Haramaya University College of

Agriculture and Environmental

Sciences

Agricultural Economics Program

Macroeconomics-I Handout

September, 2021
 Agricultural Economics Program: Macroeconomics-I

1. INTRODUCTION TO MACROECONOMICS

Economics is the study of the economy and the behavior of people in the economy. From the
point of view of elements of analysis (scope of study), economics is divided into
microeconomics, which studies the behavior of individuals and organizations (consumers, firms
and the like) at a disaggregated level, and macroeconomics, which studies the overall or
aggregate behavior of the economy.

1.1. Concepts and Definition of Macroeconomics

Macroeconomics is concerned with the behavior of the economy as a whole- with booms and
recessions, the economy’s total output of goods and services and the growth of output/income,
the rate of inflation and unemployment, the balance of payments and exchange rates. Moreover,
macroeconomics focuses on the economic behavior and policies that affect consumption and
investment, the determinants of changes in wages and prices, monetary and fiscal policies
(taxation, the money stock, government budget and interest rate), trade balance and national
debt. It deals with both long-run economic growth and the short run fluctuations which are
constituents of the business cycle. In brief, it deals with major economic issues and problems and
therein possible solutions. For instance, during high unemployment the policies aim at reducing
unemployment rate. During high inflation it tries to stabilize price level. During trade deficit, it
tries to find the means through which export can be expanded etc. In Ethiopia, most of these
macroeconomic elements are controlled by two major offices: Ministry of Finance and Economic
Development (MoFED) and National Bank of Ethiopia (NBE).

Macroeconomic issues play a central role in political debate. Voters are aware of how the
economy is doing, and they know that government policy can affect the economy in powerful
ways. As a result, the popularity of the incumbent president rises when the economy is doing
well and falls when it is doing poorly. Macroeconomic issues are also at the center of world
politics. In recent years, Europe has moved towards a common currency, many European
countries have experienced financial crisis and the United States has financed large trade deficits
by borrowing from abroad. When world leaders meet, these topics are often high on their
agendas.
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In macroeconomics, we usually do two things. First, we seek to understand the economic

functioning of the world we live in; and, second, we ask if we can do anything to improve the
performance of the economy. That is, we are concerned with both explanation and policy
prescription. The explanation involves and attempts to understand the behavior of economic
variables, both at that particular time and after some point of time. This means that we need to
explain the behavior of the economy both in the long run and in the short run.

Once we understand about the explanation of short run and long run behavior of national
economic variables such unemployment rate, inflation rate and contraction in aggregate (or total
demand at national level), it is easy for the policy makers to prescribe policy to achieve various
macroeconomic goals. Any action or measures that are undertaken by policy makers without
having proper knowledge about the consequences of the action may only worsen the problem.

1.2. Major Elements of Macroeconomics/National Economy

Some of the most important concepts that macroeconomics deals with are the followings.
a) Gross Domestic Product (GDP) is the sum of values of total goods and services produced
in a given country in a given period of time (a year). This can be obtained by aggregating the
values of goods and services produced in different sectors of the economy.
b) Government expenditure is the amount of resources that the government sector of a
country spends in a given fiscal year (budget year). This expenditure includes both
consumption expenditure and investment expenditure in such activities as construction of
roads, schools, clinics and hospitals, water supply, electrification and others. Government
consumption includes expenditure on non-durable goods in government offices and
expenditure on national defense. The major source of finance of the government expenditure
is taxation.
c) Total money supply is the sum of total currencies in circulation. The amount or size of
money supply is controlled to the appropriate level by Central Bank (Federal Bank) of the
country. In Ethiopia this is the duty of the National Bank of Ethiopia (NBE). National Bank
or Central Bank uses different instruments in controlling money supply.
d) Inflation represents a rise in general price level. During inflation prices of all goods and
services become high. As a result of this the purchasing power of money (or value of
Currency) decreases. For instance, 100 Birr cannot purchase what it used to purchase before
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inflation. There are several factors that lead to inflation such as excess money supply or less
production.
e) Trade Balance is the net inflow of foreign exchange from trade (export and import). It is
the value of net export of a country. It is measured by the difference between export from
and import into a country; i. e. total export value (X) minus total import value (M). A
positive value of this term/variable shows surplus balance of trade indicating good
performance of that country.
f) Current Account Balance (CA) is the net inflow of resource from trade, services and
unrepeated transfer. In addition to import and export items, the current account includes the
flow of payment to factors (labour, capital, land etc.) such as dividends, profits and wage as
well as payments to services such as shipping, banks and tourism; and unrepeated transfers
such as remittance from abroad.
g) Balance of Payment (BOP) is the net of inflow of resources to a given country/economy
from the rest of the world. This includes the flow of all resources. It does not refer to flow of
resources only from trade services. In addition to the current account balance, the balance of
payment (BOP) includes the flow of resources from foreign investment, borrowings from
the rest of the world (short term, medium term, and long term), and repayments of such
borrowings.
h) Exchange rate refers to the rate at which domestic currency is exchanged for foreign
currency. For instance, in Ethiopia, about 2.07 Birr used to be exchanged for one dollar
during the Imperial and Dergue periods. But under the existing government the exchange
rate is changed to 5 Birr per one US dollar and now to about 44 Birr per one US dollar. In
other words, birr is losing its value against dollar. The reason for this could be due to
devaluation or currency depreciation of domestic currency.
i) Consumer price Index (CPI) is the measure of weighted average of prices of goods and
services used by consumers. It is the measure of cost of living. Like GDP which measures or
converts all goods and services in a given economy/country to a single figure, CPI measures
prices of several goods and services into a single price.
j) Per capita Income (PCI) is the measure of average output of a country per person. It is the
ratio of the total output, Gross Domestic Product (GDP) to total population (N) of the
country. It is one of the best measures of the wellbeing (or the welfare) of citizens of the
country.
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1.3. Macroeconomics Schools of Thoughts

Different macroeconomic ideas/thoughts have evolved over time beginning from the mercantilist
(1500s–1600s) period to present. The focuses of most of these ideas are on the way national
development or better economic performance can be achieved. According to Mercantilists,
national development (wealth of nation) can be achieved through accumulating precious metals,
especially gold.

Later, the thinking of national economic development changed to the need or type of government
actions that should or should not be undertaken in the economy. This is related to whether the
government can or cannot intervene in the economy to improve its performance/well-being.
Different ideas have developed over time on response to this question. The Classical and
Keynesians are the dominant thoughts behind the development of these ideas. The other major
schools of economic thought share some points both with Keynesians or Classical economists. In
general term these schools can be categorized either as interventionist (similar position with
Keynesians) and non-interventionist (similar position with classical economists). Interventionist
believes that government intervention is necessary for efficient functioning of the nation.
Whereas non-interventionist believes that market are basically efficient and hence there should
not be any government intervention in the economy. Next we shall briefly discuss some of these
schools of economic thought and their positions.

1.3.1. Classical (1776-1870) and Neo classical (1870-1939) Thoughts

During the period of classicalism, the distinction between micro and macro was not very clear.
The focus was on micro economy only. They believed that by maximizing individuals’ wealth
one can maximize country’s wealth. This idea was based on the assumptions that individuals are
rational and markets are efficient. The ruling principle was the invisible hand coined by Adam
Smith. During this time there was no government intervention in economic activities. Because
economists of the time i.e. classical economists believed that the market is efficient and works
the best by itself and there is no need of government intervention (Lassez-fair economy).

The neoclassical school which criticized some of the ideas of classical economists but more or
less their ideas is the same. The main distinction between then is the tool of analysis, such as the
marginal analysis of microeconomics theory. Classical and neo-classical ideas are also now days
applied under different circumstances. The classical ideas are highly influenced by the work of
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J.B. Say a French classical economist. His work is popularly known as Say’s law of market
which is a well-known non-interventionist approach.

Say’s Law
The classical economists also accepted Say's Law of Markets propounded by the French
economist Jean Baptiste Say. Say's Law holds that every supply creates its own demand. He
believed that the total supply of products and the total demand for them must be equal. He agreed
that there may be temporarily overproduction. This over production will soon be corrected by
supplier once they know that there is no demand for the over production. He has deduced three
conclusions from his law of markets. These are:
 Higher number of markets and its coverage helps in increasing the demand and a rise in
price.
 Each class is interested in the prosperity of the other. He believed that agriculture,
manufactures and commerce all grow together.
 Imports are good for the home country and it does not harm the home industry.

We can sum up the important implications of the Classical model as follows:

1. Money supply changes have no effect on current output, and it only affects the price level.
2. Changes in government expenditure have no effect on current output and only affect the
interest rate, and the amount of investment and consumption undertaken.
3. Changes in the overall level of taxation do not affect current output.

1.3.2. Keynesian’s (1936 - 1970) school of thought

The great depression of 1933, (world economic crises in general and of American in particular)
initiated economists to recommend government intervention. The first economist was John
Maynard Keynes. The economists following his trend are called Keynesian economists. The
main thesis of the Keynesian paradigm is that economy is subjected to failure as markets are not
efficient and economy may not achieve full employment level. The Keynesian thinkers believed
that government intervention is inevitable. Following the failure of all attempts of central banks
to keep the economy on the right track, John Mynard Keynes published his book of ‘General
Theory of Employment, Interest and Money’ in year 1936. In his work, he suggested that
quantity of money is not important especially during depression. But the most important factors
are investment level, fiscal factors (government expenditure and taxes) and export level (or
foreign exchange) as these are the major determinants of the position of the business cycle. The
publication of Keynes’s book dramatically changed the economic thought.
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Keynesian’s economic theory is also known as ‘Theory of Recession’. In a very simplified form,
we can present Keynes’s Recessions. Imagine an economy is operating at full employment level
where there is smooth functioning of ‘real’ economy with a smooth financial flows as firms earn
money from their sales and pay out their earnings in wages and dividends, and household spend
these receipts on new purchases from the firms. However, now suppose that for some reasons
each household and firm in this economy decides to hold a little more cash by postponing their
purchase. This brings to a situation where demand is less than the supply of goods and services.
Keynes argued that in this case businessmen lose confidence thinking that potential investments
might not give adequate returns. As a result investment falls and output also falls below the
normal level. Either way, each individual firm or household tries to increase its holdings of cash
by cutting its spending so that its receipts exceed its outlays.

As Keynes points out, however, works for an individual does not work for the economy as a
whole, because the amount of cash in the economy is fixed. According to him, an individual can
increase her/his cash holding by spending less, but does this only by taking away cash that other
people had been holding. Obviously, not everybody can do this at the same time. Then, what
happens when everyone tries to accumulate cash simultaneously? The answer is that income falls
along with spending. I try to accumulate cash by reducing my purchases from you, and you try to
accumulate cash by reducing your purchases from me; the result is that both of our incomes fall
along with our spending and neither of us succeeds in increasing our cash holdings.

If we remain determined to hold more cash, we will react to this disappointment by cutting our
spending still further, with the same disappointing result. Looking at the economy as a whole,
you will see factories closing, workers laid off, stores becoming empty, as firms and households
throughout the economy cutting back on spending in a collectively vain effort to accumulate
more cash. The process only reaches a limit when incomes are so shrunken that the demand for
cash falls to equal the available supply. For Keynes to deal with recessions, the first and the most
obvious thing to do is to make it possible for people to satisfy their demand for more cash
without cutting their spending, thereby preventing the downward spiral of shrinking spending
and shrinking income. The simplest way to do this is by increasing government spending or by
increasing the supply of money.
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Therefore, one of the fundamental Keynesian answers to recessions is monetary expansion. But
Keynes admitted that sometimes even this might not be enough, particularly if a recession had
been allowed to get out of hand and become a true depression. Once the economy is deeply
depressed, households and especially firms may be unwilling to increase sending. No matter how
much cash they have, they may simply add any monetary expansion to their hoarding. Such a
situation, in which monetary policy has become ineffective, has come to be known as a “liquidity
trap”. In such a case, the government has to do what the private sector will not: spend. When
monetary expansion is ineffective, fiscal expansion must take its place. Such a fiscal expansion
can break the vicious circle of low spending and low incomes and help the economy to return
back to its normal path.

In summary, Keynesians believed that the cause of the Great Depression was due to a
combination of events that led to great uncertainty, huge decreases in investment, and economies
being stuck in an unemployment trap. The implications of the fundamental Keynesian thought
are the following.
1. The economy is inherently unstable and is subject to erratic shocks.
2. The economy can take a long time to return to being close to full equilibrium after being
subjected to a shock.
3. Government intervention is necessary for the smooth function of the economy.
4. Aggregate demand is the predominant determinant of output and employment, and it can be
altered by the authorities.
5. Fiscal policy is preferred to monetary policy for carrying out stabilization policies.
6. The access to information about the economic variables is the key.

1.3.3. Monetarism
Monetarism, as advocates of free market started challenging Keynes’s theory in the 1970. Milton
Friedman, the founder of monetarism, attacked ideas of Keynes i.e. smoothing business cycle on
the ground that such active policy is not only unnecessary, but also is harmful as it worsen the
very economic instability that it is supposed to correct and should be replaced by simple
mechanical monetary rules. This doctrine later came to be known as “monetarism”.
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Friedman began with a factual claim that most recessions, including the huge slump that initiated
the Great Depression, did not follow Keynes’s script. That is, they did not arise because the
private sector was trying to increase its holdings of a fixed amount of money. Friedman argued
that they occurred rather because of a fall in the quantity of money in circulation. According to
Friedman, if economic slumps begin people spontaneously decide to increase their money
holdings. Then the monetary authority must monitor the economy and pump money in when it
finds a slump is imminent. If such slums are always created by a fall in the quantity of money,
then the monetary authority need not monitor the economy; it needs only to make sure that the
quantity of money not slump. In other words, a straightforward rule “keep the money supply
steady” is good enough so that there is no need for a “discretionary’ policy of the form “pumps
money in only when your economic advisers think a recession is imminent”.

The studies of the time produced strong evidence supporting the view that money supply is
important and monetary conditions were more important in explaining changes in money income
than fiscal conditions. This led to the acceptance of the importance of monetary policy by the
followers of Keynes. However, it is worth noting that though Keynesians recognized the
importance of money stock but they still dispute on the impact of money supply on money
income. The reason is that causality is a very difficult thing to establish in an economy where
there are many other variables which may have its impact on money income. Essentially what
monetarists have been stating was that money is a substitute for a wide range of real and
financial assets, but that there is no single asset could be considered a close substitute for money.
For example, money is liquid and can be sued any time but bond, stocks and property are assets
but not as liquid as money.

1.3.4. The New Classical School

Monetarism and Keynesian economics debated the unsettled issues until the early 1970s, after
which a combination of two things were to lead to their demise as the main schools of
macroeconomic thought. The successor macroeconomic way of thinking was the New Classical
School. The new classical macroeconomics remained influential in the 1980s. This school of
macroeconomics shares many policy issues with Friedman. It sees the world as one in which
individuals act rationally to meet their self-interest in the market that adjust itself rapidly to
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changing conditions. They claim that government is likely only to make things worse by
intervening in economic activities.

There are three central working assumptions of the new classical school:
1. Economic agents maximize. One view of the new classical school is that households and
firms make optimal decisions given all available information in reaching decisions and that
those decisions are the best possible in circumstances in which they find themselves. It is such
maximization behavior that leads to the common interest of economic agents (market
equilibrium, where both demanders and suppliers are satisfied).
2. Expectations are rational. This according to the new classical school means that
expectations of economic agents are statistically the best predictions about the future that can
be made using the available information. Rational expectations imply that people will
eventually come to understand whatever government policy used, and thus it is not possible to
fool most of the people all the time or even most of the time. This argument is based on the
perception that government interventions are effective only if economic agents have no
correct information about the policy actions undertaken by the government.
3. Markets clear. It means market is efficient enough to adjust supply with demand in each and
every market. In labour market, there is no reason why firms or workers would not adjust
wages or prices if that would make them better off accordingly if prices and wages adjust in
order to equate supply and demand. In other words, the wages and prices adjustment
continues till market clears i.e. supply is equal to the demand. For instance, any unemployed
person who really wants a job will offer to cut his/her wage until the wage is low enough to
attract and offer from an employer. Similarly, anyone with an excess supply of goods will cut
prices so as to sell.

According to new classical economists, prices and wages are flexible all the time allowing all
individuals all the time to be in a satisfactory working situation and firms to produce and supply
as much as they want. The essence of the new classical approach is the assumption that markets
are efficient enough to bring the economy into equilibrium. Despite these explanations, they
failed to explain the occurrence of the ‘great depression’ and occasionally large unemployment
rates around the world which are the cases of market failure.
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1.3.5. The New Keynesians

A new generation of scholars called the new Keynesians, trained mostly in the Keynesian
tradition, but moving beyond it, emerged in the 1980. They do not believe that markets clear all
the time, but seek to understand and explain exactly why markets fail. The new Keynesians
argue that markets sometimes do not clear even when individuals are looking out for their own
interests. According to them, both information problems and costs of changing prices lead to
some price rigidities and that they cause macroeconomic fluctuations in output and employment.
For example, in the labour market, firms that cut wage not only reduce the cost of labour, but
also are likely to wind up with poorer quality labour/workers. Thus firms will be reluctant to cut
wages.

According to the New Keynesian economists, prices and wages are not flexible as opposed to the
classical economists’ position owing to the following major reasons:
 Imperfect information: since every change in consumer tastes and change in producers
plan are not easily observable in the market and even if it is observable there is information
lag. As a result markets do not instantly adjust to the equilibrium market clearing wages and
prices. For example, if producer wants to reduce wage rate and also wants to reduce the
price. Here we know that it takes time to produce and finally sell in the market. During this
time wage reduction may not be acceptable by the labourers and hence market may not clear
instantly.
 Long-term contract: consumers and producers and/or workers and employers stick to the
agreed upon prices and/or wages in spite of changing market clearing (equilibrium) wages
and prices. Any reduction in wage may not be acceptable to the laborers despite the fall in
prices because of strong trade unions.
 Menu costs: once a firm set a price of its products it is difficult for the firm to change it
frequently. To change its price a firm may need to change its price menu and inform the
consumers about the new price menu. Since this will add to the cost of the firms, they may
not change their price frequently.
 Minimum wage rate legislation: This is imposed by the government economic policy with
the aim to meet the inevitable wellbeing of the low income groups or workers. Minimum
wage rate legislation refers to the case that the government fixes minimum wage rate that
employers have to pay for a worker they employ and is intended to avoid unnecessary
exploitation.
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 Monopoly power of labour unions: This is the consequence of maximization behavior of

the market itself. Under this pressure producer are forced to pay high wage to avoid labour
unionization even if it is not the market clearing one.
 Efficiency wage hypothesis: According to this hypothesis, producers are also forced by the
market to pay higher wages above the market clearing one with the intention to retain
quality workers. For example, in highly technical jobs it is difficult to get trained manpower
so in order to retain them employers pay high wage.
 Nutrition Condition: Since better paid workers can have better nutrition and efficiency on
their work, employers usually pay wage rate above the market clearing one. For example,
some employers pay food allowances to the workers who engage in heavy physical labour.

1.3.6. Real Business Cycle (RBC) economists

This new group of economists has similar position to that of new classical economists in several
aspects. According to this group of economists:
1. Expectations are formed rationally.
2. Markets are always clearing.
3. Money is Neutral. Change in nominal money supply does not affect real variables such as
output.
4. Economic fluctuations are due only to supply side factors.

Given the assumptions about the way an economy behaves in #1 to #3, RBC economists argue
that the implication is that output and employment change because of changes to things like:
 The rate of technological change.
 Natural disasters or good growing seasons.
 Tax rates.
 Input price changes.
 Changes to incentives from things like the social welfare system.

There were four main criticisms of New Classical and RBC theories:
1. Unhappy Workers: Several workers usually complain about lack of job or and low wage
rate.
2. The 1982 US Recession: Recessions were observed to occur even in countries that follow
economic policy of these schools.
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3. Intertemporal Substitution of Labour: The available evidence concerning the

substitution of labour between periods seems to suggest that such substitutions are not
nearly as large as required by RBC theories of the economy.
4. Hysterics of unemployment: The level of unemployment for several countries seemed to
be strongly influenced by past values of unemployment.

All schools of macroeconomics agree on the purpose/objectives of macroeconomic policy such

as growth in national output, lower rate of inflation, higher employment rate or lower
unemployment rate and level, improved or positive trade balance and balance of payment etc.
However, they disagree on how to achieve these macroeconomic goals of higher output, lower of
unemployment and low rate of inflation. Currently there is no single dominant school of thought
in the area of macroeconomics. Thus, different economic views are used in different economies
under different circumstances. As a result, different countries around the world are using or
applying different degrees of elements of these schools of economic thought. More developed
countries are closer toward the free market than developing countries.
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2. NATIONAL INCOME ACCOUNTING

2.1. Definitions of National Income Accounting
Whether economy of a country is growing or not is not known unless we can measure the total
value of goods and services produced in the country for different years. This can be made with
the help of national income accounting process. ‘National Income Accounting’ refers to the
process of record keeping for the overall economic activities of a given country. It includes the
goods and services produced in a country in (part of) a fiscal year.

National income is often considered as the most comprehensive measure of how well an
economy is performing. It is necessary and important, therefore, to measure the national income
of a country so as to have an idea of the performance of the economy. Measuring national
income is an extremely complicated large task. However, economists have devised various ways
of estimating national income. In fact, national income estimates are made in every country these
days. In Ethiopia, the task of estimating national income is entrusted with the Central Statistical
Organisation (CSO), that works in collaboration with ministry of finance. In this unit we discuss
the various concepts related to national income accounting and the methods of measuring
national income.

2.2. The Basic Model: The Circular Flow Diagram

The economy consists of millions of people engaged in many activities-buying, selling, working,
hiring, manufacturing, and so on. To understand how the economy works, we must find some
way to simplify our thinking about all these activities. In other words, we need a model that
explains, in general terms, how the economy is organized and how participants in the economy
interact with one another. The circular-flow diagram offers a simple way of organizing all the
economic transactions that occur between different sectors in the economy.
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The circular-flow diagram is a visual model of the economy that shows how money flows
through markets among the sectors of the economy. Accordingly, from the point of view of the
number of sectors involved in the analysis or in the model, there are three major macroeconomic
models:

a) Two sector model

b) Three sector model (closed economy model)
c) Four sector model (open economy model)

a) Two sector model

This model represents the case where there are only two sectors in the economy: the household
sector and the firm sector. This model is represented by the relation or use of income by
households i.e. consumers or households either consume or save their income. This relation is
given by the following equation:

Y = C + S,

Where, Y = income, C = Consumption expenditure, S = Saving

Since saving is used for investment or saving is by itself a form of investment, S = I, the above
equation can be rewritten as:

Y=C+I Where, I = investment spending.

This model can be demonstrated using circular flow of income and expenditure as follows.

The inner loop of the circular-flow diagram represents the flows of goods and services, and
factors of production between households and firms. Whereas the outer loop of the circular-flow
diagram represents the corresponding monetary (Birr or dollar) flows.

Figure 2.1: Circular flow of income and spending in two sector model
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Households sector is the owner of factors of production like land, labour and capital. These
factors of payments are exchanged in resource market. In other words, factors of production are
used by the firms and in return firms pay in terms of wages, interests and rent. These payments to
the factors of production are nothing but the income (Y) from firms in the form of wage for their
labour or in the form of rent on their land or interest in the form of capital. These factors of
production spend part of their income on consumption goods (C) produced by firms and save the
rest given by (S). For the sake of simplicity let us assume that all the income received by the
households is consumed. We will introduce savings later. Business sectors produce the outputs to
be sold in product market. These outputs are consumed by the households by spending their
income. Business sector receives revenue from the consumption.

b) Three sector model (closed economy model)

This model incorporates government sector. Therefore, household, firms or the business sector
and government are the three parties involved in the economy. This model is also known as
closed economy model because it does not include or consider trade with other countries. This
model is represented by the following equation:

Y=C+S+G

Y = C + I + G,

Where, G = Government spending/ expenditure

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This model can also be demonstrated using the use of circular flow of income and expenditure as
follows (Figure 2.2). In addition to activities mentioned in two sector models above, households
receive income from government transfer payments and pay tax to the government. In similar
ways, business firms also sell their goods and services to the government and pay tax to the
government. Government sector on their part use the tax income to finance its expenditure.

Figure 2.2: Circular flow of income and spending in three sector model

c) Four sector model (open economy model)

In addition to the three sector model, this model includes trade with other countries. As a result,
the elements of trade such as import and export are incorporated in the model. This model is
represented by the following equation:

Y = C + I + G + NX

Where: C= Consumption expenditure,

I= Investment expenditure, G= Government expenditure

NX= Net export (X – M), M= Import value, X= export value

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The four sector (open economy) model can also be demonstrated by the use of circular flow of
income and expenditure as follows (figure 2.3).

Figure 2.3: Circular flow of income and spending in four sector model

By the introduction of foreign sector, the household sector and business sector can benefit by the
imports and exports. Households can get imported products at the same time, business sector can
also export to other countries. Households spend on imported commodities by paying foreign
exchange and business firms receive foreign exchange income by exporting their products. In
this model the government plays a crucial role in regulating the foreign exchange market along
with its previous role of collecting taxes and government spending.
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Since almost all countries around the world have government involvement in the economy and
have foreign trade with other countries, the third model is a more realistic one. Therefore, in this
chapter, we discuss the national income accounting based on the four sector model or open
economy model.

2.3. National Income Accounts Measures

‘National Income Accounting’ is the process of finding out the net output of a country through
additions of value added and payments received after deductions of depreciations and payments
to foreign economy.

National Income Accounting is about measuring the value of economic activity such as Gross
Domestic Product (GDP) and /or Gross National Product (GNP). Note also that there are two
major activities in the national income accounting process implied in the above definition:
additions and deductions. In other words, the process involves additions of all the goods and
services produced in a particular period (usually fiscal year) in the country and deductions of all
losses and costs incurred and all payments made by the country to the external economy.

We learn the national income accounting process for two major reasons:

1) It gives formal structure for macroeconomic theory models. It gives a clear picture of
production side and consumption side (supply side and demand side economic
performances).
2) It helps us learn about what is constituted in national economy and their
properties/behaviors.
The single most important measure of overall economic performance is gross domestic product
(GDP). GDP is the market value of all final goods and services produced within a country in a
given period of time (normally the period of time is one year). Measuring GDP is an attempt to
summarize all economic activity over a period of time in terms of a single figure/number; it is a
measure of the economy’s total output and total income.

GDP is a flow variable (where its value changes from time to time) not a stock variable. Flows
are always measured in units per time period, such as liters per month, billions of birr per year.
Stocks are measured in tons, dollar, litters, etc. at a given point of time. An inventory of goods,
the amount of water in a tank is the example of stock.
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2.4. Approaches to ‘National Income Accounting’

It is through measure of GDP or GNP of a country that economists can identify or know whether
a country’s economy is growing or not. There are three major approaches/methods of measuring
GDP or GNP. These are the value added approach, the expenditure approach; and the income
approach.

2.4.1. Value Added Approach

According to the value added approach to national income accounting process, the total output of
a country, GDP is obtained by adding the new values of goods and services created at different
stages of process or in different sectors. Only the value added at each stage of process in
different sectors is recorded. For instance, take one ‘quintal’ of wheat, costing 200 Birr in the
farm. In the process of making sandwich from the wheat cereals, the following should be
recorded at each stage (Table 2.2).

Table 2.2: Computing value added in production

Stage of process Total value of the quintal wheat at Value added

each stage (in Birr) (in Birr)

Wheat at farm 200 200

Wheat in the market including 250 50

transportation

Wheat flour in the market 310 60

Bread in the market 460 150

Sandwich at cafeteria 530 70

If all the process are undertaken in 530

the same year

If the wheat was produced one year earlier it would be recorded in GDP of that year (previous
year), so that year’s income or GDP includes only 330 Birr. That is, we exclude the value of
wheat at the farm (200 birr) since it should be recorded in the GDP of previous year. Such record
must be made for all items produced in the different sectors of the country.
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It should be stressed that it would be difficult to record everything at every stage. That means
this method involves very complex steps as it involves continuous recordings from time to time
carefully. Since the value of the item should be recorded several times (at different stages of the
production process), this method is very prone to error of double recording. Because of this
defect this method is not frequently used. The other two approaches i.e. expenditure approach
and income approach are widely used.

2.4.2. Expenditure Approach

In expenditure approach, the total output of a country, gross domestic product (GDP) is
measured as the sum of expenditures made in all sectors of the country. The underlying
assumption of using expenditure in measuring income is that the expenditure of one sector or
person is the income of the other (receivers of that money spent by other sectors). Thus, the
national income identity is given as follows:

GDP = Y= C + I + G + X – M = C + I + G + NX

Where; GDP = Y = Gross domestic income/product

C = Personal consumption expenditures

I = Gross private domestic investment expenditures

G = Government expenditure (on defense, infrastructures, etc.)

NX = net export (export (X) minus import (M)) = X – M

Personal consumption expenditure (C) accounts for the largest portion of GDP. It consists of
the goods and services bought by households. It is divided into three subcategories: nondurable
goods, durable goods, and services. Nondurable goods are goods that last only a short time, such
as food and clothing. Durable goods are goods that last a long time, such as cars and TVs.
Services include the work done for consumers by individuals and firms, such as haircuts and
doctor visits.

Private domestic investment expenditure (I) includes expenditure on raw materials (factors of
production) and final goods such as capital investments to generate more output. This includes
land, labour, machineries, buildings, inventories of unsold goods (for merchants) and so on.
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Investment is divided into three subcategories: business fixed investment, residential fixed
investment, and inventory investment. Business fixed investment is the purchase of new plant
and equipment by firms. Residential investment is the purchase of new housing by households
and landlords. Inventory investment is the increase in firms’ inventories of goods (if inventories
are falling, inventory investment is negative). Interest is the price and profit is the reward.

Note that replacement of old machinery represents a negative value in national income because it
is nothing but depreciation.

Government expenditure (G) is the goods and services bought by federal, state, and local
governments. It represents all expenditure on goods and services by government on behalf of the
nation. This category includes such items as military equipment, highways, and the services that
government workers provide. It also includes goods of immediate consumption (car, planes,
stationary etc), investment goods (buildings and machineries for production purposes) and so on.
It does not include transfer payments to individuals, such as Social Security benefits,
unemployment compensations and subsidies. Because transfer payments reallocate existing
income and are not made in exchange for goods and services, they are not part of G.

Net exports (NX) are the value of goods and services exported to other countries minus the
value of goods and services that foreigners provide us. Exports (X) represents foreign
expenditure on our goods and services which should be added on our national income while
imports (M) represent our expenses on foreign goods and services which overstate our output to
be deducted from the national income.

Example: Given the following summarized information about the values of national output, we
can calculate the value of the total output (GDP) of the country as follows:

Table 2.3: GDP value of using Expenditure approach

Components Value in Birr

Personal consumption expenditure (C) 11,400

Gross private domestic investment (I) 6,500

Government expenditure (G) 7,300

Exports (X) 900

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Imports (M) (1,100)

Total Expenditure (equivalent to national income/output, GDP) 25,000

Note that we are using the aggregated or summarized figures of values of the national output in
the above example. This means that we should note that each value given in the example has its
own importance and estimated differently. For instance, there are different components of
government expenditure such as: current expenditure and capital expenditure, its expenditures in
different sectors (in agriculture, on health, on education etc.).

2.4.3. Income Approach

When we use the income approach to measure GDP or GNP, we add up all the incomes earned
by different factors of production: land, labour, capital and so on. Thus, the national income
identity is given by the following relation.

GDP = Y = W + R + I + Π + IT – D.

Where, GNP = Y = Gross national product,

W = Wages of all workers (compensations of employees)

R = Rents paid to property owners (reward for services),

I= Interest on borrowed capitals

Π = Profit of business organizations,

IT = Indirect business taxes

D = Depreciation (Capital consumption allowance)

Profits (Π) include dividends and retained earnings of corporate organizations; proprietors’
income and so on. Indirect taxes (IT) are said to be indirect because consumers pay it indirectly.
When we calculate total national output or GDP or GNP, we take different taxes as positive as it
is income of the government. Note that in some cases, the depreciation element is considered or
used only in calculating NDP or NNP which, we have discussed in earlier sections. Yet
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depreciation does not bring much significant difference or it doesn’t change the lo gic or the
underlying concept.

Example: Given the following information about the values of some national income accounts,
GDP can be calculated as follows, using the income approach to national income accounting
process.

Table 2.4: GDP using Income Approach

Income Components Value (in million Birr)

Compensation of employees (W) 14,750

Rents paid to property owners (R) 1,090

Interest on borrowed capital (I) 2,180

Proprietor’s incomes 2,040

Retained earnings 1,800

Dividends 1,720

Corporate income taxes 1,670

Indirect taxes (IT) 2,500

Depreciation allowances (D) (2,750)

Total income = GDP = Y 25,000

GDP = Y = W + R + I + II + IT – D

= 14,750 + 1,090 + 2,180 + (2,040 + 1800 + 1720 + 1670 + 2500) – 2750

GDP = 25,000 (in million Birr) = 25 billion Birr

Note that in this calculation all the values in the parenthesis are the components of the profit of
business organizations. Moreover, the values of taxes are added when calculating the value of
GDP because it is the income of the government sector. Note also that in some texts depreciation
allowance is considered or deducted only to calculate net GDP or net GNP.

2.5. Limitations of GDP as a Measure of Welfare

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GDP is reasonably accurate and extremely useful measure of social and economic wellbeing and
level of economic performances. Yet, as a measure of social welfare or economic activity of a
country, these figures are not free from weakness as some of the problems with the GDP are the
following:

1) The figure of GDP does not tell us the long term sustainability of gains from production.
These values do not tell us whether the current trend of growth is going to continue in the
future. A year value(s) of GDP does not tell us what its value will be in the coming year or
in the future.
2) The values of GDP do not indicate composition of national outputs. We can see the
composition of the national aggregate output only during the computation/calculation of
GDP or GNP. Thus, readers of the GDP report cannot observe the composition of these
values.
3) Relative improvement in quality of some items and relative growth in some sectors is not
known from the value of GDP or GDP measures are quantitative and do not account for
quality improvement. Moreover, since outputs generated in different sectors for example
agricultural output, industrial output, output of service sector and values generated in trade
sector are aggregated, one cannot identify from which sector that improvement in the value
of GDP comes.
4) Income distribution is not known from the figure of GDP. One of the major determinants of
social welfare is proper or fair income distribution among citizens of the country. However,
the single value of GDP does not tell us anything about such distribution.
5) GDP accounts only for marketed transactions. Some economic activities have no place in
market. Some of these activities are home based activities such as cooking, child caring,
homemade laundries and so on. Goods and services that are not marketed are not included in
GDP. In countries like Ethiopia where subsistent agriculture is dominant (i.e. farmers
producing only for their consumption), GDP does not properly account for such production.

6) GDP also ignores leisure time. Leisure time and recreation are part of or related to economic
activities which should have been considered. Different countries at different level of
development provide different leisure times. This cannot be observed from the values of
GDP
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7) GDP ignores underground economy. The underground economy is the part of the economy
that people hide from the government either because they wish to evade taxation or because
the activity is illegal. Most of the time GDP does not account or measure the goods and
services generated in the informal sectors. Services generated in the black markets,
unregistered small businesses, drug dealers, and so on are not considered. In this case, the
GDP is understating the value of national economy.
8) The side effects of economic growth on environment are not accounted for by GDP. The
higher the production, the larger the amount will be of polluting byproducts generated by
factories and through consumption activities of different sectors. These are not usually
considered in measuring national output. In this case, the GDP is overstating the value of
total output of the country.
9) GDP is again very difficult for international comparison. This is because countries’ GDP are
calculated using their respective countries currencies. One US dollar is not equal to one
Ethiopian Birr. Even after changing to similar currency it is difficult to compare GDP
because price of commodities is different in different countries and thus cost of living are
different in different countries. To minimize such differences, attempts are made to
appropriately capture differences in the costs of living of countries by using Purchasing
Power Parity (PPP) in place of Official Exchange Rate (OER). PPP is the rate at which one
currency would be exchanged for the other for cost of living between countries was to be
comparable. PPP considers price differences of products between two countries.

2.6. Real GDP versus Nominal GDP

Nominal GDP is the value of all final goods based on the prices existing during the time period
of production. In other words, it is the price we pay in the market. Nominal GDP can grow in
three ways:

 When output rises and prices remain constant.

 Prices rises and output remains unchanged.
 When both prices and output rises
The problem, then, is how to adjust GDP so that it reflects only changes in output and not
changes in prices. This adjustment helps us in comparing the GDP over time when prices are
changing. In order to know this we must understand the meaning of real GDP.
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Real GDP is the value of all final goods produced during a given time period based on the prices
existing in a selected base year. The value of national output obtained by the use of such base
year price is known as Real Gross Domestic Product (RGDP). Real GDP is also known as GDP
in constant price or Birr. It is GDP adjusted for inflation.

Note that the base year may change from time to time. For instance, a given base year price may
be used only for five years and then another year price may be used as the base year price of the
next five or more years.

2.7. GDP Deflator and Inflation Rate

To get the most appropriate measure of national economic performances, nominal GDP (NGDP)
should be adjusted to the real GDP (RGDP). This can be done by deflating NGDP when price is
rising and by inflating it when price is falling. The adjustment factor is known as GDP deflator.
GDP deflator is the ratio of nominal GDP to real GDP.

 No min al GDP

i.e. GDP deflator =  Re al GDP


 =
NGDP
RGDP
 
Rearranging this equation, the value of real GDP is obtained by the following relation.

RGDP  NGDP 

 GDP deflator 

Similarly, nominal GDP is calculated by multiplying real GDP by the GDP deflator.

NGDP = RGDPGDP deflator 

The GDP deflator is an index measure of change in the general price level. GDP deflator can also
be calculated from the outputs and services produced and their respective base year as well as
from the current prices as follows.

QC1 PC1   QC 2 PC 2  .........

GDP deflator 
QC1 PB1   QC 2 PB 2   .........

Where; QCi = current unit of output or service or item ‘i’. (i = 1, 2, 3, ………)

PCi = current price of output or service or item ‘i’ (i = 1, 2, 3, ………)

 Agricultural Economics Program: Macroeconomics-I

PBi = base year price of output or service or item ‘i’(i = 1, 2, 3, ………)

Here, the numerator represents the value of the current year outputs (goods and services) at
current price whereas the denominator represents the total value of the current output at base
year price.

Illustrating Example: Given the following data/information on total output (goods and services)
and price level (average price) in respective years, we can calculate nominal GDP, real GDP and
GDP deflator. Note that in this particular exercise, we assume that all goods and services are
measurable in similar units for the sake of simplicity. Let us take year 1990 as the base year and
assume that the base year is changed to the year 2010. So the real GDP is calculated using price
of the year 1990 up to the year 2009, but after the year 2009 we will use the 2010 price in
calculating the RGDP, because year 2010 is selected as base year for the periods to come after
this year. Thus, the result is given by the following table (Table 2.1).

From the table we can understand that in the year selected as base year both nominal GDP and
real GDP are equal. This is because both values are calculated using the same price. That means,
since the year which is selected as the base year is also the current year, the base year price and
the current year price will be the same. From this example we can also see that nominal GDP
may change simply because of change in price level even if there is no change in fiscal output.
However, real GDP remains unchanged if there is no change in physical output. For instance,
compare both values of real GDP and nominal GDP of the years 2000 and 2005. Since there was
no change in physical output (15 units in both year s), there is no change in real GDP too,
which remains 30 million Birr in both years. We can see the same case in the years 2014 and
2016 where there is no change in real GDP whereas the nominal GDP has increased simply
because of an increase in price level (i. e. from 10 to 11 Birr per unit) even if there is no change
in physical output which remains at 30 million Birr in both years.

Table 2.1: Real GDP, Nominal GDP and GDP deflator

Year Unit of goods and Price Nominal GDP Real GDP GDP deflator
services (in millions) level (NGDP) (in (RGDP) (in (NGDP/
million Birr) million Birr) RGDP)

1990 10 2 20 20 1

1995 12 3 36 24 1.5
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2000 15 4 60 30 2

2005 15 6 90 30 3

2008 20 7 140 40 3.5

2010 25 8 200 200 1

2014 30 10 300 240 1.25

2016 30 11 330 240 1.375

2018 32 15 480 256 1.875

2019 34 18 612 272 2.25

2020 35 20 700 280 2.5

3. ECONOMIC PERFORMANCE AND BUSINESS CYCLE

Economic performances of countries change from time to time due to different factors such as
weather condition, political situation and economic policies followed by countries. Such
fluctuation in economic performance of a country is best depicted by almost regularly fluctuating
curve or path known as Business Cycle. The concept of Business Cycle was developed in formal
way only after The World Economic Crises of 1933, known as Great Depression.

3.1. Definition and Concepts of Business Cycle

Business cycle can be defined as a more or less regular pattern of path or line fluctuating with the
level of economic activity of a country or an economy around the trend path. It shows alternating
periods of economic growth and contraction, which can be measured by the changes in real
Gross Domestic Product (RGDP). The total national output of a country changes from time to
time depending on different negative and positive factors. Negative factors are factors that
adversely affect total national output. When real GDP falls, businesses have trouble. Firms
experience declining sales and profits. For instance, drought reduces agricultural outputs; civil
wars or war between countries divert resources from production to war and inappropriate
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economic policies mislead countries economic growth path thereby leading to reduction or fall in
total national output. The fall in total output is represented by downward moving curve or path of
the business cycle.

Positive factors increase the total national output. When real GDP grows rapidly, business is
good. Firms find that customers are plentiful and that profits are growing. For instance, favorable
climate conditions increases agricultural output; political stability also helps people concentrate
on production and government use resources for production and good trade polices enable a
country to get more foreign exchange. These all increases total output (values of goods and
services) of a country. This increase in economic performance is depicted by increasing the path
of the business cycle.

Since economic variables are related, any change in real Gross Domestic Product (RGDP) brings
similar changes in employment, trade and other key indicators of the economy. In other words,
all other aggregate economic activities get affected. The upswing and downswing in the level of
real output are cyclical in nature and move around its trend path. The trend path is given by
straight-line that shows the movement of the economy if it is in full employment. In other words,
the trend path of aggregate economic activities is the normal path the indicators (GDP,
employment, trade, growth etc.) would take if factors of production were fully employed.

3.2. Phases of the Business Cycle

These phases are stages through which an economy passes to complete the business cycle (to
complete one cycle). The business cycle has two phases and two turning points. The two phases
are Recession (Contraction) and Recovery (Expansion); while the two turning points are Peak
(Boom) and Trough (Bottom). Once completed, these phases repeat themselves. That means, the
sequence of changes is recurrent (is repeating itself), but not periodic and varies in duration. The
duration depends on factors like good or bad economic policies and favorable or unfavorable
natural conditions.

We can clearly represent this sequence of different phases of the business cycle in the following
way:
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(A) Peak (Boom) → (B) Contraction (Recession) → (C) Trough (Bottom) → (D) Expansion
(Recovery) → (A) Peak (Boom) →…..
This sequence repeats itself in different length of periods for different economies or different
countries. From ‘A’ to ‘B’, ‘B’ to ‘C’, ‘C’ to ‘D’, ‘D’ to ‘A’, ‘A’ to ‘B’ and so on.

Normal business cycles vary from one year to ten or twelve years. They represent a rise and fall
of a nation’s economic activities, such as GDP or GNP, inflation, growth and unemployment.
Contraction or recession follows bad economic policy (national or international) and bad natural
or social factors likes drought or conflict whereas expansion or recovery follows the opposite
factors like good economic policies or favourable natural factors.

During peak, economic activities reach their maximum after rising during a recovery. In
recession or contraction, generally economy witnesses a downturn in the business cycle during
which real GDP declines. During trough economic activities reach its minimum after falling
during recession. Recovery represents an upturn in the business cycle during which real GDP
rises. One can observe similar patterns in other economic indicators such as inflation, growth,
unemployment, etc.

We can see from the figure 3.1 that economic activities fluctuate from time to time leading to
output fluctuations in the economy. In the figure, X-axis represents the time period and Y-axis
represents the aggregate economic activities. Trend Line is indicated by the straight dotted line
and business cycle which passes through points of actual economic activity measured by GDP is
shown by bold line.

Figure 3.1: Business Cycle

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From ‘O’ to ‘P1’ in the figure, one can find that economy is moving upward. This phase is
therefore, known as expansion phase. Economy reaches its peak, which is at point ‘P1’. From
‘P1’ to ‘T’ economy is in recession, which means economic activities are slowing down. This
trend is shown by the downward movement of the cycle. This phase is known as contraction
phase. The figure depicts that contraction phase brings or leads to the bottom of the economic
activities, which is known as trough represented by point ‘T’. From the figure one perceives that
from bottom point the economy again starts recovering because of some corrective measures or
favorable conditions created for the economy; i.e. expansion phase begins. This process
continues again that is by reaching peak followed by trough.

3.3. Causes and Effects of Business Cycle

3.3.1. Causes of Business Cycle
Why GDP moves from its trend? Here we discuss the sources and characteristics of the different
phases of the business cycle.
Over time, real GDP (which is a measure of aggregate economic activities) changes for two
reasons. First, more resources become available which allow the economy to produce more
goods and service, thereby resulting in rise of the trend level of output. Second, factors are not
fully employed all the time due to many reasons. Hence, economy produces below its capacity
and deviates from its trend path.
Each phase of the business cycle has its own sources or factors leading the economy to take that
phase. These phases have also some characteristics. Economic variables like total output,
employment or unemployment, aggregate demand for commodities and factors of production
have different values throughout the different phases of the business cycle.

For instance, economic recessions (or contractions) and economic troughs are the result of the
following major factors:
 Natural factors such as drought caused by shortage of rainfall;
 War which diverts resources from production;
 Inappropriate economic policies;
 Underemployment of the existing economic resources or factors of production; and so on.
These phases are again characterized by the following cyclical recession or cyclical trough:
 Low output or GDP;
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 High unemployment (or low employment);

 Low aggregate demand for both products and factors of production;
 Low per capita income (PCI); and so on.

On the other hand, economic expansion (or recovery) and peak are the result of the following
major factors which are opposite to the factors that lead to cyclical recession and cyclical trough.
 Political stability;
 Use of appropriate economic or macroeconomic policies;
 Discovery and use of new economic resources or factors of production such as minerals
like petroleum or oil and deposits of precious metals like gold.
 Utilization of idle resources or factors of production such as labour;
 Use of improved quality workers through training and so on.
These phases of cyclical expansion or recovery and peak are characterized by:
 Higher aggregate output or GDP;
 Low unemployment (high employment) of factors of production such as labour and
capital;
 High aggregate demand for products and factors of production;
 Larger Per capita Income (PCI); and so on.

The phases of business cycle show the movements of the economy at different periods. Economy
sometimes performs well and sometimes it lags behind from its trend path which is nothing but
the average performance of the economy. The deviation from the trend path creates gap in the
output.

3.3.2. Effects of Business Cycle

These business cycle fluctuations can be costly in different aspects. These affect not only the lon
g run growth but also distribution of income and wealth in the economy. This means these fluctu
ations not only reduce the average aggregate consumption of the household but its impacts may d
iffer across the individuals and across the generations.
Though a group of economist does not consider these fluctuations costly but majority of the polic
ymakers and economists now believe that business fluctuations are costly in social as well as in e
conomic terms. Those who believe that business cycle fluctuations are costly argue that the
business cycles leave permanent scars on output through their effects on
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the growth process. Growth related variables, such as investment or R&D expenditures, are pro
cyclical. Recessions decelerate or even halt the growth process while recoveries bring
the growth
rate back to its normal level but below the level had recession not occurred. As a result, output ne
ver returns to the trend it was following before the recession started.

The business cycles fluctuations also affect different segments of the society differently.For example, cha
nge in total factor productivity, as a result of technology shock, alters the capital‐ labor
ratio in production process and may change the distribution of income and wealth in an economy. The oth
er reason, that business cycles have asymmetric effects on the households falling in different income tiers,
is that not all individuals can fully insure themselves against income risk. A world where financial market
s are incomplete, imperfect, and not all economic agents have access to these markets,
accomplished the business cycles fluctuations having long‐lasting distributional consequences.

3.3. Theories of Business Cycle

The uneven historical pattern of economic growth gives rise to the question about the factors that
cause business cycle. Many theories have been developed to explain the business cycle;
however, no single theory has had outstanding success in explaining and successfully predicting
business cycle. Most of the theories concentrate on Aggregate Demand and Aggregate Supply
(AD-AS) model. In all of the theories economists make certain assumption pertaining to
fluctuations in Aggregate Demand (AD) or Aggregate Supply (AS) and assumption regarding
how they interact with each other to create a business cycle. Impulses can affect supply factors or
demand factors or both. But there are no pure supply-side theories. Broadly these theories can be
classified as either Aggregate Demand Theories, or Real Business Cycle Theories. The aggregate
demand theories further categorized into Keynesian theory, Monetarist theory and rational
expectations theory. Having these major categories of theories, let us see how they explain the
relationship between macroeconomic variables and characterization of business cycle.

3.3.1. Keynesian theory

Keynesian theory holds that changes in aggregate spending are the cause of variations in real
GDP. Let’s take a simple example by dividing economy into households (C), business (I),
government (G) and foreign buyers (X-M). The aggregate spending includes the sum of all these
four sectors. Mathematically, we can represent this by the national income identity or equation
discussed earlier under expenditure approach to national income accounting process.
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GDP = C + I +G+ (X-M)

If the total spending increases, business firms find it profitable to invest and increase output.
When business firms increase the output, they use more land, labour and capital. Hence,
increased spending leads to increase in output, employment and incomes, thereby leading to
expansion or recovery phase of the business cycle.

When total spending falls, however, businesses or producers will find them profitable by
producing a lower volume of goods and services and avoid inventory. This is because; there is
low demand for their products. In this case, output, employment and income falls. This leads to
recession.

3.3.2. Monetarist Theory of Business Cycle

In this theory, a fluctuation in the money stock is the main source of economic fluctuations. The
impulse in the monetarist theory of business cycle is the growth or the quantity of money. An
increase in the money supply brings expansion and a decrease in money supply brings recession.

When the money growth rate increases, the quantity of real money in the economy also
increases. At the same time, interest rates fall and real money balance increases. The foreign
exchange rate also falls. These initial financial market effects begin to spread to other markets.
Again, investment demand and exports increases and consumers spend more on the durable
goods. These changes have multiplier effect and finally aggregate demand curve shifts to the
right from AD1 to AD2 and brings expansion (Figure 3.2).

Assuming upward slopping supply curve, a rightward shift in aggregate demand brings not only
an increase in GDP, but also the price level. Similarly, one can analyze for a decrease in the
money supply and show that the result of it is recession or contraction or trough of the business
cycle.
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Figure 3.2; Money Supply and Aggregate Output

3.3.3. Rational Expectation Theory

A rational expectation theory is a forecast that is based on the available and relevant information.
According to this theory, an anticipated fluctuation in aggregate demand has no impact on
economic performance. It is unanticipated changes in aggregate demand that bring fluctuation
which leads to business cycle. A larger than anticipated increase in aggregate demand brings
expansion whereas a smaller than anticipated increase in aggregate demand brings a recession.

When aggregate demand decreases, if money wage doesn’t change, then real GDP and price
level decreases. The fall in price level in turn leads to an increase in the real wage rate and
unemployment rate. These changes in the economy lead to recession. This is because when
prices fall producers become less profitable and they thus cut their production and reduce
employment or their workers. This happens if the decrease in aggregate demand is unanticipated.

3.3.4. Real Business Cycle Theory (RBC)

Real Business Cycle Theory asserts that fluctuations in the output and employment are due to a
variety of real shocks that hit the economy. According to this theory markets adjust rapidly due
to these shocks and always remain in equilibrium. These real shocks are basically due to random
fluctuations in productivity. Scholars who belong to this theory assume that random fluctuations
in productivity are the result of fluctuations in the pace of technological changes, international
disturbances, climatic changes and natural disasters.
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The origin of RBC can be traced to the rational expectations approach developed by Robert E.
Lucas, who says that anticipated monetary policy has not real effects as people will correctly
anticipate and nullify the impact is aimed at. This theory explains business cycle through shocks
or disturbances and propagation of shocks throughout the economy.

Disturbances are due to the shocks to productivity, supply shocks and shocks to government.
This thereby asserts that productivity shocks are due to change in weather and new method of
production. For example, if due to favorable productivity shocks people want to take advantage,
they would work hard to increase their output. They also invest more capital to spread the
productivity shock into future periods by raising the stock of capital leading to cyclical
expansion or peak.

The shocks due to the disturbances are spread through the economy. This principle is known as
propagation mechanism. This propagation mechanism basically tries to explain why people work
more sometimes than during other times.

During peak, employment is generally high and jobs are easy to get; during recession
employment is lower and jobs are difficult to get. Again people supply more labor when wage is
high. By intertemporal substituting of leisure between years, they work the same total amount,
but earn more total income. This clearly generates large movements in the amount of work done
in response to small shifts in wages and this could account for large output changes in the cycle
accompanied by small changes in wages.

3.3.5. Political Business Cycle

Another explanation is where government deliberately causes business cycle. This situation is
known as political business cycle. It refers to a business cycle, which is caused by policy makers
to improve re-election chances. Governments adopt tight monetary and fiscal policy soon after
an election, but then adopt more expansionary policies as the election approaches to encourage a
‘feel-good’ factor. This theory views politics to be a short-run game where the self-interest of the
politicians is to maximize votes. Voters are also short sighted and want good news now rather
than being promised. For example, just prior to election if a politician comes with attractive
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benefits for the voters then he is likely to be favourite candidate. This is due to the reason that
voters are shortsighted.

The difference of this theory of creating recession from other theories is that political business
cycle is deliberate and created by politicians while other theories are not deliberately created. In
case of developing countries, business cycles have not received much attention. This is because
the cyclical movements are caused by highly unpredictable factors like droughts, famine and
contraction of exports. These factors are mostly natural or an act of god. In such cases, the study
or forecasting of business cycle becomes an extremely difficult task.

3.5. Forecasting Business Cycle: Indicator Forecasting

Economic variables are inter-related and they show cyclical movements. Some of these variables or
indicators are known as lead indicators. These indicators turning points occur before those of total
economic activity. For instance, capacity utilization of manufacturing sector, residential construction,
stock prices etc. start turning up and down before aggregate economic variables like changes in GNP and
employment. This means that a stimulation of large scale residential construction leads to increased
demand for construction materials. This will then contribute to boosting in production and income of the
sector, which in turn adds to cyclical expansion.

Variables like industrial production and business expenditures roughly coincide with the overall cycle
while some other variables like job vacancies and unit labour costs lag behind the business cycle called
lag variables. Based on the historical experiences of business cycles across the world the economy can
decide about which the lead is and which is the lag variable.

The lead and the lag variables differ depending on the development level of an economy, institutional set-
up of the economy and structure of the economy. The indicators for a county whose economy is
dominated by agricultural sector is not the same as the indicators (or lead variables) of an industrially
advanced economy. In the former, the lead variables may be natural factors such as good weather
condition, whereas in the later the lead variables may be market factors such as demand and income.

Uses of lead indicators

Monitoring lead indicators can give advance warning about the turning points in the economic activity.
Thus, the country can take corrective measures to avoid recession. In other words, appropriate policy in
the right time may help the country to overcome the problems associated with the business cycle. For
instance, when we observe lead variable like capacity utilization we get signals like if capacity utilization
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is falling then very soon economy is heading towards a recession or economic contraction. This helps the
policy makers to act accordingly by launching an expansionary fiscal policy such as increasing
government investment. This may postpone the recession for some time.

4. AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS

Economists use the model of aggregate demand and aggregate supply to explain short-run
fluctuations in economic activity around its long-run trend. Aggregate demand-aggregate supply
model (AD-AS model), enables us to analyze changes in both real GDP and the price level
simultaneously. The AD-AS model therefore, provides insights on inflation, unemployment, and
economic growth. It also explains the logic of macroeconomic stabilization policies.
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4.1. Aggregate Demand

4.1.1. Definition and Concepts of Aggregate Demand
Aggregate demand (AD) refers to the total amount of goods and services demanded in the
economy at a given overall price level in a given time period. It shows the level of real GDP
including the purchases by households, business, government, and foreigners (net exports) at
different possible price levels during a given time period. The relationship between the general
price level (as measured by the consumer price index) and the amount of real GDP demanded is
inverse or negative, which is depicted by the downward sloping aggregate demand curve (Figure
4.1). This means that, other things equal, a fall in the economy’s overall level of prices (say, P1 to
P2) tends to raise the quantity of goods and services demanded (from Y1 to Y2).
Figure 4.1: Aggregate Demand Curve

Why the aggregate-demand curve slopes downward?

The quantity of real GDP demanded equals the sum of consumption expenditure (C), investment
(I), government purchases (G), and net export (NX). AD=C+I+G+NX

For now, we assume that government spending is fixed by policy. The other three components of
spending-consumption, investment, and net exports-depend on economic conditions and, in
particular, on the price level. To understand the downward slope of the aggregate-demand curve,
therefore, we must examine how the price level affects the quantity of goods and services
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demanded for consumption, investment, and net exports. The explanation rests on three effects of
a price-level change.
a) Real-Balances Effect/ The Wealth Effect
A higher price level reduces the purchasing power of the public’s accumulated saving balances.
In particular, the real value of assets with fixed money values, such as savings accounts or bonds,
diminishes. Because a higher price level erodes the purchasing power of such assets/wealth, the
public is poorer in real terms and will reduce its spending. So a higher price level means less
consumption spending.
b) The interest-rate Effect
When we draw an aggregate demand curve, we assume that the supply of money in the economy
is fixed. But when the price level rises, consumers need more money for purchases, and
businesses need more money to meet their payrolls and to buy other resources. In short, a higher
price level increases the demand for money. So, given a fixed supply of money, an increase in
money demand will drive up the price paid for its use. The price of money is the interest rate.

Higher interest rates restrain investment spending and interest-sensitive consumption spending.
Firms that expect a 6 percent rate of return on a potential purchase of capital will find that
investment profitable when the interest rate is, say, 5 percent. But the investment will be
unprofitable and will not be made when the interest rate has risen to 7 percent. Similarly,
consumers may decide not to purchase a new house or automobile when the interest rate on loans
goes up. So, by increasing the demand for money and consequently the interest rate, a higher
price level reduces the amount of real output demanded.

c) The Exchange-Rate/Foreign-Trade Effect

When the Ethiopian price level rises relative to foreign price levels, foreigners buy fewer
Ethiopian goods and Ethiopians buy more foreign goods. Therefore, Ethiopian exports fall and
Ethiopian imports rise. In short, the rise in the price level reduces the quantity of Ethiopian goods
demanded as net exports.
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4.1.2. Changes in Aggregate Demand

Other things equal, a change in the price level will change the amount of aggregate spending and
therefore change the amount of real GDP demanded by the economy. Movements along a fixed
aggregate demand curve represent these changes in real GDP. However, if one or more of those
other things changes, the entire aggregate demand curve will shift. We call these “other things”
determinants of aggregate demand. These include: change in consumer spending, investment
spending, government spending and change in net export spending

The rightward shift of the curve from AD1 to AD2 shows an increase in aggregate demand
(Figure 4.2). At each price level, the amount of real goods and services demanded is larger than
before. The leftward shift of the curve from AD 1 to AD3 shows a decrease in aggregate demand;
the amount of real GDP demanded at each price level is lower.

Figure 4.2: Change in aggregate demand

1. Consumer Spending: Even when the Ethiopian price level is constant, domestic consumers
may change their purchases of Ethiopian-produced real output. If consumers decide to buy more
output at each price level, the aggregate demand curve will shift to the right, while they decide to
buy less output; the aggregate demand curve will shift to the left.
Several factors other than a change in the price level may change consumer spending and thus
shift the aggregate demand curve. Those factors are real consumer wealth, consumer
expectations, household borrowing, and taxes.
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a) Consumer Wealth: Consumer wealth is the total monetary value of all assets owned by
consumers in the economy less the monetary value of their liabilities (debts). Assets include
stocks, bonds, and real estate. Liabilities include mortgages, car loans, and credit card balances.
Consumer wealth sometimes changes suddenly and unexpectedly due to surprising changes in
asset values. An unforeseen increase in the stock market is a good example. The increase in
wealth prompts pleasantly surprised consumers to save less and buy more out of their current
incomes than they had previously been planning. The resulting increase in consumer spending-
the so-called wealth effect-shifts the aggregate demand curve to the right.
b) Consumer Expectations: When people expect their future real income to rise, they spend
more of their current income. Thus current consumption spending increases (current saving
falls), and the aggregate demand curve shifts to the right. Similarly, a widely held expectation of
surging inflation in the near future may increase aggregate demand today because consumers
will want to buy products before their prices rise.
c) Household Borrowing: Consumers can increase their consumption spending by borrowing.
Doing so shifts the aggregate demand curve to the right. By contrast, a decrease in borrowing for
consumption purposes shifts the aggregate demand curve to the left. The aggregate demand
curve will also shift to the left if consumers increase their savings rates in order to pay off their
debts.
d) Personal Taxes: A reduction in personal income tax rates raises take-home income and
increases consumer purchases at each possible price level. Tax cuts shift the aggregate demand
curve to the right.
2. Investment Spending: A decline in investment spending (the purchase of capital goods) at
each price level will shift the aggregate demand curve to the left. An increase in investment
spending will shift it to the right.
a) Real Interest Rates: Other things equal, an increase in interest rates will lower investment
spending and reduce aggregate demand. We are not referring here to the interest-rate effect
resulting from a change in the price level. Instead, we are identifying a change in the interest rate
that results from, say, a change in the nation’s money supply. An increase in the money supply
lowers the interest rate, thereby increasing investment and aggregate demand.
b) Expected Returns: Higher expected returns on investment projects will increase the demand
for capital goods and shifts the aggregate demand curve to the right. Expected returns, in turn,
are influenced by several factors:
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• Expectations about Future Business Conditions: If firms are optimistic about future
business conditions, they are more likely to invest more today. On the other hand, if they think
the economy will deteriorate in the future, they will invest less today.
• Technology: New and improved technologies increase expected returns on investment and
thus increase aggregate demand. For example, recent advances in microbiology have motivated
pharmaceutical companies to establish new labs and production facilities.
• Degree of Excess Capacity: Other things equal, firms operating factories at well below
capacity have little incentive to build new factories. But when firms discover that their excess
capacity is dwindling or has completely disappeared, their expected returns on new investment in
factories and capital equipment rises. Thus, they increase their investment spending and the
aggregate demand curve shifts to the right.
• Business Taxes: An increase in business taxes will reduce after-tax profits from capital
investment and lower expected returns. So investment and aggregate demand will decline.

3. Government Spending: An increase in government purchases (for example, more

computers for government agencies) will shift the aggregate demand curve to the right, provided
tax collections and interest rates do not change as a result.

4. Net Export Spending: Other things equal, a rise of Ethiopian exports means increased
foreign demand for Ethiopian goods, whereas lower Ethiopian imports imply that Ethiopian
consumers have decreased their demand for foreign-produced products. So, a rise in net exports
(higher exports and/or lower imports) shifts the aggregate demand curve to the right. What might
cause net exports to change, other than the price level? Two possibilities are changes in national income
abroad and changes in exchange rates.
a) National Income Abroad: Rising national income abroad encourages foreigners to buy
more products, some of which are made in Ethiopia. Ethiopian net exports thus rise and the
Ethiopian aggregate demand curve shifts to the right.
b) Exchange Rates: Changes in the prices of foreign currencies in terms of the Ethiopian Birr
may affect Ethiopian net exports and therefore aggregate demand. Suppose the Ethiopian Birr
depreciates in terms of the euro (the euro appreciates in terms of the Birr). The new relative
lower value of Birr and higher value of euro make Ethiopian goods less expensive, so European
consumers buy more Ethiopian goods and Ethiopian exports rise. But Ethiopian consumers now
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find European goods more expensive, so reduce their imports from Europe. Ethiopian exports
rise and Ethiopian imports fall.

4.2. Aggregate Supply

Definition and Concepts of Aggregate Supply

Aggregate supply (AS) refers to the amount of total national output that businesses willingly
produce and sell in a given period. It is the relationship between the quantity of real GDP
supplied and the price level. This relationship varies depending on the time horizon and how
quickly output prices and input prices can change. There are two time horizons: the short run and
the long run periods.
Since the firms that supply goods and services have flexible prices in the long run but sticky
prices in the short run, the long run aggregate-supply curve is vertical, whereas the short run
aggregate-supply curve is upward sloping.

4.2.1. Short Run Aggregate Supply Curve

The short-run aggregate supply curve (SRAS) is the relationship between the quantity of real
GDP supplied and the price level when the money wage rate, the prices of other resources, and
potential GDP remain constant.

Figure 4.3 Short Run Aggregate Supply curve

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The short-run aggregate supply curve slopes upward because with input prices fixed, changes in
the price level will raise or lower real firm profits (Figure 4.3). Consider an economy that has
only a single multi-product firm called ABC and in which the firm’s owners must receive a real
profit of Dollar 20 in order to produce the full-employment output of 100 units. Assume the
owner’s only input (aside from entrepreneurial talent) is 10 units of hired labour at Dollar 8 per
worker, for a total wage cost of Dollar 80. Also assume that the 100 units of output sell for
Dollar 1 per unit, so total revenue is Dollar 100. ABC’s nominal profit is Dollar 20 (= Dollar 100
– Dollar 80), and using the Dollar 1 price to designate the base-price index of 100 its real profit
is also Dollar 20 (= Dollar 20/1.00). Well; the full-employment output is produced.

Now, the doubling of the price level will boost total revenue from Dollar 100 to Dollar 200, but
since we are in the short run input prices are fixed, the Dollar 8 nominal wage for each of the 10
workers will remain unchanged so that total costs stay at Dollar 80. Nominal profit will rise from
Dollar 20 to Dollar 120 (=200–80). Dividing that Dollar 120 profit by the new price index of 200
(= 2.0 in hundredths), we find that ABC’s real profit is now Dollar 60. The rise in the real reward
from Dollar 20 to Dollar 60 prompts the firm (economy) to produce more output. So, in the short
run, there is a direct, or positive, relationship between the price level and real output. The result
is an upward-sloping short-run aggregate supply curve.

Macroeconomists have proposed four theories for the upward slope of the short run aggregate-
supply curve. These models are: sticky wage model, workers misperception model, imperfect
information model and sticky price model. Soon, we will study each of the aggregate supply
models/theories in detail.
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4.2.2. Long Run Aggregate Supply Curve

The long-run aggregate supply curve (LRAS) is the relationship between the price level and real
GDP when real GDP equals potential GDP which is vertical at the economy’s full-employment
output (GDPf) (Figure 4.4). The vertical curve means that in the long run the economy will
produce the full-employment output level no matter what the price level is. How can this be? The
explanation lies in the fact that in the long run when both input prices and output prices are
flexible, profit levels will always adjust to give firms exactly the right profit incentive to produce
exactly the full-employment output level GDPf.

To see why this is true, look back at the short-run aggregate supply curve shown in Figure 4.3
above. Suppose the economy starts out producing at the full-employment output level GDP f and
that the price level at that moment has an index value of 100. Now suppose that output prices
double, so that the price index goes to 200. Doubling of the price level would cause profits to rise
in the short run and that the higher profits would motivate the firm to increase output.

Figure 4.4 Long Run Aggregate Supply curve

This outcome, however, is totally dependent upon the fact that input prices are fixed in the short
run. Consider what will happen in the long run when they are free to change. Firms can produce
beyond the full-employment output level only by running factories and businesses at extremely
high rates of utilization. This creates a great deal of demand for the economy’s limited supply of
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productive resources. In particular, labour is in great demand because the only way to produce
beyond full employment is if workers are working overtime.

As time passes and input prices are free to change, the high demand will start to raise input
prices. In particular, overworked employees will demand and receive raises as employers
scramble to deal with the labour shortages that arise when the economy is producing at above its
full-employment output level. As input prices increase, firm profits will begin to fall. And as
they decline, so does the motive firms have to produce more than the full-employment output
level. This process of rising input prices and falling profits continues until the rise in input prices
exactly matches the initial change in output prices (in our example, they both double). When that
happens, firm profits in real terms return to their original level so that firms are once again
motivated to produce at exactly the full-employment output level. This adjustment process
means that in the long run the economy will produce at full employment regardless of the price
level (in our example, at either P = 100 or P = 200). That is why the long-run aggregate supply
curve LRAS is vertical above the full-employment output level.

4.2.3. Determinants of Change in Aggregate Supply

Since the behavior of short run aggregate supply and long run aggregate supply are different, we
examine the factors which determine the quantity of goods and services supplied in the short run
and in the long run separately.

A. Changes in the Short-Run Aggregate-Supply Curve

An existing aggregate supply curve identifies the relationship between the price level and real
output, other things equal. But when one or more of these “other things” change, the curve itself
shifts. The rightward shift of the curve from AS 1 to AS3 represents an increase in aggregate
supply, indicating that firms are willing to produce and sell more real output at each price level
(Figure 4.5). The leftward shift of the curve from AS 1 to AS2 represents a decrease in aggregate
supply. At each price level, firms will not produce as much output as before. The “other things”
that shift the aggregate supply curve are called the determinants of aggregate supply; they
collectively determine the location of the aggregate supply curve and shift the curve when they
change. Changes in these determinants cause per-unit production costs to be either higher or
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lower than before at each price level. These changes in per-unit production cost affect profits,
which leads firms to alter the amount of output they are willing to produce at each price level.

Determinants of the short-run aggregate supply: factors that shift the aggregate supply curve are:
change in input prices, change in productivity and change in legal-institutional environment.

Figure: 4.5. Shift in Short Run Aggregate Supply curve

1. Input Prices: Input or resource prices are key determinants of aggregate supply. These
resources can be either domestic or imported.

a. Domestic Resource Prices: wages and salaries make up about 75 percent of all business
costs. Other things equal, decreases in wages and salaries reduce per-unit production costs. So,
the aggregate supply shifts to the right. Increases in wages and salaries shift the curve to the left.
Similarly, the aggregate supply curve shifts when the prices of land and capital inputs change.
Examples:
• Labour supply increases because of substantial immigration. Wages and per-unit production
costs fall, shifting the AS curve to the right.
• Labour supply decreases because a rapid increase in pension income causes many older
workers to opt for early retirement. Wage rates and per-unit production costs rise, shifting the
AS curve to the left.
• The price of capital (machinery and equipment) falls because of declines in the prices of steel
and electronic components. Per-unit production costs decline and the AS shifts to the right.
• Land resources expand through discoveries of mineral deposits, irrigation of land, or
technical innovations that transform “non-resources” (say, vast shrub lands) into valuable
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resources (productive lands). The price of land declines, per-unit production costs fall, and the
AS curve shifts to the right.
b. Prices of Imported Resources: Generally, a decrease in the price of imported resources
increases Ethiopian aggregate supply, and an increase in their price reduces Ethiopian aggregate
supply. A good example is the oil price hikes of the 1970s, which drove up per-unit production
costs and jolted the oil importing countries aggregate supply curve leftward.

Exchange-rate fluctuations are one factor that may change the price of imported resources.
Suppose the Ethiopian Birr appreciates. This means that domestic producers face a lower Birr
price of imported resources. Ethiopian firms would respond by increasing their imports of
foreign resources, thereby lowering their per-unit production costs at each level of output.
Falling per-unit production costs would shift the Ethiopian aggregate supply curve to the right. A
depreciation of the Birr will have the opposite effects.
2. Productivity: Productivity is a measure of real output per unit of input. An increase in
productivity enables the economy to obtain more real output from its limited resources. It does
this by reducing the per-unit cost of output (per-unit production cost). Suppose, for example, that
real output is 10 units, that 5 units of input are needed to produce that quantity, and that the price
of each input unit is Birr 2. Then, Productivity = total output/total input= 10/5= 2 and
Per-unit production cost = total input cost/total output= (Birr 2x5)/10= Birr 1.

Now suppose productivity increases so that real output doubles to 20 units, while the price and
quantity of the input remain constant at Birr 2 and 5 units. Using the above equations, we see that
productivity rises from 2 to 4 and that the per-unit production cost of the output falls from Birr 1
to Birr 0.50. The doubled productivity has reduced the per-unit production cost by half.

By reducing the per-unit production cost, an increase in productivity shifts the aggregate supply
curve to the right. The main source of productivity advance is improved production technology,
often embodied within new plant and equipment that replaces old plant and equipment. Other
sources of productivity increases are a better educated and a better-trained workforce, improved
forms of business enterprises, and the reallocation of labour resources from lower productivity to
higher productivity uses.
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3. Legal-Institutional Environment: Changes in the legal-institutional setting in which

businesses operate may alter the per-unit costs of output and, if so, shift the aggregate supply
curve. Two changes of this type are: changes in business taxes and subsidies, and changes in the
extent of regulation.

a. Business Taxes and Subsidies: Higher business taxes-corporate income taxes and capital,
sales, excise, and payroll taxes-increase per-unit costs and reduces aggregate supply in much the
same way as a wage increase does. An increase in such taxes paid by businesses will increase
per-unit production costs and shift the aggregate supply curve to the left. Similarly, a business
subsidy-a payment or tax break by government to producers-lowers production costs and
increases aggregate supply.
b. Government Regulation: It is usually costly for businesses to comply with government
regulations. More regulation therefore tends to increase per-unit production costs and shift the
aggregate supply curve to the left. “Supply-side” proponents of deregulation of the economy
have argued forcefully that by increasing efficiency and reducing the paperwork associated with
complex regulations deregulation will reduce per-unit costs and shift the aggregate supply curve
to the right.

Furthermore, the short-run aggregate-supply curve can also shift due to the expected price level
changes-that influences misperceptions, sticky wages, sticky prices and imperfect information
models. A decrease in the expected price level raises the quantity of goods and services supplied
and shift the short-run aggregate-supply curve to the right.

B. Changes in the Long-Run Aggregate-Supply Curve

Any change in the economy that alters the natural rate of output (potential output or full-
employment output, GDPf) shifts the long-run aggregate-supply curve. Because output in the
classical model depends on labour, capital, natural resources (land, minerals, and weather), and
technological knowledge, we can categorize shifts in the long-run aggregate-supply curve as
arising from these sources.
Shifts arising from labour: Imagine that an economy experiences an increase in immigration
from abroad. Because there would be a greater number of workers, the quantity of goods and
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services supplied would increase. As a result, the long-run aggregate-supply curve would shift
to the right.
Shifts arising from capital: An increase in the economy’s capital stock (physical capital or
human capital) increases productivity and, thereby, the quantity of goods and services
supplied. An increase either in the number of machines or in the number of college degrees
will raise the economy’s ability to produce goods and services. Thus, either would shift the
long-run aggregate-supply curve to the right.
Shifts arising from natural resources: An economy’s production depends on its natural
resources, including its land, minerals, and weather. A discovery of a new mineral deposit
shifts the long-run aggregate-supply curve to the right. A change in weather patterns that
make farming more difficult shifts the long-run aggregate-supply curve to the left.
Shifts arising from technology: the economy today produces more than it did a generation ago
due to our technological knowledge have advanced. The invention of the computer, for
instance, has allowed us to produce more goods and services from any given amounts of
labor, capital, and natural resources. As a result, it has shifted the long-run aggregate-supply
curve to the right.

Although not literally technological, many other events act like changes in technology. For
instance, opening up international trade has effects similar to inventing new production
processes, so it also shifts the long run aggregate-supply curve to the right. Conversely, if the
government passed new regulations preventing firms from using some production methods,
perhaps because they were too dangerous for workers, the result would be a leftward shift in
the long-run aggregate-supply curve.

4.2.4. Aggregate Supply Models

There are four major aggregate supply models, which are developed by different scholars viewing the
markets from different angles. These models are: sticky wage model, workers misperception model,
imperfect information model and sticky price model. These models differ from one another depending on
the market (labour market or commodity market) to which the individuals who first developed the
concepts gave emphasis and on their beliefs whether these markets clear or not. Note that all the models
try to explain the relationship between the price and the aggregate supply or output of goods and services.
In other words, we can put these models as different explanations given about the shape of the aggregate
supply curves.
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A. Sticky Wage Model

The sticky wage model focuses on the wage setting process in the labour market to explain the
relationship between price and output in the commodity market and so the slope of the aggregate supply
curve. According to this model wage is set based on long-term contracts. So wage is sticky or remains
unchanged in the short run or during the period on which the agreement is made. This means workers’
salary are not changed with every event that alters their employers’ profits.

The sticky-wage model starts with the presumption that when a firm and its workers sit down to bargain
over the wage, they have in mind some target real wage upon which they will ultimately agree. The level
of this real wage depends upon the relative bargaining strengths of the firm and its workers, on the
presence of efficiency-wage considerations, and so forth. The level of employment at this real wage thus
corresponds to full employment (L̅ ). But the contract to which they ultimately agree is written in terms
not of the real wage but of the nominal wage. To set the nominal wage, the firm and the workers also
form an expectation of the general price level. They ultimately set the nominal wage using the formula:

W= w×Pe,

Nominal wage rate W

w  e
Where, w is the target real wage given by: Expected product price P ,

Since the wage is set in advance in a contract, the actual price level (P) may turn out to be different from
the expected price level (Pe). Suppose, in accordance with the typical features of contracts, that firms have
the right to choose the level of employment. They choose this, as usual, by equating the marginal product
of labor to the actual real wage:

MPL= W/P= w×(Pe/P)

We can then write the demand for labor as L= Ld(W/P).

Output is determined in the usual way by substituting this amount of labor into the production function:
Y= F (K̅ , L) = F (K̅ , Ld (w× (Pe/P))). Where, K= capital

Concerning the price changes, there are three possibilities.

1. If actual price is equal to the expected price (p e); i.e. P = Pe, the economy is at full employment (L d
(w) = ̅L, i.e. employment will be at the natural rate when the actual real wage equals the target real
wage) and output is at full capacity (Y=Y̅ ). That means if price does not change, output does not
change either.
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2. If the actual price turns out to be higher than anticipated (P>P e), then the actual real wage is lower
than anticipated (W/P<W/Pe). This implies that labour gets cheaper since the firms pay lower real
wage rate. So firms will employ more workers and output will increase.
3. If the actual price is lower than expected (P<P e), the actual real wage rate will be higher than the
agreed real wage rate (W/P>W/Pe). This implies that labour gets expensive. Firms are getting less
revenue for their output than they anticipated, so they cut back production and labour demand
decreases.
The above change in the real wage rate occurs as a result of change in price because the nominal wage
does not change along with the price. Rather, the nominal wage rate remains fixed or sticky at the agreed
level. This is why the model is known as sticky wage model. Here it is also important to note that the
basic points of this model as a basis of analysis are that the labour market is very important and the labour
market itself does not clear. The above explanation tells us that the output (or supply) changes when price
deviates from the expected price summarized as follows.

 
Y Y  α p  p e                             (4.1)

Where, Y is actual output, Y is average or planned initial output

P is actual price, Pe is expected price,  is a positive constant

Rearranging the above identity, we can get the following function known as Lucas aggregate supply
curve or function and both are similar.

P P e 
1

Y  Y                          (4.2)

From the above identities, we can see that there is positive relationship between price (P) and aggregate
supply (Y). As price increase above the expected price, output increases above the average or planned one
(Figure 4.6). An increase in price from P1to P2 reduces real wage rate W/P1 to W/P2. This increases labour
demand from Ld to L’d which in turn increases aggregate supply from Y 1 to Y2. So this increase in price
from P1 to P2 leading to an increase in output (Y) from Y 1 to Y2. This chain of related changes can be
summarized with the following symbolic expression.

 P  (W )  Ld  Y 
P
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This implies upward sloping aggregate supply curve. The basic message of this model is that given wages
are fixed/sticky; a rise in price level would lead to a lower real wage rate and hence higher labour demand
which again increases output.

Figure 4.6: sticky wage rate –aggregate supply

B. Workers Misperception Model

Like the sticky wage model, this model also emphasizes the labour market. As opposed to the sticky wage
model, this model assumes that wages are fully flexible and the labour market clears, but workers have
imperfect information, in that they suffer from money illusion, so they temporarily mistake/confuse
nominal wage increases for real wage increases. Firms, on the other hand, have better information and
their demand for labour depends on the actual real wage, which is written as:

Demand for Labor: Ld = L (W/P)

While the quantity of labour supplied depends upon workers’ expected real wage. Analytically, the
supply of labour is described as:

Supply for Labor: Ls = L (W/Pe)

Workers are assumed to know the nominal wage, W, but not the overall price level, P. In choosing how
much labor to supply, workers base their decision on the expected real wage, W/Pe. The expected real
wage can be rewritten as W/P e = W/P × P/Pe, which shows how the expected real wage is related to the
degree of misperception about the price level.
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When P/Pe is greater than one, workers will believe, incorrectly, that their real wage is higher than it
actually is, and when P/Pe is less than one, workers will mistakenly believe that their real wage is lower
than it actually is. Substituting into the labor supply function gives:

Ls = Ls((W/P) × (P/Pe)).

Labor supply thus depends on the real wage and worker misperceptions of the price level.

To see what this model says about aggregate supply, consider the equilibrium in the labor market, (Figure
4.7). The wage adjusts to equilibrate supply and demand. Note that the position of the labor supply curve
and thus the equilibrium in the labor market depend on worker misperception P/Pe.

Whenever the price level P rises, the reaction of the economy depends on whether workers anticipate the
change. If they do, then Pe rises proportionately with P. In this case, workers’ perceptions are accurate,
and neither labor supply nor labor demand changes. The nominal wage rises by the same amount as
prices, and the real wage and the level of employment remain the same.

By contrast, if the price increase catches workers by surprise, then Pe remains the same when P rises.
The increase in P/Pe shifts the labor supply curve to the right (Ls1 to Ls2), lowering the real wage and
raising the level of employment (Figure 4.7). In essence, workers believe that the price level is lower, and
thus the real wage is higher, than actually is the case. This misperception induces them to supply more
labor. Firms are assumed to be better informed than workers and to recognize the fall in the real wage, so
they hire more labor (L1 to L2) and produce more output (Y1 to Y2).

Figure 4.7 Workers misperception-aggregate supply

Thus, according to this model as well, higher product price leads to higher aggregate supply. In other
words, the price level and the aggregate supply are positively related and this is summarized as follows.
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P w P
e  . e   L s  Y 
P P P

To sum up, the worker-misperception model says that deviations of prices from expected prices induce
workers to alter their supply of labor and that this change in labor supply alters the quantity of output
firms produce. The model implies an aggregate supply curve of the form:

Y Y   P  P e  
This model is usually combined with or considered as part of the third model (imperfect information
model). This is because the misperceived higher real wage rate is the result of imperfect or lack of
information by the workers about what the product price would be and make estimation about price
depending on their expectation.

C. Imperfect Information Model

According to the imperfect information model, the lack of information about the other side of a market
determines the relationship between the price and the output or aggregate supply. This model is believed
to be the simplest model since it doesn’t distinguish between firms and workers. For the analysis of this
model, there are some simplifying conditions or assumptions.

a) A supplier produces a single good or product and consumes many goods.

b) Because the number of goods and services produced is so large, suppliers cannot observe all prices
at all the times.
c) Suppliers more closely monitor their own products than their own consumption goods.
d) Changes in overall price level are often confused with relative price change or individual product
price.
According to this model, producers know the nominal price of their product; but not the overall price
level on basis of which they have to estimate the relative price change of their product. So a producer
observes the price of her/his product and increases her/his output when the price increases and all other
producers do the same. They all act rationally but mistakenly. They act rationally because the rational
response for producers to an increase in demand for their product is to increase production or supply, sell
more and get more revenue. But they act mistakenly because the information they have is not correct and
the change they observe does not have the incentive to which they respond by producing and supplying
more. So, according to the imperfect information model, suppliers increase their output when prices
exceed expected prices. This means, the output deviates from the natural rate when price level deviates
from expected price level, given by the following identity (called Lucas aggregate supply curve).

Y Y   P  P e  
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The difference between the imperfect information model and the sticky wage model is that in the former
the market clears; i.e. there is no market rigidity and output will be at full capacity (Y=Y̅ ) if there is
perfect information and individual suppliers know exactly what happens to aggregate demand and what
actual price would be. So they adjust themselves directly from (P 1=Pe) to P2 when aggregate or overall
demand increases from AD1 to AD2 (Figure 4.8).

But when there is imperfect information there is no such quick adjustment. Because producers think that
only price of their commodity is raised and produce more at Y 1 in the figure above as an attempt to take
the advantage of higher demand they perceived. However, the increase in price is not of individual
product only, but it is an increase in overall price level which may be the result of an increased money
supply for which producers have no idea or information.

When price level rises unexpectedly, all suppliers in the economy observe increases in the prices of goods
they produce and so increase their output. They think only the demand of their product increased. But
they adjust to point ‘b’ after realizing the fact that the rise is in the whole price level or for all producers
product.

Figure 4.8: Automatic adjustment with perfect information

D. Sticky Price Model

This model emphasizes the product market itself to be the area where the major factors that determine the
relationship between price and aggregate supply or output exist. The analysis of the model focuses on the
process how prices are set. According to the model, the prices are not flexible or free to adjust to clear the
market once it is fixed or agreed upon and implemented.

The model assumes that some firms cannot quickly change prices as a result of variations in aggregate
demand, because either, they may have long-term contracts or it is costly to alter prices once they have
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been published in catalogues. This means that firms do not instantly adjust prices in response to changes
in demand because of the following major reasons.

A) Sometimes prices are fixed through agreement on a long term contracts between firms and
customers. For instance, a producer may agree to an organization to supply stationery at a
given price level for the next two years. In this case it is difficult during this contract period for
the producer to change price even if cost of production and demand change.
B) Firms hold prices steady in order not to annoy their regular customers with frequent price
changes. This is related to fear of loss of their market shares or customers.
C) Sometimes, prices are sticky because of market structure. The kinked demand curve market model is
the best example for this.
D) Once price catalog is prepared or printed and distributed to customers, firms tend to continue charging
the same price since it is costly to change it from time to time.

In particular, the price equation is analytically described as:


P  sP e  1  s  P  a Y  Y   --------------------------------------- (4.3)
where ‘s’ is the share of firms with sticky prices, setting the price level according to their expectations;
‘(1 – s)’ is the share of flexible price firms, which can immediately change the price level in response to
an increase in demand above the natural level of output; and α> 0 is the response coefficient of flexible
prices to demand. If we first subtract P(1– s) from both sides of the above and then dividing by s, the
price level under the sticky price model becomes:

P P e 
1  s

aY  Y 
s

This equation shows two features of the sticky-price model. First, a high-expected price level leads to a
high actual price level; since firms that set the price in advance expect a high price level, they will set
high prices in order to face future high costs. These high prices cause all other firms also to set high
prices. Second, the effect of changes in output/income on the price level depends upon the proportion of
firms with flexible prices, as measured by the parameter (1 – s)/s. Those firms with flexible prices set
their prices high which in turn leads to high price level.

Like the other models, the sticky price model says that the deviation of output from the natural rate is
associated with the deviation of price level from the expected price level.


Y Y  α P  P e 
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Although the sticky price model emphasizes the goods market, it also implicitly considers what is
happening in the labour market. If a firm’s price is stuck in the short run at the point, which does not clear
the market, and firms are not able to sell all their output, then they cut their output and so labour
employment. The firm responds to the drop in sales by reducing its production and its demand for labour.
Fluctuations in output are associated with inward shifts in the labour demand curve. Because of these
shifts in the labour demand, employment, production and the real wage can all move in the same
direction. Thus, the real wage can be pro-cyclical to production and employment (Figure 4.9).

Figure 4.9: Real Wage, Labour demand and output

Although these four models differ in assumption and emphasis, their implications for an economy are

 
similar. All can be summarized by the equation: Y Y   P  P . If price level is higher than the
e

expected price level, output exceeds its natural rate. So we need not accept one and reject other of these
models. The world may contain all such imperfections and all may contribute to the analysis of the
behavior of short run aggregate supply.

4.3. Macroeconomic Equilibrium and Changes in Equilibrium

The intersection of the aggregate demand curve and the aggregate supply curve establishes the
economy’s equilibrium price level and equilibrium real domestic output. Since the aggregate
supply curve behaves differently in the short run than in the long run we illustrate the
macroeconomic equilibrium in both cases.
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4.3.1. Short-Run Macroeconomic Equilibrium

Short-run macroeconomic equilibrium occurs at the price level at which aggregate quantity
demanded and short-run aggregate quantities supplied are equal.

In Figure 4.10, the equilibrium price level and level of real output are 100 and dollar 510 billion,
respectively. Suppose the price level were 92 rather than 100. The lower price level would
encourage businesses to produce real output of dollar 502 billion. This is shown by point a on the
AS curve. But, as revealed by the point b on the AD curve, buyers would want to purchase dollar
514 billion of real output at price level 92. Competition among buyers to purchase the lesser
available real output of dollar 502 billion will eliminate the dollar 12 billion (=514 billion –502
billion) shortage and pull up the price level to 100. The excess demand for the output of the
economy causes the price level to rise from 92 to 100, which encourages producers to increase
their real output from dollar 502 billion to dollar 510 billion, thereby increasing GDP. In
increasing their real output, producers hire more employees, reducing the unemployment level in
the economy. When equality occurs between the amounts of real output produced and purchased,
the economy has achieved equilibrium (here at dollar 510 billion of real GDP).

Note also that any shift in aggregate demand and/or aggregate supply curves may change
equilibrium level of the output and price level.
Figure 4.10: Short run macroeconomic equilibrium

4.3.2. Long-Run Macroeconomic Equilibrium

In the long run equilibrium, the quantity demanded of real GDP equals the long run quantity
supplied of real GDP. As can be seen from Figure 4.11 that the long run equilibrium output level
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is Y1 and the price level is P1. Note that the impact of any changes in aggregate demand when the
long run aggregate supply is constant will be on the price level only.
Figure 4.11: The long-run equilibrium
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5. MACROECONOMIC PROBLEMS

Inflation and unemployment are the most important and recurrent economic problems that
have characterized modern economic history throughout the world. The problem
unemployment is associated with recessions and inflation is associated with the loss of
purchasing power of our incomes. Most economic policy focuses on mitigating these, most
serious, of problems in the macroeconomics.

5.1. Unemployment

5.1.1. Definitions and Concepts of Unemployment

The participation of labours in different productive activities helps in bringing wellbeing of
the economy as a whole. Labours comes from household sector of the economy and a larger
proportion of the aggregate demand arises from the household sector or their income. The
income of labour depends on employment and their ability to purchase in turn determines
national output.

Unemployment refers to a situation where workers of the working age could not find job
while they are ready to work at prevailing market wage rate. The problem of unemployment
and its intensity is usually measured in terms of unemployment rate. This is because talking
about the actual number of unemployed people makes no sense for countries of different
population size. Unemployment of 10,000 people in a given country with total population of
500,000 people is much compared to unemployment of 10,000 people in a country with total
population of 500,000,000 people. Under this condition, we can say there is unemployment
problem in the former where as there is no significant unemployment problem in the later.
This is why it is better to measure unemployment problem in terms of unemployment rate.
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Unemployment rate is defined as the percentage or the proportion of the labour force that is
unemployed. Labour force (L) is the sum of both employed (E) and unemployed people of
working age and working or ready to work (U). People who are employed may be either full
time or part time employees. The labour force can be given by the following equation:
L = E + U ---------------------------------------------- (5.1)
Labour force does not include part of the working age population which are not working or
looking for work, that is, the working age population that is not in the labour market. Retired
persons, children, those who are either incapable of working or those who choose not to
participate in the labor market are not counted in the labor force. The related concept is
labour force participation rate. Labour force participation is the percentage of adult or
working age population who are in the labour force. These two concepts are summarized by
the following equations:
 Number of Unemployed 
Unemployment Rate    X (100)
 Labour Force 

 Labour Force 
Labour Force Participat ion Rate    X (100)
 Adult Population 
The concept of natural rate of unemployment is used as reference to the existence of
unemployment problem. Natural rate of unemployment is the average rate of
unemployment around which an economy fluctuates given by U/L = n at that point. It is
related to the rate at which workers lose job (job loss rate) and the rate at which jobless
workers find or get job (job finding rate). This can be more elaborated as follows using the
steady state unemployment rate. Steady state unemployment rate is the point or condition
in which the number of workers leaving or losing job are equal to the number of unemployed
getting or finding job given by the following equation:
fU=sE -------------------------------------------------- (5.2)
Where, ‘f’ is rate of job finding,
‘s’ is rate of job separation or loss
‘U’ is unemployed population,
‘E’ is Employed population
Rearranging equation (5.1) into E = L – U and substituting in (5.2), we obtain:
fU = s(L – U) dividing both sides by L fU/L = (s/L)(L – U)
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fU/L = s( 1 – U/L) dividing both sides by ‘f’ we obtain

U/L = s/(s + f) = n --------------------------------------------- (5.3)
Where, U/L = n is the natural rate of unemployment
The policy implication of this is that any policy aimed at reducing the natural rate of
unemployment should either reduce the rate of job separation (losing job), or increase the
rate of job finding (f). Moreover, any policy that affects the rate of job separation (s) or job
finding (f) also affects the natural rate of unemployment ‘n’.

Examples:
1) If 90% of labour force of a given country with 10 million labour force population are
employed on average, find the unemployment rate of the country.
2) If 3% of workers are on average leaving or losing their job and on average 40% of
unemployed workers and workers newly joining labour market are finding or getting job,
then what is the natural rate of unemployment?
3) In question number ‘1’ if the size of the adult population of the country is 12 million,
what is the labour force participation rate?

Solutions:
1. L=E+U=90%(L)+U  L-0.9L=U  U/L=0.1=10%
2. Given: job separation rate (s)=3%=0.03 and Job finding rate (f)=40%=0.4
U/L=n=(s/(s+f)) =(0.03/(0.03+0.4))=0.0698=6.98%
3. Labour force participation rate = (labour force/adult population) x100
= (10 million /12 million) x100=83.33%

5.1.2. Types of Unemployment

The major causes of unemployment are contraction of aggregate demand or national output
which, may arise from natural or manmade disasters; and/or temporary shifts between
different jobs or other types of frictions in the labour market such as technological change.
High unemployment rate has also different impacts on economy and political environment of
a country. For example, it may lead to social violence. Depending on the causes or sources
of the unemployment and the duration of the unemployment, we can divide unemployment
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into different categories. In this respect, economists divide unemployment into three or four
major categories. These are frictional unemployment, structural unemployment, cyclical
unemployment and/or seasonal unemployment.

I. Frictional unemployment

Frictional unemployment is a type of unemployment usually caused by constant changes in

the labour market. It occurs due to two reasons. The first reason is when employers are not
aware of the available workers and their job qualifications. The second reason is when
workers are not fully aware of the jobs being offered. The basic cause of frictional
employment is thus lack of information flow among workers and employers called imperfect
information. So for workers this is the period of unemployment until they get a job and the
duration of unemployment is equal to the time it takes workers to search for a job. New
graduating student from colleges and universities or training institutions are usually
frictionally unemployed. This is the period when such people look for vacancies and apply to
different offices getting interviewed and so on.

The change in composition of demand among economic sectors, industries or regions called
sectoral shift. Due to this shift, the demand for workers also shift and some workers have to
leave some sectors, industries or regions and look for jobs and join some other sectors which
always involve frictional unemployment. The main characteristics of frictional
unemployment are that:
- it affects large number and wide range of people
- it tends to be of short period
- certain amount of fractional unemployment is unavoidable

One of the policy options to solve such unemployment is improving labour market
information (e.g. establishment of information office about workers and vacancies). Note that
in trying to reduce frictional unemployment, some policies inadvertently increase the amount
of frictional unemployment. One example of such policy is unemployment insurance. In this
case, people will be reluctant in looking for job as soon as possible since they can collect
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some money because of their unemployment and prefer to stay for certain period after
unemployment.

II. Structural Unemployment

Structural unemployment occurs due to the structural changes in the economy. These
changes eliminate some jobs while they create some new jobs for people with new skill level.
The skill sets take time to develop and hence some people lose their job simply because they
do not have the new required skill(s). This problem arises from mismatch between the types
of jobs that are available and type of job seekers. Such mismatch may be related to skill,
education level, geographical area, age, etc. For instance, some skills may no longer be
demanded. For instance, typing machines are replaced by computers. In this case type writers
who do not have computer skill would lose their job and potentially become unemployed.

Some of the charactertics of this type of unemployment are that:

- It tends to be concentrated among certain group of people who are adversely affected by
technological change.
- It tends to be long lasting (e.g. it takes time to the victims until they train themselves
under new situation or new technology).
In this respect one of the policy options used to reduce such unemployment is training
workers and improving labour mobility. Structural unemployment also arises from real wage
rigidity leading to failure of the labour market to adjust to equilibrium or the point where
demand for and supply of labour are equal. See the following figure.
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Figure 5.1: Real Wage and Structural Unemployment

Wage rigidity is the failure of wages to adjust to the point where the demand for labour
equals its supply. If the real wage is stuck above the equilibrium level given by the point of
intersection between labour supply and labour demand curves point ‘e’, then the supply of
labour exceeds its demand. This results in unemployment equal to the distance between point
‘a’ and point ‘b’. Such amount of unemployment resulting from wage rigidity and job
rationing is also known as structural unemployment. During this situation, workers are
unemployed not because they cannot find job that suits them or their skills, but at the
prevailing wage rate the supply of labour exceeds its demand. Note here that all factors that
lead to wage rigidity also lead to structural unemployment. Some of these factors are
discussed in detail under Keynesian position of the labour market.

III. Cyclical Unemployment

Cyclical unemployment occurs due to general downturn in the business activities including
production and demand for the products and services. During recession business conditions,
only few goods are produced and for such low production, only few employment
opportunities would be available. Employers are therefore, obliges to lay-off workers and cut
back employment. As we have tried to explain above, unemployment rate fluctuates around a
line known as ‘natural rate of unemployment’. It is a rate where there is no cyclical
unemployment or when all the unemployment is frictional and structural ones. Generally,
there is always some amount of unemployment and economists very frequently use the term
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full employment. Full employment occurs when the unemployment rate is equal to the
natural rate of unemployment. However, note that the concept of full employment does not
mean that all workers are employed or zero unemployment. The natural rate of
unemployment is thought to be about 4% and is a portion of structural unemployment and
frictional unemployment. However, there is not complete professional agreement concerning
the natural rate, some economists argue that the natural rate, today is, about 5%. The
disagreement centers more on observation of the secular trend, than any particular technical
aspect of the economy (and there are those in the profession who would disagree with this
latter statement).

Cyclical unemployment is also known as demand deficient unemployment. Cyclical

unemployment is the result of insufficient aggregate demand in the economy to generate
enough jobs for those seeking them. It occurs during cyclical contraction of an economy
(recession). The policy instrument to solve this problem is fiscal policy (for instance
increasing government expenditure and reducing tax rates) and/or monetary policy (such as
reducing interest rate and increasing money supply).

IV. Seasonal Unemployment

Seasonal unemployment is the type of unemployment that arises from a decline in the
economic activity in some seasons (particular time in a year) and in some sectors. Therefore,
seasonal unemployment results from fluctuations in demand for labour in these sectors
and/or seasons. The special characteristic of this type of unemployment is that fluctuation can
take a regular course of action and can be anticipated so that workers also make their own
plan to move to particular sector in specific seasons to avoid such unemployment. For
instance, workers can seek job in agricultural sector during the first season of cultivation and
during harvest time. In other seasons the demand for labour in agriculture becomes low and
as a result workers would look for job in other sectors.

In conclusion, with fractional and structural unemployment there could be enough jobs, but it
is difficult to match job seekers with job vacancies. With cyclical unemployment, on the
other hand, there are no enough jobs for job seekers. The duration of cyclical unemployment
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can be in between frictional and structural unemployment if the recession is handled and
solved quickly (not as short duration as frictional and not as long duration as structural
unemployment). Otherwise, it will take longer duration than both other types of
unemployment.

Note that sometimes concepts such as underemployment, disguised unemployment and open
unemployment are used to demonstrate different degrees of unemployment.
Underemployment refers to the people who work below their capacity. For instance, a person
may be employed for only 5 hours a day while he/she can and wants to work more than that.
Disguised unemployment is the case where the worker is employed but adding nothing to the
output. Open unemployment represents the formal definition we have discussed above where
the person has no job at all while he/she is ready to work at the prevailing market wage rate.

5.1.3. Relationship between Unemployment and Output

Unemployment is not just a single dimensional problem. Based on empirical observation an

economist determined that there was a fairly stable relation between unemployment and lost
output in the macroeconomics. This relation has a theoretical basis. As we move away from
an economy in full employment, noninflationary equilibrium, we find that we lose jobs in a
fairly constant ratio to the loss of output. This means unemployment and output of the
economy are inversely related; as unemployment increases output also decreases. As a result,
one can say that the largest single cost of unemployment is loss of production. People who do
not work they do not produce. Then, the cost of output lost becomes very high and this is the
reason why many economists studied the relationship between these two important variables.
The relationship between income or output and unemployment is first considered and
explained by Arthur Okun.

Okun’s Law
Arthur Okun studied the relationship between unemployment and output over the business
cycle. In his research and the law (Okun’s Law), he predicted that a one percent (1%) change
in unemployment rate costs 2% of GDP; i.e. GDP growth falls by 2%. This can be put in
general as follows:
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Percentage change in Real GDP = growth in real GDP (without impact of unemployment)
– 2× (change in unemployment rate)
For instance, if real GDP is growing by 3% and unemployment rate rises from 6% to 8%,
then, after accounting for impact of unemployment, the real GDP growth would be as
follows:
Percentage change in Real GDP = 3% – 2% (8% – 6%) = – 1%

Since Okun’s Law is a law which describes a relationship between growths of real output and
change in the unemployment rate it can be roughly summarized by the following
relationships:
U  X (Ya  Yt )
Where, ΔU is change in unemployment
X is a positive constant representing the magnitude, in which unemployment
declines due to a percentage output growth,
Ya is actual growth rate of output, and
Yt is trend output growth rate.
This general equation simply shows the implied negative relationships between the two
variables (growth of real output and change in the unemployment rate).

5.1.4. Labour Market Equilibrium

It is important to understand different positions of different schools of economic thought

about labour market equilibrium. The two opposite labour market reaction (labour demand
and labour supply) theories are the positions of the classical frictionless labour market and
the Keynesian position of the labour market equilibrium.

5.1.4.1. Classical Frictionless Labour Market Equilibrium

Both the demand for and supply of labour depend on the real wage, W/P. Real wage
measures the amount of goods that can be bought with a reward of an hour of work or
received wage income. According to classical economists the real wage adjusts to the point
where demand for labour equals its supply. The argument of these economists is that during
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low demand for labour unemployment will be high. During such period there is no reason
why workers do not cut their wage rate to get job. That means workers would be ready to cut
their wage or to work at lower wage rate during high unemployment. Similarly, during high
employment or low unemployment, which is the case of high demand for labour or when the
demand for labour is higher than its supply, employers are ready to pay higher wage rate.
This means that wage rate increases to the point where the demand for labour equals its
supply. Due to this the labour market is always in equilibrium given by the following graph.

Figure 5.2: Classical Frictionless Labour market equilibrium

At market clearing condition, ‘e’, there is only natural or voluntary unemployment. The
equilibrium is said to be frictionless because the classical economists believe that the market
always clears. Underlying the classical model is the assumption that there is no
unemployment. In equilibrium, everyone who wants to work is working. But there is always
some unemployment. That level of unemployment is accounted for by labour market
frictions, which occur because the labour market is always in a state of flux. Some people are
moving and changing jobs; other people are looking for job for the first time; some firms are
expanding and hiring new workers while others have lost business and are obliged to reduce
employment by firing workers.

The frictionless classical model is an idealized case and is based on the idea that:
- wages and prices are fully flexible;
- no costs to either workers in finding jobs or firms in increasing or reducing their labour
force;
- firms behave competitively;
- a firm is expected to sell all its products at prevailing prices;
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Figure 5.3: Frictionless Labour market equilibrium and voluntary unemployment

According to classical economists whatever the wage level is the labour supply must not
increase because there is no involuntary unemployment. At equilibrium real wage (W/P)* the
equilibrium employment level is L* defined at the point of intersection between short run
labour supply curve (SRLs) and labour demand curve (L d). According to classical
economists, the distance or the difference between L * and Lf is the Natural rate (voluntary)
unemployment. ‘Lf’ is full employment level of labour supply equal to long run labour
supply level.

5.1.4.2. New–Keynesian view of unemployment

Keynesian economists say that the market does not clear because of commodity price rigidity
in commodity market and real wage rigidity in the labour market for several reasons some
which are mentioned and explained next to the figure below.
Figure 5.4: Keynesian Labour market Equilibrium
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For new Keynesians, the real wage can be (fixed) at (W/P)* and employment will be at L*.
Thus, the difference between L f and L* is wait unemployment or involuntary unemployment.
This arises from wage rigidities and job rationing. However, what are the reasons for real
wage rigidities? The following are some of the major reasons.

1) Minimum wage rate legislation

This is the result of government policy of welfare protection or of labour- union pressure. It
represents the case where the real wage rate is fixed above the market clearing one (figure
5.5). When minimum wage is fixed at (W/P) min, the difference between L 1 and L2, (L2-L1),
will be involuntary unemployment. This amount of unemployment exists even people are
willing to work at wage rate below minimum wage rate (W/P)min for instance, at (W/P)*.

Figure 5.5: Minimum wage rate

If the minimum wage is set at a point less than equilibrium wage rate, (for instance at W 1),
this will not be a constraining factor.
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2) Monopoly power of labour unions

Sometimes firms might be interested to pay high wage (which is larger than the equilibrium
wage rate) to avoid unionization. Wage tends to be rigid because of interest conflict between
insiders and outsiders. Outsiders (employers and unemployed workers) argue for or accept
low wage while insiders (employed workers) argue for high wage.

3) Efficiency wage hypothesis

Firms prefer to pay above the equilibrium wage rate for several reasons. Some of the reasons
are:
a. Nutrition condition: Better paid worker is well-fed, healthy and efficient. And this in
turn reduces absenteeism from work.
b. To reduce labour turn over: By paying higher wage firms can avoid or reduce frequent
recruitment costs, advertisement cost and training costs. This is because higher wage rate
make workers prefer to stay with the high paying firm.
c. To keep quality workers and improve work effort: Qualified workers seek for high
paying firms. High payment also avoids shirking constraints.

4) Imperfect information
Imperfect information about changes in prices in the commodity market may lead to lag in
change of wage rate in the labour market. Thus, because of lack of information, the real wage
rate may also fail to adjust to the market clearing one.

5.1.5. Labour supply and Business Cycle

Labour supply responds not only to changes in economic opportunities over a worker’s life
time, but may also show adjustments to changes in labour opportunities induced by business
cycle. In this respect, two major hypotheses are developed namely added worker effect
hypothesis and discouraged worker effect hypothesis.

The added worker effect hypothesis suggests that secondary workers (who lack commitment
to the labour market such as students, house wives, retired persons, etc) will tend to become
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labour market participant during economic recessions; and then withdraw their labour during
prosperity. The added worker effect thus implies that the labour force participation rate of
secondary workers has a counter cyclical trend (i.e. it moves in opposite direction to the
business cycle). This is because, for primary workers, there are no enough jobs during
recession.

The discouraged workers effect hypothesis, on the other hand, argues that unemployed
primary workers finds so difficult to get work that they eventually are discouraged and stop
looking for work. As a result the labour force participation rate (labour supply) declines. So
the supply of primary workers has a pro-cyclical trend (it falls during recession and increases
during boom).

5.2. Inflation

5.2.1. Concepts and Definition of Inflation

A birr today doesn’t buy as much as it did ten years ago. The cost of almost everything may
go up. This increase in the overall level of prices is called inflation, and it is one of the
primary concerns of economists and policymakers.

The inflation rate measures how fast prices are rising. Inflation rate is the rate at which the
average of these prices or overall price level increases from period to period. We can use the
following formula to calculate inflation rate.

Inflation rate   P 1
 P 0

 X 100
 
 P 0  ,
Where, P0= previous year price index,
P1=current year average price
If the inflation rate is very high, it is known as hyperinflation. There is no consensus on
when a particular rate of inflation becomes hyper but most of the economists would agree
that inflation rate of about 100% per year would be hyper. Or it is defined as the level of
inflation that exceeds 50% per month or a level of inflation which is greater than 1% per day.
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For example, if a person is having 200 birr in 1995 then the value of the same money is
around 100 birr in 1996.

During hyperinflation, everything on the market becomes too costly. The purchasing power
of money will fall down since one needs a larger amount of money to purchase small good or
service. Thus, during hyperinflation money loses its role as store of value, unit of account
and medium of exchange. Under this condition, the demand for money will be very low and
people resort to using commodity money or bartering system where commodities are
exchanged for commodity. In some countries people go wild by rioting and breaking the
shops and stores in order to get food. Sometimes they even blame the government for the rise
in price level leading to the toppling down of heads of the state.

5.2.2. Price indexes

Economists measure changes in the cost of living using the price indexes. Price indexes are
the way we attempt to measure inflation and adjust aggregate economic data to account for
price level variations.

There are three ways of measuring price index/ average price. These are: GDP deflator,
consumer price index and producer price index.

a. GDP deflator: As we have just seen, nominal GDP reflects both the prices of goods and
services and the quantities of goods and services the economy is producing. By contrast, by
holding prices constant at base-year levels, real GDP reflects only the quantities produced.
From these two statistics, we can compute a third, called the GDP deflator, which reflects the
prices of goods and services but not the quantities produced.


GDP deflator  Nominal GDP
Real GDP
x100
Because nominal GDP is current output valued at current prices and real GDP is current
output valued at base-year prices, the GDP deflator reflects the current level of prices relative
to the level of prices in the base year. Because nominal GDP and real GDP must be the same
in the base year, the GDP deflator for the base year always equals 100.
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Imagine that the quantities produced in the economy rise over time but prices remain the
same. In this case, both nominal and real GDP rise together, so the GDP deflator is constant.
Now suppose, instead, that prices rise over time but the quantities produced stay the same. In
this second case, nominal GDP rises but real GDP remains the same, so the GDP deflator
rises as well. In both cases, the GDP deflator reflects what’s happening to prices, not
quantities.

Numerical example: Suppose that for year 2001, nominal GDP is dollar 200, and real GDP
is dollar 200, so the GDP deflator is 100. Again assume that for the year 2002, nominal GDP
is dollar 600, and real GDP is dollar 350, so the GDP deflator is 171. Because the GDP
deflator rose in year 2002 from 100 to 171, we can say that the price level increased by 71
percent.

b. Consumer price index (CPI): is a measure of the overall cost of the goods and services
bought by a typical consumer. In other words, CPI measures the cost of buying a fixed basket
of goods and services representative of the purchases of urban consumers.
 Total expenditur e on market basket in current year 
CPI  
 Total expenditur e on market basket in base year 
To calculate the consumer price index and the inflation rate, data on the prices of thousands
of goods and services is required. However, to see exactly how these statistics are
constructed let’s consider a simple economy in which consumers buy only two goods-bread
and apple. Table 6.1 shows the five steps that we follow. In the example in the table, the year
2001 is the base year and hence, the consumer price index is 100. The consumer price index
is 175 in 2002. This means a basket of goods that costs dollar 100 in the base year costs
dollar 175 in 2002. Finally, use the consumer price index to calculate the inflation rate,
which is the percentage change in the price index from the preceding period. That is, the
inflation rate between two consecutive years is computed as follows:
 CPI in year 2  CPI in year 1 
Inflation rate in year 2  
 CPI in year 1 
In our example, the inflation rate is 75 percent in 2002 and 43 percent in 2003.
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Table 5.1: Calculating the consumer price index and the inflation rate
Step 1: Survey Consumers to Determine a Fixed Basket of Goods
Basket of 4 bread and 2 apples
Step 2: Find the Price of each Good in each Year
Year Price of Bread Price of Apple
2001 dollar 1 dollar 2
2002 dollar 2 dollar 3
2003 dollar 3 dollar 4
Step 3: Compute the Cost of the Basket of Goods in each Year
2001 (dollar1 per bread x 4 bread) + (dollar2 per apple x 2 apples) = dollar8
2002 (dollar2 per bread x 4 bread) + (dollar3 per apple x 2 apples) = dollar14
2003 (dollar3 per bread x 4 bread) + (dollar4 per apple x 2 apples) = dollar20
Step 4: Chose One Year as a Base Year (2001) and Compute the Consumer Price Index
2001 (dollar8/dollar8) x100=100
2002 (dollar14/dollar8)x100=175
2003 (dollar20/dollar8)x100=250
Step 5: Use the Consumer Price Index to Compute the Inflation Rate from Previous Year
2002 (175-100)/100 x100=75%
2003 (250-175)/175 x100=43%

The GDP Deflator versus the Consumer Price Index

Economists and policymakers monitor both the GDP deflator and the consumer price index
to gauge how quickly prices are rising. Usually, these two statistics tell a similar story. Yet
there are three important differences that can cause them to diverge. These are:
 The deflator measures the prices of a much wider group of goods than the CPI does.
 The CPI measures the cost of a given basket of goods, which is the same from year to
year. The basket of goods included in the GDP deflator, however, differs from year to
year, depending on what is produced in the economy in each year. When corn crops are
large, corn receives a relatively large weight in the computation of the GDP deflator.
 The CPI directly includes prices of imports, whereas the deflator includes only prices of
goods produced in the country, say Ethiopia.
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c. Producer price index (PPI): measures the cost of a basket of goods and services bought
by firms rather than consumers. Because firms eventually pass on their costs to consumers in
the form of higher consumer prices, changes in the producer price index are often thought to
be useful in predicting changes in the consumer price index.
 Cost of production in current year 
PPI   
 Cost of production in base year 

5.2.3. Causes and Effects of inflation

5.2.3.1. Causes of inflation

Some of the major causes or sources of inflation are an increase in money supply, high
demand for goods and services and shortage of supply of goods and services.

There are three theories of inflation that arise from the real conduct of the macroeconomics.
These three theories are demand-pull, cost-push, and pure inflation. There is also a fourth
theory that suggests that inflation has little or nothing to do with the real output of the
economy, this is called the quantity theory of money.

a. Demand - Pull Inflation

When there is high or increase in demand for goods and services individuals or users of the
goods and services would be ready to pay higher price. Suppliers have the incentive to charge
higher price when there is high demand for their product. As a result of these incentives, the
price level will swing upward. This type of inflation is known as demand pull inflation.

On aggregate demand-aggregate supply model, as the aggregate demand shifts to the right or
increases from (AD1 to AD2 see the following figure), all prices increase (P 1 to P2). However,
this increase in aggregate-demand is also associated with an increase in total output (Y 1 to
Y2). Total output is associated with employment (remember Okun's Law). In other words,
even though this increase in aggregate demand causes inflation, it does not result in lost
output, hence unemployment.
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Policy measures designed to control demand-pull inflation, will shift the aggregate demand
curve to the left, (i.e., reduce aggregate demand) and this reduction in aggregate demand is
associated with loss of output, hence increased unemployment.

Figure 5.6: Increase in the aggregate demand

b. Cost - Push Inflation

When there is high cost of production, there will be shortage of supply of goods and services.
Then to cover their high cost of production and get profit margin producers of goods and
services charge higher prices. Moreover, when there is shortage of supply, consumers or
users of goods and services are willing to pay higher price to get the limited goods and
services. This means, both actions lead to an increase in price level. Such inflation or an
increase in price level arises from the supply side or from the cost of production and is
therefore, called cost push inflation. For instance, there was a supply shock of oil during
1970s across the world and this increased cost of production and distribution that finally
resulted in inflation during the period. If the problem of inflation arises along with low
aggregate output or during economic stagnation or recession the situation is called
stagflation.
Again using an aggregate supply-aggregate demand approach, cost-push inflation results
from a decrease in the aggregate supply curve. The following diagram shows a shift to the
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left or decrease in aggregate supply curve (from AS 1 to AS2) and a price increase from P 1 to
P2.

Figure 5.7: Decrease in the aggregate supply

c. Pure Inflation

Pure inflation results from an increase in aggregate demand and a simultaneous decrease in
aggregate supply. For output to remain unaffected by these shifts in aggregate demand and
aggregate supply, then the increase in aggregate demand must be exactly offset by an equal
decrease in aggregate supply.
Figure 5.8: Change in both aggregate demand and aggregate supply
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Notice in this diagram, that aggregate supply shifted to the left, or decreased (from AS 1 to
AS2) by exactly the same amount that the aggregate demand curve shifted to the right or
increased (from AD1 to AD2). The result is that output remains exactly the same, but the price
level increased.

d. Quantity Theory of Money

Inflation, in the monetarist view, can only occur if the money supply is increased which
permits all prices to increase. If the money supply is not increased there can be changes in
relative prices, for example, oil prices can go up, but there has to be offsetting decreases in
the prices of other commodities. An increase in all prices or in the price of a particular good,
therefore, is a failure of the central bank (Fed) to appropriately manage the money supply.

5.2.3.2. Effects/consequences of Inflation

Whatever its sources or its causes, inflation has some common major effects on the society or
the country where inflation occurred. Some of these effects are high living costs, higher
wage rates, excess nominal money supply over the real products, shortage of supply of goods
and services due to high cost of production, very low value of domestic currency (or money),
expensive imports, and so on.
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When inflation occurs, each unit of consumer goods is bought at higher price and living
expenses become higher unless the income of individuals increases as well. This is why
workers push wage rate upward during inflation period. This implies that the purchasing
capacity of money or domestic currency deteriorates. Compared to foreign currencies the
value of domestic currency becomes very low and becomes subject to be changed to smaller
amount of foreign currency. Thus, when one purchases smaller amount of foreign
commodity or imports becomes expensive. There will be inflow of foreign currency if
exports and imports are elastic. But normally, in developing countries petroleum products
constitute the major part of imports and hence imports are inelastic. Imports remain the same
despite it becomes costly for the domestic country, the country becomes poorer.

The effects of inflation may impact different people in different ways. Creditors and those
living on a fixed income will generally suffer. However, debtors and those whose incomes
can be adjusted to reflect the higher prices will not, and perhaps this group may even benefit
from higher rates of inflation.

If inflation is fully anticipated and people can adjust their nominal income or their purchasing
behavior to account for inflation then there will likely be no adverse effects, however, if
people cannot adjust their nominal income or consumption patterns people will likely
experience adverse effects. This is the same as if people experience unanticipated inflation.
Normally, if you cannot adjust income, are a creditor with a fixed rate of interest or are living
on a fixed income you will pay higher prices. The result is that those individuals will see
their standard of living eroded by inflation.

Debtors, whose loans specify a fixed rate of interest, typically benefit from inflation because
they can pay loans-off in the future with money that is worth less. It is this paying of loans
with money that purchases less that harms creditors.

Savers may also find themselves in the same position as creditors. If savings are placed in
long-term savings certificates that have a fixed rate of interest, inflation can erode the
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earnings on those savings substantially. Savers that anticipate inflation will seek assets that
vary with the price level, rather than risk the loss associated with inflation.

Inflation will affect savings behavior in another way. If a person fully anticipates inflation,
rather than to save money now, consumers may acquire significant debt at fixed interest rates
to take advantage of the potential inflationary leverage caused by fixed rates. Rather than to
save now, consumers spend now. Therefore, inflation typically creates expectations among
people of increasing prices, and if people increase their purchases aggregate demand will
increase. An increase in aggregate demand will cause demand-pull inflation. Therefore,
inflationary expectations can create a spiraling of increased aggregate-demand and
inflationary expectations that can feed off one another. At the other extreme, recessionary
expectations may cause people to save, that results in reduced aggregate demand, and another
spiral effect can result (but downwards).

5.3. Relationship between Unemployment and Inflation

The relationship between inflation and unemployment is a topic that has attracted the
attention of some of the most important economists of the last half century. These theories
show why the tradeoff between inflation and unemployment holds in the short run, why it
does not hold in the long run, and what issues it raises for economic policymakers. This
relation can be described by Phillips curve.

Phillips Curve
The Australian economist, A.W. Phillips plotted data on unemployment rates and rate of
change in wage rates between 1861 and 1957 in UK. He first found that there was more or
less stable relationship between these two variables. Later he and other economists extended
the concept to cover larger range of data and found out that there is negative relationship
between unemployment rates and rate of change in wage rates. Then they termed the curve
showing this relationship as Phillips Curve. The Phillips Curve is a downward sloping curve
that shows an inverse relationship between the inflation rate and the unemployment rate.
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When unemployment rate is very low (employment is high), then workers have the market
power to push up wages. Higher wage rate again implies that the cost of production is high
and that sellers charge high prices. When unemployment rate is very high, then workers do
not have much bargaining power; rather they would be ready to accept lower wage to get job.
Due to this, the pressure on prices also remains low. This relation can be described by the
following figure.
Figure 5.9: Short run Phillips Curve

Such relationship between inflation and unemployment generated the idea of policy trade off.
It suggests that policymakers could choose different combinations of unemployment and
inflation rates. If the world works the way Phillips Curve suggests then policy makers must
choose inflation and unemployment combinations along Phillips Curve. This is because the
curves suggest that less unemployment can always be attained by incurring more inflation so
that the inflation rate can always be reduced by incurring the costs of more unemployment.
However, after 1960, the Phillips Curve became unstable and people started questioning
about the tradeoff. In mid-1960s, economists like Milton Friedman and Edmund Phelps
suggested that the unemployment rate and rate of inflation are vertical straight line in long
run. In long run there is always natural rate of unemployment (N).
The natural rate of unemployment depends on various features of the labor market, such as
minimum-wage laws, the market power of unions, the role of efficiency wages, and the
effectiveness of job search. By contrast, the inflation rate depends primarily on growth in the
money supply, which a nation’s central bank controls. In the long run, therefore, inflation
and unemployment are largely unrelated problems.
Figure 5.10: Long Run Phillips Curve
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The implication of the vertical long run in Philips Curve is that there is change or deviation
in unemployment rate from the natural rate is only of short run. An increase above the natural
rate of unemployment or a fall below it would be adjusted in the long run. On the contrary, it
is expected that inflation has positive impact on the labour market. Some economists argue
that some level of inflation may make labour markets work better. They say that it “greases
the wheels” of the labour markets. This is because with some level of inflation, the wage rate
increases and workers get initiated simply by increased nominal wage rate.
6. MACROECONOMIC POLICIES

Macroeconomic policies affect the overall performance of the economy. Two main
macroeconomics policies are the financial policy or monetary policy and fiscal policy. These
policies will be used to achieve macroeconomics objectives, such as full employment, price
stability and satisfactory economic growth.

Monetary and fiscal policies can each influence aggregate demand. Thus, a change in one of
these policies can lead to short-run fluctuations in output and prices. Policymakers will want
to anticipate this effect and, perhaps, adjust the other policy in response. Central banks have
to decide how to control the money supply and interest rates (if they can), and whether to fix
the exchange rate or let it float. Governments have to decide how much to spend and how to
finance their spending through taxes, borrowing, or printing money.

Many factors influence aggregate demand besides monetary and fiscal policy. In particular,
desired spending by households and firms determines the overall demand for goods and
services. When desired spending changes, aggregate demand shifts. If policymakers do not
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respond, such shifts in aggregate demand cause short-run fluctuations in output and
employment. As a result, monetary and fiscal policymakers sometimes use the policy levers
at their disposal to try to offset these shifts in aggregate demand and thereby stabilize the
economy.

6.1. Monetary Policy

Monetary/financial policy is the process by which the monetary authority (Central Bank-
Fed) of a country controls the supply of money, often targeting a rate of interest to attain a set
of objectives oriented towards the growth and stability of the economy. It is the changes in
interest rates and money supply to expand or contract aggregate demand. In a recession,
expansionary monetary policy-"easy money" involves lowering interest rates and increasing
the money supply. In an overheated expansion, contractionary monetary policy-"tight
money" raises interest rates and decreases the money supply.

6.1.1. Monetary policy tools

The tools of monetary policy are those available to the central bank to control the excess
reserves of banks. They include open market operations, changes in required reserve ratios
and changes in the discount rate.

It is normal to believe that control over the physical printing of bank notes is the essence of
monetary policy, but that is not entirely correct. Since the monetary multiplier shows that
banks have the ability to create most of the money, control over reserves which banks can
lend, is the real focus of monetary policy.

Reserve requirement: Banks are required to hold a certain percentage (cash reserve ratio, or
CRR) of their deposits in reserve in order to ensure that they always have enough cash to
meet withdrawal requests of their depositors. Not all depositors are likely to withdraw their
money simultaneously. So the CRR is usually around 10%, which means banks are free to
lend the remaining 90%. By changing the CRR requirement for banks, the Central Bank can
control the amount of lending in the economy, and therefore the money supply with reserve
requirements, which are regulations on the minimum amount of reserves that banks must
hold against deposits.
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An increase in reserve requirements means that banks must hold more reserves and,
therefore, can loan out less of each dollar that is deposited; as a result, it raises the reserve
ratio, lowers the money multiplier, and decreases the money supply. Conversely, a decrease
in reserve requirements lowers the reserve ratio, raises the money multiplier, and increases
the money supply.

The central bank uses changes in reserve requirements only rarely because frequent changes
would disrupt the business of banking. When the Fed increases reserve requirements, for
instance, some banks find themselves short of reserves, even though they have seen no
change in deposits. As a result, they have to curtail lending until they build their level of
reserves to the new required level.

Open market operations: Open market operations consist of buying and selling of
government securities/ bonds by the central bank. To increase the money supply, the central
bank instructs its bond traders to buy bonds in the nation’s bond markets. The cash the
central bank pays for the bonds increase the number of dollars in circulation. Some of these
new dollars are held as currency, and some are deposited in banks. Each new dollar held as
currency increases the money supply by exactly dollar 1. Each new dollar deposited in a bank
increases the money supply to an even greater extent because it increases reserves and,
thereby, the amount of money that the banking system can create.

To reduce the money supply, the Central bank does just the opposite: It sells government
bonds to the public in the nation’s bond markets. The public pays for these bonds with its
holdings of currency and bank deposits, directly reducing the amount of money in
circulation. In addition, as people make withdrawals from banks, banks find themselves with
a smaller quantity of reserves. In response, banks reduce the amount of lending, and the
process of money creation reverses itself.

Open-market operations are easy to conduct. In fact, the Central bank’s purchases and sales
of government bonds in the nation’s bond markets are similar to the transactions that any
individual might undertake for his own portfolio. Of course, when an individual buys or sells
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a bond, money changes hands, but the amount of money in circulation remains the same. In
addition, the Central bank can use open-market operations to change the money supply by a
small or large amount on any day without major changes in laws or bank regulations.
Therefore, open-market operations are the tool of monetary policy that the Central bank uses
most often.

Discount rate: is the interest rate on the loans that the central bank makes to banks. It is the
cost of borrowing or, essentially, the price of money. The Central bank can alter the money
supply by changing the discount rate. This means by manipulating interest rates, the central
bank can make easier or harder to borrow money. A higher discount rate discourages banks
from borrowing reserves from the Central bank. Thus, an increase in the discount rate
reduces the quantity of reserves in the banking system, which in turn reduces the money
supply. Conversely, a lower discount rate encourages bank borrowing from the central bank,
increases the quantity of reserves, and increases the money supply. When money is cheap,
there is more borrowing and more economic activity. Lower rates also discourages saving
and induce people to spend their money rather than save it because they get so little return on
their savings.

6.1.2. Monetary Policy and Aggregate Demand

6.1.2.1. Interest Rate Effect
To understand how policy influences aggregate demand, we examine the interest-rate effect
in more detail. Here we develop a theory of how the interest rate is determined, called the
theory of liquidity preference.
Keynes proposed the theory of liquidity preference to explain what factors determine the
economy’s interest rate. The theory is, in essence, just an application of supply and demand.
According to Keynes, the interest rate adjusts to balance the supply and demand for money.
Economists distinguish two interest rates: the nominal interest rate and the real interest rate.
The nominal interest rate is the interest rate as usually reported, and the real interest rate is
the interest rate corrected for the effects of inflation. In the analysis, we hold the expected
rate of inflation constant. Thus, when the nominal interest rate rises or falls, the real interest
rate that people expect to earn rises or falls as well.
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The first piece of the theory of liquidity preference is the supply of money. The Central Bank
(Fed) alters the money supply primarily by changing the quantity of reserves in the banking
system through the purchase and sale of government bonds in open market operations. In
addition to these open market operations, the Central Bank can alter the money supply by
changing reserve requirements (the amount of reserves banks must hold against deposits) or
the discount rate (the interest rate at which banks can borrow reserves from the Central
Bank).

Assume that the Central Bank controls the money supply directly. In other words, the
quantity of money supplied in the economy is fixed at whatever level the Central Bank
decides to set it. Because the quantity of money supplied is fixed by Central Bank policy, it
does not depend on other economic variables. In particular, it does not depend on the interest
rate. We represent a fixed money supply with a vertical supply curve (Figure 6.1).

The second piece of the theory of liquidity preference is the demand for money. Recall that
any asset’s liquidity refers to the ease with which that asset is converted into the economy’s
medium of exchange. Money is the economy’s medium of exchange, so it is by definition the
most liquid asset available.

Although many factors determine the quantity of money demanded, the one emphasized by
the theory of liquidity preference is the interest rate. The reason is that the interest rate is the
opportunity cost of holding money. That is, when you hold wealth as cash in your wallet,
instead of as an interest-bearing bond, you lose the interest you could have earned. An
increase in the interest rate raises the cost of holding money and, as a result, reduces the
quantity of money demanded. A decrease in the interest rate reduces the cost of holding
money and raises the quantity demanded. Thus, the money-demand curve slopes downward,
as shown in Figure 6.1.
According to the theory of liquidity preference, the interest rate adjusts to balance the
supply and demand for money. There is one interest rate, called the equilibrium interest rate,
at which the quantity of money demanded exactly balances the quantity of money supplied.
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If the interest rate is at any other level, people will try to adjust their portfolios of assets and,
as a result, drive the interest rate toward the equilibrium. For example, suppose that the
interest rate is above the equilibrium level, such as r 1 in Figure 6.1. In this case, the quantity
of money that people want to hold, Md1, is less than the quantity of money that the Central
Bank has supplied. Those people who are holding the surplus of money will try to get rid of
it by buying interest-bearing bonds or by depositing it in an interest-bearing bank account.
Because bond issuers and banks prefer to pay lower interest rates, they respond to this
surplus of money by lowering the interest rates they offer. As the interest rate falls, people
become more willing to hold money until, at the equilibrium interest rate, people are happy
to hold exactly the amount of money the Central Bank has supplied.

Figure 6.1: money market equilibrium

Conversely, at interest rates below the equilibrium level, such as r 2 in Figure 6.1, the quantity
of money that people want to hold, M d2, is greater than the quantity of money that the Central
Bank (Fed) has supplied. As a result, people try to increase their holdings of money by
reducing their holdings of bonds and other interest-bearing assets. As people cut back on
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their holdings of bonds, bond issuers find that they have to offer higher interest rates to
attract buyers. Thus, the interest rate rises and approaches the equilibrium level.

The price level is one determinant of the quantity of money demanded. At higher prices, more
money is exchanged every time a good or service is sold. As a result, people will choose to
hold a larger quantity of money. That is, a higher price level increases the quantity of money
demanded for any given interest rate. Thus, an increase in the price level from P 1to P2 shifts
the money-demand curve to the right from MD1 to MD2, as shown in panel (a) of Figure 6.2.
For a fixed money supply, the interest rate must rise to balance money supply and money
demand. The higher price level has increased the amount of money people want to hold and
has shifted the money demand curve to the right. Yet the quantity of money supplied is
unchanged, so the interest rate must rise from r1 to r2 to discourage the additional demand.

At a higher interest rate, the cost of borrowing and the return to saving are greater. Fewer
households choose to borrow to buy a new house, and those who do buy smaller houses, so
the demand for residential investment falls. Fewer firms choose to borrow to build new
factories and buy new equipment, so business investment falls. Thus, when the price level
rises from P1 to P2, increasing money demand from MD1 to MD2 and raising the interest rate
from r1 to r2, the quantity of goods and services demanded falls from Y1 to Y2 (panel (b) of
Figure 6.2).

Hence, this analysis of the interest-rate effect can be summarized in three steps: (1) A higher
price level raises money demand. (2) Higher money demand leads to a higher interest rate.
(3) A higher interest rate reduces the quantity of goods and services demanded. Of course, in
the reverse, a lower price level reduces money demand, which leads to a lower interest rate,
and this in turn increases the quantity of goods and services demanded. The end result of this
analysis is a negative relationship between the price level and the quantity of goods and
services demanded, which is illustrated with a downward-sloping aggregate-demand curve.
Figure 6.2 change in price level and aggregate demand curve
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6.1.2.2. Changes in the Money Supply

Whenever the quantity of goods and services demanded changes for a given price level, the
aggregate-demand curve shifts. One important variable that shifts the aggregate-demand
curve is monetary policy. To see how monetary policy affects the economy in the short run,
suppose that the Central Bank (Fed) increases the money supply by buying government
bonds in open-market operations. An increase in the money supply shifts the money-supply
curve to the right from MS1 to MS2, as shown in panel (a) of Figure 6.3. Because the money-
demand curve has not changed, the interest rate falls from r 1 to r2 to balance money supply
and money demand. That is, the interest rate must fall to induce people to hold the additional
money the Central Bank has created.
The lower interest rate reduces the cost of borrowing and the return to saving. Households
buy more and larger houses, stimulating the demand for residential investment. Firms spend
more on new factories and new equipment, stimulating business investment. As a result, the
quantity of goods and services demanded at a given price level, P, rises from Y 1 to Y2, as
shown in panel (b) of Figure 6.3. The monetary injection raises the quantity of goods and
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services demanded at every price level. Thus, the entire aggregate-demand curve shifts to the
right.
Figure 6.3 change in money supply and aggregate demand curve

To sum up: when the Central Bank increases the money supply, it lowers the interest rate and
increases the quantity of goods and services demanded for any given price level, shifting the
aggregate-demand curve to the right. Conversely, when the Central Bank contracts the
money supply, it raises the interest rate and reduces the quantity of goods and services
demanded for any given price level, shifting the aggregate-demand curve to the left.

Changes in monetary policy that aim to expand aggregate demand can be described either as
increasing the money supply or as lowering the interest rate. Changes in monetary policy that
aim to contract aggregate demand can be described either as decreasing the money supply or
as raising the interest rate.

6.2. Fiscal Policy

Fiscal policy is changes in the taxing and spending of the government for purposes of
expanding or contracting the level of aggregate demand thereby achieving economic
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objectives of price stability, full employment, and economic growth. In a recession, an

expansionary fiscal policy involves lowering taxes and increasing government spending. In
an overheated expansion, a contractionary fiscal policy requires higher taxes and reduced
spending.

When government spends more than the income tax collected, it suffers a budget deficit.
Meanwhile, if the government’s revenue is more than its expenditure, then the government
will have a budget surplus.
6.2.1. Changes in Government Purchases
When policymakers change the money supply or the level of taxes, they shift the aggregate-
demand curve by influencing the spending decisions of firms or households. By contrast,
when the government alters its own purchases of goods and services, it shifts the aggregate-
demand curve directly.
Suppose the government purchase of goods has increased by Birr 20 billion. This order raises
the demand for the output, which induces the company to hire more workers and increase
production. The increase in the demand for product means an increase in the total quantity of
goods and services demanded at each price level. As a result, the aggregate-demand curve
shifts to the right but not exactly by Birr 20 billion.
There are two macroeconomic effects that make the size of the shift in aggregate demand
differ from the change in government purchases. The first-the multiplier effect-suggests that
the shift in aggregate demand could be larger than government purchase Birr 20 billion. The
second-the crowding-out effect-suggests that the shift in aggregate demand could be smaller
than Birr 20 billion.

The Multiplier Effect

When the government buys Birr 20 billion of goods from a company, that purchase has
repercussions. The immediate impact of the higher demand from the government is to raise
employment and profits at company. Then, as the workers see higher earnings and the firm
owners see higher profits, they respond to this increase in income by rising their own
spending on consumer goods. As a result, the government purchase from company raises the
demand for the products of many other firms in the economy. Because each dollar spent by
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the government can raise the aggregate demand for goods and services by more than a dollar,
government purchases are said to have a multiplier effect on aggregate demand. This
multiplier effect continues even after this first round. When consumer spending rises, the
firms that produce these consumer goods hire more people and experience higher profits.
Higher earnings and profits stimulate consumer spending once again, and so on. Thus, there
is positive feedback as higher demand leads to higher income, which in turn leads to even
higher demand. Once all these effects are added together, the total impact on the quantity of
goods and services demanded can be much larger than the initial impulse from higher
government spending.

The increase in government purchases of Birr 20 billion initially shifts the aggregate-demand
curve to the right from AD1 to AD2 by exactly Birr 20 billion. But when consumers respond
by increasing their spending, the aggregate-demand curve shifts still further to AD 3 (Figure
6.4).
This multiplier effect arising from the response of consumer spending can be strengthened by
the response of investment to higher levels of demand. For instance, the company might
respond to the higher demand for goods by deciding to buy more equipment or build another
plant. In this case, higher government demand spurs higher demand for investment goods.
This positive feedback from demand to investment is sometimes called the investment
accelerator.
Figure 6.4 Government purchase multiplier effect
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A formula for the size of the multiplier effect arises from consumer spending. An important
number in this formula is the marginal propensity to consume (MPC)-the fraction of extra
income that a household consumes rather than saves. For example, suppose that the marginal
propensity to consume is 3/4. This means that for every extra Birr that a household earns, the
household spends Birr 0.75 (3/4 of the Birr) and saves Birr 0.25.

To gauge the impact on aggregate demand of a change in government purchases, we follow

the effects step-by-step. The process begins when the government spends Birr 20 billion,
which implies that national income (earnings and profits) also rises by this amount. This
increase in income in turn raises consumer spending by MPC x Birr 20 billion, which in turn
raises the income for the workers and owners of the firms that produce the consumption
goods. This second increase in income again raises consumer spending, this time by MPC
(MPC x Birr 20 billion). These feedback effects go on and on.

To find the total impact on the demand for goods and services, we add up all these effects:
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Change in government purchases………….. Birr20 billion

First change in consumption …………….MPCxBirr20 billion
Second change in consumption ………….MPC2xBirr20 billion
Third change in consumption ……………MPC3xBirr20 billion
Total change in demand………………... (1+MPC+MPC2+MPC3+…) x Birr 20 billion
Here, “. . .” represents an infinite number of similar terms. Thus, we can write the multiplier
as follows: Multiplier=1+MPC+MPC2+MPC3+· ·

This multiplier tells us the demand for goods and services that each Birr of government
purchases generates. To simplify this equation for the multiplier, recall that this expression is
an infinite geometric series. For X between -1 and +1,
1+X+X2+X3· ·=1/ (1-X). In our case, X=MPC.
Thus, Multiplier (dY/dG) =1/ (1-MPC).

The size of the multiplier depends on the marginal propensity to consume. Whereas an MPC
of 3/4 leads to a multiplier of 4, an MPC of 1/2 leads to a multiplier of only 2. Thus, a larger
MPC means a larger multiplier. The multiplier arises because higher income induces greater
spending on consumption. The larger the MPC is, the greater is this induced effect on
consumption, and the larger is the multiplier.

The Crowding-Out Effect

While an increase in government purchases stimulates the aggregate demand for goods and
services, it also causes the interest rate to rise, and a higher interest rate reduces investment
spending and chokes off aggregate demand. The reduction in aggregate demand when a fiscal
expansion raises the interest rate is called the crowding-out effect.

The increase in demand raises the incomes of the workers and owners of this firm (and,
because of the multiplier effect, of other firms as well). As incomes rise, households plan to
buy more goods and services and choose to hold more of their wealth in liquid form. That is,
the increase in income caused by the fiscal expansion raises the demand for money. Because
the Fed has not changed the money supply, the vertical supply curve remains the same. When
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the higher level of income shifts the money-demand curve to the right from MD 1 to MD2, the
interest rate must rise from r1to r2 to keep supply and demand in balance, as shown in panel
(a) of Figure 6.5.
The increase in the interest rate, in turn, reduces the quantity of goods and services
demanded. In particular, because borrowing is more expensive, the demand for residential
and business investment goods declines. That is, as the increase in government purchases
increases the demand for goods and services, it may also crowd out investment. This
crowding-out effect partially offsets the impact of government purchases on aggregate
demand, as illustrated in panel (b) of Figure 6.5. The initial impact of the increase in
government purchases is to shift the aggregate-demand curve from AD 1 to AD2, but once
crowding out takes place, the aggregate-demand curve drops back to AD3.
To sum up: When the government increases its purchases by Birr 20 billion, the aggregate
demand for goods and services could rise by more or less than Birr 20 billion, depending on
whether the multiplier effect or the crowding-out effect is larger.

Figure 6.5 Crowding out effect

6.2.2. Changes in Taxes

When the government cuts personal income taxes, for instance, it increases households’ take-
home pay. Households will save some of this additional income, but they will also spend
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some of it on consumer goods. Because it increases consumer spending, the tax cut shifts the
aggregate-demand curve to the right. Similarly, a tax increase depresses consumer spending
and shifts the aggregate-demand curve to the left.

The size of the shift in aggregate demand resulting from a tax change is also affected by the
multiplier and crowding-out effects. When the government cuts taxes and stimulates
consumer spending, earnings and profits rise, which further stimulates consumer spending.
This is the multiplier effect. At the same time, higher income leads to higher money demand,
which tends to raise interest rates. Higher interest rates make borrowing more costly, which
reduces investment spending. This is the crowding-out effect. Depending on the size of the
multiplier and crowding-out effects, the shift in aggregate demand could be larger or smaller
than the tax change that causes it.
In addition to the multiplier and crowding-out effects, there is another important determinant
of the size of the shift in aggregate demand that results from a tax change: households’
perceptions about whether the tax change is permanent or temporary. For example, suppose
that the government announces a tax cut of Birr 1,000 per household. In deciding how much
of this Birr 1,000 to spend, households must ask themselves how long this extra income will
last. If households expect the tax cut to be permanent, they will view it as adding
substantially to their financial resources and, therefore, increase their spending by a large
amount. In this case, the tax cut will have a large impact on aggregate demand. By contrast,
if households expect the tax change to be temporary, they will view it as adding only slightly
to their financial resources and, therefore, will increase their spending by only a small
amount. In this case, the tax cut will have a small impact on aggregate demand.

6.3. Stabilization Policy

Fluctuations in the economy as a whole come from changes in aggregate supply or aggregate demand.
Economists call exogenous changes/shifts in these curves shocks to the economy. These shocks
disrupt economic well-being by pushing output and employment away from their natural rates. One
goal of the model of aggregate supply and aggregate demand is to show how shocks cause economic
fluctuations.
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Another goal of the model is to evaluate how macroeconomic policy can respond to these shocks.
Economists use the term stabilization policy to refer to policy actions aimed at reducing the severity
of short-run economic fluctuations. Because output and employment fluctuate around their long-run
natural rates, stabilization policy dampens the business cycle by keeping output and employment as
close to their natural rates as possible.

Some economists, such as William McChesney Martin, view the economy as inherently unstable.
They argue that the economy experiences frequent shocks to aggregate demand and aggregate supply.
Unless policymakers use monetary and fiscal policy to stabilize the economy, these shocks will lead
to unnecessary and inefficient fluctuations in output, unemployment, and inflation. According to the
popular saying, macroeconomic policy should “lean against the wind,’’ stimulating the economy
when it is depressed and slowing the economy when it is overheated.

Other economists, such as Milton Friedman, view the economy as naturally stable. They blame bad
economic policies for the large and inefficient fluctuations we have sometimes experienced. They
argue that economic policy should not try to “fine-tune’’ the economy. Instead, economic
policymakers should admit their limited abilities and be satisfied if they do no harm. This debate has
persisted for decades, with numerous protagonists advancing various arguments for their positions.
The fundamental issue is how policymakers should use the theory of short-run economic fluctuations.
In this section we ask two questions that arise in this debate. First, should monetary and fiscal policy
take an active role in trying to stabilize the economy, or should policy remain passive? Second,
should policymakers be free to use their discretion in responding to changing economic conditions, or
should they be committed to following a fixed policy rule?

6.3.1. Active Policy versus Passive Policy

The monetary and fiscal policy can affect the economy’s aggregate demand for goods and services.
These theoretical insights raise some important policy questions: Should policy makers use these
instruments to control aggregate demand and stabilize the economy? If so, when? If not, why not?
Therefore, in this section, let’s consider some of the arguments on using active or passive policy and
examine how stabilization policy works and what practical problems arise in its use.

6.3.1.1. Active Stabilization Policy

When the government cuts spending, aggregate demand will fall. This will depress production and
employment in the short run. If the Central Bank wants to prevent this adverse effect of the fiscal
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policy, it can act to expand aggregate demand by increasing the money supply. A monetary expansion
would reduce interest rates, stimulate investment spending, and expand aggregate demand. If
monetary policy responds appropriately, the combined changes in monetary and fiscal policy could
leave the aggregate demand for goods and services unaffected.

This response of monetary policy to the change in fiscal policy is an example of a more general
phenomenon: the use of policy instruments to stabilize aggregate demand and, as a result, production
and employment.

Keynes emphasized the key role of aggregate demand in explaining short-run economic fluctuations.
Keynes claimed that the government should actively stimulate aggregate demand when aggregate
demand appeared insufficient to maintain production at its full-employment level.

Keynes (and his many followers) argued that aggregate demand fluctuates because of largely
irrational waves of pessimism and optimism. When pessimism reigns, households reduce
consumption spending, and firms reduce investment spending. The result is reduced aggregate
demand, lower production, and higher unemployment. Conversely, when optimism reigns,
households and firms increase spending. The result is higher aggregate demand, higher production,
and inflationary pressure. Notice that these changes in attitude are, to some extent, self-fulfilling.

In principle, the government can adjust its monetary and fiscal policy in response to these waves of
optimism and pessimism and, thereby, stabilize the economy. For example, when people are
excessively pessimistic, the Fed can expand the money supply to lower interest rates and expand
aggregate demand. When they are excessively optimistic, it can contract the money supply to raise
interest rates and dampen aggregate demand.

6.3.1.2. Passive Policy

Some economists argue that the government should avoid active use of monetary and fiscal policy to
try to stabilize the economy. They claim that these policy instruments should be set to achieve long-
run goals, such as rapid economic growth and low inflation, and that the economy should be left to
deal with short-run fluctuations on its own. Although these economists may admit that monetary and
fiscal policy can stabilize the economy in theory, they doubt whether it can do so in practice.

The primary argument against active monetary and fiscal policy is that these policies affect the
economy with a substantial lag. Economists distinguish between two lags in the conduct of
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stabilization policy: the inside lag and the outside lag. The inside lag is the time between a shock to
the economy and the policy action responding to that shock. This lag arises because it takes time for
policymakers first to recognize that a shock has occurred and then to put appropriate policies into
effect. The inside lag, hence, is divided into recognition, decision, and action lags. The recognition
lag is the period that elapses between the time a disturbance occurs and the time the policy makers
recognize that action is required. The lag might be somewhat shorter when the required policy is
expansionary and somewhat longer when restrictive policy is required. The decision lag is the delay
between the recognition of the need for action and the policy decision. Further, the action lag is the
lag between the policy decision and its implementation. The inside lag is a discrete lag-so many
months-from recognition to decision and implementation.

The outside lag is the time between a policy action and its influence on the economy. This lag arises
because policies do not immediately influence spending, income, and employment. The outside lag is
generally a distributed lag: once the policy action has been taken, its effects on the economy are
spread over time. There may be a small immediate effect of a policy action, but other effects occur
later.

Monetary policy has a much shorter inside lag than fiscal policy, because a central bank can decide
on and implement a policy change in less than a day, but monetary policy has a substantial outside
lag. But many firms make investment plans far in advance. Thus, most economists believe that it
takes at least six months for changes in monetary policy to have much effect on output and
employment. Moreover, once these effects occur, they can last for several years. Critics of
stabilization policy argue that because of this lag, the Fed should not try to fine-tune the economy.
They claim that the Fed often reacts too late to changing economic conditions and, as a result, ends up
being a cause of rather than a cure for economic fluctuations. These critics advocate a passive
monetary policy, such as slow and steady growth in the money supply.

Unlike the lag in monetary policy, the lag in fiscal policy is largely attributable to the political
process. A long inside lag is a central problem with using fiscal policy for economic stabilization.
This is especially true in the United States, where changes in spending or taxes require the approval
of the president and both houses of Congress. The slow and cumbersome legislative process often
leads to delays, which make fiscal policy an imprecise tool for stabilizing the economy. Completing
this process can take months and, in some cases, years. By the time the change in fiscal policy is
passed and ready to implement, the condition of the economy may well have changed. This inside lag
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is shorter in countries with parliamentary systems, such as the United Kingdom, because there the
party in power can often enact policy changes more rapidly.

These lags in monetary and fiscal policy are a problem in part because economic forecasting is so
imprecise. If forecasters could accurately predict the condition of the economy a year in advance,
then monetary and fiscal policy makers could look ahead when making policy decisions. In practice,
however, major recessions and depressions arrive without much advance warning. The best
policymakers can do at any time is to respond to economic changes as they occur.

6.3.1.3. Automatic Stabilizers

All economists-both advocates and critics of stabilization policy-agree that the lags in implementation
render policy less useful as a tool for short-run stabilization. The economy would be more stable,
therefore, if policymakers could find a way to avoid some of these lags. In fact, they have. Some
policies, called automatic stabilizers, are designed to reduce the lags associated with stabilization
policy. Automatic stabilizers are policies that stimulate or depress the economy when necessary
without any deliberate policy change.

The most important automatic stabilizer is the tax system. When the economy goes into a recession,
the amount of taxes collected by the government falls automatically because almost all taxes are
closely tied to economic activity. The personal income tax depends on households’ incomes, the
payroll tax depends on workers’ earnings, and the corporate income tax depends on firms’ profits.
Because incomes, earnings, and profits all fall in a recession, the government’s tax revenue falls as
well. This automatic tax cut stimulates aggregate demand and, thereby, reduces the magnitude of
economic fluctuations.

Government spending also acts as an automatic stabilizer. In particular, when the economy goes into
a recession and workers are laid off; more people apply for unemployment insurance benefits, welfare
benefits, and other forms of income support. This automatic increase in government spending
stimulates aggregate demand at exactly the time when aggregate demand is insufficient to maintain
full employment.

6.3.2. Policy by Rule versus Policy by Discretion

A second topic of debate among economists is whether economic policy should be conducted by rule
or by discretion. Policy is conducted by rule if policymakers announce in advance how policy will
respond to various situations and commit themselves to following through on this announcement.
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Policy is conducted by discretion if policymakers are free to size up events as they occur and choose
whatever policy seems appropriate at the time.

The debate over rules versus discretion is distinct from the debate over passive versus active policy.
Policy can be conducted by rule and yet be either passive or active. For example, a passive policy rule
might specify steady growth in the money supply of 3 percent per year. An active policy rule might
specify that: Money Growth =3% + (Unemployment Rate -6%)

Under this rule, the money supply grows at 3 percent if the unemployment rate is 6 percent, but for
every percentage point by which the unemployment rate exceeds 6 percent, money growth increases
by an extra percentage point. This rule tries to stabilize the economy by raising money growth when
the economy is in a recession. Why policy might be improved by a commitment to a policy rule?

Distrust of Policymakers and the Political Process

Some economists believe that economic policy is too important to be left to the discretion of
policymakers. Although this view is more political than economic, evaluating it is central to how we
judge the role of economic policy. If politicians are incompetent or opportunistic, then we may not
want to give them the discretion to use the powerful tools of monetary and fiscal policy.

Incompetence in economic policy arises for several reasons. Some economists view the political
process as erratic, perhaps because it reflects the shifting power of special interest groups. In addition,
macroeconomics is complicated, and politicians often do not have sufficient knowledge of it to make
informed judgments. This ignorance allows charlatans to propose incorrect but superficially appealing
solutions to complex problems. The political process often cannot weed out the advice of charlatans
from that of competent economists.

Opportunism in economic policy arises when the objectives of policymakers conflict with the well-
being of the public. Some economists fear that politicians use macroeconomic policy to further their
own electoral ends. If citizens vote on the basis of economic conditions prevailing at the time of the
election, then politicians have an incentive to pursue policies that will make the economy look good
during election years. A president might cause a recession soon after coming into office to lower
inflation and then stimulate the economy as the next election approaches to lower unemployment; this
would ensure that both inflation and unemployment are low on Election Day. Manipulation of the
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economy for electoral gain, called the political business cycle, has been the subject of extensive
research by economists and political scientists.

Distrust of the political process leads some economists to advocate placing economic policy outside
the realm of politics. Some have proposed constitutional amendments, such as a balanced-budget
amendment, that would tie the hands of legislators and insulate the economy from both incompetence
and opportunism.

The Time Inconsistency of Discretionary Policy

If we assume that we can trust our policymakers, discretion at first glance appears superior to a fixed
policy rule. Discretionary policy is, by its nature, flexible. As long as policymakers are intelligent and
benevolent, there might appear to be little reason to deny them flexibility in responding to changing
conditions.

Yet a case for rules over discretion arises from the problem of time inconsistency of policy. In some
situations policymakers may want to announce in advance the policy they will follow in order to
influence the expectations of private decision makers. But later, after the private decision makers
have acted on the basis of their expectations, these policymakers may be tempted to renege on their
announcement. Understanding that policymakers may be inconsistent over time, private decision
makers are led to distrust policy announcements. In this situation, to make their announcements
credible, policymakers may want to make a commitment to a fixed policy rule.

Time inconsistency is illustrated most simply in a political rather than an economic example-
specifically, public policy about negotiating with terrorists over the release of hostages. The
announced policy of many nations is that they will not negotiate over hostages. Such an
announcement is intended to deter terrorists: if there is nothing to be gained from kidnapping
hostages, rational terrorists won’t kidnap any. In other words, the purpose of the announcement is to
influence the expectations of terrorists and thereby their behavior.

But, in fact, unless the policymakers are credibly committed to the policy, the announcement has little
effect. Terrorists know that once hostages are taken, policymakers face an overwhelming temptation
to make some concession to obtain the hostages’ release. The only way to deter rational terrorists is to
take away the discretion of policymakers and commit them to a rule of never negotiating. If
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policymakers were truly unable to make concessions, the incentive for terrorists to take hostages
would be largely eliminated.

The same problem arises less dramatically in the conduct of monetary policy. Consider the dilemma
of a central bank that cares about both inflation and unemployment. According to the Phillips curve,
the tradeoff between inflation and unemployment depends on expected inflation. The Central Bank
would prefer everyone to expect low inflation so that it will face a favorable tradeoff. To reduce
expected inflation, the Central Bank might announce that low inflation is the paramount goal of
monetary policy.

But an announcement of a policy of low inflation is by itself not credible. Once households and firms
have formed their expectations of inflation and set wages and prices accordingly, the Central Bank
has an incentive to renege on its announcement and implement expansionary monetary policy to
reduce unemployment. People understand the Central Bank’s incentive to renege and therefore do not
believe the announcement in the first place. Just as a president facing a hostage crisis is sorely
tempted to negotiate their release, a Central Bank with discretion is sorely tempted to inflate in order
to reduce unemployment. And just as terrorists discount announced policies of never negotiating,
households and firms discount announced policies of low inflation.

The surprising outcome of this analysis is that policymakers can sometimes better achieve their goals
by having their discretion taken away from them. In the case of rational terrorists, fewer hostages will
be taken and killed if policymakers are committed to following the seemingly harsh rule of refusing
to negotiate for hostages’ freedom. In the case of monetary policy, there will be lower inflation
without higher unemployment if the Central Bank is committed to a policy of zero inflation.

The time inconsistency of policy arises in many other contexts. Here are some examples:

 To encourage investment, the government announces that it will not tax income from
capital. But after factories have been built, the government is tempted to renege on its
promise to raise more tax revenue from them.
 To encourage research, the government announces that it will give a temporary
monopoly to companies that discover new drugs. But after a drug has been
discovered, the government is tempted to revoke the patent or to regulate the price to
make the drug more affordable.
 Agricultural Economics Program: Macroeconomics-I

 To encourage good behavior, a parent announces that he or she will punish a child
whenever the child breaks a rule. But after the child has misbehaved, the parent is
tempted to forgive the transgression, because punishment is unpleasant for the parent
as well as for the child.
 To encourage you to work hard, your professor announces that this course will end
with an exam. But after you have studied and learned all the material, the professor is
tempted to cancel the exam so that he or she won’t have to grade it.

In each case, rational agents understand the incentive for the policymaker to renege, and this
expectation affects their behavior. And in each case, the solution is to take away the policymaker’s
discretion with a credible commitment to a fixed policy rule.