Debre Markos University Burie Campus

Department of Economics
Macroeconomics
 UNIT ONE
INTRODUCTION TO- MACROECONMICS
 Macroeconomics is a branch of economics that deals with economic
aggregates like national income, employment, aggregate consumption,
savings and investment, general price level, and balance of payments position.
 Macroeconomics is the study of the behavior of an economy as a whole. It is
an applied science. Moreover, macroeconomics is concerned with the
behavior of the economy as a whole with booms and recessions.
 Macroeconomics is a policy-oriented part of economics. The subject matter of
macroeconomics includes factors that determine both the level of
macroeconomic variables such as: total output, aggregate price level,
employment and unemployment, interest rates, wage rates, foreign exchange
rates, etc., and how the variables change over time.
 At all ,Macroeconomics is concerned with the study of performance of
national economy rather than that of households and firms.
…………
The role of making economic policy falls to leaders, but the job of
explaining how the economy as a whole works falls to
macroeconomists.
Macroeconomists collect data on different variables from different
time periods and different countries. They, then, attempt to formulate
general theories that help to explain these data. In macroeconomics, we
do two things:
First, we seek to understand the economic functioning of the world we
live in; and,
Second, 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.
…………
Concepts and Definition of Macroeconomics
• Macroeconomics is the study of aggregate economic behaviors. In
macroeconomics, we analyze the principal determinants of an economy’s
level of income, general price level and growth of income.
• This can be contrasted to microeconomics, where the behavior of the
individual units is analyzed.
• National economic behavior (for that matter behavior of an economy as
whole) is expressed or described by the following factors
 Booms and recessions
 The economy’s total volume output of goods and services
 Growth of output
………
 Inflation / deflation (raise or fall in general price level)
 Unemployment (national level or rate),
 The balance of payment (balance of foreign exchange paid and/or
received),
 Exchange rates (e.g. Birr per dollar),
 National debt (especially, loans from foreign countries),
 Trade balance (the difference between total export and total import)
 Other economic variables which are measured at national level.
…………
 Moreover, macroeconomics focuses on the economic behavior and
policies that affect consumption and investment, determinants of
changes in wages and prices, monetary policies and fiscal policies (such
as taxation, the money stock, government budget, interest rate, etc).

• It deals with both long-run economic growth and the short run
fluctuations which are constituents of the business cycle.

• In brief it deals with major economic issues and problems and therein
possible solutions. For instance, during high unemployment the policies
aim at reducing unemployment rate.
………

• During high inflation it tries to stabilize price level. During trade deficit,
it tries to find the means through which export can be expanded etc. In
Ethiopia, most of these macroeconomic elements are controlled by two
major offices: Ministry of Finance and Economic Development
(MoFED) and National Bank of Ethiopia (NBE).
• The explanation involves and attempts to understand the behavior of
economic variables, both at that particular time and after some point of
time.
• Modern macroeconomics recognizes that it is important to focus on more
than just short period of time, and so has an explicitly dynamic focus.
• We would also try to explain the behavior of economic variable over
time.
…..
• This means that we need to explain the behavior of the economy both
in the long run and in the short run. Short-run generally refers to a time
period of less than a year. Long run refers to a time period of more than
one year.
• Once we understand about the explanation of short run and long run
behavior of national economic variables such unemployment rate,
inflation rate and contraction in aggregate demand (or total demand at
national level), it is easy for the policy makers to prescribe policy to
achieve various macroeconomic goals.
• Any action or measures that are undertaken by policy makers without
having proper knowledge about the consequences of the action may
only worsen the problem.
Major Elements of Macroeconomics

Elements of National Economy

• Some of the most important concepts that macroeconomics deals with Gross
National Product (GNP) or Gross Domestic Product (GDP), Government
Expenditure, Total money supply or currency in circulation, Inflation, Balance
of Payment (BoP), Current Account Balance (CA), Trade Balance, Exchange
rate, and so on.
• These and other related concepts will be briefly explained in the following
paragraphs.
• Gross Domestic Product (GDP) is the sum of values of total goods and
services produced in a given country in a given period of time (a year).
• This can be obtained by aggregating the values of goods and services
produced in different sectors of the economy.
…………
.Government expenditure is the number of resources that the government
sector of a country spends in a given fiscal year (budget year).

• This expenditure includes both consumption expenditure and investment

expenditure in such activities as construction of roads, schools, clinics and
hospitals, water supply, electrification and others.

• Government consumption includes expenditure on non-durable goods in

government offices and expenditure on national defense. The major source of
finance of the government expenditure is taxation.
……

.Total money supply is the sum of total currencies in circulation. The

amount or size of money supply is controlled to the appropriate level by
Central Bank (Federal Bank) of the country.
• In Ethiopia this is the duty of the National Bank of Ethiopia (NBE).
National Bank or Central Bank uses different instruments in controlling
money supply.
.Inflation represents a rise in general price level. During inflation prices
of all goods and services become high. As a result of this the purchasing
power of money (or value of Currency) decreases. For instance, 100 Birr
can not purchase what it used to purchase before inflation. There are
several factors that lead to inflation such as excess money supply or less
production.
 ……
• Trade Balance is the net inflow of foreign exchange from trade (export and
import). It is the value of net export of a country. It is measured by the
difference between export from and import into a country; i. e. total export
value (X) minus total import value (M).
• A positive value of this term/variable shows surplus balance of trade
indicating good performance of that country.
• Current Account Balance (CA) is the net inflow of resource from trade,
services and unrepeated transfer. In addition to import and export items, the
current account includes the flow of payment to factors (labour, capital, land
etc.) such as dividends, profits and wage as well as payments to non-services
such as shipping, banks and tourism; and unrepeated transfers such as
remittance from abroad
………
• Balance of Payment (BoP) is the net of inflow of resources to a given
country/economy from the rest of the world. This includes the flow of all
resources. It does not refer to flow of resources only from trade services.
• In addition to the current account balance, the balance of payment (BoP)
includes the flow of resources from foreign investment, borrowings from the
rest of the world (short term, medium term, and long term), and repayments of
such borrowings.
• Exchange rate refers to the rate at which domestic currency is exchanged for
foreign currency. For instance, in Ethiopia, about 2.07 Birr used to be
exchanged for one dollar during the Imperial and Dergue periods.
………
• But under the new government the exchange rate is changed to 5 Birr per one
US dollar and then to about 28.4 Birr per one US dollar recently around
130.80 Birr per one US dollar currently.
• In other words, birr is losing its value against dollar. The reason for this could
be due to devaluation or currency depreciation of domestic currency.
• There are several determinants of the exchange rate of a country some of
these are the level of development, capacity of the export sectors, demand for
foreign exchange, supply of foreign exchange, natural calamites etc.
Macroeconomic Policy: Objectives and Instruments
1. Macroeconomic Policy Objectives:
……….
The macroeconomic policy objectives are the following:
[Link] Full employment,
2. Price stability
[Link] growth,
[Link] of payments equilibrium
5. exchange rate stability, and Social objectives
Full employment:
 Performance of any government is judged in terms of goals of achieving full
employment and price stability. These two may be called the key indicators of
health of an economy.
 In other words, modern governments aim at reducing both unemployment
and inflation rates
……
• Unemployment refers to involuntary idleness of mainly labor force and
other productive resources. Unemployment (of labor) is closely related
to the economy’s aggregate output.
• Higher the unemployment rate, greater the divergence between actual
aggregate output (or GNP/CDP) and potential output. So, one of the
objectives of macroeconomic policy is to ensure full employment.
• The objective of full employment became uppermost amongst the
policymakers in the era of Great Depression when unemployment rate in
all the countries except the socialist country, the USSR, rose to a great
height. It may be noted here that a free enterprise capitalist economy
always exhibits full employment.
……..
• But, Keynes said that the goal of full employment may be a desirable one but
impossible to achieve. Full employment, thus, does not mean that nobody is
unemployed
• The goal for high employment should therefore be not to seek an
unemployment level of zero, but rather a level of above zero consistent with
full employment at which the demand for labor equals the supply of labor.
This level is called the natural rate of unemployment.”
Price stability:
• No longer the attainment of full employment is considered as a
macroeconomic goal. The emphasis has shifted to price stability. By price
stability we must not mean an unchanging price level over time.
………
• price increase is unwelcome, particularly if it is restricted within a
reasonable limit. In other words, price fluctuations of a larger degree
are always unwelcome.
• However, it is difficult again to define the permissible or reasonable
rate of inflation. But sustained increase in price level as well as a
falling price level produce destabilizing effects on the economy.
• Therefore, one of the objectives of macroeconomic policy is to
ensure (relative) price level stability. This goal prevents not only
economic fluctuations but also helps in the attainment of a steady
growth of an economy.
………..
Economic growth:
• Economic growth in a market economy is never steady. These
economies experience ups and downs in their performance. This
objective became uppermost in the period following the World War II
(1939-45).
• Economists call such ups and downs in the economic performance as
trade cycle/business cycle. In the short run such fluctuations may
exhibit depressions or prosperity (boom).
• One of the important benchmarks to measure the performance of an
economy is the rate of increase in output over a period of time. There
are three major’ sources of economic growth, viz.
………..
(i) the growth of the labor force, (ii) capital formation, and (iii)
technological progress. A country seeks to achieve higher economic
growth over a long period so that the standards of living or the
quality of life of people, on an average, improve
Balance of payments equilibrium and exchange rate stability:
• From a macro- economic point of view, one can show that an
international transaction differs from domestic transaction in terms
of (foreign) currency exchange.
• Over a period of time, all countries aim at balanced flow of goods,
services and assets into and out of the country. Whenever this
happens, total international monetary reserves are viewed as stable.
……..
Social objectives
 Macroeconomic policy is also used to attain some social ends or
social welfare. This means that income distribution needs to be
fairer and more equitable.
 In a capitalist market-based society some people get more than
others. In order to ensure social justice, policymakers use
macroeconomic policy instruments.
Macroeconomic Policy Instruments:
There are three instruments of macroeconomic policy
 Fiscal policy
 Monetary policy
 Income policy
 Fiscal policy is a policy that used to change government expenditure
and tax to achieve some objectives by expansionary and contractionary
fiscal policy.
• Monetary policy is a policy that used to change money supply in order
to achieve a certain goals by using open market operation, discount rate,
and reserve required ratio through national bank.
• Income policy is a set of rule and regulations which used by government
through using wage and price.
State of Macroeconomics: Evolution and Recent Developments
 Economic thinking has begun since the birth of human being. This is
because archeological excavations evidenced that our ancestors were
having some economic thinking such as saving due to scarcity of
resources and division of labor even when gathering and hunting were
their means of survival.
………..
• Further studies made in ancient civilizations of Egypt, Babylon,
Persia, Axum, China, India, Byzantine, Greek, and Rome confirms
that trade and tax were the sources of their civilization.
• The above findings, therefore, attest that people make economic
decision since birth at different age levels (child, youth, adult, and
old) to death whether knowingly or unknowingly.
• Available document, however, suggest that formal study on
economic issues was started around 2 century AD in ancient Greek
philosophy/wisdom.
• This implies that economics is an old science like Art, literature,
Astronomy, Mathematics, Physics, Medicine, and the like.
………
• Plato and Aristotle were the two prominent ancient Greek philosophers
who produced enormous economic articles on economics that served as
foundation/basis for further studies and advancement of economics.
• However, the studies of scholars conducted on economic issues and
theories developed up to the industrial revolution of the 18th century
focus only on microeconomic issues.
• Macroeconomics as a branch of economics was emerged some 230
years back with the writing of Adam Smith “The wealth of Nations” in
1776.
• The evolution of macroeconomics from 1776 to date is discussed briefly
in the section that follows.
• As an arbitrary dichotomization, its historical evolution is divided into
two broad categories, namely the orthodox and recent/contemporary
macroeconomics schools
The orthodox macroeconomics (1776-1975):

• This includes macroeconomics thinking of schools of thought evolved

between 1776 and 1975.
• The three schools of thought categorized under the orthodox
macroeconomics school are the classical school of thought, the neo-
classical school of thought, and the Keynesian macroeconomics.
A. The classical school of thought (1776 - 1870).
• During the period of classicalism, the distinction between micro and
macro was not very clear. The focus was on micro economy only.
They believed that by maximizing individuals’ wealth one can
maximize country’s wealth.
• This idea was based on the assumptions that individuals are rational
and markets are efficient. The ruling principle was the invisible hand
coined by Adam Smith.
……….
 During this time there was no government intervention in
economic activities. Because economists of the time i.e. classical
economists believed that the market is efficient and works the best
by itself and there is no need of government intervention (Lassez-
fair economy).
• Classical and neo-classical ideas are also now days applied under
different circumstances. The classical ideas are highly influenced
by the work of J.B. Say a French classical economist.
• His work is popularly known as Say’s law of market which is a
well known.
Say’s Law
………..
• The classical economists also accepted Say's Law of Markets
propounded by the French economist Jean Baptiste Say. Say's Law
holds that every supply creates its own demand and hence there
cannot be general over production in the economy.
• He believed that the total supply of products and the total demand for
them must be equal. He agreed that there may be temporarily
overproduction due to inefficient application of the means of
production.
• This over production will soon be corrected by supplier once they
know that there is no demand for the over production.
• He has deduced three conclusions from his law of markets. First,
higher number of markets and its coverage helps in increasing the
demand and a rise in price.
• Secondly, each class is interested in the prosperity of the other.
………
• He believed that agriculture, manufactures and commerce all grow
together.
• Lastly, imports are good for the home country and it does not harm the
home industry.
Implications of the Classical Model or thought
• We can sum up the important implications of the Classical model as
follows:
Money supply changes have no effect on current output, and it only
affect the price level.
Changes in government expenditure have no effect on current output
and only affect the interest rate, and the amount of investment and
consumption undertaken.
Changes in the overall level of taxation do not affect current output
B. The neo-classical school of thought (1870-1936).

• As expressed by E. Roy Weintraub, neoclassical economics rests on

three assumptions, although certain branches of neoclassical theory may
have different approaches:
• People have rational preferences among outcomes that can be identified
and associated with a value.
• Individuals maximize utility and firms maximize profits.
• People act independently on the basis of full and relevant information.
• From these three assumptions, neoclassical economists have built a
structure to understand the allocation of scarce resources among
alternative ends—in fact understanding such allocation is often
considered the definition of economics to neoclassical theorists.
……….
• The idea of marginalism and maximizing marginal utility is attributed
to the neoclassical school, as well as the notion that economic agents
act on the basis of rational expectations.
• Since neoclassical economists believe the market is always in
equilibrium, macroeconomics focuses on the growth of supply factors
and the influence of money supply on price levels.
• The idea of this school of thought was not different from the
classical.
……..

• C. The Keynesian macroeconomics (1936-1975).

• An American economist called Keynes challenged/criticized the
classical wisdoms of macroeconomics based on the events or episodes
during the great economic depression of the early 1930s (1929 to
1935).
• The great depression was caused by excessive or overproduction wheat
and coffee.; implying supply fails to create its demand as argued by the
classical.
• Keynesians focus on aggregate demand as the principal factor in issues
like unemployment and the business cycle.
• Keynesian economists believe that the business cycle can be managed
by active government intervention through fiscal policy (spending more
in recessions to stimulate demand) and monetary policy (stimulating
demand with lower rates).
……….

Keynesians and their Economic Policy

• Keynesian’s economic theory is also known as ‘Theory of
Recession’ since it was developed following the event of the
1933 world economic crises/recession extended to depression,
the Great Depression.
• In a very simplified form, we can present Keynes’s theory of
recessions. Imagine an economy is operating at full
employment level where there is smooth functioning of ‘real’
economy with a smooth financial flows as firms earn money
from their sales and pay out their earnings in wages and
dividends, and household spend these receipts on new
purchases from the firms.
……….

• However, now suppose that for some reasons each household and
firm in this economy decides to hold a little more cash by postponing
their purchase.
• This brings to a situation where demand is less than the supply of
goods and services.
• Keynes argued that in this case businessmen lose confidence
thinking that potential investments might not give adequate returns.
• As a result, investment falls and output also falls below the normal
level. Either way, each individual firm or household tries to increase
its holdings of cash by cutting its spending so that its receipts exceed
its outlays.
…….
• As Keynes points out, however, works for an individual does
not work for the economy as a whole, because the amount of
cash in the economy is fixed.
• According to him, a individual can increase her/his cash
holding by spending less, but does this only by taking away
cash that other people had been holding.
• Obviously, not everybody can do this at the same time. Then,
what happens when everyone tries to accumulate cash
simultaneously?
The answer is that income falls along with spending. I try to
accumulate cash by reducing my purchases from you, and you
try to accumulate cash by reducing your purchases from me; the
result is that both of our incomes fall along with our spending
and neither of us succeeds in increasing our cash holdings
• If we remain determined to hold more cash, we will react to this
disappointment by cutting our spending still further, with the same
disappointing result.
• Looking at the economy as a whole, you will see factories closing,
workers laid off, stores becoming empty, as firms and households
throughout the economy cutting back on spending in a collectively vain
effort to accumulate more cash.
• The process only reaches a limit when incomes are so shrunken that the
demand for cash falls to equal the available supply.
• For Keynes to deal with recessions, the first and the most obvious thing
to do is to make it possible for people to satisfy their demand for more
cash without cutting their spending, thereby preventing the downward
spiral of shrinking spending and shrinking income.
……..
• The simplest way to do this is by increasing government spending or by
increasing the supply of money.
• Therefore, one of the fundamental Keynesian answers to recessions is
monetary expansion. But Keynes admitted that sometimes even this
might not be enough, particularly if a recession had been allowed to get
out of hand and become a true depression.
• Once the economy is deeply depressed, households and especially firms
may be unwilling to increase sending.
• No matter how much cash they have, they may simply add any
monetary expansion to their hoarding. Such a situation, in which
monetary policy has become ineffective, has come to be known as a
“liquidity trap”.
…….

• In such a case, the government has to do what the private sector will
not: spend. When monetary expansion is ineffective, fiscal expansion
must take its place.
• Such a fiscal expansion can break the vicious circle of low spending
and low incomes and help the economy to return back to its normal
path.
• In summary, Keynesians believed that the cause of the Great
Depression was due to a combination of events that led to great
uncertainty, huge decreases in investment, and economies being
stuck in an unemployment trap.
………
• The implications of the fundamental Keynesian thought are the
following
The economy is inherently unstable and is subject to erratic shocks.
The economy can take a long time to return to being close to full
equilibrium after being subjected to a shock.
Government intervention is necessary for the smooth function of the
economy.
Aggregate demand is the predominant determinant of output and
employment, and it can be altered by the authorities.
Fiscal policy is preferred to monetary policy for carrying out
stabilization policies
………
The access to Information about the economic variables is the key.
• Thus, Keynesian macroeconomic theory has provided the policy
makers a tool to intervene in the economy. In many countries
Keynesian ideas are still in use and government intervenes directly or
indirectly in the markets.
Differences between Classical & Keynesian Economics
• These schools take a different approach to the economic study of
monetary policy, consumer behavior and government spending.
• A few basic distinctions separate these two schools.
…………

Basic Theory
• Classical economic theory is rooted in the concept of a laissez-
faire economic market. A laissez- faire--also known as free--
market requires little to no government intervention.
• It also allows individuals to act according to their own self interest
regarding economic decisions. This ensures economic resources
are allocated according to the desires of individuals and businesses
in the marketplace.
• Classical economics uses the value theory to determine prices in
the economic market. An item value is determined based on
production output, technology and wages paid to produce the item.
……….
• Keynesian economic theory relies on spending and aggregate
demand to define the economic marketplace. Keynesian economists
believe the aggregate demand is often influenced by public and
private decisions.
• Public decisions represent government agencies and municipalities.
Private decisions include individuals and businesses in the
economic marketplace.
• Keynesian economic theory relies heavily on the fact that a nation’s
monetary policy can affect a company economy.
Government Spending
• Represents the more important parts of a nation economic growth.
• Too much government spending takes away valuable economic
resources needed by individuals and businesses
………
• Government spending is not a major force in a classical economic
theory. Classical economists believe that consumer spending and
business investment and involvement can retard a nation’s
economic growth by increasing the public sector and decreasing
the private sector.
• Keynesian economics relies on government spending to jumpstart
a nation’s economic growth during sluggish economic downturns.
Similar to classical economists, Keynesians believe the nation
economy is made up of consumer spending, business investment
and government spending.
• However, Keynesian theory dictates that government spending
can improve or take the place of economic growth in the absence
of consumer spending or business investment.
……….
Short vs. Long-term Effects
• Classical economics focuses on creating long-term solutions for
economic problems.
• The effects of inflation, government regulation and taxes can all play
an important part in developing classical economic theories.
• Classical economists also take into account the effects of other
current policies and how new economic theory will improve or
distort the free market environment.
• Keynesian economics often focuses on immediate results in
economic theories. Policies focus on the short-term needs and how
economic policies can make instant corrections to a nation economy.
………
• This is why government spending is such a key mechanism of
Keynesian economics.
• During economic recessions and depressions, individuals and
businesses do not usually have the resources for creating immediate
results through consumer spending or business investment.
• The government is seen as the only force to end these downturns
through monetary or fiscal policies providing instant economic
results.
Recent/contemporary macroeconomics schools
• A. The New Classical School: is built largely on the neoclassical
school. The New Classical School emphasizes the importance of
microeconomics and models based on that behavior.
…………
• New Classical economists assume that all agents try to maximize their
utility and have rational expectations. They also believe that the market
clears at all times. New Classical economists believe that
unemployment is largely voluntary and that discretionary fiscal policy
is destabilizing, while inflation can be controlled with monetary policy.
• The primary disagreement between new classical and new Keynesian
economists is over how quickly wages and prices adjust.
• New classical economists build their macroeconomic theories on the
assumption that wages and prices are flexible.
………
• They believe that price clear market balance SUPPLY and DEMAND—
by adjusting quickly.
• New Keynesian economists, however, believe that market-clearing
models cannot explain short-run economic fluctuations, and so they
advocate models with “sticky” wages and prices.
• New Keynesian theories rely on this stickiness of wages and prices to
explain why involuntary UNEMPLOYMENT exists and why
MONETARY POLICY has such a strong influence on economic activity.
• B. New Keynesian economics is a school of contemporary
macroeconomics that strives to provide microeconomic foundations
for Keynesian economics. It is developed partly as a response to
criticisms of Keynesian macroeconomics by adherents of New
Classical macroeconomics.
……….
• Two main assumptions define the New Keynesian approach to
macroeconomics. Like the New Classical approach, New
Keynesian macroeconomic analysis usually assumes that
households and firms have rational expectations.
• But the two schools differ in that New Keynesian analysis usually
assumes a variety of market failures.
• In particular, New Keynesians assume that there is imperfect
competition in price and wage setting to help explain why prices
and wages can become "sticky", which means they do not adjust
instantaneously to changes in economic conditions.
• Wage and price stickiness, and the other market failures present in
New Keynesian models, imply that the economy may fail to attain
full employment.
• Therefore, New Keynesians argue that macroeconomic stabilization
by the government (using fiscal policy) or by the central bank (using
monetary policy) can lead to a more efficient macroeconomic
outcome than a laissez faire policy would
C. Monetarism
• Milton Friedman developed an alternative to Keynesian
macroeconomics eventually labeled monetarism. Generally
monetarism is the idea that the supply of money matters for the macro
economy
• When monetarism emerged in the 1950s and 1960s, Keynesians
neglected the role money played in inflation and the business cycle,
and monetarism directly challenged those points. Monetarists focus
on controlling the growth rate of the money supply instead of
controlling interest rate
…
• If economic collapses begin when people suddenly decide to increase
their money holdings, then the monetary authority must monitor the
economy and pump money in when it finds a slump is imminent.
• If such slumps are always created by a fall in the quantity of money,
then the monetary authority need not monitor the economy; it need
only make sure that the quantity of money doesn’t slump.
• In other words, a straightforward rule- “Keep the money supply
stable”- is good enough, so that there is no need for a “flexible”
policy of the form, “Pump money in when your economic advisers
think a recession is coming up.”
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