
economy would create fewer jobs & thus unemp’t
rate would rise.
 For Keynesians, inflation can be controlled with
contractionary fiscal or monetary policy.
1.2.3 Monetarists
 Strongly debated against the Keynesians on:
 the ability of government to improve the operation of the
economy;
 the relative importance of fiscal & monetary policy;
 the tradeoff between inflation & unemp’t (the Phillips Curve) –
problem of stagflation (= stagnation + inflation).
 Expansionary fiscal policy, with monetary authority raising M
growth, leads to inflation.
 Fiscal policy affects the mix b/n private & government use of
resources so fiscal policy is insignificant or has no multiplier effect.
 Monetary policy is very powerful & changes in M explain
most fluctuations in output.
The Great Depression resulted from major mistake in
monetary policy.
 Because of uncertainty in the position of the economy & lags
in policy effects, policy measures may do more harm than
good things.
 Though an economy can be unstable in the short-run, it has a
good self-correcting mechanism in the long run.
 Inflation is chiefly a monetary phenomenon .
1.2.4 New Classicals
 In the 1970s, the debate on active policy brought to the fore new
groups – new classicals & new Keynesians.
 New classicals attached great importance to the role of
expectation in influencing macro-economic equilibrium.
 They introduced macroeconomic analysis from micro
foundations.
 Expansionary fiscal policy tends to increase inflationary
expectations, shifting AS, causing real GDP to fall & the price
level to rise.
 Many of them supported supply-side policies meant to raise
growth rate of potential GDP.
 Their central working assumptions are:
 forward looking economic agents with rational
expectations.
 Markets clear via market forces.
 AS is responsive to changes in expectations about
inflation.
 Incentives to produce, work & save are affected
by government policies which influence marginal
tax rates and subsidize households and businesses.
 The self-correction mechanism is based on shifts in
AS caused by changes in expectations of inflation.
1.2.5 New Keynesians

 They gave attention to micro foundation like Keynesian

thoughts.
 Markets sometimes do not clear even when individuals are
rationally looking out for their own interests.
 Emphasize imperfections in various markets (labor, credit,
product).
 Information problems & costs of changing prices may lead
to price rigidities, causing macroeconomic fluctuations in
output & emp’t.
Conclusion:
 Much is to be learned from the insights of all these
schools of macroeconomics, and each has contributed
to our understanding of the way the economy works.
 However, there is no single school that best describes
how an economy operates.
 The majority of economists now agree that:
 Stabilization policies are likely to influence incentives
of households & firms,
 Long-term growth (in real GDP), resulting from capital
accumulation & technological progress, is the key to
raise living standards.
 Changes in AD affect output (at least) in the short run.
 Some of the disagreements involve:
 The length of the “short run,” the period of time over which AD
affects output is not fixed.
 The role of policy.
• Those who believe that output returns quickly to the natural
level advocate the use of tight rules on both fiscal & monetary
policy.
• Those who believe that the adjustment is slow prefer more
flexible stabilization policies.