•

INTERMEDIATE MACROECONOMICS NOTES

Macroeconomics:

Definition:

• Macroeconomics is a part of economic study which analyzes the economy as a whole. It is the
average of the entire economy and does not study any individual unit or a firm. It studies the
national income, total employment, aggregate demand and supply etc.

Macroeconomics is the study of the performance, structure, behaviour and decision-making of

an economy as a whole. It focuses on the national, regional, and global scales to maximize
national income and provide national economic growth.

Concept of Macroeconomics:

• The term ‘Macro’ has been derived from a Greek word ‘Macros’ meaning ‘large’. Thus Macro-
economics is the study and analysis of an economy as a whole.

• The study of the performance, structures behavior and decision making of an economy as a
whole, rather than individual units.

• Macroeconomists focus on the national, regional and global scales

• For most macroeconomists the purpose of this discipline is to maximize national income and
provide national economic growth.

• This growth further increases utility and improve standard of living for the economy’s
participants.

Macro Economics involves the study of:

• The behaviour of an economic system as a whole

• Aggregate and average covering the entire economy
• Behaviour of large aggregators such as – total employment, national product, national income,
price- levels etc.

Macro Economics deals with problems such as:

• Unemployment in the country

• Inflation/ deflation

• Economic growth
 •
• International trade

• National output

National expenditure
• Level of saving & investment

Scope of Macro Economics:

The scope of Macro Economics lies in the study of analysis of the following:

• Theory of employment

• Theory of income
• Theory of price level

• Theory of growth

• Theory of distribution
• Theory of national income

Nature of Macro Economics:

• It is a study of national aggregates

• It studies economic growth
• It ignores individual differences between aggregates

Importance of Macro- economic Analysis:

• It never neglect the relationship between demand & supply as in case of micro-
economic analysis.
• It always gives the complete picture about the economy as whole hence it helps to
understand working of the whole economy.
• Macro- economic has increased the utility of economics.

• It can be used for the development of micro- economic theories

• It helps in formulation of economic policies.

• It studies and analyses growth and development in an economy.

Difference between Micro Economics and Macro Economics:

Micro Economics Macro Economics
 •

Meaning it studies individuals units It studies the economy as a whole

Of an economy

Fields of It studies individual economic unit It studies national

study such as: a consumer, a firm, a Aggregate such as: national income,
household, an industry a national output, general price level,
commodity etc. level of employment etc.

Problems it deals with micro problems such It deals with problems at a macro
as determination of: price of level like problems of employment,
commodity, a factor of production, trade cycles, international trade,
satisfaction of a consumer etc. economic growth etc.

Nature It is based on disaggregation of It is based on aggregation of units

units. It does not consider
It considers individual differences individual differences
between different units between aggregates

Objectives Maximize utility Full employment

Maximize profits Minimize costs Price stability
Static analysis i.e. Economic growth
Favorable balance of
payment situation

Methodology Does not explain the time element

Equilibrium conditions are Dynamic analysis i.e. it is based on
measured at a particular period time lags, rates of change, past and
expected values of variables.
 •

DETERMINATION OF THE EQUILIBRIUM NATIONAL INCOME IN AN OPEN

ECONOMY

A Mathematical Approach to the National Income Equilibrium

A simple Keynesian model can be represented in the following way:

Y=C+1o +Go ……………… 1

Where;

C= Consumption expenditure

1o= Investment expenditure

Go= Government expenditure

The equation (1) above implies that national income equals total expenditure.

A functional relationship can further developed between consumption(C) and the national
income which is given by:

C= a + bY…………………2

In the above function, a does not depend on the level of national income and is therefore referred
to as autonomous consumption. Autonomous consumption is defined as the expenditures that
consumers must make even when they have no disposable income. Certain goods need to be
purchased, regardless of how much income or money a consumer has in their possession at any
given time. When a consumer is low on resources, paying for these necessities can force them to
even borrow or access money that they had previously been saving. The component bY of the
function, on the other hand depends on the level of income and is known as induced
consumption. Induced consumption is the portion of consumption that varies with disposable
income. When a change in disposable income “induces” a change in consumption on goods and
services, then that changed consumption is called “induced consumption”. In contrast,
 •

expenditures for autonomous consumption do not vary with income since the consumption
function has a positive slope, this implies that as the level of national income increases, so does
the consumption expenditure. The slope coefficient b is referred to as the marginal propensity to
consume. The marginal propensity to consume is the change in consumption that arises from an
additional unit of income.

The equation Y= a+ bY + 1o+ Go

Y- bY = a + 1o +Go

(1- b )Y= a + 1o + Go

. . Y = a + 1o + Go

1- b

EXAMPLE

Taking a simple numerical example, assume that a= 270, b= 0.8, 1o= 150, and Go= 60. We can
solve for equilibrium level of income.

Y= C+ I + G = 270 + 0.8 Y+ 150 + 60

Y= 480 + 0.8Y

Y - 0.8Y= 480

(1 - 0.8)Y= 480

0.2Y = 480

Y = 480

0.2

Y= 2,400
 •

Two Sector Sector Model of National

Income Determination
Introduction:

To simplify the analysis deals with a two-sector model of income determination.

A two sector is related to a closed economy in which there is no foreign trade.

Two-Sector Model:

A two-sector model of income determination of an economy consists only of domestic and

business sectors.

Assumptions:

The income determination in a closed economy is based on the following assumptions:

1. It is a two-sector economy where only consumption and investment expenditures take place.
Thus the total output of the economy is the sum of consumption and investment expenditure.

2. Investment relates to net investment after deducting depreciation.

3. It is a closed economy in which there are no exports or imports.
4. There are no corporate firms in the economy so that there are no corporate undistributed
profits.
5. There are no business taxes, no income taxes and no social security taxes so that disposable
personal income equals NNP.
There are no transfer payments.
6. There is autonomous investment.
7. The economy is at less than full employment level of output.
The price level remains constant up to the level of full employment.
8. The money wage rate is constant.
9. There is stable consumption function.
10. The rate of interest is fixed.

The analysis relates to the short period.

 •

Explanation:

Given these assumptions, the equilibrium level of national income can be determined by the
equality of aggregate demand and aggregate supply or by the equality of saving and investment.

Aggregate demand is the summation of consumption expenditure on newly produced consumer

goods by households and on their services (C), and investment expenditure on newly produced
capital goods and inventories by businessmen (I).

It is shown by the following identities:

Y = C+I ….(1)
Personal Income: Yd = C+S….(2)
But Y= Yd
C+I=C+S
Or I = S
Where Y = national income, Yd = disposable income, C = consumption, S = saving, and I =
investment.
In the above identities, C + l relate to consumption and investment expenditures which represent
aggregate demand of an economy. C is the consumption function which indicates the relation
between income and consumption expenditure.
The consumption function is shown by the slope of the C curve in Fig. 1 which is MPC
(marginal propensity to consume). I is investment demand which is autonomous. When
investment demands (I) is added to consumption function (C), the aggregate demand function
becomes C+I.
C+S identity is related to the aggregate supply of an economy. That is why, consumer goods and
services are produced from total consumption expenditure and aggregate savings are invested in
the production of capital goods.
In an economy, the equilibrium level of national income is determined by the equality of
aggregate demand and aggregate supply (C+I=C+S) or by the equality of saving and investment
(S=I).
We explain these two approaches one by one with the help of Figure 1 (A) and (B).
 •

Equality of Aggregate Demand and Aggregate Supply:

The equilibrium level of national income is determined at a point where the aggregate demand
function (curve) intersects the aggregate supply function. The aggregate demand function is
represented by C+I in the figure. It is drawn by adding to the consumption function C to the
investment demand I.

The 45° line represents the aggregate supply function, Y = C+S. The aggregate demand function
C+I intersects the aggregate supply function Y= C+S at point E in Panel (A) of Figure 1 and the
equilibrium level of income OY is determined. Equilibrium level of income refers to when an
economy or business has an equal amount of production and market demand.

Suppose there is disequilibrium in aggregate supply and aggregate demand of the economy.
Disequilibrium can be in either case, aggregate supply exceeding aggregate demand or
aggregate demand exceeding aggregate supply. How will the equilibrium level of income be
restored in the two situations?

First, take the case when aggregate supply exceeds aggregate demand. This is shown by OY2
level of income in Panel (A) of the figure. Here aggregate output or supply is Y2E2 and aggregate
demand is Y2k. The disposable income is OY2 (=Y2E2). At this income level OY2, consumers
will spend Y2d on consumption goods and save dE2.
 •

But businessmen intend to make investment equal to dk in order to buy investment goods. Thus
the aggregate demand for consumption goods and investment goods is Y2d + dk = Y2k. But
aggregate supply (or output) Y2E2 is greater than aggregate demand Y2k by kE2 (=Y2E2 – Y2k).

Therefore, the surplus output of goods worth kE2 accumulated by businessmen in the form of
unintended inventories. In order to avoid further inventory accumulation, they will reduce
production. As a result of the reduction in output, income and employment will fall and the
equilibrium level of income will be restored at OY where the aggregate supply equals aggregate
demand at point E.

The second situation of disequilibrium when aggregate demand exceeds aggregate supply is
shown by the income level of OY1 in Panel (A) of the figure. Here the aggregate demand is Y1E1
and the aggregate output is Y1a. The disposable income is OY1 (=Y1a).

At this income level, consumers spend Y1b on consumption goods and save ba. But businessmen
intend to invest bE, to buy investment goods. Thus the aggregate demand is Y1b + bE1= Y1E1
which is greater than the aggregate supply of goods Y1a by aE1.

To meet this excess demand worth aE1, businessmen will have to reduce inventories by this
amount. In order to stop further reduction in their inventories, businessmen will increase
production. As a result of the increase in production, output, income and employment will
increase in the economy and the equilibrium level of income OY will be restored again at point
E.

Equality of Saving and Investment Approach:

The equilibrium level of income can also be shown by the equality of the saving and investment
functions. Since the equilibrium level of income is determined when aggregate supply (C+S)
equals aggregate demand (C + I) in the economy, intended (or planned) saving also equals
intended (or planned) investment. This can be shown algebraically

C+S=C+l
S=I
The equilibrium level of income in terms of the equality of saving and investment is shown in
Panel (B) of Figure 1, where I is the autonomous investment function and S is the saving
function. The saving and investment functions intersect at point E which determines the
equilibrium level of income OY.
If there is disequilibrium in the sense of inequality between saving and investment, forces will
operate in the economy and the equilibrium position will be restored. Suppose the income level
is OY2 which is above the equilibrium income level OY.
At this income level OY2, saving exceeds investment by gE2. It means that people are consuming
and spending less. Thus aggregate demand is less than aggregate supply. This will lead to the
accumulation of unintended inventories with businessmen. To avoid further accumulation of
 •

inventories, businessmen will reduce production. Consequently, output, income and employment
will be reduced till the equilibrium level of income OY is reached at point E where S=I.
On the contrary, if the income level is less than the equilibrium level, investment exceeds saving.
This is shown by OY1 level of income when investment Y1E1 is greater than saving. The excess
of intended investment over intended saving means that aggregate demand is greater than
aggregate supply by eE1.
Since aggregate output (or supply) is less than aggregate demand, businessmen will have a
reduction of inventories held by them. To stop further reduction in their inventories, they will
increase production. Consequently, output, income and employment will increase in the
economy and the equilibrium level of income OY will be again reached at point E.
The determination of equilibrium level of income simultaneously by the equality of aggregate
demand and aggregate supply and of saving and investment is explained in Table I below.

MONETARY POLICY

Monetary policy can be defined as one of the public intervention measures aimed at influencing
the level and pattern of economic activity so as to achieve certain desired goals. Monetary policy
can be said to cover all actions by the central bank and the government which influence the
quantity, cost and availability of money and credit in the economy.

Many developing countries place a lot of emphasis on monetary policy to accelerate an orderly
process of economic development. The importance and hence effectiveness of monetary policies
is much disputed. Whereas monetarism as a doctrine holds that monetary policy is is determinant
 •

of aggregate demand, J.M. Keynes holds that monetary policy matters only in as far as it affects
fiscal variables.

Objectives of the monetary policy

Following are some of the goals or objectives which monetary policy may be expected
accomplish.

(i) Attainment of full employment. It will be idealist to argue that the only
acceptable level of employment is zero employment. Full employment can thus at least be said to
be consistent with some frictional unemployment as some potential workers search for
employment. Moreover, it is argued by some economists that a certain amount of structural
employment is acceptable since individuals without jobs may not have the skills needed by the
employers at least in the short-run. monetary policy can raise the level of employment by
discouraging credit to capital intensive sectors while at the same time, directing investment to
labour intensive sectors like rural agriculture, and light industries such as those dealing with
textiles through selective lending. In addition, a policy that lowers the rate of interest constitutes
expansionary monetary policy and is likely to lead to increased investment and hence more job
opportunities.

(ii) The achievement of price stability. This has been by large the problem of
avoiding inflation. Unanticipated inflation reduces the ability of money to effectively perform its
functions, especially as a store of value and as a standard of deferred payments. Moreover, price
stability can be maintained by regulating money supply through the tools of the central bank
such as discount rate, minimum reserve requirements and open market operations.

(iii) Attainment of economic growth which can be defined as the process

whereby the real GNP capital increases over a period of time. Monetary policy can contribute to
this end by providing investment funds through cheaper credit and by mobilising savings which
can then be used for investment. The flow of funds can be institutionalised so that investment
funds are allocated to those sectors with the highest rates of return. This better allocation of
resources brings about increased output.
 •

(iv) To maintain an equilibrium in the balance of payment. Monetary policy

can be used in such a way that credit is selectively directed to the export sector and away from
the import sector. At the same time, capital inflow can be encouraged and outflow discouraged
through say exchange controls. Another related goal is that exchange rate stability which often
requires the intervention of policy makers in the foreign exchange market.

(v) The creation of sound banking and financial institutions to mobilise

savings for capital formation. Thus, for example, branch banking should be encouraged in the
rural and urban areas. While this objective could be regarded as a means to achieving the
previous goals. It is also a consideration that appears to be an independent goal.

Instruments of Monetary Policy

The central bank has a number of instruments of monetary control, which it employs on various
occasions. They are as follows;

(i) Open market operations: This is one of the instruments of monetary policy.
It refers to the sales or purchases of marketable securities conducted in the open market by the
central bank. The sale or purchase of securities will depend on the excess or deficiency in the
liquidity level. When there is excess money circulating in the economy, the central bank sells
government securities to the commercial banks in order to mop up excess reserves with
commercial banks. On the other hand when there is less money circulating in the economy, the
central bank injects additional liquidity into the economy by purchasing from the existing stock
of government securities.

(ii) Interest rate policy: This policy is one of the widely used policies aimed at
regulating the amount of money supply in the economy. When there is excess supply of money
in the economy, the central bank directs all commercial banks to increase their rates of interest.
This makes it costly for the people seek loans from such banks. This puts a cap or a stop to the
increasing number of people seeking loans thereby reducing the amount of money in circulation

(iii) Selective credit control: This is a qualitative measure of credit control used
to encourage those sectors of the economy considered essential and to discourage those which
are of lower priority. This policy has been effected by the Central Bank through issuance of
 •

special directives regarding loans, advances or investments made by commercial banks. The
Central Bank is also authorised under its statute to impose limits on any category of loans,
advances or investments made by made by commercial banks. Thus, for example, it may advise
commercial banks and other financial institutions to approve loans for industrial development
and limit loans for growing of khat and tobacco.

(iv) The minimum liquidity assets ratio: The liquidity assets ration can be
defined as the proportion of the total assets of a bank which are held in form of cash, and liquid
assets. The instrument affects banks lending and has the advantage that it affects all banks
equally and has a powerful effect on controlling credit creation since it is a direct method and its
effects are immediate. A related instrument has been the cash ratio whereby the Central Bank
may instruct commercial banks to keep a higher or lower percentage of deposits received by
them in cash form. The Central Bank may also require commercial banks to maintain minimum
cash balances with it against their total deposit liabilities although the prescribed balances may
not exceed 20% of total deposit liabilities. The main purpose of this instrument is to reduce the
bank’s free cash base and hence their capacity to give loans and advances.

ECONOMIC STABILISATION MONETARY POLICY

Introduction

Monetary policy is another important instrument with which objectives of

microeconomic policy can be achieved. It is worth noting that it is the Central Bank of a country
which formulates and implements the monetary policy in a country. In some countries such as
Kenya, the Central Bank enjoys an independent status and pursue its independent policy. Like
the fiscal policy the broad objectives of monetary policy are to establish equilibrium at full-
employment level of output, to ensure price stability and to promote economic growth of the
economy. Monetary policy is concerned with changing the supply of money stock and rate of
interest for the purpose of stabilizing the economy at full-employment or potential output level
by influencing the level of aggregate demand. More specifically, at times of recession monetary
policy involves the adoption of some monetary tools which tend to increase the money supply
and lower interest rates so as to stimulate aggregate demand in the economy. On the other hand,
 •

at times of inflation, monetary policy seeks to contract the aggregate spending by tightening the
money supply or raising the rate of interest.

It may however be noted that in a developing country such as Kenya, in addition to

achieving equilibrium at full employment or potential output level, monetary policy has also to
promote and encourage economic growth both in the Industrial and agricultural sectors of the
economy. Thus, in the context of developing countries the following three are the important
goals or objectives of monetary policy.

(1) To ensure economic stability of full-employment or potential level of output;

(2) To achieve price stability by controlling inflation and deflation; and
(3) To promote and encourage economic growth in the economy.

The role of monetary policy in achieving economic stability at a higher level of output and
employment will be discussed below and its role in promoting economic growth in developing
country.

Tools of monetary policy

There are four major tools or instruments of monetary policy which can be used to achieve
economic and price stability by influencing aggregate demand or spending in the economy. They
are:

1. Open market operations

2. Changing the bank rate;
3. Changing the cash reserve ration; and
4. Undertaking selective credit controls

How these three tools of monetary policy work to influence aggregate spending and
economic activity has been explained in preceding pages. We shall explain how these various
tools can be used for formulating a proper monetary policy to influence levels of aggregate
output, employment and prices in the economy. In times of recession or depression,
expansionary monetary policy or what is also called easy money policy is adopted which raises
aggregate demand and thus stimulates the economy. On the other hand, in times of inflation and
excessive expansion, contractionary monetary policy or what is also called tight money policy is
 •

adopted to control inflation and achieve price stability through reducing aggregate demand in the
economy. We discuss below both this policies.

EXPANSIONARY MONETARY POLICY TO CURE RECESSION OR

DEPRESSION.

When the economy is faced with recession or involuntary cyclical unemployment, which
comes about due to fall of aggregate demand, the central bank intervenes to cure such a situation.
Central bank takes steps to expand the money supply in the economy and/or lower the rate of
interest with a view to increase the aggregate demand which will help in stimulating the
economy. The following three monetary policy measures are adopted as a part of expansionary
monetary policy to cure recession and to establish the equilibrium of national income at full
employment level of output.

1.) The central bank undertake open market operations and buys securities in the open
market.

Buying of securities by the central bank from the public, chiefly from commercial banks will
lead to the increase in reserves of the bank or amount of currency with the general public. With
greater reserves, commercial banks can issue more credit to the investors and business men for
undertaking more investments. More private investment will cause aggregate demand curve to
shift upwards. Thus buying of securities will have an expansionary effect.

2.) The central bank may lower the bank rate or what is also called discount rate, which is
the rate of interest rate charged by the central bank of country on its loans to commercial
banks.

At a lower bank rates, the commercial banks will be induced to borrow more from the central
bank and will be able to issue more credit at the lower rates of interest to business men and
investors. This will not only make credit cheaper but also increase the availability of credit of
money supply in the economy. The expansion in credit or money supply will increase the
investment demand which will tend to raise aggregate output and income.
 •

3.) Thirdly, the central bank may reduce the Cash Reserve Ration (CRR) to be kept by the
commercial banks. This is a more effective and direct way of expanding credit and
increasing money supply in the economy by the central bank.

With lower reserve requirements, a large amounts of funds is released for providing loans to
business men and investors. As a result, credit expands and investments expand in the economy
which has an expansionary effect on output and employment.

It may be noted that the use of all the above tools of monetary policy leads to an increase
in reserves of liquid resources with the bank. Such reserves are the basis on which the banks
expands their credit by lending, the increase in reserves raises the money supply in the economy.
Thus, appropriate monetary policy at times of recession or depression can increase spending
which has an expansionary effect on the economy.

How Expansionary Monetary Policy Works: Keynesian View

Now, it is important to understand how expansionary monetary policy works to cause

increase in output and employment and thus help the economy to recover from recession. In the
Keynes’ theory, rate of interest is determined by the demand for and supply of money.
According to Keynesian theory, expansion in money supply causes the rate of interest to fall and
this fall in the rate of interest will encourage business men to borrow more for investment
spending. As is well known, rate of interest is the opportunity cost of funds invested for
purchasing capital goods. As rate of interest falls, it becomes profitable to invest more in
producing or buying capital goods. Thus, fall in the rate of interest raises the investments
expenditure which is an important component of aggregate demand. The increase in aggregate
demand causes expansion in aggregate output, National income and employment. According to
Keynesian view, expansion in money supply can help to cure recession as illustrated in figure
48.1. In panel (a) of Fig. 48.1, it will be seen that when as a result of some measures taken by the
central bank, the money supply increase from M1M2, the rate of interests falls from r1 to r2. It will
be seen from panel (b) that with this fall the in rate of interest, investment increases from I 1 to I2.

From above, it is clear that monetary policy can play an important role in stimulating the
economy and ensuring stability at full employment level.

Y
 •

Quantity of Money Panel (a)

Y

Rate of Interest
r1

r2 I

ΔI
X
0 I1 I2

Investment Demand Panel

Thus, because of several weak links in the process or chain in expansion in money supply
bringing about expansion, Keynes remarked that there are many a slip between the cup and the
lip. Therefore, for all these reasons (especially because of the liquidity trap in the demand for
money curve at lower rates of interest). Keynes was of the view that monetary policy is not an
effective instrument in bringing about revival of the economy from the depressed state.

It may however be noted that modern Keynesians do not share the pessimistic view of the
effectiveness of monetary policy. They think that liquidity preferences curve is not lat and
further that investment demand is fairly sensitive to the changes in the rates of interest.
 •

Therefore, modern Keynesians equally advocate for the adoption of discretionary monetary
policy as for the discretionary fiscal policy to get rid of recession.