Macroeconomics

By

Gemechu Daba (MSc.)

Course code: Econ 1031

Course Load: 3 Credit Hours

Number of Contact Hours: 3 Hours a Week

Competency at the End of the Course:

Able to Analyze and Evaluate Macroeonomy

Module Objectives: To show students

 How to present and analyze the interrelationship among

macroeconomic variables; situation and growth trend of
the economy;

 How government uses macroeconomic policy

instruments & the transition mechanisms to influence
aggregate economic variables;

 How can academic learning and professional practice are

linked to analyze economic situations.
 Macroeconomics –Econ 1031
 What is it?
Ch.1: The State of  Concepts and methods of analysis
Macroeconomics  Evolution and recent developments
Ch.2: National  GDP, GNP, NI, NNP, PCI, DI,RGDP,
Deflator, GDP & Welfare,
Course Income Accounting
 Business Cycle
outline  Unemployment
(Five Ch.3: AD in closed  Theory of AD
Chapters) economy  Goods Market & Is
 Money Market & LM
 SR Equilibrium
 AD curve from IS & LM
 Course outline Cont’d
Ch.4: AD in Open Economy
 Flow of Capital Goods from abroad
 S&I in Small Open Economy
 Exchange Rate
 Mundell-Fleming Model
 FP and MP in Open Economy
Ch.5:Aggregate Supply
 Classical Approach
 Keynesian Approach
 References
• Mankiw, N. Gregory (2007): Macroeconomics, 4thed.
Worth Publishers;

• Branson, William H (1989): Macroeconomic Theory

and Policy, 3rd ed., Harper & Row Publishers;

• Dornbush, R., S.Fisher& R. Startz (2008),

Macroeconomics, 10thed. McGraw-Hill Irwin.
Basic Requirements to Pass the Course

 Continuous Assessment (test & assignment)

50%

 Final Examination: 50%

 Ch.1:The state of Macroeconomics
1.Definition and Scope of Macroeconomics
 Describes and explains the aggregate behavior and
processes of an economy.
 Measures and explains overall consequences of the
decisions and operations of economic agents [households,
firms, government, and foreigners/countries] on the
economy using macroeconomic variables/parameters.
 Deals with structure, behavior, performance and growth
of the overall economy.
 Analyzes the underlying determinants of the aggregate
trends in the economy with respect to GDP,
unemployment and inflation.
Major macroeconomic issues
 Output (GDP/GNP) and its growth

• Cost of living, inflation

• Unemployment

• Budget deficit,

• Trade deficit, current account and balance of payment

deficit

• Why countries become poor or rich? How could

countries grow?
Why do we learn macroeconomics?
 Macroeconomics deals with issues that affect society’s well-
being such as unemployment, budget deficit,etc.Why?
 Unemployment: dissatisfaction, helplessness, mental
problems, homelessness, violence and suicide, political
unrest.
 Inflation: High cost of living, low saving, low investment and
political unrest;
 Budget deficit: Government revenue fails to expenditure;
leading to high inflation, crowding out effect on (replacing)
private investment and lowering investors confidence;
 Trade deficit: Imports > exports and imply high foreign debt
and dependence
 Macroeconomic issues attract media attention, central issues
for political debate.
 Successful economy: Low unemployment, low inflation, and
steady and sustained economic growth.
1.2 Methods of Macroeconomics Analysis
 Macroeconomics research aims to understand how the
economy functions or how the economy reacts to policies
and shocks that cause instability.
 Research requires a theory to test against the perception
about the reality.
 Theories are simplifications of complex realities.
 Macroeconomics cannot conduct controlled scientific
experiments.
 Macroeconomic theory consists of a set of views about
the way the economy operates. It is organized in a logical
framework & become a basis for economic policy design.
 Unlike pure science, historical economic episodes allow
diverse interpretations and many conclusions.
1.2 Methods of Macroeconomics Analysis…..
 Macroeconomics uses models to display the
interaction of macroeconomic variables to understand
the complex world.
 Theories and models help to identify important
factors that need to be analyzed as causes and
consequences of various economic phenomena.
 Successful theories enable to
 Understand the relationship among macroeconomic
variables;
 Make better predictions about the consequences of
alternative courses of action, and
 Indicate the policies most likely to achieve society’s chosen
objectives.
1.2 Methods of Macroeconomics Analysis…..
 Successful economic policy design depends on theoretical
models, which are:
i. Internally consistent
ii. Explain satisfactorily the behavior of macroeconomic
variables and
iii. not rejected by the available empirical evidence.
 No consensus among economists about the best theories
or models or policies relevant to any country at any
given time.
 Uninterrupted controversies among economists lead to
alternative theories and models what constitute
macroeconomic thought.
1.2 Methods of Macroeconomics Analysis…..
 As Blanchard (1997a) points out macroeconomics:
Is not an exact science but an applied one where ideas,
theories, and models are constantly evaluated against
the facts, and often modified or rejected…
Is thus the result of a sustained process of
construction.
Is built on theories by eliminating those ideas that
failed and keep those that appear to explain reality
well.
1.3.Macroeconomic Goals and Instruments
Economists may disagree on theories, empirical
evidence and policy instruments.
 1.3.Macroeconomic Goals and Instruments…..
 However, there is almost a consensus on major goals of
economic policy such as high/full employment,
stability and rapid growth.
 Full employment: Full use of all available resources
(labor, capital, land, and entrepreneurship) in the
economy. Unemployment/underemployment is sub-
optimal/below capacity operation; affecting income and
wellbeing of individuals and society.
 Economic Stability: Smooth movement of production,
employment, and prices on socially desirable growth
path.
 Instability: High-inflation, unemployment, fiscal deficit,
trade and balance of payment deficit and erratic
movement of GDP.
1.3.Macroeconomic Goals and Instruments…..
Instability affects (i) the welfare of society, (ii) the
planning and functioning of firms and also (iii) causes
potential political unrest.
 Economic growth is simply an increase in the production
of goods and services overtime, shown as: g = (GDPt-
GDPt-1)/GDPt-1;g>0.
Economic growth arises from increased labour
productivity, TFP, R&D, etc.
Gains from economic growth (income/wealth) needs
to be fairly/equitably distributed among members of
society.
Is there a broad spectrum medicine that addresses
these problems in one spot? No!
1.3.Macroeconomic Goals and Instruments…..
Does policy prescribed for one problem/imbalance cause
positive/negative effect on other variables on an
economy? Yes!
1.Trade-offs: These goals may not be mutually compatible.
For instance:
Increased money supply enhances employment but
possibly leads to inflation.
Use of modern technologies may enhance economic
growth but possibly leads to workers-lay off.
2.Disagreement on mechanisms of achieving
macroeconomic goals:
Classical school: Market forces solve macroeconomic
instability.
1.3.Macroeconomic Goals and Instruments…..
 Keynesian school: Because of market failure
government should intervene to address imbalances or
economic disequilibrium.
Macroeconomists use different policies such as monetary
and fiscal policies.
 MP uses policy instruments (interest rate, reserve
requirements, domestic credit, treasury bills, etc.)
managed by monetary authorities or Central Banks.
 FP uses policy instruments (taxes, government
expenditure, social security, etc.) that are used by the
government bodies to manage the country’s budgetary
revenue and expenditure.
1.3.Macroeconomic Goals and Instruments…..
Expansionary Policy: Increased money supply (MP) and
increased government expenditure or declining tax rate
(FP).
Contractionary Policy: Reduced money supply (MP)
and declined government spending and increased tax (FP).
Example: If tax increases (contractionary measure)
government revenue may increase and budget deficit may
be eliminated; but disposable income and consumption and
AD may decline; profit of firms may also be affected; thus
affect economy.
1.4. State of Macroeconomics: Evolution & Recent
Developments
1.Mercantilists
 Wealth and power of a nation is determined by its stock of
precious metals (stock of foreign currency assets).
Implication for policy: A need to use export subsidies and
import duties to maximize the stock of precious
metals/foreign currency.
2.Classical School
 Main contributors: Adam Smith, (Wealth of Nations in
1776), Ricardo, etc.
 Ups and downs of economic activities are reflected in up
and down movements of prices. Imbalances are short-
lived.
State of Macroeconomics….
 Prices are flexible. Economic agents react to price
changes as immediate as possible so that market clears;
equilibrium is ensured. Just leave the economy for the
market (laissez faire).
 The theory was dominant up to the 1930 incidence.
3.Keynesian school
 Between 1929 and 1932, Western economies faced a
tragic performance. Unemployment increased (USA
25%), price fell (40% in Germany and USA) and output
declined (USA 50%, 40% in Germany and 30% in
France).
 The Great Depression of the 1930 in USA and other
western economies challenged the role of markets and
gave rise to aggregate economics or macroeconomics.
State of Macroeconomics….
 Keynes, Hicks (1937), Modigliani (1944) and Tobin
(1958) are main contributors for Keynesian school.
 Keynes argued that the classical economic thinking failed
to explain the causes of depression.
 The assumption of flexible prices is wrong.
 Prices (including wages) are upward sticky.
 Workers engage in long-term contracts. Workers are not
usually willing to see their wage fall even if prices fall.
There is money illusion; no focus on real wage. Thus,
markets are not always self-regulating.
 Output fluctuations are partly caused by private sector
behavior (animal sprit). Investors pessimism reduces
investment and output and causes for unemployment.
State of Macroeconomics….
 Market failure leads to involuntary unemployment.

 Example: Assume initial labour market equilibrium at:

W0 =W/P0

 If price declines from P0 to P1: will it cause

unemployment?
State of Macroeconomics….
 Classical school: Firms will not be profitable as P
declines; real wage increases to (w1); labour becomes
expensive.
w1 = W0 /P1
 Demand for labour declines; firms lay off workers,
 Thus, workers voluntarily reduce their nominal wage
from W0 to W1 so that the real wage remains the same at:
w0=W1/P1=W0/P0
 Thus, no unemployment, initial equilibrium is restored.
Keynesian School:
Workers do not reduce their wages. Thus, real wage
increases to w1; demand for labour declines and labour
supply increases.
 Unemployment arises by LS – LD.

 A need for government intervention, AD management.

 If money supply increases, aggregate demand increases,

price increases and thus real wage goes back to w0.
State of Macroeconomics….

 As money supply increases; unemployment decreases and

inflation rises; which leads to Philips curve or an inverse
relationship between inflation and unemployment
State of Macroeconomics….

 MP is used to make advantage of money illusion of

workers to increase employment. Government policies
can improve macroeconomic performance and stabilize
the economy.
State of Macroeconomics….
Monetarists:
There is natural unemployment level that could not be
addressed by increased money supply. Friedman: Avoid
arbitrary money supply measures. Because it aggravate
inflation and does not eliminate unemployment in the long-
run. Otherwise, it leads to staginflation: both unemployment
and inflation.
New Classicalists:
 No need for use of demand management policies by
government (Lucas, 1981a).
 Economic agents (HHs and firms):
 Make rational expectations about the future.
State of Macroeconomics….
Make optimal decisions or maximize their benefits/profits;
Their forecasts are on average accurate; deviations or
errors in forecasts are random;
economy operates at the natural rate of unemployment
level;
Market forces remove disturbances quickly by
equilibrating demand and supply through wages and prices
adjustments, and return to natural level of output and
employment.
Economy is inherently stable; but disturbed by instable
monetary growth (as also argued by monetarists) and other
government interventions; for instance, rate of increase in
money wages equals expected rate of inflation, no change
in real wage.
State of Macroeconomics….
 Stabile money supply and minimal government role help
to correct macroeconomic imbalances;
Main arguments by the new classical school:
i. Policy ineffectiveness proposition: Random or arbitrary
MP bring short-run real effects because they are not
anticipated by rational economic agents; (Sargent and
Wallace, 1975, 1976). In the long-run, they do not have
any effect.
ii. Keynesian-style macro-econometric models do not
accurately predict the consequences of various policy
changes on key macroeconomic variables (Lucas 1976).
iii. Remove discretionary government powers to improve
economic performance.
State of Macroeconomics….
The New Keynesian School:
The school considered:
 Rational expectations hypothesis, wage and price stickiness and
Friedman’s natural rate of unemployment hypothesis (No long-
run trade-off between unemployment and inflation).
 The school argues:
 Demand and supply shocks cause output and employment
fluctuations.
 Stagflation could result due to supply shocks (cost-pushed
inflation).
 Markets may not clear even if agents are rational and optimizing
because of information problems, transaction costs and thus
price rigidity in the economy.
 Government policies can improve macroeconomic performance
and stabilize the economy.