CHAPTER ONE

THE STATE OF
MACROECONOMICS
 1.1 What macroeconomics is about?
• Economics is divided in to two major branches:
Microeconomics and Macroeconomics.
• Microeconomics
– Deals with economic behavior of an individual
decision-making unit (consumer and producer) or
an economic variable (Price and quantity of a
good)
 Cont.…
• Macroeconomics
• Macroeconomics, branch of economics concerned
with the aggregate, or overall, economy.
Macroeconomics deals with economic factors such as
total national output and income, unemployment,
balance of payments, and the rate of inflation.
• Is the study of the behaviour of the economy as a
whole. It concerns the business cycles that lead to
unemployment and inflation, as well as the longer-
term trends in output and living standards.
 Cont..
• The state of macroeconomics affects everyone’s life;
they play a central role in political debate.
• Countries fix their relation with the others based on
their macroeconomic policies.
• It is also the base for the regional economic
integration. example, Europe has moved towards a
common currency, COMESA set a tax exemption
region among the member countries etc.
 Cont.…
 Macroeconomics is a young and imperfect science
 Macroeconomists were not generally successful in
predicting the global economic crisis of 2008
 Even after the crisis, they were unable to agree on
what should be done to deal with the crisis
 Nevertheless, the importance of the subject is
clearer than ever
 1.2 Method of macroeconomics
analysis
• Macroeconomics is the study of the economy
as a whole
• Macroeconomists collect data on incomes,
price levels, interest rates, unemployment,
and many other macroeconomic variables
from different time periods and different
countries
• They then try to build general theories to
explain the data that history gives them
 Cont..
• Economic Model: is a theory that summarises,
often in mathematical terms, relationships
among economic variables.
• Theory: is a system of ideas explaining something,
especially one based on general principles
independent of the particular things to be
explained. Or,
• An economic theory is a generalisation based on
a few principles that enables us to understand
and predict the economic choices made by
people.
 Cont..
• Exogenous Variables: are determined outside of
the model.
• Endogenous Variables: are determined within the
model. And do capture the decisions made by
people in which we are primarily interested in
learning about.
• In building economic models economists tend to
assume two general principles about how people
and the societies in which they exist behave in
trying to understand the decisions made by
people:
 Cont..

• Optimisation Principle-people are motivated

by self-interest, or equivalently, that people try
and do the best they can.
• Equilibrium Principle-that people’s actions
tend to become consistent with each other. In
the limit the economic forces are so balanced
that there is no tendency for people’s
behaviour to change.
 1.3 Macro goals Continues…
– Full employment
– High living standards
– Price stability
– Reduction of economic inequality
– Rapid economic growth
– Steady foreign exchange position
 Policy Instruments
• Fiscal Policy
• Monetary Policy
• Other, employment, international trade, price
& income policy
 Cont.
• Fiscal Policy
– concerned with the use of taxes and
government expenditures.
– Government has to meet various
expenditures like salaries, defense expenses,
infrastructure development, etc
– All these expenses leave a positive effect on
the overall economy
 Cont…
– The other part of the fiscal policy is generation of revenues
for the government.
– Taxes are the main source of revenue for any government.
– Taxes affect the economy and the individuals in two ways.
• bring down the disposable income in the hands of the
consumers. This reduces the spending in the economy.
• Second, the taxes levied on goods and services make
them costlier. This discourages the firm to invest in
capital goods.
 Monetary Policy
– is the second most widely used macroeconomic
policy instrument.
– helps government, managing the nation’s money,
credit, and banking system.
– There are various entities that are part of the
monetary system of an economy.
– Central bank regulates the monetary system, and
other entities like banks, insurance companies are
also a part of the monetary system.
– In Ethiopia, National Bank of Ethiopia is the
custodian of the monetary system of the economy.
 Cont.
• Central bank brings changes in the interest rates, reserve
requirements, etc. These changes make significant impact on
the overall functioning of the economy.
• For example, the lowering of interest rates on housing
loans helped the growth of the housing sector. As a result
of low rate of interest, it became easier to avail a housing
loan and to own a house.
Employment Policy
– adopted by government in order to increase the
employment level in the country.
Price and Incomes Policy
– This policy aims at regulating the prices in the market
and also to ensure the minimum wages to the workers.
 Cont.…
• International Trade Policy
– Globalization has given a big push to the
international trade. This has resulted in framing of
specific polices by many countries to cope with
the new challenges. International trade policy
addresses issues like tariff and non tariff barriers.
 1.4 Evolution of macroeconomics
• Economic thinking has begun since the cradle of
mankind
• Since today’s knowledge of the economics evolves
over time based on preexisting knowledge and some
historical events. To do so, we have to look different
schools of thought of macroeconomics.
 Classical 1776-1936
 Keynesian 1936- 1970
 After 1970 there is no dominant school of thought in
macroeconomics .there are different schools of
thought with different ideas (Monetarism, new
classical, new Keynesians, institutional and others).
 Pre classical school
Mercantilist
• They try to explain how growth of an economy achieved based
on their observation about situation that Britain experiences at
the time. During 17thand 18th centuries Britain becomes a
prosperous nation due to over sea trade.
• When there is balance of trade deficit, which means import >
export a country pays or spending more on foreign goods than
spending on domestic goods. i.e. more money(gold)flow
abroad and boosts (increase) foreign income through
increasing effective demand and reduces effective demand
for domestic output.
• on the other hand when there is balance of trade
surplus(export is greater than import) there is more money
(gold) inflow which increases effective demand for domestic
goods (output) then increase output production then which
bring economic growth for the nation.
 Physiocrates
• Physiocrates deal with feudal economy of French and
illustrates the flow of commodities through the process of
production and consumption like the modern input –output
analysis.
• In feudal economy there are three social classes: land lords,
peasant and Artisans.
• Physiocrates draw two policy implications to bring
economic growth (output expansion).
1. It was wrong for the government to tax peasants since
taxation depletes the stock that is necessary for them to
use in the course of reproducing the surplus.
2. It was necessary to improve method of production to
increase the productivity of land to expand the total
surplus.
 Classical school of thought
• It is a macroeconomics idea of 1776-1936 periods.
During this time, there was no unified or formalized
theory of aggregate employment and origin of business
cycle.
• The ruling principle was the invisible hand coined by
Alfred Marshall.
Major Assumption
• All markets including labor market always clear (the
economy always operates at equilibrium and at
equilibrium all resources are fully employed).
• No government intervention is needed in the form of
stabilization policies, it is neither desirable nor
necessary to achieve full employment.
 Cont.…
• Economic agents (firms and households) are rational
and aim to maximize their profit or utility.
• All markets are perfectly competitive so that agents
decide how much to buy and sell on the basis of a
given set of prices which are perfectly flexible.
• All agents have perfect knowledge of market
conditions and prices before engaging in trade.
• Trade only takes places when market –clearing prices
have been established in all markets.
• Agents have stable expectation.
 Cont..
• Classical macroeconomists explain the determination of
crucial macro variables by dividing the economy in to
two sectors: the real sector and monetary sector. This
is usually known as classical dichotomy. They should
be studied separately.
• Demand-side policies mainly affect nominal variables
such as interest rate and prices while supply side
polices affect real variables such as real wage,
employment and output.
 Cont..
• Classical used short run production function to
explain the determinants of real output. At micro
level production function shows the relationship
between the maximum outputs levels produced
from a given amount of inputs.
• The more input, labor and capital that a firm uses,
the greater will be the output produced. When we
consider the economy as whole the quantity of total
output (GDP) will also depends on the amount of
input used and how efficiently they are used.
• Where; Y - real output, L-amount labor used, K-
capital used, and
• Y= f A(K,L)
 Cont.…
Say’s Law
• classical however, there is no possibility of deficiency of
aggregate demand by appealing to say’s law. This law
would be stated as: supply creates its own demand. In
other words, the act of production simultaneously creates
income and purchasing power, so there would be no
impediment to full employment caused by deficiency of
aggregate demand.
• For classical the equality of aggregate demand and supply
consistent with labour market equilibrium. That is the
aggregate spending in the economy will always be
sufficient to purchase the full employment level of output.
 Keynesian School (1936 – 1970s)
• In general theory of Keynes interest rate is purely a
monetary phenomenon determined by the liquidity
preference (demand for money) of the public in
conjunction with the supply of money which is
determined by monetary authorities.
• Keynesian rejects the classical notion of neutrality of
money
• Rise in the general price (Inflation) is the result of
increase in nominal wage. An increase in wage
causes an increase in aggregate demand. These will
cause excess demand over the amount of output
supplied resulting inflationary condition.
 Cont.…
• Keynes and Economic Policy
• 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.
• basic Keynesian answer to recessions is a monetary expansion.
• 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”
• “liquidity trap”- the government has to do what the private
sector will not: spend.
 Cont..
• 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.
Features of the Keynesian school
• The economy is inherently unstable and subject to erratic
shocks.
• The economy can take long time to return to full employment
level after being subjected to some disturbance, i.e. the
economy is not rapidly self-equilibrating because of the
rigidities of prices. As a result involuntary unemployment of
labor is the major feature of Keynesian.
• fiscal and monetary policies play an important role in
stabilizing the economy.
• The aggregate level of output and employment is essentially
determined by aggregate demand. The authorities can
intervene to influence the level of aggregate effective demand
to ensure a more rapid return to full employment to improve
the performance of the economy.
 Monetarism
• Monetarism, as advocates of free market, started
challenging Keynes’s theory in the 1970s. Milton
Friedman, the founder of monetarism, attacked Keynes
idea.
• 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”.
• Monetary policy is best tool to make the economy stable
 The New Classical School
• The new classical macroeconomics remained influential in the
1980s. This school of macroeconomics shares many policy views
with Friedman.
The central working assumptions of the new classical school.
 Economic agents maximize
 Expectations are rational
 Markets clear
The New Keynesians
• The new classical group remains highly influential in today’s
macroeconomics. But a new generation of scholars, the new
Keynesians, mostly trained in the Keynesian tradition but
moving beyond it, emerged in the 1980s. They do not believe
that markets clear all the time but seek to understand and
explain exactly why markets fail.