CHAPTER ONE

Introduction the state of macroeconomics

1.1 Micro Vs Macro economics

A. Micro Economics: - it is the branch of economics which concentrates on the individual entities
of an economy such as choice and decision-making process of households and businesses, the
behaviour of markets, and the role of prices in resource allocation.
B. Macro Economics: - on the Other hand, macroeconomics studies the activities and behaviour of
the economy as a whole. The following are some Macroeconomic concepts: Total national
output, the general price level, the unemployment rate etc.

1.2 Goals (Objective) of Macro Economics

A) High economic growth

 Economic growth is an increase in real national income or real national output over a period of time.
High economy growth will lead to a rapid in the standard of living. High economic growth will also
help the economy achieve full employment and will put the gov't in a good position to redistribute
income from high economy groups to low income groups.
B) Low unemployment

 Unemployment is the state of the economy where same people who are able and willing to work
are not employed in the production of goods and services. It causes the economy to lose a
large amount of output, a large number of people to lose their income, lose their skill and
knowledge, firms to lose a large amount of profit and gov’t will lose a large amount of tax revenue.
It will lead to a high crime rate, high divorce rate, high suicide rate and social unrest.
C) Low inflation

Inflation is a rise in the general price level over a period of time

When inflation is high:-

 Decrease in investment expenditure. Domestic goods and service become relatively more
expensive than foreign goods and services. Net exports will tall (export-import).

D) Balance of payment equilibrium

 The balance of payments is a record of all the transactions between the residents of the economy and
the rest of world over a period of time through international trade. Bop=money out flow-money in
flow and
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Bop deficit (money out flow exceeds money in flow

It causes: --High imported inflation, Lower national income, High unemployment and Rising foreign
debt

-Bop-surplus (money out flow less than money in flow):-

 It causes-the standard of living would have been higher

E) Exchange rate stability

 Foreign exchange rate represented the price of own currency in terms of the currency of other nation
-When a nations exchange rate rises, the price of imported good fall while exports become more
expensive for foreigners, the nation become less competitive in world market and net export
decline .Change in exchange rates can also affect output, employment and inflation.

1.3 Macroeconomics problem

Macroeconomics problems will occur if the macroeconomics goals of the government are not achieved.

Common macroeconomic problem:-

A) The business cycle

It measures the fluctuation in aggregate production as measured by the ups and down of the real GNP

Real GNP Peak

Peak Peak Recovery

RecessionRecession

Trough

Trough

Time

Peak- is highest level of real GNP in the business cycle.

Trough- is the lowest level of real GNP.

Contraction (recession) - is down ward from peak economic activities during which real GNP decline
from the previous values.

Expansion (recovery) - is an upturn of economic activities between a trough and peak during which real
GNP increases. Advantage: - employment opportunity increase, business investment increase

B) Unemployment

In modern economics, we think of the population as having three components

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 Employed labor force

POPULATION unemployed

Neither are working nor are seeking work

Unemployed - a person said to be unemployed if he or she is looking for work, is willing to work at the
prevailing wage, but unable to find a job.

To measure the importance of unemployment in a nation's work force, we use the unemployment rate.

Unemployment rate - is a ratio, obtained by dividing the number of unemployed persons by the number of
persons in the labor force.

Unemployment rate=unemployed/labor force

Unemployment seems to be an instance of failure to use the available labor. This is why economists see
unemployment as an economic problems.

Kinds of unemployment:-

1. Frictional unemployment- The practical minimum proportion of the work that is between jobs in a
given circumstances. This category of unemployment can never be eliminated or reduced to zero.

2. Cyclical unemployment-It is unemployment generated due to absence of jobs. The decline in

production in recession is associated with a decline in the demand for labor. The declined in the demand
for the labor leads to an increase in unemployment, this increased unemployment is called cyclical
unemployment.

3. Structural unemployment-economist often use the term structural unemployment, for employment
problems that arise because of mismatch between the needs of employers and the skills and training of the
labor force.

C) Inflation-inflation defined as an increase in the average price level in the economy.

-the best known price index to measure price is the consumer price (cost of living) index (CPI).

D) Recessions- A recession is defined as a period of two or more successive quarters of decreasing

production. A number of variables measures production. Real Gross Domestic product is one important
measure

E) Stagnation - Is a period of many year of slow growth of gross domestic product in which the growth
is, on the average, slower than the potential growth in the economy?

1.4 Macroeconomic policy instruments

Stabilization policies are the procedures undertaken by governing authorities to maintain full employment, a
reasonably stable price level and desired economic growth. i.e, to say to correct unemployment and inflation

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 A) Monetary policy

Is defined as the deliberate action of government to control the supply of money and the interest rate with the
goal to achieve and maintain full employment of labor and the other productive resources without inflation.
There are three ways (tools) to implement monetary policy

I. Open market operation

As the national bank has the duty to control the supply on money in the economy, one of the ways that it uses
this purpose is to involve itself in the market by selling and buying bonds. As the supply of money increased the
reserve position of banks will be increased, thus they will be willing to provide more credits to investors. This
will lead to an expansion in economic activity. And therefore employment, output and income increases. The
opposite is also true as the supply of money is reduced. So the reserve position of banks will be reduced, thus
the availability of credits will also be limited which leads to decline in economic activities, thus unemployment
and reduced income

II. Change in bank reserves

Suppose the national bank requires all commercial banks to keep to reserve 20% of their deposits. These banks
therefore, cannot lend out of the reserve sum. The national bank can also manage to control the supply of
money by increasing or decreasing the reserve requirements of commercial banks. If there is an overall decline
in the economy, the national bank, lower the reserve requirements of bank, so that now they could be able to
make credits available for investors .The availability of credits will lead to invest in certain activities there by
creating more employment and income.

III. Change in discount rate

Discount rate is the interest rate that the national bank charges when it lends reserves temporarily to
commercial banks .If the national bank wants to keep the supply of money lower, it can discourage banks for
borrowing by increasing the discount rate (interest rate).

B) Fiscal policy
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Fiscal policy refers to the change in government spending (expenditures) and tax collection designed to achieve
a full employment and non-inflationary domestic output. Discretionary fiscal policy -is deliberate manipulation
of taxes and government spending to alter real GNP and employment, control inflation and stimulate economic
growth. Nondiscretionary fiscal policy - is the increase(decrease) in net tax (taxes- transfer payment) which
occur without deliberate action of the government when GDP rises (falls) and which tend to stabilize the
economy also called built in stabilizers.

1.3 Schools of thoughts in Macroeconomics

Let us now see different school of thought in macroeconomics:

1. Classical economist (1776-1870)

 A Market economy is self-equilibrating, it adjust so that the supply of and demand for labor are
equated and sustained state of involuntary unemployment (where people wish to work at the
existing Wage rate but cannot find a job - cannot occur). Essentially, macro-economic
relationship, and wages and prices are assumed to be flexible at macro as well as micro-level.
The best government policy, therefore, was one of laissez-faire principles. The ruling principle
was the invisible hand coined by Adam Smith.
2. Keynesians (1936-1970)

 The economy is not self-equilibrating and sustained states of involuntary unemployment may
occur. The government can do something to reduce and/or prevent unemployment by making
appropriate use of monetary and fiscal policy. He thus provided a justification for a policy of
macro-economic intervention, in contrast to the laissez faire principles of the classical economists
who proceeded him.

3. New classical macro-economic

 A market economy is self-equilibrating and it will automatically tend to full employment,

provided wages and process are flexible. In theory, there is no need for the government to
intervene in the economy, but in practice the automatic mechanisms may take so long to work
that some limited intervention may be justified. Much of Keynesian - neoclassical debates were
conducted in terms of IS-LM model

Let us now see in detail different school of thought in macroeconomics.

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Keynesian’s View of the Economy

In a very simplified form we can present Keynes’s theory of recessions. Imagine an economy that is
chugging along happily at full employment. Alongside the smoothly functioning ‘real’ economy there
will be a smooth financial flows, as firms earn money from their sales, pay out their earnings in wages
and dividends, and household spend these receipts on new purchases from the firms.

But now suppose that for some reason each household and firm in this economy decides that it would like
to hold a little more cash. Keynes argued, in particular, this happens when businessmen lose confidence
and start to think of potential investments as risky, leading them to hesitate and accumulate cash instead;
today we might add the problem of nervous households who worry about their jobs and cut back on
purchases of big-ticket consumer items. 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.

But as Keynes pointed out, what works for an individual does not work for the economy as a whole,
because the amount of cash in the economy is fixed. An individual can increase her cash holding by
spending less, but she does so only by taking away cash that other people had been holding. Obviously,
not everybody can do this at the same time.

Can you guess what will happen when everyone tries to accumulate cash simultaneously?
The answer is that income falls along with spending. We try to accumulate cash by reducing my
purchases from you, and you try to accumulate cash by reducing your purchases from us; 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; and so on and so on. Looking at the economy as a whole,
you will see factories closing, workers laid off, stores empty, as firms and households throughout the
economy cut back on spending in a collectively hopeless effort to accumulate more cash. The process
only reaches a limit when incomes are so wasted that the demand for cash falls to equal the available
supply.

Keynes and Economic Policy

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For Keynes to do about recessions, the first and most obvious thing to do is to make it possible for people
to satisfy their demand for more cash without cutting their spending, preventing the downward spiral of
shrinking spending and shrinking income.

How is it possible to increase income of individual without cutting their spending?

The way to do this is simple to print more money, and somehow get it into circulation.

So the usual and basic Keynesian answer to recessions is a monetary expansion. But Keynes worried that
even this might sometimes 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 spending 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 getting the economy
moving again.

Monetarism

Monetarism, as advocates of free market, started challenging Keynes’s theory in the 1970s. Milton
Friedman, the founder of monetarism, attacked Keynes idea of smoothing business cycle (ups and downs
of the economy) on the ground that such active policy is not only unnecessary but actually harmful,
worsening the very economic instability that it is supposed to correct, and should be replaced by simple,
mechanical monetary rules. This is the doctrine that came to be known as “monetarism”.

Friedman began with a factual claim: most recessions, including the huge slump that initiated the Great
Depression, did not follow Keynes’s script. That is, they did not arise because the private sector was
trying to increase its holdings of a fixed amount of money. Rather, they occurred because of a fall in the
quantity of money in circulation.

Policy Rule under Monetarism

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If economic slumps 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.”

Activity I

1. Lists and discus the concepts of macroeconomic.

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2. What are the policy of macroeconomics?
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Exercise 1.
True or False statement
1.macroeconomics studies the activities and behavior of the economy as an aggregate.

2. Unemployment is the state of the economy where same people who are able and willing to work are
not employed in the production of goods and services.

3. A recession is defined as a period of two or more successive quarters of decreasing productions.

4 the basic function of economics is to study how individuals, households, organization and nations
utilize their limited resource to achieve maximum resource

5. economics as the social science is the study of the behavior of human as the aspects of resource
allocation.

Choice

1. is the speed up in the peace of economics activities by high level of economy and low level of
unemployment. A) Peak B) Trough C) Recession D) Expansion

2. is a well-known, the entire production of a country is not sold within the country. A part of it is the
GNP of the country. A) GDP B) GNP C) NX D) Consumption

3.Which one is not the problems of macroeconomics.

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A) economic growth B) business cycle C) inflation D) unemployment

4. which one is the concepts of macroeconomics.

A) consumer behaviors B) GDP C) Inflation D) profit maximization E) A & D F) B & C

CHAPTER TWO:
NATIONAL INCOME ACCOUNTING
Macroeconomics is ultimately concerned with the determination of the economy’s total output, the price
level, the level of unemployment, interest rate and other variables discussed in chapter one. To fully
understand the determination of those variables, we have also to understand what they are and how they
are measured in practice. To do so, we begin with the national income accounts. National income
accounts are the instruments that help us to measure the national income of the country.
The various types of national income accounts helps us to measure the level of production in the economy
at some point of time, and explain the immediate causes of the level of performance.
Thus instead of giving a single comprehensive estimate of national income, the economists use different
aggregates. The reasons for this are:
 There is disagreement among the economists over what should and what should not be counted as
national income.
 Another reason for this is that a certain total may be most useful for one purpose and a different total
for another purpose.

2.1. The Concept of GDP and GNP

Gross Domestic Product (GDP): is the total market value of currently produced final goods and services
that are produced within a country’s borders during a given period of time, usually 1 year.

Gross National Product (GNP): is the total market value of currently produced final goods and services
that are produced by domestically owned factors of production in a given period of time, usually one
year. (note that GDP is a flow not a stock).

GDP and GNP

There is a distinction between GDP and gross national product (GNP).
 The difference between GDP and GNP corresponds to the net income earned by foreigners. To
obtain Gross National product (GNP), we add receipts of factor income (wages, profit, and rent)
fromthe rest of the world and subtract payments of factor income to the rest ofthe world:
 GNP =GDP +Factor Payments from Abroad _Factor Payments to Abroad.
 When GDP exceeds GNP residents of a given country are earning less abroad than foreigners are
earning in that country.

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Two points must be kept in mind while calculating the GNP or GDP of a country.

 Firstly, we must take in to account the money value of the final goods (and services) produced in
the economy to avoid double or multiple counting. It should be remembered that final goods and
services are those, which are finally consumed by the consumers. Such goods and services do not
enter in to the manufacture of other goods. As against this, intermediate goods and services are
those goods and services, which do enter in to the production of other goods and services (Bread,
for example, is final good, but flour is an intermediate good). Intermediate products are to be
excluding from the GNP.
 Secondly, we must take in to account the money value of only currently produced goods and
services while estimating the GNP of the country. This is due to the fact that the GNP is a
measure of the economy’s productivity during a particular period of time.

2.2 Approaches of measuring national income (GDP/GNP)

There are generally two methods of estimating the GNP/GDP of a country.

A) Value Added or Total output approach.
B) Expenditure Approach
C) Income Approach
A. Product Approach: This is the method of measuring GDP/GNP by adding up the market value of
output of all firms in the country. In this approach, GDP is calculated by adding the market value of
goods and services currently produced by each sector (Agriculture and allied activities, Industry and
Service) of the economy.

B. Expenditure Approach to GNP: The GNP can be viewed as the nation’s total expenditure on goods
and services produced during the year. Each unit of goods and services produced is matched by an
expenditure on that unit. The consumers buy most of the good and services produced in the country.
But there are some goods and services, which remains unsold. If the unsold goods and services were
regarded as having been bought by the producers who hold them as stocks or inventories, then the
monetary value of the total national production would be equal to the total national expenditure.

Under the expenditure approach to GNP, the total national expenditure can be broken down in to the
following categories:
i. Personal Consumption Expenditure (C). It includes the consumption expenditure made for both
durable goods (such as, motor-cars, radio-sets, etc., but not houses) and non-durable goods (such
as, food, drinks, clothing, etc.) produced in the country during the year. This sub-head also includes
expenditure on the purchase of a house is treated as investment rather than consumption
expenditure.
ii. Gross Domestic Private Investment (I). This item includes private investment in ‘capital’ or
‘producer goods’, such as, buildings, machinery, plant, equipment, etc; Business firms primarily
purchase such goods. Houses are also included in this category of expenditure, because they are so
durable that they represent, in fact, capital goods. Three points should be carefully noted here.
 Firstly,this sub-head includes capital or investment goods needed not only to replace the existing
depreciated capital goods, but also the capital goods require increasing the society’s production of
goods and services.

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  Secondly, the term ‘investment’ here means real investment in the Keynesian sense rather than
financial investment. It means the purchase of real investment goods, such as, buildings,
machinery, plant, etc. Produced during the year. If a person buys 5-year old machinery, it is not
real investment, though it may be called financial investment, because that machinery was
included in the GNP five years ago when it was manufactured first.
 Thirdly, ‘investment’ here does not include mere financial transfer, such as, the purchase of
existing stocks and shares on the stock exchange. The purchase of existing stocks and shares does
not represent new investment for purposes of the national income accounts. Since it does not
involve any production.
iii. Governments’ Purchases of Goods and Services (G).
The governments-central, state and local-purchase from the market consumer goods, such as, paper,
stationery, cloth, etc, as well as investment goods, such as machinery, equipment, plant, etc, for their own
enterprises. In addition, the governments also purchase a number of different services-military, police,
secretarial etc. Governments do spend large amounts of money on what are called transfer payments (e.g.,
unemployment insurance and social security payments). Since these payments are not payments for
currently produced goods and services, the amount spent on transfer payments included in the GNP of the
country.
iv. Net export (NX). As is well known, the entire production of a country is not sold within the
country. A part of it is the GNP of the country. At the same time, the country imports some finished
goods from other countries during the year. To make proper allowance for such exports and
imports, the value of imports should be deducted from the value of exports. If the balance is
positive, it should be added to the other items of expenditure. If it is negative, it should be
subtracted from the sum of the other expenditure items.

It is; thus, clear that if the entire production of a country is purchased at market prices, the amount so
spent will represent the GNP of the country. Therefore, to estimate the GNP, we have to add the above
four categories of expenditure.
Illustration - Symbolically: GNP= C +I + G + NX
We know the difference between GDP and GNP is the net factor income from abroad (NFIA) which is
the difference between Income received from abroad from the citizen of the country (IRFA), and the
income paid to the foreigner (IPTA): NFIFA= IRFA - IPTA

Gross domestic product, the market value of all final goods and services produced in the country territory
irrespective of citizenship, is the difference between GNP and net factor income from abroad.
Symbolically: GDP= GNP – NFIFA
As a result the above approach to calculate GNP also works to Calculate GDP. Therefore, we reach up
onGDP= C +I + G + FI +NFIFA
If there is no net factor income received from abroad:
GDP=GNP= C +I + G + FI

B. Income Approach to GNP-The expenditure incurred on purchasing goods and services produced in a
country during the year also becomes the income of the various factors, which collaborated in the
production of those goods and services. We can group these factor-incomes in the following categories:
v. Wages and salaries of the employees (or compensation to employees),
vi. Incomes of non-company business
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vii. Rental incomes of persons
viii. Corporate profits, and
ix. Incomes from Interest

 The first category, as said above, includes the wages and salaries received by the employees
during the year plus certain supplements. These supplements are the contributions, which the
employers make to social security and other provident funds or pension funds of the workers.
 The second category includes the incomes earned by individual proprietors, parents and self-
employed persons.
 The third category comprises rental income earned by individuals on agricultural and non-
agricultural property.
 The fourth category includes corporate profits earned by business corporations before the
payment of corporate profit taxes or the payment of dividends to the shareholders. Thus, the
corporate profits, used in calculating the GNP, are equal to the sum of corporate profit taxes plus
dividends paid top the shareholders plus undistributed corporate profits.
 The fifth category contains net interest earned by individuals from sources other than the organs
of the government.

An aggregate of the above five categories of incomes will not be equal to the GNP as estimated by
the Expenditure Method. The reason is that a part of the total expenditure incurred by the community
does not become available to the other factors of production in the form of incomes. There are two
such leakages.
 First, indirect taxes levied by the government on goods and services; and
 Second, depreciation of machinery, plants and buildings.

The expenditure incurred by the households (factors) on goods and services includes the indirect
taxes levied by the government. The income from these indirect taxes goes to the government and is
not available to the households (factors). Likewise, while calculating the GNP, we include the
depreciation (loss in value suffered by machinery, equipment, buildings etc.). Like the indirect taxes,
the payment on account of depreciation does not become available to the households (factors) in the
form of income. In other words depreciation is no part of the factor incomes. Therefore, while
estimating the GNP by the Income Method, we have to add indirect taxes and depreciation charges to
the factor incomes.

Illustration
GNP in the Income Method can be calculated as follows:
Symbolically: GNP= W/S +I + R + Π + r + IT + D
Therefore, GDP= W/S +I + R + Π + r +IT+ D -NFIFA

Or
GDP= GNP –NFIFA

GDP and GNP are the most frequently used national income concepts. They have their own merits and
demerits.

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Merits
 They are better index, than any other concept, of the actual conditions of production and
employment in a country during a specified period.
 They are also statistically simpler concepts, as it takes no account of depreciation and
replacement problems.

Demerits
 They are not a net measure of the nation’s economic performance, for they are, as the term states,
a gross measure.
 They don’t include the cost for environmental protection
 Since they are the measure of the market value of all final goods and service they don’t
incorporate the non-market activities i.e., Underground Economy

2.3 Other Social Accounts (NNP, NI, PI and DI)

The national income accounts include other measures of income that differ slightly in definition from
GDP. It is important to be aware of the various measures, because economists and the press often refer to
them.

i. Net National Product (NNP) and Net Domestic Products NDP)

The other important concepts of national income are net national product and net domestic product. Net
national product is defined as the net production of goods and services produced by citizens of a country
during a year and net domestic product is defined as the net production of goods and services produced in
a country territory during a year.
As we know, in the course of a year’s production, part of the physical plant that was on hand at the
beginning of the year is worn out, or it may depreciate in value as it becomes outdated. Building
gradually deteriorate, machinery wears out or becomes obsolete, and so on for others. No sooner or later,
if depreciated capital is not replaced, the income of the nation will decline, and the economy as a whole
will become poorer. If we want to measure the level of income that can be sustained therefore, we must
deduct from gross output (GNP or GDP) the depreciation of capital during the period concerned. What is
left after this deduction is the net national product. Thus,

NNP= GNP – Depreciation

NDP= GDP - Depreciation

Net products are better concepts than gross products, because it makes proper allowance for the
depreciation suffered by capital goods during the period under consideration. These concepts give a
proper idea of the net increase in total production of a country. They are, therefore, used in analyzing the
long-period problems of maintaining and increasing the supply of capital goods in the country.

In spite of this fact that for some purposes of economic growth NNP is much more important than GNP, it
is more difficult to measure statistically, because we have no accurate record of the amount of
depreciation for various capital goods, such as, buildings, equipments, plants etc. The result is that the
deduction that has to be made from GNP to arrive at NNP is a matter of judgement, rather than of exact
measurement. Because of this difficulty, this concept of NNP is not fairly used.

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 ii. Net National Income at Factor Cost (NNI)
National Income at factor cost means the sum of all incomes earned by resource suppliers for their
contribution of land, labour, capital and entrepreneurship during the year’s net production. In other
words, national income at factor cost shows how much it costs society in terms of economic resources
to produce that net output. Sometimes, we simply call it national income.

Both GNP and NNP measure the values of goods produced in industry at the prices that those goods
actually bring in the market. Here the difficulty is that when we buy these goods at market prices,
then the prices include the respective taxes on these goods levied by the government. Hence, not all
of the payment made for goods goes to the people who produced them. Some part of it goes to the
government. It does not constitute a part of the true cost of producing the goods concerned. This
violates the basic identity that the value of goods produced is equal to the sum of the money incomes
received by the producers. In other words, the GNP will exceed the sum money incomes received by
people of the country (resource suppliers). The excess is explained by the fact that we have included
in GNP the entire out put of government services, but we have also included part of the payments
made for these services in the prices of the products (in terms of sales tax). In other words, a part of
the cost of government has been counted twice. In order to get rid of this double counting, we may
introduce the concept of net national income at factor cost. It is equal to net national product minus
indirect tax plus subsidies.

To put it differently:
National income (at Factor Cost)
EqualsNI= NNP-Indirect taxes +Subsidies

The concept of national income at factor cost occupies an important place in economics. It indicates the
nature of distribution of wealth among various factor inputs. This concept is more satisfactory than the
concept of GNP and NNP, because it eliminates the element of double counting inherent in those two
concepts. It accords with the basic principle of economic theory, that the payments received by the factor
suppliers equal the value of the goods produced. Further, the components of national income (at factor
cost) are very useful in dealing with certain economic problems. Changing relative shares of different
elements in the population from time to time have an important bearing on the fluctuations of economic
activity, and on the personal inequality of incomes, which has much to do with economic welfare.

iii. Net Domestic product at Factor Cost (NDP)

Net domestic product at factor cost is defined as that national production which is made by the
domestic factors of a country during the period of a year. In other words, we can get net domestic
product
(At factor cost) if we deduct net income received from abroad from the net national product at factor
cost. Thus,

NDP at Factor Cost= NNP at Factor Cost – Net Income from Abroad

iv. Personal Income (PI)

Personal income is the sum of all incomes actually received by all individuals or households during a
given year. National income (that is, total income earned during a year) is different from personal income
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 (That is, the income actually received by households). We know that all, which is produced by industry
and government, must necessarily belong to someone, and hence can be regarded as national income
received or accrued by the people (of the country), but not all of the value of this product is paid to them
as money income. Part of the net earnings of business firms are taken away from them by government in
the form of corporate income taxes excess profits taxes, and the like, before being paid to the owners of
the business firms. These are direct taxes that do not enter into the prices of commodities. Further, many
firms retain part of their earnings in the business, to make addition to their plants or as a reserve for future
emergencies, instead of distributing the entire profits to their shareholders. Therefore, these earnings are
not allowed to receive in money all of the salaries or wages that they earn. The government charges a
withholding tax, which is used to finance social security payments to the aged, the unemployed and
certain other persons. Similarly, the government make some other transfer payments to people of the
country.

All these things create a difference between the total incomes received by individuals and the total social
income produced. We subtract from national income all undistributed corporate profits, corporate income
taxes and social security withholding taxes and then add transfer payments from government and business
firms directly to persons; the resulting figure will be the personal income. Thus,

Personal Income (PI) = Net National Income – undivided corporate Profits – Corporate Income
Tax- Social Security Contribution + Transfer payments.

The above concept of personal income is useful for certain special purposes. For example, it shows the
ability of people to pay taxes. The personal income data are available on monthly basis whereas the data
for national product and national income are not published so frequently and, therefore, the accurate idea
cannot be drawn. This is the reason that personal income data are used for analysing current changes in
the economy.

v. Disposable Income (DI)

The main drawback of personal income is that they do not tell us how much is actually at the disposable
of people for their personal expenditure. For this we use the concept of disposable income. After a good
part of personal income is paid to government in the form of personal taxes (such as income tax, property
tax etc.), what remains of personal income is called Disposable Income. Thus,
Disposable Income (DI) = Personal Income – Personal Taxes
Disposable income data are useful for studying the purchasing power of the consumers. Since disposable
income can either be consumed or it can be saved; with its help we may study of consumption and saving
that individuals make in the economy.
2.4 Nominal versus Real GDP
Nominal GDP measures the value of output in a given period in the prices of that period For example;
the 2010 Nominal GDP measures the value of the goods and services produced in 2010 at the market
prices prevailing in 2010.The Nominal GDP changes from year to year for two reasons. The first reason is
that the physical output of goods changes. The second reason is that prices change.

Real GDP measures changes in physical output in the economy between different time periods by valuing
all goods produced in the two periods at the same prices, or in constant dollars/birr. For example, if the

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year 2001 is the base year, Real GDP is measured in the national income accounts in the prices of 2001.
That means in calculating Real GDP, today’s physical output is multiplied by the prices that prevailed in
2001 to obtain a measure of what today’s output would have been worth had it been sold at the prices of
2001.

2.5. Price Indexes

The GDP Deflator
From nominal GDP and real GDP we can compute a statistic known as: the GDP deflator. The GDP
deflator, also called the implicit price deflator for GDP, is defined as the ratio of nominal GDP to real
GDP:

GDP deflator=

The GDP deflator reflects what’s happening to the overall level of prices in the economy. In this form, we
can see how the deflator earns its name: it is used to deflate (that is, take inflation out of ) nominal GDP
to yield real GDP.

The Consumer Price Index (CPI)

One birr today doesn’t buy as much as it did 10 or 5 years ago. The cost of almost everything has gone
up. This increase in the overall level of prices is called Inflation, and it is one of the primary concerns of
economists and policy makers.

The most commonly used measure of the level of prices is the consumer price index (CPI). The Statistical
Authority has a job of computing the CPI. It begins by collecting the prices of thousands of goods and
services. Just as GDP turns the quantities of many goods and services in to a single number measuring the
value of production, the CPI turns the prices of many goods and services in to a single index measuring
the overall level of prices.

But how should economists aggregate the many prices in the economy in to a single price index that
reliably measure the price level?
They could simply compute an average of all prices. Yet this approach would treat all goods and services
equally. Because people might buy more of product X than product Y. Product X should have a greater
weight in the CPI than the price of Y. The statistical authority weights different items by computing the
price of a basket of goods and services purchased by a typical consumer. The CPI is the price of this
basket of goods and services relative to the price of the same basket in some base year.
Illustration
Suppose that the typical consumer buys 5 apples and 2 oranges every month. Then the basket of goods
consists of 5 apples and 2 oranges, and the CPI is

(5×CurrentpriceofApples )+(2×CurrentpriceofOranges)
CPI=
(5×2006 Pr iceofApples )+(2×2006 Pr iceofOranges )

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In this CPI, 2006 is the base year. The index tells us how much it costs now to buy 5 apples and 2 oranges
relative to how much it costs to buy the same basket of fruit in 2006.

The consumer price index is the most closely watched index of prices, but it is not the only such index.
Another is the producer price index, which measures the price of a typical basket of goods bought by
firms rather than consumers.

The Producer Price Index (PPI) is another price index that is widely used. Like the CPI, this is the
measure of the cost of a given basket of goods. It differs from the CPI partly in its coverage, which
includes, for example, raw materials and semi finished goods. It differs too, in that it is designed to
measure prices at the early stages of the distribution system. Whereas the CPI measures prices where
urban households actually do their spending-that is at the retail level- the PPI is constructed from prices at
the level of first significant commercial transaction.

The CPI versus the GDP Deflator

The GDP Deflator and the CPI give somewhat different information about what’s happening to the
overall level of prices in the economy. There are three key differences between the two measures
 The first difference is that the GDP deflator measures the prices of all goods and services
produced, whereas the CPI measures the prices of only the goods and services bought by
consumers. Thus, an increase in the price of goods bought by firms or the government will show
up in the GDP deflator but not in the CPI.
 The second difference is that the GDP deflator includes only those goods produced domestically.
Imported goods are not part of GDP and do not show up in the GDP deflator. Hence, an increase
in the price of a Toyota made in Japan and sold in Ethiopia affects the CPI, because consumers
buy the Toyota, but it does not affect the GDP deflator.
 The third and most subtle difference results from the way the two measures aggregate the many
prices in the economy. The CPI assigns fixed weights to the prices of different goods, whereas
the GDP deflator assigns changing weights. In other words, the CPI is computed using a fixed
basket of goods, whereas the GDP deflator allows the basket of goods to change over time as the
composition of GDP changes. The following example shows how these approaches differ.
Suppose that major frosts destroy the nation’s orange crop. The quantity of oranges produced
falls to zero, and the price of the few oranges that remains on grocers’ shelves is driven sky-high.
Because oranges are no longer part of GDP, the increase in the price of oranges does not show up
in the GDP deflator. But because the CPI is computed with a fixed basket of goods that includes
oranges, the increase in the price of oranges causes a substantial rise in the CPI.

The consumer price index is a closely watched measure of inflation. Policymakers in the Federal
Reserve monitor the CPI when choosing monetary policy. In addition, many laws and private
contracts have cost-of-living allowances, called COLAS, which use the CPI to adjust for changes in
the price level. For instance, social security benefits are adjusted automatically every year so that
inflation will not erode the living standard of the elderly.

Many economists believe that CPI tends to overstate inflation. The reasons are:

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  Because the CPI measures the price of a fixed basket of goods, it does not reflect the ability
of consumers to substitute toward goods whose relative prices have fallen. Thus, when
relative prices change, the true cost of living rises less rapidly than the CPI.
 A second problem is the introduction of new goods. When a new good is introduced in to the
marketplace, consumers are better off, because they have more products from which to
choose. In effect, the introduction of new goods increases the real value of the dollar. Yet this
increase in the purchasing power of the dollar is not reflected in a lower CPI.
 A third problem is unmeasured changes in quality. When a firm changes the quality of a good
it sells, not all of the good’s price change reflects a change in the cost of living. Many
changes in quality, such as comfort or safety, are hard to measure. If unmeasured quality
improvement (rather than unmeasured quality deterioration) is typical, then the measured CPI
rises faster than it should.
2.6. GDP and Welfare
2.7. Measuring Unemployment Rate
One aspect of economic performance is how well an economy uses its resources. Because an
economy’s workers are its chief resource, keeping workers employed is a dominant concern of
economic policy makers.

Unemployed: A person who is willing to have a job and actively seeking it but couldn’t find the
job.
Employed:A person who have a job and actively participate at a paid job

Having the concept unemployment now let us discuss how the rate of unemployment is measured.
Then unemployment rate is the statistic that measures the percentage of those people wanting to work
who do not have jobs.
Numberofunemployed
UnemploymentRate= ×100
Labourforce

The labour force is defined as the sum of the employed and unemployed, and the unemployment rate is
defined as the percentage of the labour force that is unemployed.

LabourForce=NumberofEmployed +NumberofUnemployed

A related statistics is the Labour-force-participation Rate, the percentage of the adult population that is in
the labour force:
LabourForce
Labour−ForceParticiaptionRate= ×100
AdultPopulation

Illustration

Spouses the Statistical Authority in Ethiopia have the following result from the census taken in 1994. The
number of unemployed is 45 billion, employed 20 billion and adult population 50 billion.

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Find
1. Unemployment Rate
2. Labour-Force Participation rate
Solution
To find the unemployment rate first we need to have the Labour Force;
Labour Force= Unemployed + Employed
= 45 billion + 20 Billion
= 65 billion
Then;
Numberofunemployed
UnemploymentRate= ×100
Labourforce

45 billion
UnemploymentRate= ×100=0 .6923 %
65billion

Labour-Force participation rate can be also calculated as follows:

LabourForce
Labour−ForceParticiaptionRate= ×100
AdultPopulation
65 billion
Labour−ForceParticiaptionRate= ×100=1. 3 %
50billion
2.8. Relationship between Macroeconomic Variables
The Business Cycle and the Output Gap
Inflation, growth, and unemployment are related through the business cycle. The business cycle is the
more or less regular pattern of expansion (recovery) and contraction (recession) in economic activity
around the path of trend growth. At a cyclical peak, economic activity is high relative to trend; and at a
cyclical trough, the low point in economic activity is reached. Inflation, growth, and unemployment all
have clear cyclical patterns.

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In short, Business cycle shows us the ups and downs of country’s GDP.

The trend path of GDP is the path GDP would take if factors of production were fully employed.

Over time, real GDP changes for the two reasons.

 First, more resources become available which allows the economy to produce more goods and
services, resulting in a rising trend level of output.
 Second, factors are not fully employed all the time. Thus, increasing capacity utilization can
increase output.

Output is not always at its trend level, that is, the level corresponding to full employment of the factors of
production. Rather output fluctuates around the trend level. During expansion (or recovery) the
employment of factors of production increased, and that is a source of increased production. Conversely,
during recession unemployment increases and less output are produced than can in fact be produced with
the existing resources and technology. Deviations of output from trend are referred to as the output gap.

The output gap measures the gap between actual output and the output the economy could produce at full
employment given the existing resources. Full employment output is also called potential output.
Output gappotential output – actual output

When looking at the business cycle fluctuation, one question that naturally arises is whether expansions
give way inevitably to old age, or whether they are instead brought to an end by policy mistakes. Often a
long expansion reduces unemployment too much; causes inflationary pressures, and therefore triggers
policies to fight inflation- and such policies usually create recessions.

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Because employed workers help to produce goods and services and unemployed workers do not,
increases in the unemployment rate should be associated with decreases in real GDP. This negative
relationship between unemployment and GDP is called Okun’s Law.
Okun’s Law
A relationship between real growth and changes in the unemployment rate is known as Okun’s law,
named after its discoverer, Arthur Okun. Okun’s law says that the unemployment rate declines when
growth is above the trend rate.
u = -x (ya – yt)
Where u is change in unemployment, x the magnitude in which unemployment declines due to a
percentage point growth, yaactual growth rate of output, andyt is trend output growth rate.The figure
below shows the Okun’s law relationship between unemployment and growth in output.
Percentage change in real GDP

Growth and Unemployment Dynamics

12

0
-3 -2 -1 0 1 2 3

-3
Change in unemployment rate

Fig2.2 Growth and Unemployment Dynamics

Inflation –Unemployment Dynamics

The Phillips curve describes the empirical relationship between inflation and unemployment: the higher
the rate of unemployment, the lower the rate of inflation. The curve suggests that less unemployment can
always be attained by incurring more inflation and that the inflation rate can always be reduced by
incurring the costs of more unemployment. In other words the curve suggests there is a trade-off between
inflation and unemployment.

Inflation
Rate

0
Unemployment rate
Fig 2.3 Phillips curve
Questions for Review

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1. Explain the following concepts
a) Gross domestic product (GDP)
b) Consumer price index (CPI)
c) Unemployment rate
d) National income accounting
e) Nominal versus real GDP
f) GDP deflator
g) Okun’s law

2. Briefly explain the idea of each school of thought formacro-economic problem and their
similarities and differences in macroeconomics.

3. A farmer grows a kilogram of wheat and sells it to a Miller for $1.00. The Miller turns the wheat
into flour and then sells the flour to a baker for $3.00. The baker uses the flour to make bread and
sells the bread to an engineer for $6.00.The engineer eats the bread. What is the value added by
each person? What is GDP?

4. Consider an economy that produces and consumes bread and automobiles. In the following table
are data for two different years.

Year year

Item 2000 2010

Price of an automobile $50,000 $60,000

Price of a loaf of bread $10 $20

Number of automobiles produced 100 120

Number of loaves of bread produced 500,000 400,000

a) Using the year 2000 as the base year, compute the following statistics for each year: nominal
GDP, real GDP, the implicit price deflator for GDP, and a fixed-weight price index such as the
CPI.
b) How much have prices risen between year 2000 and year 2010?
Activity 1.
1. Compare contrast between GDP and GNP.
________________________________________________________________________
________________________________________________________________________
___________________________________________________________________

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 2. Discus between GDP and welfare.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
_______________________________________________________________________
CHAPTER THREE:
AGGREGATE DEMAND ANALYSIS
INTRODUCTION
Dear learner! In the first chapter we have seen about macroeconomics and the major macro
economic variables; we have also discussed how the national income is measured. Now in this
chapter we continue our study of economic fluctuations by looking more closely at aggregate
demand. Our goal is to identify the variables that shift the aggregate demand curve, causing
fluctuation in national income.
The model of aggregate demand developed in this chapter, called the IS-LMmodel is the leading
interpretation of Keynes’s theory. The goal of the model is to show what determines national
income for any given price level. There are two ways to view this exercise. We can view the IS-
LMmodel as showing what causes income to change in the short run when the price level is
fixed. Or we can view the model as showing what causes the aggregate demand curve to shift.

The two parts of the IS-LM model are, not surprisingly, the IS curve and the LM curve. IS
stands for ‘investment’ and ‘saving’, and the IS curve represents what’s going on in the market
for goods and services. LM stands for ‘liquidity’ and ‘money’, and the LM curve represents
what’s happening to the supply and demand for money. Because the interest rate influences both
investment and money demand, it is the variable that links the two halves of the IS-LM model.
The model shows how interactions between these markets determine the position and slope of
the aggregate demand curve and, therefore, the level of national income in the short run.

2.1. The Goods Market and the IS Curve

2.1.1. The Keynesian Cross
In The General Theory, Keynes proposed that an economy’s total income was, in the short run,
determined largely by the desire to spend by households, firms, and the government. The more people
want to spend, the more goods and services firms can sell. The more firms can sell, the more output they
will choose to produce and the more workers they will choose to hire. Thus, the problem during
recessions and depressions, according to Keynes, was inadequate spending. The Keynesian cross is an
attempt to model this insight.
To derive the Keynesian cross, we begin by looking at the determinants of planned expenditure
or planned aggregate demand. Planned expenditure (or planned aggregate demand) is the amount
of households, firms, and the government plan to spend on goods and services.
The difference between actual and planned expenditure is unplanned inventory investment.
When firms sell less of their product than planned, their stock of inventories automatically rises.
23 | P a g e
Conversely, when firms sell more than planned their stock of inventories falls. Because these
unplanned changes in inventory are counted as spending by firms, actual expenditure can be
either above or below planned expenditure.
Assuming that the economy is closed, so that net exports are zero, we write planned aggregate
demand (or planned expenditure) AD as the sum of consumption (C), planned investment (I),
and government purchases G:
AD = C+I+G.......................................................................................................................... (1)
Consumption (C) in [1] is a function of disposable income (Y-T) i.e.
C=C (Y-T)............................................................................................................................. (2)
Disposable income is total income Y minus taxes T. Assume that planned investment is fixed
I=I , and that the levels of government purchases and taxes are also
fixed.
G =G
T =T .
Combining these equations, we obtain
AD = C(Y − T ) +I + G .......................................................................................................................
........... (3)
Equation [3] states that planned aggregate demand (planned expenditure) is a function of income
Y, the exogenous level of planned investment I , and the exogenous fiscal policy variables G and
T.
Figure .3.1. Planned expenditure a function of income

The figure above graphs planned expenditure as a function of the level of income since the other
variables are fixed. The line slopes upward because higher income leads to higher consumption
and thus higher planned expenditure. The slope of this line is the marginal propensity to
consume, the MPC: it shows how much planned expenditure increases when income rises by one
unit.
24 | P a g e
Proof: AD = C(Y − T ) +I +G
d ( AD) dC (Y −T ) d I d G
= + +
dY dY dY dY
Since the T, G and I are constants

d ( AD) dC (Y )
=
dY dY ; Which is the marginal propensity to consume

3.1.1. The Economy in Equilibrium

The economy is in equilibrium when actual aggregate demand equals planned aggregate demand.
Total output of the economy Y equals not only total income but also actual aggregate demand.
We can write the equilibrium condition as
Actual aggregate demand = Planned aggregate demand
Y= AD
Figure 3.2: Keynesian Cross

In figure 2.2, the 45o line serves as a reference line that translates any horizontal distance into an
equal vertical distance. Thus, anywhere on the 45 o line, the level of aggregate demand is equal to
the level of output. For instance, at point A, both output and aggregate demand are equal.
The equilibrium output would be achieved through inventory adjustment. Unplanned changes in
inventories induce firms to change production levels, which in turn changes income and
expenditure.

Fig 3.3: Adjustment to equilibrium in the Keynesian cross

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For example, suppose GDP is at a level greater than equilibrium level, such as level Y 1 in figure
above, because of the miscalculation of firms about the aggregate demand. In this case, planned
aggregate demand AD1 is less than production (Y1). Firms are selling less than they produce.
Firms add the unsold goods to their stock of inventories. This unplanned rise in inventories
induces firms to lay off workers and reduce production, which reduce GDP. This process of
unintended inventory accumulation and falling income continues until income falls to the
equilibrium level. At the equilibrium, income equals planned aggregate demand.

Similarly, suppose GDP is at a level lower than the equilibrium level, such as the level Y 2. In this
case, planned aggregate demand is AD2, which is more than output Y2. Because planned
aggregate demand exceeds production, firms are selling more than they are producing. As firms
see their stock of inventories fall, they hire more workers and increase production. This process
continues until income equals planned aggregate demand.
In summary, the Keynesian cross shows how income Y is determined for given levels of planned
investment (I) and fiscal policy G and T. We can use this model to show how income changes
when one of these exogenous variables changes.
3.1.2. Fiscal Policy and the Multiplier
Fiscal Policy Multiplier: Government purchase
Since government purchases are one component of expenditure, high government purchases
imply, for any given level of income, higher planned aggregate demand. If government
purchases rise by DG, then the planned aggregate demand schedule shifts upward by DG, as
shown in the figure below.
Fig .3.4: an increase in Government Purchase in the Keynesian Cross

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The graph shows that an increase in government purchases leads to an even greater increase in
income. That is, DY >DG. The ratio DY/DG is called the government purchase multiplier; and it
tells how much income rises in response to a one-unit increase in government purchases. An
implication of the Keynesian cross is that the government purchases multiplier is larger than one.

Why does fiscal policy have a multiplied effect on income? The reason is that, according to the
consumption function, higher income causes higher consumption. Because an increase in
government purchases raises income, it also raises consumption, which further raises income and
so on. Therefore, in this model, an increase in government purchases causes a greater increase in
income.

Illustration of the multiplier process

G Y C Y C…

The process of the multiplier begins when expenditure rises by DG, which implies that income
rises by DG as well. This increase in income in turn raises consumption by MPC* DG, where MPC
is the marginal propensity to consume. This increase in consumption raises aggregate demand
and income once again. This second increase in income of MPC * DG again raises consumption
by MPC* (MPC * DG), which again raises aggregate demand and income, and so on. We can
thus write this process compactly as
DY= DG + MPC * DG + MPC2 * DG + MPC3 * DG + …
= (1 + MPC + MPC2 + MPC3 +…)*DG
The government purchase multiplies is
DY/DG = 1 + MPC + MPC2 + MPC3 +…
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This expression for the multiplier is an example of an infinite geometric series. A result from
algebra allows us to write the multiplies as
1
DY/DG = 1-MPC .

Fiscal Policy Multiplier: Taxes

A decrease in taxes of DT immediately raises disposable income Y-T by DT and, therefore,
consumption by MPC * DT. For any level of income Y, aggregate demand is now higher. As
shown in the figure below, the aggregate demand schedule shifts upward by MPC*DT. The
equilibrium of the economy moves from point A to point B and income rises from Y1 to Y2
Fig 3.5: A decline in tax in the Keynesian Cross

As in government purchases has a multiplied effect on income; taxes do also have multiplier
impact. Starting with the national income identity

Y= C (Y-T) + I + G
Assuming I and G to be constant, and differentiating the above expression we obtain
dY = C’(dY – dT),
dY(1-C’) = -C’dT
And then rearranging to find
dY C'
=−
dT 1−C' < 0
Since C’ is MPC we can rewrite the tax multiplier as follows;
ΔY MPC
=−
ΔT 1−MPC

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The multiplier implies that taxes and income are inversely related and a unit change in taxes
increase income by more than proportionately.
For example: If the marginal propensity to consume is 0.3, then the tax multiplier is
ΔY 0.3
=−
ΔT 1−0 .3
This is equal to -0.428.
In this example, a 1 birr cut in taxes raises equilibrium income by 0.428 birr.
3.1.3. The Interest rate, Investment and the IS Curve
The Keynesian cross is useful because it shows what determines the economy’s income for any
given level of planned investment. Yet it makes the unrealistic assumption that the level of
planned investment is fixed. However, planned investment depends negatively on the interest
rate.
The transition from the Keynesian cross model to the IS curve is achieved by noting that if the
real interest rate changes, this changes planned investment. The Keynesian cross analysis tells us
that change in planned investment change GDP. Thus, for example, if interest rates increase,
planned investment falls, and so does output. Thus higher levels of the interest rate are associated
with lower level of output.
To add the relationship between the interest rate and investment, we write the level of planned
investment as I = I(r).
Thus, we can write equation [1] as Y = C (Y-T) +I(r) +G

29 | P a g e
Fig.3.6. Deriving the IS curve

We can now use the investment function and the Keynesian cross diagram to determine how
income changes when the interest rate changes. Because investment is inversely related to the
interest rate, an increase in the interest rate from r1 to r2 reduces the quality of investment from
I(r1) to I(r2). The reduction in planned investment, in turn, shifts the expenditure function
downward as shown in the upper panel of the figure above. The shift in the expenditure function
leads to a lower level of income. Hence, an increase in the interest rate lowers income.

The IS curve summarizes the relationship between the interest rate and the level of income that
results from the investment function and the Keynesian cross. The higher the interest rate, the
lower the level of planned investment, and thus the lower level of income. For this reason the IS
curve slopes downward.

How Fiscal Policy Shifts the IS Curve

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The IS curve shows us the level of income for any given interest rate. The IS curve is drawn for a given
fiscal policy; that is, the IS curve holds G and T fixed. When fiscal policy changes, the IS curve shifts.

IS: Y=C(Y-T) + I(r) + G

dY = C’(dY – dT) +I’dr + dG

Assuming that dT = dr = 0

dY = C’dY + dG

dY/dG = 1/(1-C’); where C’ is MPC and thus 1/1-C’ is greater than zero.

This shows that for a given interest and tax rate, an increase in government spending will lead to a higher
level of output. This can be shown as a shift in the IS curve.

Fig 3.8: Fiscal policy and shift in the IS curve

In summary, the IS curve shows the relationship between the interest rate and the level of income
that arises from the market for goods and services. The IS curve is drawn for a given fiscal
policy. Changes in fiscal policy that raise the demand for goods and services shift the IS curve to
the right. Changes in fiscal policy that reduce the demand for goods and services (such as an
increase in tax) shift the IS curve to the left.
1.1. The Money Market and the LM Curve

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The LM curve is the relationship between the interest rate and the level of income that arises in the
market for money balances.

1.1.1. The Theory of Liquidity Preference

The theory of liquidity preference explains how the supply and demand for real money balance
determines the interest rate.
We begin with the supply of real money balances. If M stands for the supply of money and P stands for
the price level, then M/P is the supply of real money balances. The theory of liquidity preference
assumes there is a fixed supply of real balance. That is,

(M/P)s = M /P .
The money supply M is an exogenous policy variable chosen by the central bank. The price level P is
also an exogenous variable in this model. (We take the price level as given because the IS-LM model
considers the short run when the price level is fixed). These assumptions imply that the supply of real
balances is fixed and, in particular, does not depend on the interest rate as shown in the figure below.

Money Supply

M /P M/P

Next, consider the demand for real money balances. People hold money because it is a
“liquid” asset- that is, because it is easily used to make transactions. The theory of
liquiditypreference postulates that the quantity of real money balances demanded
depends on the interest rate. The interest rate is the opportunity cost of holding money.
When the interest rate rises, people want to hold less of their wealth in the form of money.

We write the demand for real money balances as

(M/P)d = L(r).

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 Where the function L( ) denotes the demand for the liquid asset- money. This equation states that the
quantity of real balances demanded is a function of the interest rate. This inverse relationship between
money demand and interest rate can be shown as a downward sloping demand curve.

L(r)

M/P

To obtain the theory of the interest rate, we combine the supply and the demand for real money balances.
According to the theory of liquidity preference, the interest rate adjusts to equilibrate the money market.
At the equilibrium interest rate, the quantity of real balances demanded equals the quantity supplied. The
equilibrium condition is shown in the figure below.

The adjustment of the interest rate to this equilibrium of money supply and money demand
occurs because people try to adjust their portfolios of assets if the interest rate is not at the
equilibrium level. If the interest rate is too high, the quantity of real balances supplied exceeds
the quantity demanded. Banks and other financial institutes respond to this excess supply of
money by lowering the interest rates they offer. Conversely, if the interest rate is too low, so that
the quantity of money demanded exceeds the quantity supplied, individuals try to obtain money
by making bank withdrawals, which drives the interest rate up. At the equilibrium interest rate
people are content with their portfolios of monetary and non-monetary assets.

33 | P a g e
The theory of liquidity preference implies that decreases in the money supply raise the interest rate and
that increases in the money supply lower the interest rate. Suppose there is a reduction in money supply.
A reduction in M reduces M/P, since P is fixed in the model. The supply of real balances shift to the left,
as shown in the figure below. The equilibrium interest rate rises from r1 to r2. The higher interest rate
induces people to hold a smaller quantity of real money balances.

1.1.2. Income, Money Demand, and the LM Curve

So far we have assumed that only the interest rate influences the quantity of real balances
demanded. More realistically, the level of income Y also affects money demand. When income
is high, expenditure is high, so people engage in more transactions that require the use of money.
Thus, greater income implies greater money demand. We now write the money demand function
as
(M/P) d = L(r, Y).
The quantity of real money balances demanded is negatively related to the interest rate and
positively related to income. Using the theory of liquidity preference, we can see what happens
to the interest rate when the level of income changes. For example, consider what happens when
income increases from Y1 to Y2.

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As the above figure shows the increase in income shifts the money demand curve outward. To equilibrate
the market for real money balances, the interest rate must rise from r1 to r2. Therefore, higher income
leads to a higher interest rate. The LM curve plots this relationship between the level of income and the
interest rate. The higher the level of income, the higher the demand for real money balances, and the
higher the equilibrium interest rate. For this reason the LM curve slopes upward as illustrated above.

How Monetary Policy Shifts the LM Curve

The LM curve tells us the interest rate that equilibrates the money market for any given level of income.
The theory of liquidity preference shows that the equilibrium interest rate depends on the supply of real
balances. The LM curve is drawn for a given supply of real money balances. If real balances change, the
LM curve will shift.
Suppose that the money supply is decreased from M 1 to M2, which causes the supply of real balances to
fall from M1/P to M2/P. Holding constant the amount of income and thus the demand curve for real
balances, a reduction in the supply of real balances raises the interest rate that equilibrates the money
market. Hence, a decrease in real balances shifts the LM curve upward.

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In summary, the LM curve shows the relationship between the interest rate and the level of
income that arises in the market for real money balances. The LM curve is drawn for a given
supply of real money balances. Decreases in the supply of real money balances shift the LM
curve upward. Increases in the supply of real money balances shift the LM curve downward.
A Quantity-Equation Interpretation of the LM Curve

The quantity theory of money states that MV(r) = PY; where V is velocity.

A higher interest rate raises the cost of holding money and reduces money demand. As people respond to
a higher interest rate by reducing the amount of money they hold, each currency in the economy
circulates from person to person more quickly- i.e. velocity of money increases. This implies that r and V
are positively related.
An increase in the interest rate raises the velocity of money. For a given money supply (M) and price
level (P), it raises the level of income (Y) (to maintain the equality). The LM curve expresses this positive
relationship between the interest rate and income. This equation also shows why changes in the money
supply shift the LM curve. For any given interest rate (i.e. constant velocity) and price level, an increase
in the money supply raises the level of income. Thus, increases in the money supply shift the LM curve to
the right, and decreases in the money supply shift the LM curve to the left.
The Short-Run Equilibrium
We now have all the components of the ISLM model. The two equations of this model are
Y= C (Y-T) + I(r) +G------------------------------------------IS

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 M/P = L(r, Y) ----------------------------------------------------LM
The model takes fiscal policy, G and T, monetary policy M, and the price level P as exogenous. Given
these exogenous variables, the IS curve provides the combination of r and Y that satisfy the equation
representing the goods market, and the LM curve provides the combinations of r and Y that satisfy the
equation representing the money market. These two curves are shown together in the figure below.

The equilibrium of the economy is the point at which the IS curve and the LM curve cross. This point
gives the interest rate r and the level of income Y that satisfy both the goods market equilibrium and the
money market equilibrium condition. In other words, at this intersection, actual expenditure equals
planned expenditure, and the demand for real money balances equals the supply.

3.1. Monetary and Fiscal Policy Analysis

The intersection of the IS curve and the LM curve determines the level of national income.
National income fluctuates when one of these curves shifts, changing the short-run equilibrium
of the economy.

3.1.1. Change in Fiscal Policy

Suppose that we start in equilibrium and that government spending is increased by DG. Then the
IS curve shifts to the right. The increased spending increases income and, through the multiplier
effects from the circular flow, also increases consumption; income increases further. (Recall that
the rightward shift of the IS curve equals DG/(1-MPC).) If we only had to worry about the goods
market, this would be the end of the story. But the increase in income, in turn, increases the
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demand for money for transaction purposes. This increased demand for money forces up the
interest rate, leading, in turn, to a decline in investment. Thus we observe short-run crowding
out: The increase in GDP is less than the simple Keynesian cross model would have predicted
because that model omits changes in the interest rate. A decline in taxes, like an increase in
government spending, shifts the IS curve out, causing interest rates and GDP to rise.
Fig: how change in G changes the short run equilibrium in the ISLM Model

3.1.2. Changes in Monetary Policy

Consider the effects of an increase in the money supply. This shifts the LM curve out. The
increased money supply causes interest rates to fall in order to bring the demand for money in
line with the new higher supply. This fall in interest rates encourages investment, leading
ultimately to an increase in GDP. Thus interest rates are lower and GDP is higher. The linkage
from a change in the money supply to GDP is known as the monetary transmission mechanism

Fig: how an increase in Money supply changes equilibrium income in the ISLM model

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3.2. Aggregate Demand and the IS-LM
We now consider how the ISLM model can also be viewed as a theory of aggregate demand. We
defined the IS and LM curves in terms of equilibrium in the goods and money markets,
respectively. Aggregate demand summarizes equilibrium in both of these markets.
Recall that the ISLM model is constructed on the basis of a fixed price level. For a given value of
the price level and the nominal money supply, the position of the LM curve is fixed. The real
money supply changes if either the nominal money supply or the price level changes. Thus we
can see that changes in the price level are associated with changes in the equilibrium level of
output and interest rates. This is the relationship that is summarized by the aggregate demand
curve.
If the price level is high, other things equal, the real money supply is low. This implies high
interest rates, and thus low investment and output. If the price level falls, then the real money
supply increases. Equilibrium in the money market implies that interest rates must fall.
Equilibrium in the goods market thus implies that output must rise, since investment rises. Thus
we find that the aggregate demand curve is downward sloping; high values of the price level are
associated with low level of output, and vice versa. Notice that the reason this curve slopes
downward is not easy to describe; it is not like the regular microeconomic demand curve for a
good.

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Because the aggregate demand curve summarizes the results of the ISLM model, shocks that shift the IS
curve or the LM curve cause the aggregate demand curve to shift. Thus, the result can be summarized as
follows: A change in income in the ISLM model resulting from a change in the price level represents a
movement along the aggregate demand curve. A change in income in the ISLM model for a fixed price
level represents a shift in the aggregate demand curve.

Numerical example

Consider the economy of Nepal.

 The consumption function is given by C = 250+0.75(Y-T). The investment

function is I = 200-25r, where r is the interest rate. Government purchases
and taxes are both 100. For this economy, find the IS equation.
Solution:

Consumption: C = 250 + 0.75(Y − T)

Investment: I = 200 − 25r

Balanced budget: T = G = 100

IS equation?
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 We know in three sector economy, the IS equation is

Y = C + I + G.

Solution:

Now substituting the value of C, I and G.

Y = 250 + 0.75(Y −T )+ 200 − 25r +100

or, Y = 250 + 0.75Y – 0.75T + 200 – 25r + 100

or, Y – 0.75Y = 550 – 0.75x100 - 25r

or, 0.25Y = 550 – 75 - 25r = 475 - 25r

or, Y = 1900 – 100r …………………(i)

 The money demand function in Nepal is (M/P)d = Y -100r. The money

supply Ms is 1,000 and the price level is 2. For this economy, find the LM
equation.
Solution:

 The money demand function (M/P) d = Y -100r.

 Money Supply (Ms) = 1000 and
 Price Level (P) = 2
LM equation?

Money market equilibrium, Ms = Md

Substituting the value of Ms and Md,

1000 = Y −100r

Or,Y = 1000 + 100r or …………..(2)

or, r = - 10 + 0.01Y

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CHAPTER FOUR:

AGGREGATE DEMAND IN THE OPEN ECONOMY

In previous chapters we simplified our analysis by assuming a closed economy. In

actuality, however, most economies are open: they export goods and services
abroad, they import goods and services from abroad, and they borrow and lend in
world financial markets. This chapter begins our study of open-economy
macroeconomics. To understand how the open economy works, we must
understand the key macroeconomic variables that measure the interactions among
countries. Accounting identities reveal a key insight: the flow of goods and
services across national borders is always matched by an equivalent flow of funds
to finance capital accumulation.

4. l.The International Flows of Capital and Goods

The key macroeconomic difference between open and closed economies is that, in
an open economy, a country’s spending in any given year need not equal its output
of goods and services. A country can spend more than it produces by borrowing
from abroad, or it can spend less than it produces and lend the difference to
foreigners. To understand this more fully, let’s take another look at national
income accounting, which we first discussed in Chapter 2.

4.1.1 The Role of Net Exports

Consider the expenditure on an economy’s output of goods and services. In a

closed economy, all output is sold domestically, and expenditure is divided into
three components: consumption, investment, and government purchases. In an
open economy, some output is sold domestically and some is exported to be sold
abroad. We can divide expenditure on an open economy’s output Y into four
components:

 Cd, consumption of domestic goods and services,

 I d, investment in domestic goods and services,
 Gd, government purchases of domestic goods and services,
 X exports of domestic goods and services.
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The division of expenditure into these components is expressed in the identity

Y=Cd+Id+Gd+X……………………………………………………………... (1)

The sum of the first three terms, C d+ I d+ Gd, is domestic spending on domestic
goods and services. The fourth term, X, is foreign spending on domestic goods and
services.

We now want to make this identity more useful. To do this, note that domestic
spending on all goods and services is the sum of domestic spending on domestic
goods and services and on foreign goods and services. Hence, total consumption C
equals consumption of domestic goods and services Cd plus consumption of
foreign goods and services Cf; total investment I equals investment in domestic
goods and services Id plus investment in foreign goods and services If; and total
government purchases G equals government purchases of domestic goods and
services Gd plus government purchases of foreign goods and services Gf. Thus,

C = Cd+ Cf……………………………………………(2)

I = I d + If………………………………………………(3)

G = Gd+ Gf………………………………………(3)

We substitute these three equations into the identity above:

Y = (C -Cf )+ (I - I f ) + (G - Gf ) + X………………………………(4)

We can rearrange to obtain

Y = C + I + G + X, (Cf+I+Gf )………………………………(5)

The sum of domestic spending on foreign goods and services (Cf+ I f+ Gf) is
expenditure on imports (M).We can thus write the national income accounts
identity as

Y =C +I +G +X-M…………………………………………(6)

Because spending on imports is included in domestic spending (C + I + G), and

because goods and services imported from abroad are not part of a country’s

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output, this equation subtracts spending on imports. Defining net exports to be
exports minus imports (NX = X - M), the identity becomes

Y=C+I+G+
NX……………………………………………………………… (7)

This equation states that expenditure on domestic output is the sum of

consumption, investment, government purchases, and net exports. This is the most
common form of the national income accounts identity; it should be familiar from
Chapter 2.

The national income accounts identity shows how domestic output, domestic
spending, and net exports are related. In particular,

NX = Y − (C + I + G) …………………………………… (8)

Net Exports = Output − Domestic Spending.

This equation shows that in an open economy, domestic spending need not equal
the output of goods and services. If output exceeds domestic spending, we
exportthe difference: net exports are positive. If output falls short of domestic
spending, we importthe difference: net exports are negative.

4.2ExchangeRates

Having examined the international flows of capital and of goods and services, we
now extend the analysis by considering the prices that apply to these transactions.
The exchange rate between two countries is the price at which residents of those
countries trade with each other. In this section we first examine precisely what the
exchange rate measures, and we then discuss how exchange rates are determined.

4.2.1. Nominal and Real Exchange Rates

Economists distinguish between two exchange rates: the nominal exchange rate
and the real exchange rate. Let’s discuss each in turn and see how they are related.

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The Nominal Exchange Rate: The nominal exchange rate is the relative price of
the currency of two countries. For example, if the exchange rate between the U.S.
dollar and the Ethiopian birr is 18 birr per dollar, then you can exchange one dollar
for 18 birr in world markets for foreign currency. An Ethiopian who wants to
obtain dollars would pay 18 birr for each dollar he bought. An American who
wants to obtain birr would get 18 birr for each dollar he paid. When people refer to
“the exchange rate’’ between two countries, they usually mean the nominal
exchange rate.

4.2.2. The Real Exchange Rate

The real exchange rate is the relative price of the goods of two countries. That is,
the real exchange rate tells us the rate at which we can trade the goods of one
country for the goods of another. The real exchange rate is sometimes called the
terms of trade. To see the relation between the real and nominal exchange rates,
consider a single good produced in many countries: cars. Suppose an American car
costs $10,000 and a similar Ethiopian car costs 360,000 birr. To compare the prices
of the two cars, we must convert them into a common currency. If a dollar is worth
18 birr, then the American car costs 180,000 birr. Comparing the price of the
American car (180,000 birr) and the price of the Ethiopian car (360,000 birr), we
conclude that the American car costs one-half of what the Ethiopian car costs. In
other words, at current prices, we can exchange two American cars for one
Ethiopian car.

We can summarize our calculation as follows:

Real Exchange rate=1dollar/18 birr*360,000 birr/Ethiopian car

1,000 dollar/American car

=2 American car

Ethiopian car

At these prices and this exchange rate, we obtain one-half of Ethiopian car per
American car. More generally, we can write this calculation as

Real exchange rate=Nominal exchange rate * price of Domestic good

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 Price of Foreign good

4..3Aggregate Demand in open Economy: The Mundell–Fleming model

When conducting monetary and fiscal policy, policymakers often look beyond
their own country’s borders. Even if domestic prosperity is their sole objective, it is
necessary for them to consider the rest of the world. The international flow of
goods and services and the international flow of capital can affect an economy in
profound ways. Policymakers ignore these effects at their peril.

In this chapter we extend our analysis of aggregate demand to include international

trade and finance. The model developed in this chapter, called the Mundell–
Fleming model, is an open-economy version of the IS–LM model. Both models
stress the interaction between the goods market and the money market. Both
models assume that the price level is fixed and then show what causes short-run
fluctuations in aggregate income (or, equivalently, shifts in the aggregate demand
curve).The key difference is that the IS–LM model assumes a closed economy,
whereas the Mundell–Fleming model assumes an open economy. The Mundell–
Fleming model extends the short-run model of national income from Chapter 3 by
including the effects of international trade and finance from the above discussion.

The Mundell–Fleming model makes one important and extreme assumption: it

assumes that the economy being studied is a small open economy with perfect
capital mobility. That is, the economy can borrow or lend as much as it wants in
world financial markets and, as a result, the economy’s interest rate is determined
by the world interest rate. One virtue of this assumption is that it simplifies the
analysis: once the interest rate is determined, we can concentrate our attention on
the role of the exchange rate.

One lesson from the Mundell–Fleming model is that the behavior of an economy
depends on the exchange-rate system it has adopted. We begin by assuming that
the economy operates with a floating exchange rate. That is, we assume that the
central bank allows the exchange rate to adjust to changing economic conditions.

We then examine how the economy operates under a fixed exchange rate, and we
discuss whether a floating or fixed exchange rate is better. This question has been
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important in recent years, as many nations around the world have debated what
exchange-rate system to adopt.

The Key Assumption: Small Open Economy with Perfect Capital Mobility

Let’s begin with the assumption of a small open economy with perfect capital
mobility. As we saw in discussion above, this assumption means that the interest
rate in this economy r is determined by the world interest rate r*. Mathematically,
we can write this assumption as

r = r*

The capital inflow would drive the domestic interest rate back toward r*.
Similarly, if any event were ever to start driving the domestic interest rate
downward, capital would flow out of the country to earn a higher return abroad,
and this capital outflow would drive the domestic interest rate back upward toward
r*. Hence, the r = r* equation represents the assumption that the international flow
of capital is rapid enough to keep the domestic interest rate equal to the world
interest rate.

The Goods Market and the IS* Curve

The Mundell–Fleming model describes the market for goods and services much as
the IS–LM model does, but it adds a new term for net exports. In particular, the
goods market is represented with the following equation:

Y = C (Y − T) + I(r*) + G + NX (e).

This equation states that aggregate income Y is the sum of consumption C,

investment I, government purchases G, and net exports NX. Consumption depends
positively on disposable income Y − T. Investment depends negatively on the
interest rate, which equals the world interest rate r*. Net exports depend negatively
on the exchange rate e. As before, we define the exchange rate e as the amount of
foreign currency per unit of domestic currency.

You may recall that in Chapter 5 we related net exports to the real exchange rate
(the relative price of goods at home and abroad) rather than the nominal exchange
rate (the relative price of domestic and foreign currencies). If e is the nominal
exchange rate, then the real exchange rate e equals eP/P*, where P is the domestic

47 | P a g e
price level and P* is the foreign price level. The Mundell–Fleming model,
however, assumes that the price levels at home and abroad are fixed, so the real
exchange rate is proportional to the nominal exchange rate. That is, when the
nominal exchange rate appreciates (say, from 18 to 10 birr per dollar), foreign
goods become cheaper compared to domestic goods, and this causes exports to fall
and imports to rise.

We can illustrate this equation for goods market equilibrium on a graph in which
income is on the horizontal axis and the exchange rate is on the vertical axis. This
curve is shown in panel (c) of Figure 4.3.1 and is called the IS* curve.

The new label reminds us that the curve is drawn holding the interest rate constant
at the world interest rate r*.

The IS* curve slopes downward because a higher exchange rate reduces net
exports, which in turn lowers aggregate income. To show how this works, the other
panels of Figure 4.3.1 combine the net-exports schedule and the Keynesian cross to
derive the IS* curve. In panel (a), an increase in the exchange rate from e1 to e2
lowers net exports from NX(e1) to NX(e2). In panel (b), the reduction in net
exports shifts the planned-expenditure schedule downward and thus lowers income
from Y1 to Y2.The IS* curves summarizes this relationship between the exchange
rate e and income Y.

The Money Market and the LM* Curve

The Mundell–Fleming model represents the money market with an equation that
should be familiar from the IS–LM model, with the additional assumption that the
domestic interest rate equals the world interest rate:

M/P=L(r*, Y).

Fig 4.3.1. Derivation of the IS*

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This equation states that the supply of real money balances, M/P, equals the
demand, L(r, Y ).The demand for real balances depends negatively on the interest
rate, which is now set equal to the world interest rate r*, and positively on income
Y. The money supply M is an exogenous variable controlled by the central bank,
and because the Mundell–Fleming model is designed to analyze short-run
fluctuations, the price level P is also assumed to be exogenously fixed.

We can represent this equation graphically with a vertical LM* curve, as in panel
(b) of Figure 4.3.2. The LM* curve is vertical because the exchange rate does not
enter into the LM* equation. Given the world interest rate, the LM* equation
determines aggregate income, regardless of the exchange rate. Figure 4.3.2 shows
how the LM* curve arises from the world interest rate and the LM curve, which
relates the interest rate and income.

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 Fig 4.3.1 Derivation of theLM* curve

Putting the Pieces Together

According to the Mundell–Fleming model, a small open economy with perfect

capital mobility can be described by two equations:

Y = C(Y − T )+ I(r*) + G + NX(e) IS*,

M/P = L(r*, Y )LM*.

The first equation describes equilibrium in the goods market, and the second
equation describes equilibrium in the money market. The exogenous variables are
fiscal policy G and T, monetary policy M, the price level P, and the world interest
rate r*.The endogenous variables are income Y and the exchange rate e.

Figure 4.3.3 illustrates these two relationships. The equilibrium for the economy is
found where the IS* curve and the LM* curve intersect. This intersection shows the
exchange rate and the level of income at which both the goods market and the

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money market are in equilibrium. With this diagram, we can use the Mundell–
Fleming model to show how aggregate income Y and the exchange rate e respond
to changes in policy.

Fig 4.3.3 The Mundell-Fleming Model

4.5-2 The Small Open Economy under Floating Exchange Rates

Before analyzing the impact of policies in an open economy, we must specify the
international monetary system in which the country has chosen to operate. We start
with the system relevant for most major economies today: floating exchangerates.
Under floating exchange rates, the exchange rate is allowed to fluctuate in response
to changing economic conditions.

Fiscal Policy

Suppose that the government stimulates domestic spending by increasing

government purchases or by cutting taxes. Because such expansionary fiscal policy
increases planned expenditure, it shifts the IS* curve to the right, as in Figure 4.3.4.
As a result, the exchange rate appreciates, whereas the level of income remains the
same. Notice that fiscal policy has very different effects in a small open economy
than it does in a closed economy. In the closed-economy IS–LM model, a fiscal
expansion raises income, whereas in a small open economy with a floating
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exchange rate, a fiscal expansion leaves income at the same level. Why the
difference?

Fig 4.3.4. A Fiscal Expansion under Floating Exchange rate

When income rises in a closed economy, the interest rate rises, because higher
income increases the demand for money. That is not possible in a small open
economy: as soon as the interest rate tries to rise above the world interest rate r*,
capital flows in from abroad. This capital inflow increases the demand for the
domestic currency in the market for foreign-currency exchange and, thus, bids up
the value of the domestic currency. The appreciation of the exchange rate makes
domestic goods expensive relative to foreign goods, and this reduces net exports.
The fall in net exports offsets the effects of the expansionary fiscal policy on
income.

Why is the fall in net exports so great that it renders fiscal policy powerless to
influence income? To answer this question, consider the equation that describes the
money market:

M/P =L(r, Y)

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In both closed and open economies, the quantity of real money balances supplied
M/P is fixed, and the quantity demanded (determined by r and Y ) must equal this
fixed supply. In a closed economy, a fiscal expansion causes the equilibrium
interest rate to rise. This increase in the interest rate (which reduces the quantity of
money demanded) allows equilibrium income to rise (which increases the quantity
of money demanded). By contrast, in a small open economy, r is fixed at r*, so
there is only one level of income that can satisfy this equation, and this level of
income does not change when fiscal policy changes. Thus, when the government
increases spending or cuts taxes, the appreciation of the exchange rate and the fall
in net exports must be large enough to offset fully the normal expansionary effect
of the policy on income.

Monetary Policy

Suppose now that the central bank increases the money supply. Because the price
level is assumed to be fixed, the increase in the money supply means an increase in
real balances. The increase in real balances shifts the LM* curve to the right, as in
Figure 4.3.5. Hence, an increase in the money supply raises income and lowers the
exchange rate.

Fig 4.3.5 A Monetary Expansion under floating exchange rate

Although monetary policy influences income in an open economy, as it does in a

closed economy, the monetary transmission mechanism is different. Recall that in
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a closed economy an increase in the money supply increases spending because it
lowers the interest rate and stimulates investment. In a small open economy, the
interest rate is fixed by the world interest rate. As soon as an increase in the money
supply puts downward pressure on the domestic interest rate, capital flows out of
the economy as investors seek a higher return elsewhere. This capital outflow
prevents the domestic interest rate from falling. In addition, because the capital
outflow increases the supply of the domestic currency in the market for foreign-
currency exchange, the exchange rate depreciates. The fall in the exchange rate
makes domestic goods inexpensive relative to foreign goods and, thereby,
stimulates net exports. Hence, in a small open economy, monetary policy
influences income by altering the exchange rate rather than the interest rate.

Questions for review

1. What are the net capital outflow and the trade balance? Explain how they are
related.
2. Define the nominal exchange rate and the real exchange rate.
3. If a small open economy cuts defence spending, what happens to saving,
investment, the trade balance, the interest rate, and the exchange rate?
4. If a small open economy bans the import of American car, what happens to
saving, investment, the trade balance, the interest rate, and the exchange
rate?
5. If small open economy has low inflation as compared to the large open
economy, what will happen to the exchange rate between the two countries?

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 6. In the Mundell–Fleming model with floating exchange rates, explain what
happens to aggregate income, the exchange rate, and the trade balance when
the money supply is reduced. What would happen if exchange rates were
fixed rather than floating?

UNIT FOUR

AGGREGATE SUPPLY ANALYSIS

INTRODUCTION
In the previous chapter we examined aggregate demand in some detail. The IS-LM model shows
how changes in monetary and fiscal policy and shocks to the money and goods market shift the
aggregate demand curve. In this chapter, we turn our attention to aggregate supply and develop
theories that explain the position and slope of the aggregate supply curve.

Objective of the chapter:

By the end of this chapter you are able to know
 How aggregate supply curve is derived
 Behaviour of aggregate supply in the short run
 Behaviour of aggregate supply in long run
 Model of aggregate supply: The sticky-wage, sticky-price and imperfect-information.
 Aggregate demand and aggregate supply analysis

Aggregate Supply

You remember that aggregate demand curve shows the negative relationship between price and
output. By it self, the aggregate demand curve does not tell us the price level or the amount of
output; it merely gives a relationship between these two variables. To accompany the aggregate
demand curve, we need another relationship between P and Y that crosses the aggregate demand
curve- an aggregate supply curve.

Definition: Aggregate supply (AS) is the relationship between the quantity of goods and services supplied
and the price level.

The aggregate demand and aggregate supply curves together pin down the economy’s price level and
quantity of output.

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Now we need to discuss two different aggregate supply curves this is because the firms that supply
goods and services have flexible prices in the long run but sticky prices in the short run, the aggregate
supply relationship depends on the time horizon.

Do you know the difference between long run and short run periods?

Most macroeconomists believe that the key difference between the short run and the long run is the
behavior of prices.

 In the long run, prices are flexible and can respond to change in supply or demand.
 In the short run, many prices are sticky at some predetermined level. Because prices behave
differently in the short-run than in the long run, economic policies have different effects over
different time horizons.

The long run: The vertical aggregate supply curve

Because the classical model describes how the economy behaves in the long run, we derive the long run
aggregate supply curve from the classical model. To show this, we write

Y= F ( K , L ) = Y

According to the classical model, out put does not depend on the price level. To show that output is the
same for all price levels, we draw a vertical aggregate supply curve, in the figure 3.1. The intersection of
the aggregate demand curve with this vertical aggregate supply curve determines the price level.

LRAS, long run aggregate supply

Price

Level=P

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 Output =Y

0 Y

Figure .3.1. The long run aggregate supply curve

If the aggregate supply is vertical, then changes in aggregate demand affects prices but not out put. For
example, if the money supply falls, the aggregate demand curves shifts down ward, as in figure 3.2. The
economy moves from the old intersection of aggregate supply and aggregate demand, point A to the
new intersection, point B. The shift in aggregate demand affects only prices.The vertical aggregate
supply curve satisfies the classical dichotomy, because it implies that the level of out put is independent
of the money supply. This long run level of out put, Y , is called the full employment or natural level of
out put. It is the level of output at which the economy’s resources are fully employed or, more
realistically, at which unemployment is at its natural rate.

LRAS

Price

AD1

AD 2

0 Y Income=output=Y

Figure 3.2 Shifts in Aggregate Demand in the long run

The short run: the Horizontal aggregate supply curve

The classical model and the vertical aggregate supply curve apply only on the long –run. In the short-run,
some prices are sticky and, therefore, do not adjust to changes in demand. Because of this price
stickiness, the short run aggregate supply curve is not vertical.
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As an extreme example, suppose that all firms have issued price catalogs and that it costly for them to
issue new ones. Thus, all prices are stuck at predetermined levels. At these prices, firms are willing to
sell as much as their customers are willing to buy, and they hire just enough labour to produce the
amount demanded. Because the price level is fixed, we represent this situation in figure 3.3 below with
a horizontal aggregate supply curve.

Price, P

short run aggregate supply, SRAS

0 Income=output=Y

Figure 3.3.The short-run Aggregate supply

The short-run equilibrium of the economy is the intersection of the aggregate demand curve and this
horizontal short-run supply curve. In this case, changes in aggregate demand do affect the level of
output. For example, if the central bank suddenly reduces the money supply, the aggregate demand
curve shifts inward, as in figure 3.4. The economy moves from the old intersection of aggregate demand
and aggregate supply, point A, to the new intersection, point B. The movement from point A to point B
represents a decline in output at a fixed price level.

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Thus, a fall in aggregate demand reduces output in the short-run because prices do not adjust instantly.
After the sudden fall in aggregate demand, firms are stuck with prices that are too high. With demand
low and prices high, firms sell less of their product, so they reduce production and lay off workers. The
economy experiences a recession.

B A SRAS

AD1

AD2

Income=output=Y

Figure .3.4. Shifts in Aggregate Demand in the short-run

3.2 Models of Aggregate supply

We have three models of aggregate supply:

 Sticky-wage model
 The imperfect-information Model
 Sticky-price model

In all the models, some market imperfection (that is, some type of friction) causes the output of the
economy to deviate from the classical target. As a result, the short-run aggregate supply curve is up
ward sloping, rather than vertical, and shifts in the aggregate demand curve causes the level of output

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to deviate temporarily from the natural rate. These temporary deviations represent the booms and
busts of the business cycle.

Although each of the three models takes us down a different theoretical route, each route ends up in
the same place. That final destination is a short-run aggregate supply equation of the form

Y=Y +α ( P−Pe ) , α >0

Where Y is output, Y is the natural rate of output, P is the price level, and P eis the expected price level.
This equation states that output deviates from its natural rate when the price level deviates from the
expected price level. The parameter α indicates how much output responds to unexpected changes in
the price level; 1/ α is the slope of the aggregate supply curve.

Each of the three models tells a different story about what lies behind this short-run aggregate supply
equation. In other word, each highlights some particular reason why unexpected movements in the
price level are associated with fluctuation in aggregate output.

3.2.1 The Sticky-Wage Model

To explain why the short-run aggregate supply curve is upward sloping, many economists stress the
sluggish adjustment of nominal wages. In many industries, nominal wages are set by long-term
contracts, so wages cannot adjust quickly when economic conditions change. Even in industries not
covered by formal contracts, implicit agreements between workers and firms may limit wage changes.
Wages may also depend on social norms and notions of fairness that evolve slowly. For these reasons,
many economists believe that nominal wages are sticky in the short run.

The sticky-wage model shows what a sticky nominal wage implies for aggregate supply. To preview the
model, consider what happens to the amount of output produced when the price level rises:

 When the nominal wage is stuck, a rise in the price level lowers the real wage, making labour
cheaper.

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  The lower real wage induces firms to hire more labour
 The additional labour hired produces more output

This positive relationship between the price level and the amount of output means that the aggregate
supply curve slopes upward during the time when the nominal wage can not adjust.

To develop this story of aggregate supply more formally, assume that workers and firms bargain over
and agree on the nominal wage before they know what the price level will be when their agreement
takes effect. The bargaining parties the workers and the firms have in mind a target real wage. The
target many be the real wage that equilibrate labor supply and demand. More likely, the target real
wage is higher than the equilibrium real wage.

The workers and firms set the nominal wage W based on the target real wage w and on their
e
expectation of the price level P . The nominal wage they set is
e
W= w ¿ P

Nominal wage = Target Real Wage ¿ Expected price level

After the nominal wage has been set and before labor has been hired, firms learn the actual price level
P. The real wage turns out to be

e
W/P = w ¿ ( P /P)

Expectedpricelevel
Real Wage= Target real Wage ¿ Actuaklpricelevel

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 This equation shows that the real wage deviates from its target if the actual price level differs from the
expected price level. When the actual price level is greater than expected, the real wage is less than its
target; when the actual price level is less than expected, the real wage is grater than its target.

The final assumption of the sticky-wage model is that employment is determined by the quantity of
labour that firms demand. In other words, the bargain between the workers and the firms does not
determine the level of employment in advance; instead, the workers agree to provide as much labour as
the firms wish to buy at the predetermined wage. We describe the firm’s hiring decisions by the labour
demand function

L= Ld (W/P),

This states that the lower the real wage, the more labour firms hire. The labour demand curve is shown
in figure 3.5A.Out put is determined by the production function

Y= F (L),

Which states that the more labour is hired, the more output is produced. This is shown in figure 3.5B
and figure 3.5C shows the resulting aggregate supply curve. Because the nominal wage is sticky, an
unexpected change in the price level moves the real wage away from the target real wage, and this
change in the real wage influences the amounts of labour hired and output produced. The aggregate
supply curve can be written as

Y=Y +α ( P−Pe )

Output deviates from its natural level when, the price level deviates from the expected price level.

Real wage,
W/P Income,Y

Y2 Y=F (L)

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W/P1 (A) Labour Demand

W/p2 Y1 (B) Production

Function

L=Ld (W/P)

0 L1 L2Labour, L 0 L 1 L2Labour, L

Y=Y +α ( P−Pe )
Price level

P2

(C) Aggregate supply

P1

Output, Y

0 Y 1 Y2

Figure. 3.5. Sticky-wage model

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3.2.2 The Imperfect-Information Model

The second explanation for the upward slope of the short-run aggregate supply curve is called the
imperfect-information model. Unlike the sticky-wage model, this model assumes that markets clear-
that is, all wages and prices are free to adjust to balance supply and demand. In this model, the short-
run and long run aggregate supply curve differs because of temporary misperception about prices.

The imperfect-information model assumes that each supplier in the economy produces a single good
and consumes many goods. Because the number of goods is so large, suppliers cannot observe all prices
at all times. They monitor closely the prices of what they produce but less closely the prices of all the
goods they consume. Because of imperfect information, they sometimes confuse changes in the overall
level of prices with changes in relative prices. This confusion influences decisions about how much to
supply, and it leads to a positive relationship between the price level and out put in the short run.

Consider the decision facing a single supplier-a wheat farmer, for instance. Because the farmer earn
income from selling wheat and uses this income to buy goods and services, the amount of wheat she
choose to produce depends on the price of wheat relative to the prices of other goods and services in
the economy. If the relative price of wheat is high, the farmer is motivated to work hard and produce
more wheat, because the reward is great. If the relative price of wheat is low, she prefers to enjoy more
leisure and produce less wheat.

Unfortunately, when the farmer makes her production decision, she does not know the relative price of
wheat. As a wheat producer, she monitors the wheat market closely and always knows the nominal
price of wheat. But she does not know prices of all the other goods in the economy. She must therefore,
estimate the relative price of wheat using the nominal price of wheat and her expectation of the overall
price level.

Consider how the framer responds if all prices in the economy, including the price of wheat, increase:

 One possibility is the she expected this change in prices. When she observes an increase in the
price of wheat, her estimate of its relative price is unchanged. She does not work any harder.
 The other possibility is that the framer did not expect the price level to increase (or to increase
by this much). When she observes the increase in the price of wheat, she is not sure whether
other prices have risen (in which case wheat’s relative price is unchanged) or whether only the
price of wheat has risen (in which case its relative price is higher). The rational inference is that
some of each has happened. In other words, the farmer infers from the increase in the nominal
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 price of wheat that its relative price has risen some what. She worked harder and produces
more.

Our wheat farmer is not unique. When the price level rises unexpectedly, all suppliers in the economy
observes increase in the price of the goods they produce. They all infer, rationally but mistakenly, that
the relative prices of the goods they produce have risen. They work harder and produce more.

To sum up, the imperfect-information model says that when actual prices exceed expected prices,
suppliers raise their output. The model implies an aggregate supply curve that is now familiar:

Y=Y +α ( P−Pe ) .

Output deviates from the natural rate when the price level deviates from the expected price level.

3.2.3. Sticky Price Model

The sticky price model emphasizes that firms do not instantly adjust the prices they charge in
response to changes in demand. Sometimes prices are set by long-term contracts between firms
and customers. Even without formal agreements, firms may hold prices stable in order not to
aggravate their regular customers with frequent price changes. Some prices are sticky because of
the way markets are structured: once a firm has printed and distributed its catalogue or price list,
it is costly to alter prices.

To see how sticky prices can help explain an up-ward –sloping aggregate supply curve, we first consider
the pricing decisions of individuals firms and then add to whole. In the previous discussions we have
thought of firms’ choosing how much output to produce, taking as given the price at which they can sell
their output. If we really want to explain why prices may be sticky, we have to think about who actually
sets prices and on what basis. In reality, firms generally set the prices at which they want to sell their
output. To analyze this situation properly, we need models of imperfect competition in which firms have
some monopoly power.

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Consider the pricing decision facing a typical firm. The firm’s desired price pdepends on tow
macroeconomic variables:

 The overall price P. A higher price level implies that the firm’s costs are higher. Hence, the
higher the overall price level, the more the firm would like to charge for its product.
 The level of aggregate income Y. A higher level of income raises the demand for the firm’s
product. Because marginal cost increases at higher levels of production, the greater the
demand, the higher the firm’s desired price.

We write the firm’s desired price as

p= P + a(Y − Y )
This equation says that the desired price p depends on the overall level of prices P and on the level of
aggregate output relative to the natural rate Y- Y . The parameter a (a > 0) measures how much the
firm’s desired price responds to the level of aggregate output.

Now assume that there are two types of firms. Some have flexible prices: they always set their prices
according to this equation. Others have sticky prices: they announce their prices in advance based on
what they expect economic conditions to be. Firms with sticky prices set prices according to

e e e
p= P + a(Y − Y )
For simplicity assume that these firms expect output to be at its natural rate, so the last term,
e e
a(Y − Y ) , is zero. Then these firms set price as
e
p= P .

That is, firms with sticky prices set their prices based on what they expect others firms to charge.

If s is the fraction of firms with sticky prices and 1 – s the fraction with flexible prices, then the overall
price level is

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 e
P = sP + (1−s)[ P +a(Y − Y )]
The first term is the price of the sticky-price firms weighted by their fraction in the economy, and the
second term is the price of the flexible-price firms weighted by their fraction. Now subtract (1-s) P from
both sides of this equation to obtain

e
P − P+ sP = sP +P +a(Y − Y ) − sP −sa(Y − Y ) − P + sP

sP = sP e + a(Y − Y ) − Sa(Y −Y )
e
sP = sP + a(1 − s)[Y −Y ]
Dividing both sides by s to solve for the overall price level:

a(1 − s)
P = Pe + [Y −Y ]
s

The two terms in this equation are explained as follows:

 When firms expect a high price level, they expect high costs. Those firms that fix prices in
advance set their prices high. These high prices cause the other firms to set high prices also.
Hence, a high-expected price level leads to a high actual price level P.
 When output is high, the demand for goods is high. Those firms with flexible prices set their
prices high, which leads to a high price level. The effect of output on the price level depends on
the proportion of firms with flexible prices.

Hence, the overall price level depends on the expected price level and on the level of output.

From the price equation above, we can derive the aggregate supply equation using some algebraic
manipulation.

a(1 − s)
Letting s to be n, the price equation above can be written as

e
P = P + n[Y −Y ] , And we can solve for Y- i.e.
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 nY =nY + P−P e
1
Y =Y + ( P−P e )
n
1
Letting to be equals to α
n
e
Y=Y +α ( P−P )
The sticky-price model says that the deviation of output from the natural rate is positively associated
with the deviation of the price level from the expected price level.

3.3. Aggregate demand and aggregate supply in long and short run

P AS2

P3=Pe3

AS1

P2 B
P1=P1e=p2e A

AD2
AD1

Y1=Y3= Y

Figure .3.6. Aggregate Demand and Aggregate Supply

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In the short run, the equilibrium moves from point A to B. the increase in aggregate demand raises the
actual price level from P 1 to P2. Because people did not expect this increase in the price level, the
expected price level remains at Pe2, and output rises from Y1 to Y2, which is above the natural rate Y .
Thus, the unexpected expansion in aggregate demand causes the economy to boom.

Yet the boom does not last forever. In the long run, the expected price level rises to catch up with
reality, causing the SR aggregate supply curve to shift upward. As the expected price level rises from P e2
to Pe3, the equilibrium of the economy moves from point B to point C. The actual price level rises from P 2
to P3, and output falls from Y2 to Y3 = Y . In other words, the economy returns to the natural level of
output in the long run, but at a much higher price level.

CHAPTER SUMMURY

 The crucial difference between the long run and short run is that prices are flexible in the long
run but sticky in the short run. The model of aggregate supply and aggregate demand provides a
framework to analyze economic fluctuation and see how impact of policies varies over different
time horizons.
 In the long run, the aggregate supply curve is vertical because output is determined by the
amounts of capital and labor and by the available technology, but not by the level of prices.
Therefore, shifts in aggregate demand affect the price level but nit output or employment.
 In the short run, the aggregate supply curve is horizontal, because wages and prices are sticky at
predetermined levels. Therefore, shifts in aggregate demand affect output and employment.
 The three theories of aggregate supply- the sticky-wage, imperfect-information and the sticky-
price models attribute deviations of output and employment from the natural rate to various
market imperfections. Accordingly, to all three theories, output rises above the natural rate
when the price level exceeds the expected price level, and output falls below the natural rate
when the price level is less than the expected price level.
 The aggregate demand curve slopes downward. It tells us that the lower the price level, the
greater the aggregate quantity of goods and services demanded.
 Shocks to aggregate demand and aggregate supply cause economic fluctuation. Because the
central bank shifts the aggregate demand curve, it can attempt to offset these shocks to
maintain output and employment at their natural rates.

Self test 7

Discussion question

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1. Give an example of a price that is sticky in the short run and flexible in the long run
2. Why does the aggregate demand curve slope down ward?
3. Explain the impact of an increase in the money supply in the short run and in the long run
4. Explain the three theories of aggregate supply. On what market imperfection does each theory
rely? What do the theories have in common?

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