TECHNO STAR COLLEGE

DEPARTMENT OF ACCOUNTING
AND FINANCE

Distance Module for Degree

Program
Course Title: - Macroeconomics
Course Code: - Econ1061
January, 2021

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CHAPTER-ONE...................................................................................................................................................................... 3
THE STATE OF MACROECONOMICS.....................................................................................................................................3
1.1. Definition of Macro economics............................................................................................................................4
1.2. Evolution of macroeconomics schools of thoughts and recent development.....................................................4
1.2.1. The orthodox macroeconomics........................................................................................................................4
1.2.2. Recent Developments in Macroeconomics (1970s – Present)..........................................................................5
CHAPTER TWO: NATIONAL INCOME ACCOUNTING............................................................................................................6
2.1. Basic Concepts and Methods of Macroeconomic Analysis..................................................................................6
2.2. National Income Accounts Identity......................................................................................................................7
2.3. Approaches of Measuring National Income.........................................................................................................7
2.4. The GDP Deflator and Consumer price Index.....................................................................................................8
CHAPTER THREE: AGGREGATE DEMAND AND SUPPLY ANALYSIS.....................................................................................10
3.1. Income Expenditure Approach..........................................................................................................................10
3.1.1. National Income Accounts Identity................................................................................................................10
3.1.1.1. In an open economy..................................................................................................................................10
3.1.1.2. In a closed economy..................................................................................................................................11
3.2. Equilibrium in the goods and services market:..................................................................................................12
3.2.1. The supply and demand for the economy output..........................................................................................12
3.3. Saving-Investment Balance................................................................................................................................13
3.4. Planned and actual Expenditure........................................................................................................................13
3.5. Fiscal Policy and the Multiplier..........................................................................................................................13
CHAPTER- FOUR: OPEN ECONOMY MACROECONOMICS.................................................................................................15
4.1. The Basic Open Economy Model......................................................................................................................15
4.1.1. The Open Economy National Income Accounts Identity...............................................................................15
4.1.2. Open-Economy Multipliers............................................................................................................................16
4.2. The International Flows of Capital and Goods...................................................................................................17
4.2.1. International Capital Flows and the Trade Balance........................................................................................17
4.3. Exchange Rates..................................................................................................................................................18
4.3.1. Nominal Exchange Rate.................................................................................................................................18
4.3.2. Real Exchange Rate.......................................................................................................................................18
CHAPTER FIVE: CONSUMPTION AND INVESTMENT..........................................................................................................19

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 5.1. Consumption Function.......................................................................................................................................19
5.1.1. Keynesian theory of consumption..................................................................................................................19
5.1.2. Irving Fisher and Inter-temporal Choice........................................................................................................19
5.1.3. Franco Modigliani and the Life-Cycle Hypothesis........................................................................................19
5.1.4. Milton Friedman and the Permanent-Income Hypothesis..............................................................................20
5.1.5. Robert Hall and the Random-Walk Hypothesis.............................................................................................20
5.2. Investment Spending..........................................................................................................................................20
5.2.1. BUSINESS FIXED INVESTMENT..............................................................................................................20
5.2.2. RESIDENTIAL INVESTMENT...................................................................................................................23
5.2.3. INVENTORY INVESTMENT......................................................................................................................23
REVIEW QUESTIONS: CHOOSE THE CORRECT ANSWER.................................................................................................23
ASSIGNMENT (30%).......................................................................................................................................................31

CHAPTER-ONE

THE STATE OF MACROECONOMICS

Introduction
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Economics is the study of the economy and the behavior of people in the economy.
Traditionally, economics is divided into two: microeconomics and macroeconomics. Microeconomics
studies the behavior of individuals and organizations (consumers, firms and the like) at a disaggregated
level and macroeconomics studies the overall or aggregate behavior of the economy. That means
macroeconomics explains phenomena such as inflation, unemployment, and economic growth while
microeconomics concerned with the demand for or supply of a specific commodity

1.1. Definition of Macro economics

Macroeconomics is a branch of economics that deals with aggregate components of the economy. In other
words, macroeconomics is concerned with the behavior of the economy as a whole. It is concerned with: -

 with booms and recessions,

 The economy’s total output of goods and services and the growth of output
 The rate of inflation and unemployment,
 The balance of payments, and
 Exchange rates.
 The macroeconomics policy of any country focuses in achieving the following three most important
objectives. These are:
1. Economic growth
2. Stability of the economy.
3. Reducing unemployment
 Macroeconomics instruments
To achieve the above three objectives economic policy makers of countries use mix of macroeconomics
instruments. The most important instruments among others include monetary policy, fiscal policy, income
policy, and labor policy.

1.2. Evolution of macroeconomics schools of thoughts and recent development

Macroeconomics as a branch of economics was emerged 244 years back with the writing of Adam Smith “The
wealth of Nation” in 1776. The historical evolution of macroeconomics from 1776 to date is discussed briefly
by dividing it into two broad categories: the orthodox and recent/contemporary macroeconomics schools.

1.2.1. The orthodox macroeconomics

Includes macroeconomics thinking of schools of thoughts evolved between 1776 and 1975.The three schools
of thought categorized under the orthodox macroeconomics school are the classical school of thought, the
neo-classical school of thought, and the Keynesian macroeconomics.

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 A. The classical school of thought (1776 - 1870)
► The ruling principle (the dominant idea) of this school of thought was the invisible hand or laissez-faire
(which means leave the market free or free market) coined by Alfred Marshall and advocated by Adam Smith.

►The reason for their argument was that supply will create its own demand or price set by the private sector
alone will automatically correct/equilibrate any imbalance or disequilibria created in the economy in both the
short run and the long run without government intervention. This law is called the “Says law”.
B. The Neo classical school of thought (1870 - 1936)
 The idea of the neoclassical school of thought was not different from the classical school. The only
difference between the two schools of thought is the contribution that is made by Marshall on
‘absolute and comparative advantage’ of nations in international trade.

C. The Keynesian macroeconomics (1936-1975)

An American economist called John Maynard Keynes challenged/criticized the classical wisdoms of
macroeconomics based on the events or episodes during the great economic depression of the early
1930s (1929 to 1935).
The great depression was caused by excessive or overproduction of wheat and coffee. Due to excess
production than demanded, the price of wheat and coffee goes down; implying supply fails to create its
demand as argued by the classical.
The main thesis of the Keynesian stream is that the economy is subjected to failure so that it may
not achieve full employment level. Thus, government intervention is inevitable (unavoidable).

1.2.2. Recent Developments in Macroeconomics (1970s –

Present)
A. The New Classical School
The new classical macroeconomics remained influential in the 1980s. This school of
macroeconomics shares many policy views with Friedman. It sees the world as one in which
individuals act rationally in their self-interest in the markets that adjust rapidly to
changing conditions. According to it, the government worsens things if it intervenes in the market.
The central working assumptions of the new classical school are three:
 Economic agents maximize
 Expectations are rational
 Markets clear
The essence of the new classical approach is the assumption that markets are continuously in equilibrium. That
means prices and wages adjust in order to equate supply and demand. In other words, they are market clearing.
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B. The New Keynesians
►The New Keynesian macroeconomics is the school of thought in modern macroeconomics that
evolved from the ideas of John Maynard Keynes.

►New Keynesian economists believe that market-clearing models cannot explain short-run
economic fluctuations, and so they advocate models with "sticky" wages and prices. New Keynesian
economists, however, believe that market-clearing models cannot explain short-run economic
fluctuations, and so they advocate models with "sticky" wages and prices.

CHAPTER TWO: NATIONAL INCOME ACCOUNTING

Introduction

The single most important measure of overall economic performance is Gross Domestic Product
(GDP). In other words GDP is the value of all final goods and services produced in the economy in a
given time period by using the resources supplied by either the citizens or foreigners.

2.1. Basic Concepts and Methods of Macroeconomic Analysis

Nominal GDP: - is the value of goods and services measured at current (market) prices.
Real GDP:- is the value of goods and services measured using a constant set of prices (or base-year prices).

Real GDP provides a better measure of economic well-being than nominal GDP.

Gross National Product (GNP) - is the value of all final goods and services produced by domestically owned
factors of production within a given period.

 GDP is territorial while GNP is national.

 Therefore, Gross national product (GNP) is obtained by adding receipts of factor income (wages, profit,
and rent) from the rest of the world to and subtracting payments of factor income to the rest of the
world from GDP:

GNP= GDP + Factor Payments from Abroad Factor Payments to Abroad

 Subtraction of capital depreciation (the amount of the economy's stock of plants, equipment, and residential
structures that wear out during the year) from GNP gives net national product (NNP) of a country, i.e.

NNP= GNP Depreciation

 In the national income accounts, depreciation is called the consumption of fixed capital and it

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 accounts about 10 % of GNP.
 Depreciation of capital is a cost of producing the output of the economy, subtracting depreciation shows the
net result of economic activity.
 In the national income accounts when indirect business taxes such as sales taxes are subtracted from NNP,
national income is obtained:

National Income=NNP Indirect Business Taxes

 National income measures how much everyone in the economy has earned.

2.2. National Income Accounts Identity

i. In an open economy
In an open economy, the NI accounts divided GDP in to four broad categories of spending
Consumption (C), Investment (I), Government purchases (G) and Net exports (NX).

Therefore, the open-economy NI accounts identity is:

Y C  I  G  NX ............................................(1)
Note

NXs are the value of goods and services exported to other countries minus the value of goods &
services imported to the domestic country.
ii. In a closed economy
A closed economy’s GDP has three components only: Consumption (C), Investment (I) and Government
purchases (G).

Therefore, the NI accounts identity of a closed economy is:

Y=C +I +G.........................................(2)

2.3. Approaches of Measuring National Income

 Value added method:
 Income Method-
GDP = Wage Income + After-Tax Profits + Interest Income + Taxes
 Expenditure method
GDP = Consumption (C) + Investment (I) + Government Expenditure (G) + Net Exports (NX)

Where NX (Net export) = X (export)-IM (import)

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 2.4. The GDP Deflator and Consumer price Index
Price index: - A number that represents all prices for a given period of time –say a year.
Consumer price index (CPI):- The consumer price index (CPI) is a measure of the overall cost of the
goods and services bought by a typical consumer. It is used to monitor changes in the cost of living
over time. When the CPI rises, the typical family has to spend more dollars to maintain the same
standard of living.

How the Consumer Price Index Is Calculated

Fix the Basket-identifies a market basket of goods and services the typical consumer buys,
Find the Prices: Find the prices of each of the goods and services in the basket for each point in time,
Compute the Basket’s Cost-Use the data on prices to calculate the cost of the basket of goods and services at
different times
Choose a Base Year and Compute the Index-Designate one year as the base year, making it the benchmark
against which other years are compared then Compute the index by dividing the price of the basket in one year
by the price in the base year and multiplying by 100. Finally
compute the inflation rate- the percentage change in the price index from the preceding period.

The GDP Deflator versus the Consumer Price Index

The GDP deflator is calculated as follows:

The GDP deflator reflects the prices of all goods and services produced domestically and compare the price of
currently produced goods and services to the price of the same goods and services in the base year. Whereas
the consumer price index reflects the prices of all goods and services bought by consumers and compares the
price of a fixed basket of goods and services to the price of the basket in the base year.

Calculating the CPI

Basket Quantity Price Base

Year

Food 10 $10

Doctor 2 $50

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 Rent 1 $700

Gasoline 50 $2

Basket Cost $1000

Item Quantity Price Base Year Price Today

Food 10 $10 $20

Doctor 2 $50 $100

Rent 1 $700 $1400

Gasoline 50 $2 $4

Basket $1000 $2000

Cost CPI=
200

CPI= (Basket Cost current year/ Basket Basket is 2 times more

Cost base year)*100 expensive today than in the
base year

Calculating Inflation

We use price indices to measure inflation like Consumer Price Index (CPI), Producer Price Index (PPI), Gross
Domestic Product deflator (GDP deflator).

The inflation rate is calculated as follows:

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 Or

(Deflator Year X) - (Deflator previous year)

Some of the causes of Inflationare Demand-Pull Inflation-Increases when the demand increases Example:
Good economic conditions cause demand to increase and Cost-Push Inflation-The increase in costs can push
the prices up.

CHAPTER THREE: AGGREGATE DEMAND AND SUPPLY ANALYSIS

Introduction
The total output (GDP) of an economy equals its total income or total expenditure

3.1. Income Expenditure Approach

3.1.1. National Income Accounts Identity

3.1.1.1. In an open economy

In an open economy, households consume some of the economy’s output; firms and households use
some of the output for investment; the government buys some of the output for public purposes; and
firms export some of the output to foreign countries and import some products from abroad. Because of
this the NI accounts divided GDP in to four broad categories of spending Consumption (C),Investment
(I),Government purchases (G) and Net exports (NX).

Therefore, the open-economy NI accounts identity is:

Y C  I  G  NX ............................................(1)

3.1.1.2. In a closed economy

In a closed economy, a country does not conduct trade with other countries. Therefore, net exports are always
zero. Because of this, a closed economy’s GDP has three components only: Consumption (C), Investment (I)
and Government purchases (G).
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Therefore, the NI accounts identity of a closed economy is:

Y=C +I +G.........................................(2)

Consumption

The level of consumption depends directly on the level of disposable income. Thus, consumption is a function
of disposable income and the relationship between consumption & disposable income is called consumption
function. As a result, the consumption function can be expressed as:

C=c(Y−T )...............................................(3)

Where c =is marginal propensity to consume (MPC)

 MPC is the amount by which consumption changes when disposable income changes by one unit. The
MPC is always between zero and one (1), that means an extra unit of income increases consumption by
less than one unit because of saving.

Investment

Investment consists of goods bought for future use. Investment is divided in to three: business fixed
environment, residential fixed environment and inventory environment

1. Business fixed investment

2. Residential fixed investment.
3. Inventory investment

The quantity of investment goods demanded depends on the interest rate, which measures the cost of funds
used to finance investment. For an investment project to be profitable, its return must exceed its cost (the
payment for borrowed funds). If the interest rate rises, fewer investment projects are profitable and the
quantity of investment goods demanded falls & vice versa

Government purchases (G)

Government purchases consist of the goods and services bought by federal, state & local governments. This
category includes the purchases of military equipment, library books and the services of government
employees; construction of schools, roads& other public works; hiring of teachers etc.

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 If government purchases (G) equal with tax (T), the government has a balanced budget. If G>T, the
government runs a budget deficit which is funded by issuing government debt, i.e. by borrowing in the
financial markets. If G<T, the government runs a budget surplus which is used repay some of the
government’s debt,

3.2. Equilibrium in the goods and services market:

3.2.1. The supply and demand for the economy output

Interest rate has the crucial role for equilibrating supply & demand in the goods and services market.
The demand for the economy output (goods and services) comes from consumption, investment &

government purchases. Consumption depends on disposable income, i.e. C=c (Y −T ) ; investment

depends on the real interest rate, i.e. I =I (r ) ; and government purchases & taxes are exogenous

variables set by fiscal policy makers ,i.e. G= G and T=T .

Besides, the factors of production and production function together determine the total output of goods and
services which are supplied equal to the economy’s output, i.e.

Y=F(K , L)=Y ..................................................(7) This is supply of output.

Here the supply of output is fixed since it is assumed that the supplies of labor and capital and the technology
are fixed.

Y =C +I +G. . .. .. . .. .. .(8 )
Form equation (2), the NI accounts for a closed economy is

This represents demand for the economy’s output.

ButC=c (Y −T ) , I =I (r ) ,G= G and T=T . So the NI accounts identity can be rewritten as:

Y=c(Y −T )+I (r)+G.........................................(9)

At equilibrium demand for and supply of the economy’s output are equal, i.e.
Y =Y

=>Y=c(Y −T )+I (r)+G....................................(10)

3.3. Saving-Investment Balance

The NI accounts identity Y =C + I +G can be rearranged as:

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Y−C−G=I ...................................................(11)

The term Y −C−G is the output that remains after the demands of consumers and government have been
satisfied .Because of this is it is called national saving (or saving).This national saving can be divided in to
two: saving of the private sector & saving of the government ,i.e.

(Y −T −C )+(T −G)=I ..................................(12)

Y −T −C is disposable income minus consumption & represents private saving. T −G Which is government
revenue minus government spending represents public saving. Therefore, national saving is the sum of private
& public saving. As a result,

S=(Y −T −C )+(T −G)=I

=> S=I ......................................................(12) This is called saving-investment balance.

3.4. Planned and actual Expenditure

 Actual expenditure is the amount households, firms, and the government spend on goods and services, and
it equals with the economy's gross domestic product (GDP).Planned expenditure is the amount
households, firms, and the government would like to spend on goods and services.
Assuming that the economy is closed so, net exports are zero. So, planned expenditure E can be written as the
sum of consumption C, planned investment I, and government purchases G:
E=C+I +G −−−−−−−−−−−−−−−−−(1)
Actual Expenditure= Planned Expenditure
Y= E

3.5. Fiscal Policy and the Multiplier

a. Government Purchases (government purchases multiplier)
Because government purchases are one component of expenditure, higher government purchases result in
higher planned expenditure for any given level of income. If government purchases rise by ∆ G, then the
planned-expenditure schedule shifts upward by ∆ G.
. The ratio ∆Y/∆G is called the government purchases multiplier, which shows by how much income rises
in response to a $1 increase in government purchases.
When expenditure rises by ∆G, income increases by ∆G. The total effect on income is
Initial Change in Government Purchase ∆G
First Change in Consumption = MPC × ∆G
Second Change in Consumption = MPC2 × ∆G

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Third Change in Consumption = MPC3 × ∆G
________________________________________________________
From this
ΔY =(1+ MPC+MPC 2 +MPC 3 +−−−) ΔG .. . .. .. . .. .. . .. .. . .. .. .. . .. .(8 )
So the government purchase multiplier is
ΔY
=1+ MPC+ MPC 2 + MPC 3 +−−− .. .. . .. .. . .. .. .. . .. .. . .. .. . .. .. .( 9 )
ΔG
ΔY 1
=
ΔG (1−MPC ) => Government purchases multiplier………… (10)
Example-1

If the marginal propensity to consume is 0.6, what will be the government expenditure multiplier? And
interpret it.
ΔY 1
= =2 .5
Solution: ΔG 1−0 . 6

This implies when government purchases increases by $1, equilibrium income rises by $2.50.

b. Tax multiplier
►Tax multiplier is the amount by which income changes when taxes change by one unit. A decrease in taxes
of ∆T immediately raises disposable income(Y T) by ∆ T and therefore, increases consumption by MPC× ∆ T.
► So the overall effect of a decrease in taxes on income is
First Change in Consumption = MPC × ∆T
Second Change in Consumption = MPC2 × ∆T
Third Change in Consumption = MPC3 × ∆T
________________________________________________________

From this

ΔY =( MPC+MPC 2 +MPC 3 +−−−) ΔT .. .. .. . .. .. . .. .. . .. .. . .. .. . .. .. . .(11)

So the tax multiplier is
ΔY
=MPC + MPC 2 + MPC 3 +−−− . .. . .. .. . .. .. . .. .. . .. .. .. . .. .. . .. .( 12)
ΔT
ΔY −MPC
= ..........................................................................(13)
ΔT 1−MPC
(Tax multiplier)

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Example-2

If the marginal propensity to consume is 0.6, by how much income will increase when taxes reduced by $100?

ΔY 0. 6
= =1 . 5
ΔT 1−0 .6
ΔY
ΔY = . ΔT
ΔT
ΔY =(1. 5)( $ 100 )
Solution: ΔY =$ 150

This implies when taxes are reduced by $100, equilibrium income rises by $150.

CHAPTER- FOUR: OPEN ECONOMY MACROECONOMICS

Introduction
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.

4.1. The Basic Open Economy Model

4.1.1. The Open Economy National Income Accounts Identity

In an open economy, some output is sold domestically and some is exported to be sold abroad.
Therefore, expenditure on an open economy’s output Y can be divided into four components:
C d = consumption of domestic goods and services
I d = investment in domestic goods and services

G d = government purchases of domestic goods and services

X = exports of domestic goods and services.
The division of expenditure into these components is expressed in the identity
Y =C d +I d +Gd +X . .. . .. .. .. . .. .. . .. .. . .. .. . .. .. . .. .. . .. ..(1 )
d d d
The sum of the first three terms, C + I +G , is domestic spending on domestic goods and services. The
fourth term, X, is foreign spending on domestic goods and services.

4.1.2. Open-Economy Multipliers

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The assumptions underlying basic multiplier analysis are:
1. Both domestic prices and the exchange rate are fixed.
2. The economy is operating at less than full employment so that increases in demand result
in an expansion of output, and
3. The authorities adjust the money supply to changes in money demand by pegging the
domestic interest rate.
Rearranging equation (4)
π

π
δ
Given that δ is equal to the marginal propensity to save δ , that is, the fraction of any increase in

income that is saved. By substitutingδ by δ , the following equation is obtained:

δ
Divide both sides of equation (7) by Δ

δ
Equation (8) can be transformed into difference form to yield:

δ
From equation (9) it is possible to derive various multipliers.
i. The Government Expenditure Multiplier
The first multiplier of interest is the government expenditure multiplier, which shows the increase
in national income resulting from a given increase in government expenditure. This is given by:

δ
The above equation says that an increase in government expenditure will have an expansionary effect on
national income, the size of which depends upon the marginal propensity to save and the marginal
propensity to import.
ii. Export Multiplier

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 In this simple model, the multiplier effect of an increase in exports is identical to
that of an increase in government expenditure and is given by:
Marketvalueofinstalledcapital
Re plecementCostof InstalledCapital
iii. The Current Account Multiplier
The other relationships of interest are the effects of an increase in government expenditure and of exports on
the current account balance. The current account (CA) is given by:
Δ
By differentiating equation (10) totally, it is possible to find the following:
Δ
Substituting equation (9) in to equation (11):

d ( CA )=dX−dM a−m
[ 1
s+m
( dC a + dI + dG+ dX−dM a ) ]
m
d ( CA )=dX−dM a−
s+m
( dC a+dI+dG+dX −dM a ) . . .. .. . .. .. .(12)
From equation (12) above, the effects of an increase in government expenditure on the current account balance
is derived and given by:
d (CA ) −m
= <0
dG s+ m
The other multiplier of interest is the effect of an increase in exports on the current account balance.
This is given by the expression:
d (CA ) m s
=1− = >0
dX s +m s+ m
s
Since s +m is less than unity, an increase in exports leads to an improvement in the current account
balance that is less than the original increase in exports.

4.2. The International Flows of Capital and Goods

4.2.1. International Capital Flows and the Trade Balance

In an open economy, like in the closed economy, financial markets and goods markets are closely related. This
relationship can be shown by rewriting the national income accounts identity in terms of saving and
investment. Begin with the identity
Y =C + I +G+ NX

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Subtract C and G from both sides to obtain
Y −C−G=I + NX

But ( Y −C−G ) which is the national saving S is the sum of private saving( Y −T −C ) and public saving,
( T −G ) .Therefore,
S=I +NX ........................................................(9)
By subtracting I from both sides of equation-9 the national income accounts identity can be written as
S−I =NX ......................................................(10)
The national income accounts identity shows that net capital outflow always equals the trade balance. That is,

Net Capital Outflow = Trade Balance S−I =NX

4.3. Exchange Rates
Exchange rate is the price of one national currency in terms of another. There are two types of exchange rates
which are distinguished by economists: nominal exchange rate and real exchange rate.

4.3.1. Nominal Exchange Rate

Nominal exchange rate is the relative price of currencies of two countries.

4.3.2. Real Exchange Rate

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 the goods of one country can be traded for the goods of another. The real exchange rate is
sometimes called the terms of trade.
For example, suppose an American car costs $10,000 and a similar Japanese car costs 2,400,000 yen. To
compare the prices of the two cars, the prices of the two cars must be converted into a common currency. If a
dollar is worth 120 yen, then the American car costs 1,200,000 yen. Comparing the price of the American car
(1,200,000 yen) and the price of the Japanese car (2,400,000 yen), it is possible to conclude that the American
car costs one-half of what the Japanese car costs. In other words, at current prices, two American cars can be
exchanged for one Japanese car.
This calculation can be summarized as follows:

Re al exchange rate=
( $ )(
Y 120 $ 10 , 000
American car )
Y 2 , 400 ,000 /Japanese car
=0 . 5 Japanese car/ American car
At these prices and this exchange rate, someone can obtain one-half of a Japanese car per American car.
Generally, the relationship between the real and nominal exchange rates can be expressed as:

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 No min al exchange rate×Price of domestic good
Re al exchange rate=
Pr ice of foreign good or

ε =e×
( PP )
¿

Where e =is the nominal exchange rate ,

P =is the price level of the domestic good and
P*= is the price level of the foreign good
ε = is the real exchange rate
If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively
expensive. If the real exchange rate is low, foreign goods are relatively expensive, and domestic goods
are relatively cheap.

CHAPTER FIVE: CONSUMPTION AND INVESTMENT

5.1. Consumption Function

5.1.1. Keynesian theory of consumption

Keynes made the consumption function central to his theory of economic fluctuations, and it has played a key
role in macroeconomic analysis ever since. Let's consider what Keynes thought about the consumption
function, and then see what puzzles arose when his ideas were confronted with the data.

5.1.2. Irving Fisher and Inter-temporal Choice

The economist Irving Fisher developed the model with which economists analyze how rational, forward-
looking consumers make Intertemporal choices— that is, choices involving different periods of time.
The Inter-temporal Budget Constraint
The reason people consume less than they desire is that their consumption is constrained by their income.
When they are deciding how much to consume today versus how much to save for the future, they face an
Intertemporal budget constraint, which measures the total resources available for consumption today and
in the future.

5.1.3. Franco Modigliani and the Life-Cycle Hypothesis

Modigliani emphasized that income varies systematically over people's lives and that saving allows

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 consumers to move income from those times in life when income is high to those times when it is

low. This interpretation of consumer behavior formed the basis for his life-cycle hypothesis.

5.1.4. Milton Friedman and the Permanent-Income Hypothesis

Unlike the life-cycle hypothesis, which emphasizes that income follows a regular pattern over a
person's lifetime, the permanent-income hypothesis emphasizes that people experience random and
temporary changes in their incomes from year to year.
Permanent income is the part of income that people expect to persist into the future.
Transitory income is the part of income that people do not expect to persist.

5.1.5. Robert Hall and the Random-Walk Hypothesis

Recent research on consumption has combined this view of the consumer with the assumption of
rational expectations. The rational-expectations assumption states that people use all available
information to make optimal forecasts about the future. This assumption can have profound implications
for the costs of stopping inflation. It can also have profound implications for the study of consumer
behavior.

5.2. Investment Spending

Investment is the most volatile component of GDP.
There are three types of investment spending.

5.2.1. BUSINESS FIXED INVESTMENT

The standard model of business fixed investment is called the neoclassical model of investment. The
neoclassical model examines the benefits and costs to firms of owning capital goods. The model shows how
the level of investment – the addition to the stock of capital-is related to the MPK, the interest rate, and the
tax rules affecting firms.
To develop the model, there are two kinds of firms in the economy.
A- THE RENTAL PRICE OF CAPITAL /PRODUCTION FIRM/
The firm rents capital at a rental rate R and sells output at a price P; the real cost of a unit of capital to the
production firm is R/P. The real benefit of a unit of capital is the MPK -the extra output produced with one
more unit of capital.
To maximize profit, the firm rents capital until the MP K falls to equal the real rental price. ►To see what
variables influence the equilibrium rental price, it is instructive to consider a particular production
function. Many economists consider the Cobb-Douglas production function a good approximation of how
the actual economy turns capital and labor into goods and services. The Cobb-Douglas production function

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 is
Y = AKaL1-a
where Y is output, K capital, L labor, A a parameter measuring the level of technology, and a a parameter
between zero and one that measures capital's share of output. The MP K for the Cobb-Douglas production
function is MPK = aA(L/K)1-a
Because the real rental price equals the MPK in equilibrium, we can write
R/P = aA (L/K)1-a
B- THE COST OF CAPITAL /RENTAL FIRM/
These firms like car-rental companies, merely buy capital goods and rent them out.
The benefit of owning capital is the revenue from renting it to the production firms. The rental firm
receives the real rental price of capital, R/P, for each unit of capital it owns and rents out.
 The rental firm bears three costs:
1. If the firm borrows to buy the capital, it must pay interest. If P K is the purchase price of a unit of capital,
and is the nominal interest rate, then iPK is the interest cost.
2. If the price of capital falls, the firm loses, because the firm's asset has fallen in value. If the price rises, the
firm gains. The cost of this loss or gain is - Δ PK.
3. If δ is the rate of depreciation-the fraction of value lost per period due to wear and tear-then the dollar cost
of depreciation is δ PK.
The total cost of renting out a unit of capital for one period is therefore

Cost of Capital = iPK - Δ PK + δ PK

= PK (i - Δ PK /PK + δ )
 For example, consider the cost of capital to a car-rental company. The company buys cars at $10,000
each and rents them out to other business. The company faces an interest rate i of 10% per year, so the
interest cost iPK is $1,000 per year for each car the company owns. Car prices are rising at 6% per year,
so, excluding wear and tear, the firm gets a capital gain Δ PK of $600 per year. Cars depreciate at 20%
per year, so the loss due to wear and tear δ PK is $2,000 per year. Therefore, the company's cost of
capital is
Cost of Capital = $1,000 - $600 + $2,000 =$2,400
The cost to the car-rental company of keeping a car in its capital stock is $2400 per year.
In this case, Δ PK /PK equals the overall rate of inflation π . Because i - π equals the real interest rate r, we can
write the cost of capital as

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 Cost of Capital = PK(r +δ )
The real cost of capital - the cost of buying and renting out a unit of capital measured in units of the
economy's output-is

Real Cost of Capital = (PK/P)(r + δ )

This equation states that the real cost of capital depends on the relative price of a capital good P K/P, the real
interest rate r, and the depreciation rateδ .

 THE DETERMINANTS OF INVESTMENT

For each unit of capital, the firm earns real revenue R/P and bears the real cost (P K/P)(r + δ ). The real
profit per unit of capital is
Profit Rate = Revenue - Cost

= R/P - (PK/P)(r + δ )
Since the real rental price in equilibrium equals the MPK, we can write the profit rate as

Profit Rate = MPK - (PK/P)(r + δ )

The rental firm makes a profit if the MPK is greater than the cost of capital. It incurs a loss if the MPK is less
than the cost of capital.
For a firm that both uses and owns capital, the benefit of an extra unit of capital is the MP K, and the cost is
the cost of capital. Like a firm that owns and rents out capital, this firm adds to its capital stock if the MP
exceeds the cost of capital. Thus, we can write
Δ K = In (MPK-(PK/P)(r + δ ))

where In is the function showing how much net investment responds to the incentive to invest.
We can now derive the I function. Total spending on business fixed I is the sum of net I and the replacement of
depreciated capital. The I function is

I = In (MPK-(PK/P)(r + δ )) + δ K.
Business fixed I depends on the MPK, the cost of capital, and the amount of depreciation.
This model shows why I depends on the i rate. An increase in the real i rate raises the cost of capital.
. Eventually, as the capital stock adjusts, the MP K approaches the cost of capital. When the capital stock
reaches a steady-state level, we can write

MPK = (PK/P)(r + δ )
Thus, in the long run, the MPK equals the real cost of capital. .

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 5.2.2. RESIDENTIAL INVESTMENT
Residential investment includes the purchase of new housing both by people who plan to live in it
themselves and by landlords who plan to rent it to others. To keep things simple, however, it is useful
to imagine that all housing is owner-occupied.

5.2.3. INVENTORY INVESTMENT

Inventory investment is one of the smallest components of spending, averaging about 1% of GDP. Yet its
remarkable volatility makes it important. In recessions, inventory investment becomes negative because firms
stop replenishing their inventory as goods are sold. In a typical recession, more than half the fall in spending
comes from a decline in inventory investment.
 Reasons for Holding Inventories
1) Smoothens the level of production over time.
2) Operates more efficiently.
3) Avoids running out of goods
4) A fourth explanation of inventories is dictated by the production process.

REVIEW QUESTIONS: CHOOSE THE CORRECT ANSWER

1. Which idea is not correct?
A) Economics is the study of the economy and the behavior of people in the economy.
B) Microeconomics studies the behavior of individuals and organizations (consumers, firms and
the like) at a disaggregated level
C) Macroeconomics studies the overall or aggregate behavior of the economy.
D) All of the above
2. One of the following is one phenomenon studied under macroeconomics?

A) Inflation. B) Unemployment C) Economic Growth D) National income E) All of the above

3. ______________is not a concern of macroeconomics?
A) booms and recessions
B) the economy’s total output of goods and services and the growth of output
C) The rate of inflation and unemployment
D) The balance of payments and exchange rates
E) Individual demand and supply
4. Which one is a macroeconomic instrument?
A) Monetary policy B) Fiscal policy C) Income policy D) labor policy E) All
5. How many years is since macroeconomics is emerged?

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 A) 244 B) 344 C) 238 D) 254 E) 444
6. Macroeconomics thinking of schools of thoughts evolved between 1776 and 1975 is______________.
A) Orthodox macroeconomics B) Recent macroeconomics
C)Contemporary macroeconomics D) B and C
7. The central idea of the classical macroeconomists is?
A) Supply creates its own demand B) Demand creates its own supply
C) Government intervention inevitable. D) All of the above
8. Which school of macroeconomic thought has exited from 1870 - 1936?
A) The classical school of thought B) The Neo classical school of thought
C) The Keynesian macroeconomics D) The New Classical School
9. One of the following is correct about GDP?
A) It is single most important measure of overall economic performance
B) It is a measure of the economy's total output and total income
C) GDP is not a good gauge (measure) of economic well-being
D) All of the above
10. ________is the value of all final goods and services produced by domestically owned factors of
production within a given period.
A) Gross Domestic Product B) Gross National Product C) Net Factor Income
D) Net National Product E) All of the above
11. What does “NX” indicate in the equation “Y=C+I+G+NX”?
A) Consumption B) Investment C) Government Purchase D) Net Exports
12. Which one is missed from the national income accounts of a closed economy?
A) Consumption B) Investment C) Government Purchase D) Net Exports
13. ____________ is one of the approaches to measure national income.
A) Value added Method B) Income Method C) Expenditure method D) All of the above
14. A number that represents all prices for a given period of time –say a year is called_______________.
A) Price Index B) Consumer Price Index C) Inflation rate D) Basket Cost E) GDP Deflator
15. The output the economy could produce is?
A) Actual output B) Potential output C) Output Gap D) All of the above
16. Which one is one of the types of investment?
A) Business fixed investment C) Inventory investment
B) Residential fixed investment D) All of the above

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 17. ________ is a phase of the business cycle and is also known as prosperity phase.
A) Boom B) Recession C) Depression D) Recovery E) All
18. Which one is the amount households, firms, and the government spends on goods and services, and it
equals with the economy's gross domestic product (GDP)?
A) Actual Expenditure B. Government purchase C. Planned Expenditure D. All of the above
19. _________is the amount by which income changes when taxes change by one Unit.?
A) Tax Multiplier B) Government Purchase Multiplier C) Income Multiplier D) All of the above

20. One of the following is one of the models of aggregate supply?

A) The Sticky-Wage Model B. The Imperfect-Information Model C. The Sticky-Price Model

D) The Workers -misperception Model E. All of the above

I. Say “True” if the idea is Correct and “False” if the idea is Incorrect
1. Microeconomics concerned with the demand for or supply of a specific commodity.
2. Macroeconomics concerned with both explanation and policy prescriptions.
3. The classical school of thought is coined by Alfred Marshall and advocated by Adam Smith.
4. For Adam Smith and his followers any government policy is ineffective to correct economic disorder or
disequilibrium.
5. The new classical macroeconomics remained influential in the 1980s.
6. Real GDP is the value of goods and services measured using a constant set of prices (or base-year
prices).
7. GNP= GDP + Factor Payments from Abroad Factor Payments to Abroad.
8. Demand-Pull Inflation-Increases when the demand increases.
9. Labor force is defined as the sum of the employed and unemployed persons.
10. MPC is the amount by which consumption changes when disposable income changes by one unit.
11. If government purchases (G) equal with tax (T), the government has a balanced budget.
12. Planned expenditure is the amount households, firms, and the government would like to spend on
goods and services.
13. The national income accounts identity shows that net capital outflow always equals the trade balance.
14. Nominal exchange rate is the relative price of currencies of two countries.
15. The real exchange rate is sometimes called the terms of trade.
16. Intertemporal budget constraint, measures the total resources available for consumption today and in
the future.
17. Life-cycle hypothesis of consumption was first provided by Franco Modigliani.

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 18. Transitory income is the part of income that people do not expect to persist.
19. The investment tax credit is a tax provision that encourages the accumulation of capital.
20. One of the most important determinants of housing demand is the real interest rate.
II. FILL IN THE BLANK WITH A CORRECT ANSWER
1. ________________________ refers to achieving low or stable inflation (Л), nominal interest rate (r),
and exchange rate.
2. ______________________is one of the important assumptions of the new classical school.
3. The New Keynesian macroeconomics is the school of thought in modern macroeconomics that
evolved from the ideas of ______________________________.
4. ______________________________ is a cost of producing the output of the economy, subtracting
depreciation shows the net result of economic activity.
5. ___________________________________ measures changes in prices that manufacturers and
wholesalers pay for goods during various stages of production.
6. Full employment output is also called________________________.
7. _____________________________ is defined as the percentage of the labor force that is
unemployed.
8. The level of consumption depends directly on the level of ______________________.
9. _______________________is the purchase of new housing by households and landlords.
10. T −G Which is government revenue minus government spending represents ___________.
11. ________________________ is the amount households, firms, and the government spend on goods
and services, and it equals with the economy's gross domestic product (GDP)
12. The ratio ∆Y/∆G is called _________________________ which shows by how much income rises in
response to a $1 increase in government purchases.
13. __________________ is the relationship between quantity of goods and services supplied and
the price level.
14. _________________ shows the increase in national income resulting from a given increase in
government expenditure.
15. If SI or NX are negative, there is a _______________________________.
16. _____________________ is the price of one national currency in terms of another.
17. _____________________________ exchange rate quotation quotes the price of foreign currency in
terms of dollars.
18. The real exchange rate is sometimes called the _________________.
19. _____________________________ measures the total resources available for consumption today and

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 in the future.
20. _____________________________ is the most volatile component of GDP.

III. MATCH COLUMN ‘’B’’ WITH COLUMN ‘’A’’ WITH THE CORRECT ANSWER
A B
_____1- Trade balance A) Macroeconomic concept
_____2 Economic growth B) Rise in out put
_____3- The Neo classical school of thought C) 1870 - 1936
_____4- The Keynesian macroeconomics D ) 1936-1975
_____5- Cause of Great depression E) Excessive production of coffee and wheat
_____6- Robert Lucas and Robert Barro F) New Keynesians
_____7- NNP G) GNP Depreciation
_____8- Nx H) Net Exports
_____9- Closed economy Account I) GDP=C+G+I
_____10- Output gap J) Potential Output-Actual output.
_____11- trade balance K) net export of goods and services
_____12- Terms of trade L) Real exchange rate
_____13- the Life-Cycle Hypothesis M) Franco Modigliani
_____14- Permanent-Income Hypothesis N) Milton Friedman
_____15- Investment O) Most volatile component of GDP
_____16- Profit Rate P) Revenue-Cost
_____17- GDP in a closed economy Q) C+I+G
_____18- Prices of shares and securities fall down R) Depression
_____19- Monetary disequilibrium S) One cause of Business cycle
_____20- Fiscal Policy T) Policy concerned about taxation
IV. ANSWER THE FOLLWING QUESTIONS CAREFULLY AND CORRECTLY
1. The amount of consumption in Tigray in 2019 was 2 billion Birr while the amount of Investment
flow was 5 billion Birr and government expenditure was estimated to be 1 billion Birr. The same
year Tigray imports 1billion worth of goods and exports about 500million Birr. Tigray has also
paid a net payment of 500 million Birr to the foreigners but received a net payment of 800million
Birr from abroad. Calculate

A) GDP and Net Exports of Tigray in 2019?

______________________________________________________

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 B) GNP and Net Factor Income of Tigray in the same year?
______________________________________________________

C) NNP of Tigray in the same year? (Hint: - use the amount of depreciation as a proportionate of
the GDP). ______________________________________________________

D) What will be the amount of GDP if Tigray has to follow a closed economy?
______________________________________________________

2. Let’s assume a country has earned total revenue of 20Billion Birr from taxes in 2018. The citizens
of the country have earned about 5 Billion Birr as salaries and wages where as the business
corporation after-tax income amounted 15 Billion Birr. In the same year, the amount of interest
income from the financial institutions was 7 Billion Birr.

Find the country’s total income (GDP) in 2018.

3. Given the table below

ITEM QUANTITY Price per unit ( Base Unit Price (Today)

Year)
Food 10 5 Birr 50 Birr
House rent 2 35 Birr 1400 Birr

Doctor 1 20 Birr 200 Birr

Gas oil 50 5 Birr 20 Birr

a) What is the amount of basket costs in the base year and today?
___________________________________________________
b) Calculate the consumer price index and interpret it.
_____________________________________________

4. Ethiopia’s economy can produce 900 Billion Birr if conducive economic policy has followed but
the economy of Ethiopia actually produces about 7 Billion Birr. Calculate the output gap?

5. Assume that the labor force of a country is 50 million. 75% of the labor force is employed. What
will be the unemployment rate of the country?

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 ________________________________________________
6. If the Marginal propensity to consume is 0.75.

What will be the amount government multiplier?

______________________________________________
7. If the marginal propensity to consume is 0.5, by how much income will increase when taxes
reduced by Birr 10000.00?
____________________________________________
8. Given the data below (2018 )

ITEM AMOUNT ITEM AMOUNT

Consumption of 210 Billion Consumption of foreign 120 Billion Birr

domestic goods and Birr goods and services
services
Investment in domestic 100 Billion Investment in foreign 55 Billion Birr
goods and services Birr goods and services
Government purchases 15 Billion Government purchases of 5 Billion Birr
of domestic goods and Birr Foreign goods and
services services
Exports of domestic 22 Billion Imports of foreign goods 32 Billion
goods and services Birr and services Birr
a) Calculate the amount of total consumption, total investment, total government purchase
and net exports? __________________________________________
b) Find the amount of GDP in the particular year.
9. The nominal wage which the workers and firms set is Birr 5,500.00 The expected price and the
actual price of selling is Birr 500.00 and 650.00 Birr respectively. Calculate the real wage and the
target real wage of the firms and the workers?
________________________________________________
10. The price of a car produced in Japan is sold 120,000.00 Yen when selling in Japan and Birr
245,000.00 in Tigray. The same car produced in Tigray is sold Birr 250,000.00. The nominal
exchange rate of Yen against Birr is 1:25. Calculate the real exchange rate?
11. Consider the cost of capital to Trans Ethiopia plc. The company buys 50 Trucks at 100,000.00 each
and rents them out to other business. The company faces an interest rate i of 10% per year for each

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 truck the company owns. Truck prices are rising at 6% per year excluding wear and tear. Trucks
depreciate at 20% each per year. Find
a) Interest cost ( iPk) ____________________________________________
b) Capital gain (∆Pk) ____________________________________________
c) Depreciation of the trucks ____________________________________________
d) The cost of capital and interpret it. ____________________________________________

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ASSIGNMENT (30%)
1) CHOOSE THE CORRECT ANSWER(0. 5PTS EACH)
1. One of the following is one phenomenon studied under macroeconomics?

A) Inflation. B) Unemployment C) Economic Growth D) National income E) All

2. Which one is a macroeconomic instrument?
A) Monetary policy B) Fiscal policy C) Income policy D) labor policy E) All
3. Macroeconomics thinking of schools of thoughts evolved between 1776 and 1975 is______________.
A) Orthodox macroeconomics B. Recent macroeconomics
C) Contemporary macroeconomics D. B and C

_____4- Which school of macroeconomic thought has exited from 1870 - 1936?

A) The classical school of thought

B) The Neo classical school of thought
C) The Keynesian macroeconomics

D) The New Classical School

_____5- ________is the value of all final goods and services produced by domestically owned factors of
production within a given period.

A) Gross Domestic Product

B) Gross National Product
C) Net Factor Income
D) Net National Product
E) All of the above

_____6- Which one is missed from the national income accounts of a closed economy?

B) Consumption B) Investment C) Government Purchase D) Net Exports

D) All of the above

_____7- A number that represents all prices for a given period of time –say a year is called_______________.

B) Price Index B) Consumer Price Index C) Inflation rate D) Basket Cost E) GDP Deflator
_____8- Which one is one of the types of investment?

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 E) Business fixed investment
F) Residential fixed investment
G) Inventory investment
H) All of the above

_____9- Which one is the amount households, firms, and the government spends on goods and services, and
it equals with the economy's gross domestic product (GDP)?

B) Actual Expenditure
C) Government purchase
D) Planned Expenditure
E) All of the above

_____10- One of the following is one of the models of aggregate supply?

E) The Sticky-Wage Model
F) The Imperfect-Information Model
G) The Sticky-Price Model
H) The Workers -misperception Model
I) All of the above

1) SAY “TRUE” IF THE IDEA IS CORRECT AND

“FALSE” IF THE IDEA IS INCORRECT(0. 5PTS EACH)
_____1- Microeconomics concerned with the demand for or supply of a
specific commodity.
_____2- The classical school of thought is coined by Alfred Marshall
and advocated by Adam Smith.
_____3- The new classical macroeconomics remained influential
in the 1980s.
_____4- GNP= GDP + Factor Payments from Abroad Factor
Payments to Abroad.

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_____5- Labor force is defined as the sum of the employed and
unemployed persons.
_____6- If government purchases (G) equal with tax (T), the government
has a balanced budget.
_____7- The national income accounts identity shows that net capital
outflow always equals the trade balance.
_____8- The real exchange rate is sometimes called the terms of trade.
_____9- Life-cycle hypothesis of consumption was first provided by

Franco Modigliani.
_____10- The investment tax credit is a tax provision that encourages the
accumulation of capital.

2) FILL IN THE BLANK WITH A CORRECT

ANSWER(0.5PTS EACH)
1- ______________________is one of the important assumptions of the
new classical school.
2- ______________________________ is a cost of producing the output
of the economy, subtracting depreciation shows the net result of
economic activity.
3- ___________________________________ measures changes in
prices that manufacturers and wholesalers pay for goods during various
stages of production.
4-______________________________ is defined as the percentage of
the labor force that is unemployed.

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5- _______________________is the purchase of new housing by
households and landlords.
6- ________________________ is the amount households, firms, and
the government spend on goods and services, and it equals with the
economy's gross domestic product (GDP)
7-__________________ is the relationship between quantity of goods
and services supplied and the price level.
8- If SI or NX are negative, there is a
_______________________________.
9-______________________________ exchange rate quotation quotes
the price of foreign currency in terms of dollars.
10- _____________________________ measures the total resources
available for consumption today and in the future.

3) MATCH COLUMN ‘’B’’ WITH COLUMN ‘’A’’ WITH

THE CORRECT ANSWER (0.5PTS EACH)
A B
_____1- Economic growth A) Rise in out put
_____2- The Keynesian macroeconomics B) 1936-1975
_____3- Robert Lucasand Robert Barro C) New Keynesians
_____4- Nx D) Net Exports
_____5- Output gap E) Potential Output-Actual output.
_____6- Terms of trade F) Real exchange rate
_____7- Permanent-Income Hypothesis G) Milton Friedman
_____8- Profit Rate H) Revenue-Cost
_____9- Prices of shares and securities fall down I) Depression
_____10- Fiscal Policy J) Policy concerned about taxation
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 4) ANSWER THE FOLLWING QUESTIONS
CAREFULLY AND CORRECTLY(2 PTS EACH)
12. The amount of consumption in Tigray in 2018 was 1.8 billion
Birr while the amount of Investment flow was 3.5billion Birr and
government expenditure was estimated to be 700,000,000.00 Birr.
The same year Tigray imports 1billion worth of goods and exports
about 400million Birr. Tigray has also paid a net payment of 200
million Birr to the foreigners but received a net payment of
400million Birr from abroad. Calculate
A) GDP and Net Exports of Tigray in 2018?
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________
B) GNP and Net Factor Income of Tigray in the same year?
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________

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 C) NNP of Tigray in the same year? (Hint: - use the amount of
depreciation as a proportionate of the GDP).
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________
D) What will be the amount of GDP if Tigray has to follow a
closed economy?
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________
2- Given the table below
ITEM QUANTITY Price per unit Unit Price
( Base Year) (Today)
Food 20 10 Birr 100 Birr
House 2 40 Birr 1600 Birr
rent

Doctor 1 30 Birr 300 Birr

Gas oil 100 5 Birr 20 Birr
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 a) What is the amount of basket costs in the base year and
today?
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________
b) Calculate the consumer price index and interpret it.
_____________________________________________________
_____________________________________________________
_____________________________________________________
_____________________________________________________
3- Ethiopia’s economy can produce 900 Billion Birr if conducive
economic policy has followed but the economy of Ethiopia actually
produces about 700 Billion Birr.
Calculate the output gap?
_______________________________________________________
_________________________________________
4- Assume that the labor force of a country is A120 million. 45% of the
labor force is employed. What will be the unemployment rate of the
country?
___________________________________________________________
___________________________________________________________
______________________________________

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 5- If the Marginal propensity to consume is 0.95.
What will be the amount government multiplier?
___________________________________________________________
___________________________________________________________
_______________________________
GOOD LUCK!

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