CHAPTER SIX

FUNDAMENTAL CONCEPTS OF
MACROECONOMICS AND
MACROECONOMIC
PROBLEMS
Fundamental Concepts of Macroeconomics

Macroeconomics concerns are:

economic growth(aggregate output level)
employment
inflation (aggregate price level)
economic fluctuation
distribution of income
macroeconomic policies
international trade
 Cont…
The objectives of macroeconomics are:
Full employment Price stability
Economic growth and rising the living
standard of the citizen
Fair distribution of income among all
citizen of the country
Less fluctuation in economic activities
 Macroeconomic Problems

1.Business Cycle
refers to the recurrent ups and downs (fluctuations) in
the level of economic activity
There are four phases in business cycle
A. Boom or Peak - Period of prosperity, the economy is
operating close to full capacity
B. Recession(contraction) - output, national income and
employment declines
C. Trough or Depression - The economy reached at low
point, it is the severe stage of recession
D. Recovery – economic activity and output began to rise
 Cont…

Economic activity
Growth trend

B D

Time
 2.Unemployment

Population

Labor Outside the

force labor force

<14yrs old& retired people

unemployed employed Full time students

Mentally retarded people
Very sick and disabled
people
 Cont…
Labor force = Employed + Unemployed
Types of Unemployment
i). Frictional unemployment
reasons:
Seasonality of work.eg. Due to bad weather,…
Entrance to the labor force. a student after
graduation
Voluntary switching of job
Re-entering to the labor force
 ii).Structural Unemployment
 resulting from mismatch between skills and location
eg. A nuclear physicist may not get job in Ethiopia
 Permanent shifts of demand for goods and services
 Technological change-
iii). Cyclical Unemployment
Unemployment generated due to the absence of jobs and
vacancies when the economy is in recession
Frictional and structural unemployment are known as
natural level of unemployment, because they are
unavoidable.
 Measuring Unemployment
Measured by unemployment rate
TU = FU + SU + CU
UR = TU/LF
NR = (FU + SU)/LF, where:
TU-total employment SU-structural unemployment
CU-cyclical unemployment FU- frictional unemployment
NR-natural rate of unemployment LF-labor force
 Full employment doesn’t mean zero unemployment
Economic cost of unemployment is the amount of
output that could have been produced had the
unemployed people been employed. It is the amount of
the forgone output.
3. Inflation
Is sustainable or continuous increase in the
general(average) price level of goods and
services
can be anticipated(expected to occur) or
unanticipated(actual inflation – expected
inflation)
can be measured using price index or GDP
deflator
Price index refers to consumer and producer
index
 Cont…
• Inflation rate at time t = [(CPIt – CPIt-1)/(CPIt-1)]*100
CPI this yr= current cost of a mkt basket of consumer g+s x 100
cost of the same mkt basket at the base yr

• The base yr is a reference year and it is usually a normal year when

there is neither natural nor man made catastrophe.

Example: consider that the consumer price index in Ethiopia in 1992

E.C was 120 while in 1991 E.C it was 100. calculate the inflation rate
in 1992?
Inflation rate in 1992 = [(CPI1992 – CPI1991)/(CPI1991)]*100
= [(120-100)/100] * 100
= 20%
 Causes of inflation
Generally, there are two causes of inflation
A. Demand – pull inflation
resulting from an increase in demand for g+s
Aggregate DD grows faster than aggregate SS
B. Cost -push inflation
Arises due to a continuous decline in aggregate
supply of goods and services. This may happen
due bad weather condition, an increase in wage
and price of other inputs, decline in productivity
 Cont…

Effects of inflation
There are two important effects of inflation:
1. Redistribution effects of inflation
Price effect – those people who consume those g+s whose
price are rising rapidly suffer more than those who
consume g+s whose price rise slowly.
Income effect - increase in price reduce the purchasing
power
* redistribute income from fixed income earners to flexible
income earners
* harm savers and creditors and benefit borrowers
wealth effects- people who own assets like land and
BLDG will better off than others b/c the real value of such
asset doesn’t decrease during inflationary periods.
 Cont…
2. Output effects of inflation
it creates uncertainty – difficult for producer,
investors to make production decisions
Encourage speculation
Shorten time horizon- during inflationary period
producers, sellers and consumers postpone or
cancel their expenditure plans. This may reduce
the total output and employment level in the
economy
 National income account
 Is an accounting record of the level of
economic activities of an economy
 is a measure of aggregate output, income and
expenditure in an economy
Its importance:
 To know economic performance of country
 To observe the long run trend of the economy
 To formulate economic policies
 Gross Domestic Product(GDP) and Gross
National Product(GNP)
GDP
is the market value of currently produced final goods and
services that are produced within in the country’s
borders(boundary) during a given period of time, usually one
year.
GNP
is the market value of currently produced final goods and
services that are produced by domestically owned factors of
production during a given period of time
It measure the total output or income generated by domestic
residents’ factors of production irrespective of where these
resource are used.
 Cont…
GNP = GDP + NFI
NFI- net factor income
NFI = factor income received from abroad - factor
income received by foreigners from domestic
economy
NFI can be positive, negative or zero
NFI>0,then GNP>GDP
NFI<0,then GNP<GDP
NFI=0, then GNP=GDP
 Measuring GDP and GNP
Three methods:
1. Product approach/value added approach
2. Expenditure approach
3. Income approach
1. Product approach
 Calculated by adding the market value of goods
and services produced by each sector of the
economy i.e. agriculture, service and industry
 Cont…
2.Expenditure Approach
GDP is measured by adding all spending on final goods
and services produced in the country.
Four components of GDP are;
I. Personal consumption expenditure(C).
 Eg. HH exp’re on Durables, non – durables and services
II. Gross domestic private investment expenditure(I)
Expenditure by private sectors for investment purpose
GI= Net Inv’nt + Includes three types of expenditures
 Cont…
III. Government spending on goods and services(G)
 Expenditure by local and federal government
 NB:All expenditures made by government will not
be counted.
Eg. Public transfer payments like pension and interest
payments on the country’s debt will not be counted

IV. Net export(NX)

 It means export(X) minus import(M)
GDP = C+I+G+NX
 Cont…
3. Income Approach
 GDP is measured by adding all incomes
earned by domestic factors of production to
produce goods and services
 These factors of production are labor, land ,
capital, and entrepreneurship
 Cont…
These payments includes:\
i. Compensation of employees: the reward for labor. i.e.
Wages and salaries
ii. Rental income: the reward for land
iii. Proprietor’s income/ profits/: income earned by
entrepreneurs.
iv. Interest income: the reward for capital
v. Depreciation: allowance of capital consumption
A portion of capital goods used in the production
process that wear out or used up in the current production
process
vi. Indirect business taxes: like excise and sales tax
GDP = i + ii+ iii+ iv+ v + vi
 Nominal and Real GDP
Nominal GDP
Is GDP measured at current market price
Is not useful to compare country’s economic
performance through time
Real GDP
it is the value of currently produced g+s at
constant price or it is a measure of GDP at constant
price
It is calculated by dividing the nominal GDP by
price index
Real GDP = (nominal GDP/price index)x 100
 Cont…

Eg. The Ethiopian nominal GDP and the CPI for the
year 1985 and 1986 was given below. Calculate
the real GDP and the economic growth?
Year nominal GDP CPI real GDP

1985 26,671.40 849.9 3138.18

1986 28,328.90 858.9 3298.28

Economic growth = RGDPt – RGDPt-1 x 100

RGDPt-1
5.1 %
 Other social account
• Net domestic product (NDP):
NDP = GDP – Depreciation
• National Income (NI):
NI = NDP + NFI – indirect business tax
• Personal income: income earned by persons or hhs.
PI = NI – [social security contribution + corporate
income tax + retained corporate profit] + [public
transfer payments + net interest on government debt]
• Personal disposable income(Yd): home take money
Yd = PI – personal taxes
Yd = c +s
 Income inequality and Distribution
GDP and GNP doesn’t indicate how the total output
currently produced is distributed in the economy
The distribution of income measured in two
measures
i. Functional distribution of income
 refers to the distribution of national income to
owners of factors of production, i.e. labor,
land, ...
ii. Personal distribution of income
 Shows the distribution of national income to
individual families
 Cont…
The sources of income inequalities in country can
be :
i. Differences in Wealth
ii. Differences in Ability
iii. Discrimination: which leads to difference in
opportunities for achievements.
iv. Differences in education, energy and motivation
v. Differences in human capital and investment
choices
 GDP and Informal sector
 Informal sector of the economy is part of the economy
which consists of activities that are never reported to
government authorities
 These activities can be legal or illegal
 GDP doesn’t usually include these activities due to lack
of information
 Tax evasion is usually thought to be the major incentive
for a person to participate in the informal sector.
 When the size of informal sector is large , the GDP
understates the performance of the economy
 Exercise
1. Suppose that the year 2004 exports were equal to imports
and gross investment was equal to government
expenditure. Private final consumption expenditure was
twice its government expenditure and equal to birr 300
million.
a. Calculate GDP
b. Calculate GNP assuming NFI was birr 30 million
c. Calculate the value of depreciation if the value of NNP
during the year was birr 430 million?
2. Given
C = 200 + 0.02yd
G = 500, I = 400 , NX = 200 and Yd = 0.25GDP
Find GDP, Yd, C
 CONT….
a) Using the above data, determine GDP by both
the expenditures & income methods.
Then determine GNP &NNP.
b) Determine NI
c) Obtain PI
Thank you!!!