Addis Ababa University

Department of Economics

Macroeconomics chapter 1
 CHAPTER ONE
INTRODUCTION
1.1 An Overview: Definition, Focus Areas & Instruments of
Macroeconomics
• Why Economics
• Choice opportunity cost
• Method
• Agents who act in the economy
• Economic system
• Branch
1.2 The State of Macroeconomics: Evolution & Recent Developments
1.2.1 Classical and Neo-classical Macroeconomics
1.2.2 Keynesian Macroeconomics
1.2.3 Monetarists
1.2.4 New Classicals
1.2.5 New Keynesians
The subject matter of economics:
 Economics is one of the most exciting disciplines in
social sciences. There are two facts that provide the
foundation for the field of economics:
 Human or society’s material wants are unlimited and
 Economic resources are scarce or limited in supply
Economics is a social science, which studies how

societies allocate scarce resources in the production,

distribution, exchange and consumption of goods and
services so as to attain the maximum fulfillment of
society’s material wants.
 Why We Study Economics?

The knowledge of economics is important in;

• Wisely allocating scarce resources to satisfy the unlimited
human wants
• Efficiently managing your business , since it deals about
price ,cost ,profit ,market, production, saving ,investment etc
• A better understanding of the economic problems of societies
,such as rising unemployment, inflation, budget deficit,
external debt, economic growth etc
• Formulating different policies.
 Stakeholders in Economics
The economy is made up of four sectors sometimes called
economic agents:

I. Households: -
They are owners of resources (land, labor, capital and entrepreneurship)

They make decisions on how to sell their resources to firms and governments.

They make decisions on what and how much of the commodities they can

buy from business firms.

II. Business firms: -

a production unit that uses resources to produce goods and services

They make decision on buying resources from households.

They make decision on selling their products to households and

governments.
Cont’d…
III. Government (also known as the public or state sector):
organization that has a legal and political power to exert control
over individuals, business firms and markets.

Provides social services such as defense, education, public health

and infrastructural facilities.

Tax from households and business firms is the main source of

government revenue.

IV. International/ the Foreign Sector: These flows include

exports, imports, and borrowing from other countries
Cont’d…
Figure: Decision making units and circular flow of economic
activities
Scope of Economics:
 Taking the scope of the subject matter, economics
can be divided into two main branches:-
microeconomics and macroeconomics.
 Thus, economics is divided into macroeconomics
and microeconomics largely for the sake of
pedagogical clarity: We can’t teach you everything
at once.
i. Microeconomics studies the economic behaviour of
individual economic decision makers (consumers, firms,
workers, individual households, managers...)
 It studies the behavior of economic agents (consumers,

firms and government) and variables (prices, quantities

and the like) at a disaggregated level.
 It is concerned with the decisions taken by individual

consumers and firms

 It address questions like how does a particular person or

household maximize satisfaction, how does a particular

firm maximize profit?
Examples
◦ How much a consumer is willing and able to offer
for a kilo of sugar?
◦ How will cigarette industry be affected by the
new government tax increment?
◦ How price of teff is determined? Etc…..
ii. Macroeconomics analyses how an entire ‘economy’ or
economic system performs, on a national, regional or
global level.
 It is the study of behavior of the economy as a whole.
 It deals with magnitudes such as the total output level

in an economy, national income of a country, the

overall level of prices of goods and services, total
employment in the economy, economic growth, trade
balance and balance of payments, foreign economic
relations, fiscal and monetary policies of the
government etc.
 It does not deal with single household, firm, or industry.
 Macro economics examines the economy as a whole and
concerned with the combined or aggregate effects of
choices/decisions of economic agents at economy or
macro level.
Example:
◦ Is there a rise in general price level in the economy?
◦ What is the unemployment rate of the economy?
◦ What is the total output of the Ethiopia in 2022? (GDP)
◦ Etc…
How do the two branches of the discipline differ?

In microeconomics:
 The focus is on the decisions of individual units,
no matter how large the unit is.
 The spotlight is on how individual decision-
making units like dairy farmer and consumer
behave.
 We generally ignore inflation, unemployment,
and growth, focusing instead on how individual
markets allocate resources and distribute income.
 1.1 An Overview: Definition, Focus Areas &
Instruments of Macroeconomics
 Macroeconomics: is the study of the
behavior of the economy as a whole & the
policy measures that the government uses
to influence it.
 It is concerned with:
 The economy’s total output of goods &
services and the growth of output,
 Booms & recessions,
 The rates of inflation and unemployment,
 Balance of payments & exchange rates.
 1.1 An Overview: Definition, Focus Areas &
Instruments of Macroeconomics
 Central issues (focus areas) in macroeconomics:
 economic growth,
 inflation,
 unemployment, and
 open economy market policies
 Major policy instruments in macro-economics:
 fiscal,
 monetary, and
 trade policy instruments.
 Income policy
 1.1 An Overview: Definition, Focus Areas &
Instruments of Macroeconomics
 In macroeconomics, we do two things:
1. we seek to understand the economic
functioning of the world we live in; and
2. we ask if we can do anything to improve the
performance of the economy.
 That is, we are concerned with both
explanation and policy prescriptions.
 Macroeconomics makes use of:
 algebraic & geometric tools of analysis like
differentiation & graphs;
 models like AD-AS model & IS-LM model.
 1.1 An Overview: Definition, Focus Areas &
Instruments of Macroeconomics
Two Basic Questions & Two Broad Answers in
Macroeconomics
1) Can Governments influence the Economy?
No Yes
Classicals & Neoclassicals Keynesians
New Classicals (?) Monetarists (?)
New Keynesians
2) Should Governments Intervene?
No Yes
Classicals & Neoclassicals Keynesians
Monetarists
New Classicals (?) New Keynesians
 C
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1930

Ke
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1960
Developments

Mo
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1970

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1980

New Class
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New Keyne als
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Th e
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1.2 The State of Macroeconomics: Evolution & Recent
1.2 The State of Macroeconomics: Evolution & Recent
Developments
1.2.1 Classical & Neo-classical Macroeconomics
Basic Assumptions:
Flexible wages and prices.
Supply creates its own demand, Say’s Law.
Forward-looking agents with perfect foresight.
The price level is proportional to the money
stock in the long run.
Main argument:
No need for government intervention as the
economy has a self-correction mechanism.
Inflation is caused by excessive growth in money
stock.
 No distinction b/n macro- & micro-economics.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
1.2.2 Keynesian Macroeconomics
 The birth of modern macroeconomics is linked to
the Great Depression (period of high unemp’t &
stagnant production) & Keynes.
 The market adjustment concept of classicals &
neoclassicals didn’t work during 1929-1933.
 Basic Assumptions:
 Economy is unstable due to shifts in AD.
 Nominal wages & prices are inflexible, esp.
downwards.
 Large multiplier effect for changes in
government spending & tax rates.
 Keynes emphasized “effective demand” or AD,
and proposed expansionary policies.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
These Policies are fiscal & monetary:
1. Increasing government expenditure (G):
G  AD  Y (production).
Y (output/income)  C (Consumption) 
AD  Y ... – the multiplier effect.
2. Increasing money supply (M):
M  r (interest rate)  I (investment) 
AD  Y ... – the multiplier effect.
But, all the M may be absorbed at the existing
r (esp. when recession is deep) – the economy is
in liquidity trap!
With liquidity trap, the Classical model is
incapable of producing equilibrium – Keynes.
 Keynes preferred fiscal to monetary policy.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
 Keynes focused primarily on short-term: cure for
immediate problem almost regardless of long-
term results of the cure.
 But, AD:
(given supply) may  inflation, and
may  long-term growth rate (by ring
saving/investment if firms/people decide not to
accumulate wealth in fear of future increase in
taxes). With lower long-term growth rate, the
economy would create fewer jobs & thus
unemp’t rate would rise.
 For Keynesians, inflation can be controlled with
contractionary fiscal or monetary policy.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
1.2.3 Monetarists
 Strongly debated against the Keynesians on:
 the ability of government to improve the
operation of the economy;
 the relative importance of fiscal & monetary
policy;
 the tradeoff between inflation & unemp’t (the
Phillips Curve) – problem of stagflation (=
stagnation + inflation).
 Expansionary fiscal policy, with monetary
authority raising M growth, leads to inflation.
 Fiscal policy affects the mix b/n private &
government use of resources – insignificant or no
multiplier effect in fiscal policy.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
 Monetary policy is very powerful & changes in M
explain most fluctuations in output.
The Great Depression resulted from major
mistake in monetary policy.
 The tradeoff b/n unemp’t & inflation quickly
vanishes if policy makers try to exploit it: no long-
run tradeoff b/n inflation & unemp’t.
 Because of uncertainty in the position of the
economy & lags in policy effects, policy measures
may do more harm than good.
 Though an economy can be unstable in the short-
run, it has a good self-correcting mechanism in
the long run.
 Inflation is chiefly a monetary phenomenon.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
1.2.4 New Classicals
 In the 1970s, the debate on active policy brought
to the fore new groups – new classicals & new
Keynesians.
 New classicals attached great importance to the
role of expectation in influencing macro-
economic equilibrium.
 They introduced macroeconomic analysis from
micro foundations.
 Expansionary fiscal policy tends to increase
inflationary expectations, shifting AS, causing
real GDP to fall & the price level to rise.
 Many of them supported supply-side policies
meant to raise growth rate of potential GDP.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
 Their central working assumptions are:
 forward looking economic agents with rational
expectations.
 Markets clear.
 AS is responsive to changes in expectations
about inflation.
 Incentives to produce, work & save are
affected by government policies which
influence marginal tax rates and subsidize
households and businesses.
 The self-correction mechanism is based on shifts
in AS caused by changes in expectations of
inflation.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
1.2.5 New Keynesians
 They gave micro foundation for Keynesian
thoughts.
 Markets sometimes do not clear even when
individuals are rationally looking out for their
own interests.
 Emphasize imperfections in various markets
(labor, credit, product).
 Information problems & costs of changing prices
may lead to price rigidities, causing
macroeconomic fluctuations in output & emp’t.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
Conclusion:
 Much is to be learned from the insights of all
these schools of macroeconomics, and each has
contributed to our understanding of the way the
economy works.
 However, there is no single school that best
describes how an economy operates.
 The majority of economists now agree that:
 Stabilization policies are likely to influence
incentives of households & firms,
 Long-term growth (in real GDP), resulting from
capital accumulation & technological progress, is
the key to raise living standards.
 Changes in AD affect output (at least) in the
short run.
1.2 The State of Macroeconomics: Evolution & Recent
Developments
 Some of the disagreements involve:
 The length of the “short run,” the period of time
over which AD affects output.
 The role of policy. Those who believe that output
returns quickly to the natural level advocate the
use of tight rules on both fiscal & monetary
policy. Those who believe that the adjustment is
slow prefer more flexible stabilization policies.