MACROECONOMICS I

ECON – M1031
LECTURE NOTE

Worku Gebeyehu (PhD)

Addis Ababa University

October 2018

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This note is prepared for Macroeconomics I (M-1031) for undergraduate students of
Addis Ababa University. The course discusses the different views and approaches of
economists on how an economy behaves and the role of market and government in
ensuring equilibrium among macroeconomic variables.

The main objectives of the lecture are to:

 expose students how to present and analyze the interrelationship between
aggregate economic variables and the situation and trend of an economy.
 show students how government uses macro economy policy instruments and the
transition mechanisms to influence aggregate economic variables and
 develop a closer link between academic learning and professional practice in
analyzing economic situation.

This lecture note is a work in progress extracted from macroeconomics text books. It
may not be complete and it may suffer from some errors. Thus, it should be read with
caution. Although the lecture primarily revolves around this note, it should not be
taken as a substitute for the macroeconomics books recommended as a reference in
your course outline.

1. INTRODUCTION

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 1.1. Definition and Scope of Macroeconomics

Macroeconomics (Macro-a Greek word = big) describes and explains the aggregate
behavior and processes of an economy. There are various economic agents in an
economy– households, firms, government, and foreigners/foreign firms or countries.
Macroeconomics measures and explains the overall consequences of the decisions and
operations of these agents on the aggregate economy using certain macroeconomic
parameters. Overall, macroeconomics is concerned with the structure, performance and
behaviour of the economy as a whole.

Macroeconomics analyzes the underlying determinants of the aggregate trends in the

economy with respect to:
 Total output of goods and services (GDP)
 Unemployment,
 Inflation and international transactions.

Macroeconomic analysis seeks to explain:

 The cause and impact of short-run fluctuations in GDP (the business cycle),
 Major determinants of the long-run path of GDP (economic growth).

Some Important Issues in Macroeconomics

• What determines the level of output in an economy?

• Why does cost of living keep rising?
• What is the economic consequence of inflation?
• Why does unemployment keep growing and how could it be addressed through
macroeconomic policies?
• What brings recession (output and income falls and unemployment rise) in the
economy and what can government do to address this?

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 • What is government budget deficit, what causes it and how does it affect the
economy?
• Why does huge trade deficit exist in some countries and not in others?
• Why are some countries poor and others rich? Why some countries grow and
others slow down?
• What policies might help some countries grow?

Why do we learn macroeconomics?

 Macroeconomics investigates aggregate behaviour of economic agents by
imposing simplifying assumptions but without abstracting from the essential
features.
 Microeconomics treats economic issues that concern every individual. Macro-
economy deals with issues that affect society’s well-being:
 Unemployment is likely to be a source of dissatisfaction, helplessness, mental
problems, homelessness, violence and suicide.
 Inflation & unemployment is likely to be the source of high cost of living, low
saving, low investment and political unrest;
 Budget deficit is imbalance between government revenue and expenditure;
and likely to lead into high inflation, crowding out (replacing) private
investment and lowering investors’ confidence; etc.
 Trade deficit occurs when value of imports exceeds exports and imply
increased current consumption at the expense of future consumption;
may lead to high foreign debt and foreign dependence;
 An economy that has successful macroeconomic management should experience
low unemployment and inflation, and steady and sustained economic growth.

Macro economic mismanagement brings an adverse impact on the wellbeing of society –

low employment opportunities, low per capita income, high inflation, low supply of goods, etc. ).

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Macroeconomic performance and policies are connected; thus macroeconomic issues
attract media attention and inevitably become a central issue for political debate.

Inflation, unemployment and economic growth are among the most important issues for
campaign and debate among political parties and considerations for the voting decision function
of the public.

1.2. Methods of Macroeconomics Analysis

Macroeconomics research aims to understand how the economy functions and how it is
likely to react to specific policies and wide variety of (demand and supply) shocks which can
cause instability. Macroeconomists cannot conduct controlled scientific experiments
and focuses on pure observations. Macroeconomic theory rather consists of a set of
views about the way the economy operates. Such views are organized in a logical
framework and become a basis upon which economic policies are designed and
implemented.

Historical economic episodes lead to the formation of different views on how an

economy behaves. Thus, diverse interpretations and conclusions are common in
interpreting and understanding macroeconomic issues. We use models to display the
interaction of macroeconomic variables (the causes and consequences among economic
variables) and understand the very complex world.

Successful theories enable economists to

 Understand the relationship among macroeconomic variables;
 make better predictions about the consequences of alternative courses of action
and
 indicate the policy measures most likely to achieve society’s chosen objectives.

Designing successful economic policies depends on the availability of internally

consistent theoretical models that
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 (a) explain satisfactorily the behavior of macroeconomic variables and
(b) that are not rejected by the available empirical evidences.

Is it always possible for macroeconomists to select the best theories, models and thus
design appropriate policies suitable for their countries at any given time? The answer is
NO.

Economists have different views about the ‘correct’ model of an economy. Prolonged
and uninterrupted controversies leads to alternative theories and models what
constitute macroeconomic thought.

As Blanchard (1997a) points out macroeconomics

 is not an exact science. It is an applied science where ideas, theories and models
are constantly evaluated against the facts and often modified or rejected.
 is a result of a sustained process of construction of ideas.
 builds on theories by bringing new dimensions that explain reality well.

1.3. Macroeconomic Goals and Instruments

Economists often disagree on theoretical issues, empirical evidences and the choice of
policy instruments. However, there is almost a consensus on major goals of any
economic policy:
 High/full employment,
 Economic stability and
 Rapid growth.

Full employment is full engagement of all available resources (labor, capital, land, and
entrepreneurship) in the economy. Unemployment rate (of labour) is a proxy for existence
and extent of underemployment in an economy. Why? It is because of the fact that human
resource is the main source and ultimate beneficiary of growth. Unemployment/under
employment is sub-optimal/below capacity operation. This in turn has an impact on the
income and wellbeing of individuals and society.

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Stability is smooth movement of output, employment and prices on socially desirable
growth path. High inflation, high unemployment, high fiscal deficit, high trade and
balance of payment deficit and erratic movement of GDP are signs of instability. Instability
affects the welfare of society, the planning and functioning of firms and also causes
potential political unrest.

Economic growth is simply an increase in the production of goods and services over time.
 The achievement of this goal is best indicated by measuring growth rate of GDP.
r = (GDPt-GDPt-1)/GDPt-1.
 Economic growth requires, among other things, increasing labour productivity,
improving TFP, expanding R&D, etc.
 The gain from economic growth (income/wealth) has to be fairly /equitably distributed
among members of society.
 Is there a broad spectrum medicine or a combination of medicines that address
the above problems in one spot?
 Will a medicine (policy) prescribed for one particular disease (economic
problem/imbalance) cause unintended side-effect (positive/negative) on other
balances in an economy?

1. Trade-offs: There is less agreement that these goals are mutually compatible.
For instance:
 Increased money supply enhances employment but it possibly leads to
inflation.
 Use of modern technologies may enhance economic growth but possibly
leads to workers-lay off or increased unemployment.

2. Disagreement on the broader mechanisms of achieving macroeconomic goals: No

need for government intervention and there is a need for government
intervention.
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According to Classical school, market forces solve macroeconomic instability and ensure
rapid economic growth. On the other hand, Keynesian school argues that market failure
usually arises and there is a need for government intervention to address imbalances and
bring back equilibrium in the economy. In practice, there is government intervention in
every country although the degree of intervention varies from country to country.

Macroeconomists use different policy instruments; the main ones being monetary
policy (MP) and Fiscal Policy. Monetary policy instruments are quantities (interest rate,
reserve requirements, etc.) that can be directly controlled by policy makers or monetary
authorities or Central Banks (the National Bank of Ethiopia in Ethiopia, Federal Reserve
in the USA, Central Bank in Kenya, Uganda and Tanzania) to influence monetary
aggregates/money supply.

 FP instruments (tax, tariff, government expenditure, etc.) are used by

government authorities that manage the country’s budgetary revenue and
expenditure. For instance,
 These authorities use taxes as a source of government revenue (High tax rate –
increases revenue up to a certain limit; however it can reduce disposable income
of workers and profits of firms, which would not be good for the society).
 If G-R >0, there is budget deficit because of expansionary fiscal policy. This
stimulates AD to grow but it may impose a burden to the economy (if G is not
spent to complement private investment such as building infrastructure, etc).
 If G-R<0, then it is a sign of the use of restrictive fiscal policy; which has a
tendency to reduce AD and slow down GDP growth.

1.4. State of Macroeconomics: Evolution & Recent Developments

A. Classical School

Classical economics was the dominant economic thinking up to the 1930s The economy
self-regulates itself and there is no need for government intervention. The main one in
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this school was Adam Smith, who wrote the Wealth of Nationsin 1776, was concerned
by extent and form of government intervention in Britain. Classical economists believe
that the interaction of economic agents in the market ensures equilbrium in the
economy. Ups and downs of economic activities are reflected in up and down
movements of prices. Deviations or imbalances in macroeconomic variables are
temporary. Prices are flexible. Economic agents react to price changes as immdediate as
possible so that market clears. Just leave the economy for the mercy of the market
mechanism (laissez faire).

B. Keynesian school

Keynes was the main one. However, Hicks (1937), Modigliani (1944) and Tobin (1958)
are also important contributors. Between 1929 and 1932, Western economies faced a
tragic economic performance in terms of increased unemployment (USA 25%), price fall
(40% in Germany and USA) and output decline (USA 50%, 40% in Germany and 30% in
France). This was called the Great Depression. The ups and downs of economies in the
developed world and the identification of business cycles as a frequent economic
phenomenon challenged the role of markets to address these problems.

Keynes believes that markets are not always self-regulating. Classical school policies are
based on less realistic assumptions, among others, flexible prices. Prices including
wages are upward sticky. Wages do not adjust rapidly to equilibrate the economy.
Workers engage in long-term contracts and are not usually willing to decrease their
wage even if prices may decline. What matters for workers is their nominal wage
instead of the real wage because of money illusion. In addition, output fluctuats
becuase of private sector behaviour (animal sprit). Investors are pessimistic about the
future; this behavour leads to a decline in investment and output and causes for
unemployment.

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There is usually market failure and involuntary unemployment. In the SR, when the
demand for output declines, firms may not be able to reduce wages and sell their
products at lower prices. Instead, firms may lay off workers; retain lower number of
workers at the given real wage rate and reduce their output. Hence, markets do not
guarantee low level of unemployment and high level of output on a regular basis. Thus,
there is a need for government intervention: FP and MP to restore equilibrium.

For ease of understanding the Keynesian school, initially the labour market equilibrium
is assumed to be at real wage rate w* at Figure 1:

w*=W0/P0

Assume price declines from P0 to P1. Economists in the Classical school assume that
firms will not be profitable at the reduced price because real wage increases to w 1.
Fearing that firms will lay off workers, workers will voluntarily reduce their nominal
wage from W0 to W1 so that the real wage remains the same at;

w*=W1/P1=W0/P0

This will bring back the initial equilibrium point and thus the initial equilibrium will
not be affected because of nominal changes in prices (both wages and prices of outputs
change, but quantities of output and the number of workers or employment will not be
affected).

Figure 1: The Effect of Change in Demand in Output

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 W

w1=W0/P1 Ls

w*=W0/P0

Ld

L
L* Ls
Ld

Keynesians argue that

• Workers will not be voluntary to reduce their wage and real wage increases to w1.
• Firms lay off some of their workers at the new real wage rate w 1 while the supply of
labor increases to LS.
• Unemployment will arise by the amount of L S – LD implying markets fail to clear;
and it instead causes for unemployment.
• This needs government to use (aggregate) demand management polices to
counteract the downturn and stabilize the economy.
• For instance, by increasing money supply, and increase AD. When AD increases,
to satisfy this demand, firms increase job opportunities (thus reduce
unemployment).
• According to Keynes, the Classical economists assumption of prices become
flexible in the long-run and markets clear economic imbalance is less pragmatic.
Keynes argued that in the long-run we all are dead! Market forces alone are not
capable of eliminating depression rapidly due to rigid prices. Thus, there is a
need for government intervention (FP & MP) to correct instabilities in the
economy.
• However, increased money supply and increased AD may cause inflation and
this leads to the well known Philips curve.
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Until 1960s, it was believed that unemployment and inflation are negatively related as
illustrated by the Philips curve (PC). PC enabled policy makers to predict the rate of
inflation which would arise from different target levels of unemployment.

Keynesian school became challenged since 1970s, as unemployment and output decline
was accompanied by high inflation in major industrial economies. Such a phenomenon
is called stagflation. The explanations for stagflation and the shift of Philips curve is not
found in the traditional Keynesian theory. This gave rise to monetarist macroeconomic
school after M. Friedman (Friedman 1968).

D. Monetarism
Monetarists believe that markets are self-regulating. They blame money supply
instability, activist macroeconomic policy, as a cause for output fluctuation.

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 P*

U
NU

Deviations from the natural level of output caused by unanticipated monetary shocks
will be temporary. The use of MP to make advantage of money illusion of workers and
increase employment as the expense of inflation is temporary. There is no Money
Illusion in the long-run. There will be no long-run trade-off between unemployment and
wage inflation. Thus, there is a vertical Philips curve or stagflation in the long-run if we
continue to use expansionary monetary policy.

E. New Classicalists

Authorities cannot, and therefore should not, attempt to stabilize fluctuations in output
and employment through the use of demand management policies (Lucas, 1981).
Economic agents (HHs and firms) make optimal decisions or maximize their benefits/profits.
Economic agents make rational expectations about the future (John Muth in early 1960s). Their
forecasts are on average accurate and any deviations or errors in forecasts are random.
The economy is operating at the natural rate of unemployment level and the rate of
increase in money wages will equal the expected rate of inflation. It underscores the role
of stability in money supply and minimal government role in the economy to correct
macroeconomic imbalance. Markets clear, thus, wages and prices adjust to equilibrate
demand and supply. Thus, the economy is inherently stable, unless disturbed by erratic
monetary growth (as also argued by monetarists) and that when subjected to some
disturbance will quickly return to its natural level of output and employment.

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Unanticipated monetary shocks are the dominant cause of business cycles. Government
interventions destabilize the economy and cause for fluctuations in output.

3 Main arguments by the new classical school

(a) Only random or arbitrary MP can have short-run real effects because they cannot be
anticipated by rational economic agents; (Sargent and Wallace, 1975, 1976). This
causes short-run variation in output and employment around their natural levels
but increases uncertainty. This is called policy ineffectiveness proposition.
(b). Traditional Keynesian-style macro-econometric models cannot be used to accurately
predict the consequences of various policy changes on key macroeconomic
variables (Lucas 1976).
(c).Economic performance can be improved if discretionary (flexible) powers are taken
away from the authorities.

F. The New Keynesian School

This school includes Olivier Blanchard, Gregory Mankiw, Edmund Phelps, David
Romer, andJoseph Stiglitz. The New Keynesian School incorporates (a) the rational
expectations hypothesis, (b) the assumption that markets may fail to clear due to wage and price
stickiness of Keynesians and (c) Friedman’s natural rate hypothesis (implying there is no long-
run trade off between unemployment and inflation). Economies are subjected to both
demand- and supply-side shocks which cause inefficient fluctuations in output and
employment.

Stagflation could result due to supply side shocks (cost-pushed inflation). Markets may
not clear even if agents are rational and optimizing. Information problems and
transaction costs of changing prices lead to price rigidity in the economy. If actual rate
of unemployment remains above the natural rate for a prolonged period, the natural
rate may as well increase. Government policies can improve macroeconomic
performance and stabilize the economy.

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 CHAPTER 2: NATIONAL INCOME ACCOUNTING

2.1. Introduction

Many economic agents (households, firms, government and foreign nationals) conduct
many transactions. These transactions are recorded at a national (aggregate) level. The
formal record of these economic transactions is called the National Income Accounting.

2.2. GDP and GNP: Definition and Measurement

Gross Domestic Product (GDP) is total income earned by domestically-located factors of

production, regardless of nationality. It is the monetary value of current final goods and
services produced by factors of production located within a country in a given period,
usually a year.

Gross National Product (GNP) is total income earned by factor of production nationals
regardless of where they are located.

GNP-GDP = (Factor payments from abroad) - (Factor payments to abroad). GNP and
GDP can be equal or one could be greater than the other.

In every transaction, the buyer’s expenditure becomes the seller’s income; expenditure
on goods and services is equivalent to the value of goods and services. Thus:

Sum of all expenditures in the economy = Sum of all income for factors of production= Sum of
value of goods and services produced in the economy.

Thus, there are 3 approaches of measuring GDP: (a) Product Approach; (b)
Expenditure Approach and (c) Income Approach.

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A. Product Approach: GDP is the value of final goods produced. It is the sum of value added at
all stages of production. Value added is the difference between the value of production at the
end of each stage and intermediate input/goods.

Important tips:
One needs to be careful not commit double counting.
Do not include used goods in the calculation of GDP;
Include change in inventories, if goods are in store;
Do not include spoiled inventories;
Do not count intermediate goods as part of GDP; Reason: the value of intermediate goods is
already included in the market price (? Double counting).
Use imputed value as an estimate of market value of goods, for goods which do not have market
place or market price; example some government services such as education, domestic
(household activities));

Industry Industry
Agriculture Service
A trader sells a A backery sells breads made
Farmer sells a The distributor
quintal of wheat of a quintal of wheat to
quintal of wheat sells bread made
flour to a distributors Birr
to a miller with of a quintal of
backery Birr1500 2000 what with
Birr 1000 VA2=1500-1000 VA3=2000-1500 Birr 2500 = GDP
VA1=Birr1000 Birr=500 Birr 500 VA4=Birr 2500-
2000
Birr 500

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GDP = VA1+VA2+VA3+VA4

B. Expenditure Approach (EA): Total expenditure on domestically produced final

goods and services.

GDP= C+I+G+(X-M)

C = (Private) consumption;

I = (Private) investment

G= Government expenditure,

(X-M) = Net exports, where X = Value of exports and M = Expenditures on imports.

Consumption (C): Values of all goods and services bought by households;

o Durables (lasting for a longer period – cars, computers, etc.);

o Non-durables – last a short time (food, clothing, etc.)
o Services – Work done for consumers such as dry cleaning, transport, beauty salon;

Investment (I): It includes the following types of expenditures.

 Business fixed investment (spending on plant & equipment),

 Residential fixed investment (housing units of all parties) and
 Inventory investment (changes in the value of firms’ inventories).

Government Spending (G): It includes spending on goods and services by both the
federal & local governments. G-excludes transfers payments because they are not
spending on goods and services by the government (e.g. Unemployment insurance
payments).

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C. Income Approach (IA): Total income earned by domestically – located factors of
production.

The incomes are earned in the form of:

(i) Wages and salaries (return to labor = w),

(ii) Interest (return to capital = i),
(iii) Rent (return to land =r) and
(iv) Profit (return to entrepreneurial ability = p).

These are added to give National Income (NI):

NI = w + i+ r + p

To obtain GDP, some adjustments are required.

NI excludes depreciation (D) while GDP includes (D) within gross investment (I).
NI includes factor income from abroad (FIFA) but excludes factor income paid to
abroad (FIPA); whereas GDP calculated by EA includes (FIPA) and excludes (FIFA).

GDP at current market prices

= NI + D + (FIPA – FIFA) + (Indirect Tax – Subsidies)

GDP at factor cost

= GDP Market Prices + (Subsidies – Indirect Tax)

2.3. Real versus Nominal GDP

GDP calculated at current prices is called Nominal GDP. It simply means the current
monetary value of goods and services. Take the following example.

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 2006 2007

Quantit Price Total Quantit Price Birr Value (Birr)

y Birr (Birr) y
Apple 40 150 6000 42 170 7140
Orange 25 200 5000 22 230 5060

GDP 11000 12200

Growth 11%

A change in nominal GDP could arise either from change in quantity of production and
services or price changes. If production and service remain the same year after year but
only prices rise, then nominal GDP tends to rise year after year while real quantities
remain the same. In order to control for price variations and able to assess real GDP
growth, there is a need to use constant prices or prices of goods and services at a chosen
base year.

Use of a base year (constant price) brings a significant difference between nominal GDP
and real GDP.

2006 2007

Quantity Price (Birr) Total (Birr) Quantity Price (Birr) Value(Birr)

Apple 40 150 6000 42 150 6300

Orange 25 200 5000 22 200 4400

GDP 11000 10700

Growth -2.7%

Nominal GDP in 2007: 12200

Real GDP in 2007 at 2006 constant prices: 10700

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As you can see from the above table, nominal GDP overstates the actual output of the
economy and thus the purchasing power of the people by the level of inflation rate.

Inflation Rate: (∆P/P)*100

Inflation is percentage increase in the overall level of prices (approximated by GDP

deflators) into two subsequent periods (weeks, months or, years). Thus, there is a need
for deflating nominal values based on prices of a certain normal (base) year.

To evaluate the true performance of an economy in terms of growth, one has to first
deflate the Nominal GDP using GDP deflator and get Real GDP. Real GDP measures output
valued at constant prices.

There two types of inflation measures: GDP deflator and CPI.

(a) GDP Deflator: It is the ratio of Nominal GDP and Real GDP calculated at some base
year prices.

GDP (implicit price) Deflatort = Nominal GDPt/Real GDPt;

Real GDPt = Nominal GDPt/GDP Deflatort

In the example above, the GDP deflator for the year 2007 is:

12200/10700 =1.14

GDP deflator measures the relative prices of outputs or services vis-à-vis their prices in
the base year; and reflects on average what has happened to the overall level of prices in
the economy.

(b) The Consumer Price Index (CPI):

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CPI is the weighted average of prices of many goods and services. It measures the
average price level of consumer goods. Assume only two goods are produced in an
economy; which are equally important to the society and thus, they are given equal
weights.

CPI= (5 ´ Current Price of Shoe) + (2 ´ Current Price of Sugar )

(5 ´ Year 2000 Price of Shoe) + (2 ´ Year 2000 Price of Sugar)

where Year 2000 is considered as the base year.

Goods and services of a sample of households are given weights according to past
patterns of consumption expenditures. Changes in individual prices per given period
are multiplied by weights of individual goods and services to come-up with CPI.

CPI vis-à-vis GDP Deflator

Prices of capital goods
 Included in GDP deflator (if produced domestically)
 Excluded from CPI
Prices of imported consumer goods
 Included in CPI
 Excluded from GDP deflator

CPI is calculated by the Central Statistical Agency (CSA) of FDRE in the Ethiopian Case.

How do we construct CPI? In one normal year (with low level of unemployment, low
inflation and low fluctuations in the economy as economy as a whole) is selected and
the following procedures are followed. A representative sample of households is
determined and a survey will be made on consumers to determine composition of the

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typical consumer’s “basket” of goods in terms of the type, quantity and money
allocated.

Based on the share of expenditure of each group of goods and services, weights are
given out of 100%, (wi). Every month, collect data on prices of all items in the basket;
compute cost of basket. CPI is calculated in every month.

wP 
CPI  100 X  i ic 
 wi Pib 
GDP growth rates

GDP growth rates over time measures the over performance of an economy. Only Real
GDP of two different periods could be comparable to show a more realistic picture of
the change in an economy.

Growth
Growth rate
rate of
of GDP
GDP between
between two
two consecutive
consecutive periods
periods isis given
given by:
by:
GDP  GDP
ggtt  (( GDPtt  GDPtt11))
GDP
GDPtt11

The
The average
average growth
growth rate
rate for
for aa time
time horizon
horizon TT isis given
given by:
by:
TT

avgGDP 
avgGDP ggii //TT
ttii

In some cases, it is misleading to use base year (constant) prices that prevailed 10 or 20
years ago.

Goods and services are given weights when deflators are calculated to serve for a long
period.

In practice,

(a) Composition of goods and services change.

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 (b) Consumers may substitute goods, whose relative prices have fallen.
(c) Quality of goods and services could also change; which leads to price change.
(d) Thus, base-year prices and relative prices should be up-dated periodically.

Chain weighted average prices could be used to update base year prices. For instance
average prices of 2000 and 2001 could be used to compute and compare GDP changes
between 2000 and 2001; average prices of 2001 and 2002 could be used to compute and
compare GDP changes between 2001 and 2002.

Often constant prices of a given base year are used for some time instead of weighted
average because of simplicity.

Per capita income: It is measured usually as the ratio of GDP and the total number of
people living in a given country.

Per capita income = GDP/Population

It is a measure of average welfare of society. In order for per capita GDP to grow and
the welfare of the people increase on average, GDP has to grow at a greater rate than
the rate of population growth.

2.4. The Relationship between GNP and GDP

As discussed above, Gross National Product (GNP) is the monetary value of current
final goods and services produced by factors of production owned by a country or its
citizens within a given period regardless of the geographic location of these factors of
production. GNP excludes goods and services produced by foreign nationals or factors
of production owned by foreigners.

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On the other hand, GDP excludes goods and services produced by that country’s
national working abroad or by factors of productions located abroad. Thus,

GNP = GDP+ NFIFA

where NFIFA = net factor income from abroad (FIFA-FIPA).

2.5. Derivation of Disposable income and personal savings

Gross Domestic Product (GDP)

– Plus: Net Factor Income from Abroad (NFIFA)

Gross National Product (GNP)

– Less: Depreciation
• Net National Product (NNP)
– Less: Indirect Business Taxes
– Plus: Subsidies

National Income (NI)

– Less: Retained Earnings (Corporate profits-Dividends)

– Less: Social Insurance Contributions
– Less: Net Interest
– Plus: Government Transfers to Individuals
– Plus: Personal Interest Income

Personal Income

– Less: Personal Tax

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Disposable Income

– Less: Consumer Expenditure

– Less: Transfer to Freigners

Personal Savings

2.6. Problems Associated with GDP/GNP Calculations

GDP may not correctly measure people’s welfare. Besides its failure to show income
distribution, underreporting arises because of:

 Failure to record non-traded goods: government services; volunteer work, household

activities;
 Failure to record quality improvements of goods;
 Failure to record effects of the use of resources to avoid or contain crime or risks to
national security;
 Failure to account for underground economy: example – illegal gambling, works of illegal
migrants, tips, drug dealing and selling home produced goods. Why not such
transactions are not transacted? Reasons: To hide taxes; to avoid immigration laws
and to conceal illegal transactions.
 Not all production data are available even for formal activities; thus errors arise in the
accuracy of estimations and revisions.
 Environmental pollution and degradation are not usually taken into account (negative
effect on sustainability and of the welfare of the future).

The environmentally adjusted domestic product (EDP) requires making allowance to

the use of environmental goods. It adds discoveries of new resources and subtracts the
cost of pollution and degradation.

2.7. GDP and Welfare

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GDP and GDP growth rates are crude indicators of change in welfare of the population.
If there are two countries with the same size of population, a country with a larger size
of GDP is richer than a country with a lower size of GDP. Thus, GDP alone may not
indicate the welfare of the people unless the size of the population is also taken into
account. Thus, per capita income may be a better indicator of welfare than GDP. We say
the welfare of the people tends to grow on average if GDP growth rate is higher than
population growth rate.

Per capita GDP has also its own shortcomings. It simply assumes every individual earns
the same amount of income; but which is not practically the case. Thus, it does not
appropriately measure the welfare of the people in a given country as it fails to account
income distribution issues. Thus, there is a need to consider what is called Gini
coefficient besides the size of per capita income, whether or not there is high and
equitable distribution of income.

2.8. Unemployment and inflation

Definition of Inflation (πt): It is defined as a sustained rise in the general price level.
Note that the increase in price must be a relatively sustained one for the time under
consideration, not a onetime shot. It is the general prices level, not prices of some
individual items.

where Pt is general price index (either CPI or GDP deflator) for time t and Pt-1 is
general price index for time t-1

27
Causes of Inflation

 Demand Pull Inflation: Inflation arises because of a rapid increase in Aggregate

Demand (AD) than the aggregate supply of good services (AS). Different schools
of thoughts view inflation differently.
 Classical School: AS is constant in the SR and the change in AD usually arises
because of government intervention.
 An increase in Money Supply (an increase in the flow money into the economy)
increases AD for goods and services and shifts the AD curve from AD1 to AD2.

 Classical School

Increased in Money Supply leads firms, households and government agencies to hold
excess money supply, which leads to increased AD from y-bar to Y 1. AS is at full
employment level (Y-bar). Excess demand is created in the economy (Y 1-Ybar) at the
original price level (P0); which leads to a raise in the general price level to P 1 (inflation).
28
In the Classical case, increased money supply and thus increase in AD is fully translated
into increased price or inflation without having a positive output change.

According to Classical economists, output or economic growth depends on the real

economic aggregates principally on stock of capital, the labor force, land and the level of
technology; not by money supply.

Keynesian School

The increased money supply translates into an increase in AD through (increases in

demand in consumption, investment, government expenditure and net export).
Contrary to the classical school of thought, AS is upward sloping in a normal case.
Thus, there will be a shift in AD from AD 1 to AD2; creating excess demand equals = Y2-
Y1 at P1. This will cause to an increase in price from P 1 to P2. Firms will positively react
to the increase in price and boost their supply; thus quantity supply increases from Y 1 to
Y3. The new equilibrium price and output are P3 and Y3. The change in AD could come
by other interventions as well. Given money supply, fiscal policy measures such as
increase in G or I may cause an increase in AD and inflation.

29
Fig: 2.2. Keynesian Case

Cost Push (supply side) factors

Cost push inflation occurs when the prices of different factors increases and increase the
cost of production. Other structural bottlenecks cause firms to reduce the supply of
goods and services below the existing demand because of the following factors.

(a) Negative technological shock;

Decline in the supply of quantity of raw materials & intermediate inputs including
primary goods, oil, chemicals; downward shift in labour supply (example increased
migration because of new opportunities abroad or strong labour union pushing the
firms for higher wage rate, or increased food price causing wage rise or minimum
wage legislation causing price rise).

Figure 2-3 Cost push inflation

30
 Price AS2
AS1

P2 PP2

P1

AD1

Output
Y2 Y3 Y1

 As aggregate supply shifts from AS1 to AS2 and given prices, it will create
aggregate supply shortage of Y1 to Y2. This will create a price rise as a result of
which quantity of AD decreases because of the price rise. This will cause a new
equilibrium level at price P2 and Y3, but causes inflation.

Given the normal case of Keynesian AS curve, inflation can occur either because of
increased in AD (shifting to the right) and a decline in AS (shifting upwards to the
left).

31
Aggregate Demand can increase because of increase in G and increase in money supply
or decrease in interest rate (thus reduction in money demand for speculative purposes).
Aggregate Supply can decline because of negative technological shock, downward shift
in labour supply and increased prices of raw materials, intermediate inputs, etc.

Structural School of Thought on Inflation

 Well-known economists such as Myrdal and Straite raise questions as to why

aggregate output, especially food-grains, has not been increasing sufficiently in
developing countries to match the increase in AD (because of increase in
investment expenditure and money supply).
 Why investment expenditure has not been fully financed by voluntary savings
and why government expenditure expands and causes for excessive deficit
financing?

32
  The quest for these questions gave rise to what is called Structuralist School of
Thought.
 These economists argue that increase in government expenditure and money
supply expansion to finance it are proximate and not the ultimate factors
responsible for inflation in the developing countries.
 Economies of developing countries are structurally underdeveloped as well as
highly fragmented due to the existence of market imperfections and structural
rigidities of various types.
 Because of these structural rigidities, shortages of supply may exist relative to
demand and under-utilization of resources and excess capacity exist due to lack
of demand.
 These structural features of the developing countries make the aggregate
demand-supply model of inflation less applicable.

Thus, there is a need for a separate treatment of the cause of inflation in developing
countries.

Agricultural bottleneck: Traditional and less productive agriculture because of

backward technology, subsistent farming, low skill, land tenure and land fragmentation
which prevents adequate supply of food grains despite increase in AD arising from
increase in people’s incomes, growth in population and urbanization or expansionary
policies.

Resources Gap or Government’s Budget Constraint

 Governments in developing countries strive to boost economic development

including industrialization, which requires huge public sector investment.
However, they may not raise enough resources through taxation (low tax base,
large scale tax evasion, inefficient and corrupt tax administration), borrowing

33
 from the public or surplus from public sector enterprises for investment in the
projects of economic development.
 Consequently, government may be forced to resort to increase money supply as
an indirect taxation and this could lead to inflation.

 Among others, weak private sector and inadequate capacity and limited
voluntary savings and under-development of the capital market may lead to low
private investment and governments to rely on excessive money supply in these
countries.

Foreign Exchange Bottleneck

 High demand for imports of capital goods, essential raw materials or

intermediate inputs and oil necessitates high foreign exchange requirements.
 On the contrary, exports are inadequate; dominated by income and price
inelastic supply; natural resource or agricultural products. This leads to trade
and balance of payments deficit.
 To solve the problem of foreign exchange shortage through encouraging exports
and reducing imports devaluation in the national currencies had to be made.

 Devaluation could cause a rise in prices of imported goods and materials which
further raised the prices of other goods as well due to cascading effect. This
brought about cost-push inflation in their economies.

Physical Infrastructural Bottlenecks

 Infrastructural facilities such road networks, railways, telecommunication

services, air transport facilities, water and electricity supplies are very weak or
inadequate.
 This hinders the flow of goods and services and makes cost of production to be
very high and limit also the production capacity of the economy.

34
All the above factors could cause sluggish growth of output and excessive growth of
money supply; and thus stagflation.

Consequences of Inflation:

Broadly there are two types of inflation.

 Anticipated Inflation: Inflation that is built into the expectations and the
behaviour of the public before it occurs; and people are more or less prepared. If
anticipated and actual inflation are the same, the risk would be relatively
lower.

 All economic decisions such as contracts between lenders and borrowers, rents
and wages will incorporate expected price changes. However, this type of
inflation has its own cost.

 Unanticipated Inflation: Inflation that comes as a surprise to the public or at

least comes before people have had time to adjust fully to its presence. This
occurs when the actual inflation significantly deviates from expected or
anticipated inflation.

Effect of expected inflation on prices

 If Central Bank announces that it will increase money supply next year, people
will expect next year’s P to be higher, so expected inflation (πe) rises. This will
affect P even though money supply has not changed yet.

1. Loss of Purchasing Power of Money: Money looses it purchasing power and the
nominal cost of goods and services increases. How?

 You have nominal money balance of M; but using the Classical Theory of Money
Demand Theory, your real money balances is given by M/P.
35
  The rise in prices or inflation will reduce the purchasing power of the real money
balances and affect the welfare of individuals. If you have a nominal money holdings
of M, which stays constant for some time and if price grows by 5 percent; your real
money balances will decline by 5 percent; how?

∆(M/P)/(M/P) = (∆M/M)-(∆P/P)= 0-5%= 5%.

 Similarly if nominal income increases by 10% and price grows by 5%; the real
income has grown by only by 5%; (10%-5%).

2. Shoe Leather Cost: If households hold more money, it will cost them in terms of
interest rate forgone by holding liquid money. Thus, HHs rush to the bank
repetitively and make purchases to stay ahead of price increase.

 This cost of inconveniences of reducing money balances to avoid the inflation

tax is called shoe leather cost.

3. Menu costs: Firms change price lists as prices of the goods change. The
preparation of menus each time has a cost. This cost is commonly referred as
menu costs in the literature.
4. Relative price distortions: Firms change their prices at different times and this
leads to relative price distortions and this causes inefficiencies in the allocation of
resources. For instance, firms may have a certain proportion of the composition
of inputs (labour, capital and raw materials) to be maintained; changes in the
prices of different inputs at different rates affect the cost proportion.

5. Unfair tax treatment: Taxes are not often adjusted to account for inflation.

 For instance, if income tax brackets are categorized in nominal terms, as

nominal income of a person increases, she/he will be pushed to a higher
income bracket and pay a tax using higher marginal tax rate.
36
6. Distorted real depreciation expenses: If fixed assets are not re-valued in accordance
to increased inflation, the value of depreciation allowance could be wiped out by
the rate of inflation.
7. Olivera – Tanzi Effect: Inflation affects real value of the tax burden when there
are significant lags in tax collection.

 If the tax obligation are accrued at a certain period and payment is made a
later stage within which inflation occurs, the rate of inflation reduces the tax
burden. This phenomenon is Olivera – Tanzi Effect.
 Olivera – Tanzi Effect leads to a vicious circle: An increase in inflation
reduces government revenue and thus increases fiscal deficit and this leads to
higher inflation.

8. Inconvenience in Planning: Inflation makes it harder to compare nominal values

of different time periods.

 This complicates long-range financial planning.

9. Affecting Asset/Wealth Portfolio:

 If financial institutions adjust interest according to the Fisher Equation, i = r+π,

then the demand for money (cash holding) will reduce because of its high
opportunity cost (forgone interest rate). This is the case if banks adjust upward
the nominal interest rate every time with changes in prices.
 As prices rise, HHs try to reduce their money balances (or holdings) by using
them for the purchases of consumer durables with the expectation that the prices
of consumer durables will not at least lose their values because of inflation.

 This move by HHs could affect saving and also investment and economic
growth.

37
  If the change in asset portfolio is towards the purchase of capital goods, this
will rather build the production capacity of the economy and thus boost
economic growth.

10. Effecting AD and AS and thus Overall Economic Growth

 In a country where financial institutions make an upward adjustment of the

nominal interest rate based on price fluctuations [S(i) =S(r+π), positive
relationship between interest rate and saving], investment may decline as a result
of increasing nominal interest rate [I(i)= I(r+ π)].
 A rise in prices tends to reduce the purchasing power of nominal income or
nominal money holdings and this will negatively affect consumption demand.
 Inflation reduces exports by making exportable domestic goods to be more
expensive in the domestic market and thus in the international market as well.
This will affect the trade balance or the net export.
 Investment, consumer demand and net export are part of AD; a reduction of
which will reduce the later.
 On the other hand, decline in investment would affect the production capacity
and therefore the supply side of the economy.
 The whole effect may be reflected in the slow down or stagnation of economic
growth.

Effects of Unanticipated Inflation

When inflation is unanticipated, the main effect is on redistribution of the purchasing

power of different parties.

 Many long-term contracts may not be adjusted with actual inflation. They could
be made based on expected inflation (πe).
 If π turns out to be different from πe, then some gain at others’ expense.

38
For clarity let us distinguish the two types of interest rates: Nominal and real interest
rate.

 Nominal Interest Rate (the one we observe in the banks) = Real Interest Rate +
Inflation Rate.
 I =r+ π - Fisher’s equation

Case 1: Lender and Borrower

Assume some HHs borrow and some other HHs lend their money with interest.

 Lending interest rate is real interest rate plus expected inflation:

 I =r+ πe = constant; r = I- πe
 If actual inflation (π ) > expected inflation (πe), then (I-π) < (I-πe).
 Actual real interest rate becomes lower than anticipated real interest rate. This leads to
the transfer of purchasing power from lenders to borrowers.
 If π < πe, then the actual real interest rate is higher than the expected real interest
rate and this leads to the transfer of purchasing power from borrowers to
lenders.

Case 2: Wage Contract between Employer and Worker

 Assume a wage and labour service contract is made by taking into account
expected inflation (πe).
 If actual inflation (π) exceeds anticipated inflation (πe), real wages of workers will
tend to be lower than its expected amount.

Unanticipated inflation hurts more individuals with fixed income (pension).

 Pensions are not often adjusted for inflation and thus given constant nominal
income, real income or the purchasing power of real income would decline as a result
of an increase in inflation.
39
  When inflation is high, and more variable and unpredictable, arbitrary
redistributions of wealth become more likely.
 This creates higher uncertainty, which makes risk averse people worse off.
 This will cause a decline in real money holdings and affect the wellbeing of the people.

 Inflation is considered as a proxy indicator for the ability of government to

manage the stability of the economy.

 High inflation may signal the inability of the government to properly manage the
economy and adversely affects the decision of the public (both firms and
households alike).
 Government may strive to control inflation using pricing policies such as tax and
trade policies such as fixing prices of goods at whole and retail levels.
 This may in turn create uncertainties to private investors and the general public
to make investment decisions; and this has likely to have a negative consequence
on economic growth.

Benefits of Inflation:

 Unanticipated inflation reduces real wages, increases the demand for labour by
firms and thereby enables to expand the level of employment and output in the
economy.
 Why? It is because of information constraint; workers slowly adjust their
perception about the negative consequence of prices on their real wage.
 Given that nominal wages are rarely reduced, equilibrium will be insured at
higher level of employment even if equilibrium real wage falls.

Measures to Control Inflation

40
  It is widely argued that inflation is a common phenomenon in every country.
However, if it is beyond a certain level, its negative consequence would become
significant and there may be a need to control it.
 However, there is no a straight forward policy prescription in this line because of
controversies on what might have caused it.
 The following are some of the policy prescriptions often put on the table by
economists.

 Monetary measures

 Based on the views of Monetarists, inflation is monetary phenomena that arises

because of excess money supply beyond the optimal level.
 Thus, government authorities should take appropriate monetary policy
measures to reverse the situation. These policy instruments include interest rate,
reserve requirement ratios of commercial banks and undertake open market
operation.

Fiscal measures

 Keynesians argue that inflation could originate from the real (product) side of the
economy because of an increase in AD in excess of AS; most often because of
excessive government expenditure.

 Fiscal policy such as cutting government spending would be more effective. If the
excess demand is caused by the private investment or consumption expenditure,
increasing taxes will affect disposable income and reduces the aggregate
demand; and thus reduce inflation.

 Price and wage control measures

41
  If monetary and fiscal policies are ineffective and if the inflation is primarily
caused by supply side factors or an increase in costs of production (cost push
inflation), price of inputs and output and wage regulation may be sought.

Therefore,

 According to structuralists, a broad – based strategy of development which aims at

bringing about economic, social, institutional and structural changes are needed to
enhance rate growth of the economy without or with low inflation. In other words,
supply side structural constraints need to be addressed for inflation to be curved.

UNEMPLOYMENT

Population of a given county can be categorized into the following groups based on
employment status.

 Employed (E): Working at a paid job at their own enterprise (self-employed) or in

others.
 Unemployed (U): A person, who is mentally sound and agewise allowable to
work, but not employed and eagerly looking for a job.
 Labor force (L): The amount of labor available for producing goods and services;
all employed plus unemployed persons.
 Not in the Labor Force: Not employed; neither looking for a work.
 Unemployment Rate (U/L): The percentage of the labor force that is
unemployed.

What are types of unemployment?

42
 A. Frictional unemployment: This type of unemployment occurs because of the
time it takes for workers to search for a job even when wages are flexible and
there are enough jobs in the economy.

Reasons:

 Workers have different abilities and preferences; firms may require different set
of skills in one area but different in another area. Geographic mobility of workers
may not be instantaneous;

 The flow of information about vacancies and job candidates is imperfect;

B. Structural Unemployment

 1. Wage rigidity: It arises from real wage rigidity and job rationing. If the real
wage is rigid at a certain level, firms must ration the scarce jobs among workers.

Labour Supply

43
 Unemployed
W/P S
Labour

Supply
Rigid W/P W/P

Labour Hired
L willing to work

Main Causes of Wage Rigidities

i. Minimum Wage Laws: Countries set minimum wages of workers by law, and if this
wage is above the equilibrium wage rate, unemployment arises.

ii. Labour Unions: Unions, mostly in developed countries, pressurize employers for
higher wage levels. Employed union workers, insiders, want to keep wages to be high.
Unemployed, non-unionized outsiders; would prefer wages to be lower to be employed
[but strong labour unions will not allow for lower wages and employment of workers at
lower wage rates].

iii. Efficiency Wage Theories: High wages increase productivity of workers and thus
need to increase wages.

Reasons:

44
  To attract higher quality job applicants
 To increase worker effort and reduce ‘’shirking’’
 To reduce workers’ turn over;
 To improve/maintain health of workers (a reason mostly applied in developing
countries).

2. Emerging activities or technological change

 Growth in labour demand in new industries or emerging sectors with new skill
requirements and decline in labour demand in other sectors which used to
require skills readily available in the market; this creates a mismatch between
labour demand and supply – creating unemployment;
 Changes in technology or modernization may lead to workers lay-off or
unemployment; which may not be solved by wage rate flexibility;
 Geographic pockets (in inner cities and poorer regions).

C. Cyclical Unemployment

 This type of unemployment arises as a result of economic slowdown or recession.

Unemployment declines during boom.
 There is a negative relationship between the level of unemployment and growth
of GDP.
 A one percent increase in unemployment can lead to a more than a one percent
increase in the level of unemployment of output in the economy.

Unemployment and its Economic Effect

 Unemployment is a reflection of under employment of available resources in an

economy and it has serious social consequences in terms of equity.

45
  In line with the Keynesian theory, there is an inverse relationship between
inflation and unemployment, which is characterized by the Philips curve.
 There is also an inverse relationship between unemployment and economic
growth.
 This is characterized by Okun’s law after the Arthur Okun. The Okun’s law says
that the unemployment rate declines when economic growth is above the trend
rate of growth or a rate maintains the unemployment rate constant.

du=−b( g a−g t )

where du is a change in unemployment rate, b is the rate at which unemployment

declines due to a percentage point growth deviation between the actual growth rate of
GDP (ga) and the trend level growth rate (gt).

 The implication is because of unemployment countries loose a certain percentage

of output growth rate each year (up to 3%).
 According to the original formulation of Okun’s law, each additional percent of
unemployment is associated with a deviation between actual and the trend of
economic growth.

2.10. Business Cycle

 The goal of economic policy is to keep the economy in a healthy growth rate fast
enough to create jobs for everyone, but slow enough to avoid inflation. However,
many factors can cause an economy to spin out of control or settle into
depression.

46
 The most important factor is confidence of investors, consumers, businesses and
politicians. The economy grows when there is confidence in the future and in
policymakers. The opposite happens when confidence drops.
 Business cycles are short-run fluctuations in output and employment that may be
caused by diverse “shocks” to aggregate supply or demand.
 It is often suggested that economic fluctuations are regular and predictable.
However, they are not actually the case.

There are four phases that describe the business cycle in the economic
development process:

1. Contraction/depression - When the economy starts slowing down or shrinking

before it actually turns negative; unemployment increases and firms become
bankrupt.

2. Recession (drops in prices and in output – negative or around zero growth rate,
high interest-rates and very high unemployment rate) and at trough, the
economy hits bottom.

3. Recovery/Expansion: the economy starts growing again (reporting a positive

growth rate in production and prices, low interest-rates).

4. Boom/Peak - When the economy is overheated, economy’s expansion slows

and inflation rises.

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Fig 2.4: Four Phases of Business Cycle

 Full employment output also called potential output is the level of output produced in the
economy when all available resources are employed. However, often economies do
not operate at full employment and output falls short of the potential.
 The output gap measures the gap between actual output and the output the
economy could produce at full employment given the existing resources.

 Output gap =Full employment/potential output – actual output.

 In economics, trade-off or opportunity cost has a very central position. Often a

long expansion in the economy reduces unemployment too much. This situation
boosts AD and causes inflationary pressures and therefore requires policies to
fight inflation and such policies may end up causing contraction and recession in
the economy.

48