MACROECONOMICS

(ECON 2031)
CHAPTER ONE OUTLINE
1.1 What Macroeconomics is about?
1.2 Goals and Instruments of
Macroeconomic Policy
1.3 Schools of Thought in Macroeconomics
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 &
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.
 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
2008? (GDP)
◦ Etc…
How do the two branches of the discipline differ?

i. Is it a matter of using different tools?

 It is not a matter of using different tools.
Because macroeconomic events arise
from many microeconomic interactions,
macroeconomists use many of the tools
of microeconomics.
 We use the basic organizing framework
of demand and supply models in
constructing both microeconomic and
macroeconomics issues. The basic
organizing framework is the same for
both branches.
ii. Is it a matter of size?
 Again it is not the matter of size
 There are cases in which the size of the
economy considered by microeconomics
analysis is larger than that of
macroeconomic analysis.
For example,
 Let compare study on pricing policy of
general electronics in Japan and the study
conducted on inflation of small country
Djibouti. Comparing the size of economy, the
size of general electronics in Japan is larger
than the size of Djibouti’s economy.
Thus, microeconomics focuses on the
behavior of individual units, no matter
how large, and macroeconomics
concentrates on the behavior of entire
economy.
Hence, the study on the pricing policy
of general electronics in japan is a
kind of microeconomic study and the
study conducted on inflation in
Dijibouti is a kind of macroeconomic
analysis
iii. What, then, is the basis for this long-standing
distinction?
 The answer is that, the distinction is rather based
on the issues addressed(i.e the issues of
emphasis and exposition)
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(PCI) 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 in 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,
 1.1 An Overview: Definition, Focus Areas
& Instruments of Macroeconomics
 In macroeconomics, we do two things:
[Link] seek to understand the economic
functioning of the world we live in; and
[Link] 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 with
an ample supply of good jobs, and
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
ii. Monetary policy,
 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 Macroeconomic School of Thoughts

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.
What is school of thought?
 It is a group of economists who have
common ideology concerning how an
economy make reaction to certain
shocks in a given nation.
 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.
 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 and
there is an increasing disagreement
among prior and emerging schools.
 Who are they?
 Classical 1776 – 1870.
 Neo classical 1870 – 1936.
 Keynesian 1936 – 1960s.
 Monetarists 1970s
 1980s – present. There is no dominant
school of thought of macroeconomics.
 C
N las
eo si
cl c a
as ls
si &
ca
ls
1930

Ke
yne
sians
1960

Mo
n et a
ris
ts
Recent Developments

1970

New
New Class
ic
New Keyne als
G ro sian
w th s
Th e
oris
ts
1980
1.2 The State of Macroeconomics: Evolution &
• Two basic questions bringing macroeconomics
controversies among schools of economic
thought are:
1) Can Governments influence the Economy?
No Yes
Classicals & Neoclassicals Keynesians
New Classicals Monetarists
New
Keynesians
2) Should Governments Intervene?
No Yes
Classicals & Neoclassicals Keynesians
Monetarists(?)
New Classicals New Keynesians
1.2 The State of Macroeconomics: Evolution &
Recent Developments
1.2.1 Classical & Neo-classical
Macroeconomics
• Classical economics as a body of
thought existed prior to the
publication of Keynes General
theory.
• The major contributor are the
economists like Adam Smith, David
Ricardo, John Stuart Mill, Alfred
Marshal and others.
• In this period the distinction
between micro and macro was not
clear but the classical have made a
considerable contribution to the
 Basic Assumptions:
 All markets are perfectly competitive
and thus economic agents freely
interact to buy and sell based on the
market prices .
 All economic agents (firms and
households) are rational and aim to
maximize their objectives (profit/utility)
(optimistic).
 All agents have perfect information
 Trade only takes place at a market
clearing price
 All Agents have stable expectation
 Flexible wages and prices.
 Supply creates its own demand,
Say’s Law.
 The price level is proportional to the
money stock In the long run.
Major economic ideas raised by
classical are:
 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.
 In the money market, money demand is
simply a transaction demand and money
supply has no any effect on the real
economy.
 Inflation is caused by excessive growth in
money stock.
 No need for government intervention as
the economy has a self-correction
mechanism.
 Contd….
1.2.2 Keynesian Macroeconomics
 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 Aggergate demand
 Nominal wages & prices are
inflexible(rigid)
 Large multiplier effect for changes in
government spending & tax rates to
 Contd…
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.
 Contd…
 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
 Contd…
1.2.3 Monetarists
 Include scholars like Milton Friedman
and Edmund Phelps
 Strongly debated against the
Keynesians on:
• the ability of government to
improve the operation of the
economy;
• the relative importance of fiscal &
monetary policy;
• Cause of stagflation (= stagnation
+ inflation) and the trade off b/n
inflation and and unemployement.
 Expansionary fiscal policy, with
 Contd….
 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 Money supply explain
most fluctuations in output.
The Great Depression resulted from
major mistake in monetary policy.
 Inflation is chiefly a monetary
phenomenon no long-run tradeoff
b/n inflation & unemp’t.
 Because of uncertainty in the
Though an economy can be
unstable in the short-run, it
has a good self-correcting
mechanism in the long run.
 Contd….
1.2.4 New Classicals
 In the 1970s, the debate on active
policy brought to the fore new
groups – new classicals & new
Keynesians.
 This school of macroeconomics is led
by economists like Robert
Lucas,Thomas Sargent,Robert Barro
etc…
 New classicals attached great
importance to the role of
expectation(adaptive and rational
expectations) in influencing macro-
economic equilibrium.

 Expansionary fiscal policy tends
to increase inflationary
expectations, shifting aggregate
supply(AS), causing the price
level to rise and real GDP to fall
 Many of them supported supply-
side policies meant to raise
growth rate of potential GDP.
 Contd….
 Their central working assumptions
are:
 forward looking economic agents
with rational expectations.
 Markets clear via market forces.
 Aggregate supply 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
 Contd…
1.2.5 New Keynesians
 The mostly trained keynesian
economists like David Romer,Oliver
Blanchared etc… 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
 Contd….
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),
 Contd….
 Some of the disagreements involve:
 The length of the “short run,” the
period of time over which aggregate
demand(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.