Arsi University

College of Business and Economics Department

of Economics
Lecture note on Macroeconomics

By Dechu T (MSc) October, 2024

 Chapter One: The State of Macroeconomics –
Introduction

Objective:
By the end of this unit you will be able to know:

 The difference between macro and micro economics

 Different school of thought in macro economics

 Measurement of macro-economic variables

 Relations ships between macro-economic variables

1.1 What macroeconomics is about?
 Economics is a subject which deals with how human beings allocate the
scarce (limited) resources in order to fulfill their unlimited wants.

 Economics is divided in to two major branches: Microeconomics and

Macroeconomics.

 Microeconomics is the study deals with economic behavior of an

individual decision-making unit (consumer and producer) or an economic
variable (Price and quantity of a good).
1.1 What macroeconomics is about….
 On the other hand when an economic study deals with economic aggregates
like national income, employment, aggregate consumption, savings and
investment, general price level, and balance- of- payments position, etc, it is
called Macro-economics.

 Macroeconomics focuses on the economic behavior and policies that affect

consumption and investment, trade balance, the determinants of changes in
wages and prices, monetary and fiscal policies, the money stock,
government budget, interest rate, and national debt.
1.2. Basic Concepts and Methods of Macroeconomic Analysis

 - What Are Key Macroeconomic Variables?

1-Economic Output/Income

 Economic output or income is measured in terms of the gross domestic product

(GDP), which is basically the combined earnings from a year's worth of goods
and services produced by a country.

 Analysts measure GDP income by adding consumer spending, private

investment, and government spending and net exports.

1.2. Basic Concepts and Methods of Macroeconomic Analysis…

2-Unemployment Rate

 The unemployment rate is the percentage of the working population that is

not currently employed.

 The percentage only takes into account the number of people who are actively
seeking employment.

 Those who are unemployed and not seeking jobs are "voluntarily"
unemployed. Many governments set benchmark unemployment rates since
1.2. Basic Concepts and Methods of Macroeconomic Analysis…

3-Inflation Rate

 The inflation rate is measure changes in the average price level based on a
price index. The most commonly known index is the consumer price index.

 A high or increasing CPI indicates the existence of inflation. Higher prices

tend to reduce overall consumer spending, which in turn leads to a decrease in
GDP.

 While inflation itself is not negative, rapidly increasing rates of inflation

1.2. Basic Concepts and Methods of Macroeconomic Analysis…

4-Interest Rate

 Key macroeconomic variables include interest rates, which are a reflection of

the cost of borrowing.

 In terms of macroeconomic reporting, the interest rate is the nominal rate.

Nominal rates are not adjusted for inflation.

 Lower interest rates typically occur when there is a need to stimulate

consumer spending and investment.
1.3. Macroeconomic Goals and Instruments

 Every country has macroeconomic goals that it wants to achieve, these goals
or objectives are key to ensuring long-term stable economic success.

 These are the five main macroeconomic goals that most central banks aim to
achieve.

 For example, the Ethiopian national Bank targets inflation and

unemployment rate at approximately less than 10%.
 1. Non-Inflationary Growth

 In other words, this is stable and sustainable economic growth and

development that is “real” (non-inflationary) over the long-term.

 Economic growth in an economy is an outward shift in its Production

Possibility Curve (PPC).

 Another way to define growth is the increase in a country’s total output or

Gross Domestic Product (GDP).

 The objective of the central bank and government would be an increase in

 2. Stable price

 Inflation is the sustained increase of the general price level.

 The rate of inflation is the change in inflation over a period.

 Central banks would like to keep the growth of the rate at which prices
increase at low rates.

 As inflation rises, every dollar you own buys a smaller percentage of a good
or service.
 3. Low Unemployment or Full Employment

 Full employment occurs when the labor force (people who are actively
seeking jobs or are already employed) is fully employed in productive work.

 A person is considered to be unemployed if he doesn’t currently doesn’t have

a job and is actively searching for one.

 A lower rate of unemployment means that productivity in the economy is

higher.

 This objective simply means that as many people who want to be employed
 4. Equilibrium in Balance of Payments

 Equilibrium in Balance of Payments means that a country’s exports or imports

should not be much larger than its imports or exports.

 Having a large balance of payments deficit or surplus is not beneficial for the
economy.

5. Fair Distribution of Income

 A fair or equitable distribution of income means that the gap between the rich
and the poor is not too large. Fair or equitable doesn’t mean equal, but fair is a
 1.4 The State of Macroeconomics: Evolution and Recent
Developments
-Let us now see different school of thought in macroeconomics:
 Pre classical (Mercantilist) before 1776
 Classical 1776 – 1870. In this period the distinction between micro and
macro was not clear. The ruling principle was the invisible hand coined by
Alfred Marshall.
 Neo classical 1870 – 1936. Basically the neoclassical school is not different
from the classical school. The main distinction is the tool of analysis, such as
the marginal analysis.
 1.4 The State of Macroeconomics: Evolution and Recent
Developments…..
Keynesian 1936 – 1970s. The main thesis of the Keynesian stream is that the
economy is subjected to failure so that it may not achieve full employment level.
Thus, government intervention is inevitable.
 1970s – Present. There is no dominant school of thought of macroeconomics.
 Mercantilist
 During 17th and 18th centuries Britain becomes a prosperous nation due to
growth of over sea trade and commerce.

 This led mercantilist to develop an economic doctrine, export surplus (balance

of trade surplus) add to wealth of nation.

 As a result they becomes the advocator and support of government policies

that could secure and maintain balance of trade surplus.

 When there is balance of trade deficit, a country pay or spending more on

 Mercantilist
 That is more money flow abroad and boosts foreign income through
increasing effective demand and reduces effective demand for domestic
output.

 Trade surplus on the other hand increases effective demand for domestic
output and then increase output production.

 This implies a country should keep balance of trade surplus to expand its
economy.
 Classical macroeconomics(1776-1936)
 Classical economics is body of thought that exists prior to the publication of
Keynes’s (1936) General theory.

 It is a macroeconomics idea of 1776-1936 periods. During this time, there

was no unified or formalized theory of aggregate employment and origin of
business cycle.

 According to classical model, all markets including labour market always

clear (the economy always operates at equilibrium and at equilibrium all
resources are fully employed).
 Classical macroeconomics(1776-1936)…
 They emphasize market mechanisms to maintain full employment
equilibrium.

 Classical economists are aware of the fact that capitalist economy could
deviate from its equilibrium level of output and employment.

 Such disturbances however would be temporary and very short lived. Market
mechanism operate quickly and efficiently to restore full employment level of
equilibrium..
 Classical macroeconomics(1776-1936)…
 For classical economists no government intervention is needed in the form of
stabilization policies, it is neither desirable nor necessary to achieve full
employment.

 Such policies create havoc (disturbance) rather than harmony to the system.

 In their view, the government should confine its activities to ensure

environment in which market force act to achieve market-clearing outcomes
 Classical macroeconomics(1776-1936)…
 Classical full employment notion based on the assumption of flexibility of
prices (wages, interest rate and output prices) i.e., prices are determined by
the supply and demand forces in the market.

 If there is disequilibrium condition in the market since prices are assumed to

be flexible, demand and supply forces adjusts employment level to full
employment position.

 According to the classical macroeconomic system, a downward shift of

aggregate (effective)demand will bring into play corrective forces.
 Classical macroeconomics(1776-1936)…
 falling prices so that the final impact of a reduction in aggregate demand will
be a lower price level with real output and employment quickly returning to
their full employment levels.

 In the classical world self-correcting market forces, operating via the price
mechanism, restore equilibrium without the help of government intervention.
 Classical economists reach such an optimistic conclusion based on the
following assumptions.
1. All economic agents (firms and households) are rational and aim to
Maximize their profits or utility
2. All markets are perfectly competitive so that agents decide how much to buy
and sell on the basis of a given set of prices which are perfectly flexible
3. All agents have perfect knowledge of market conditions and prices before
engaging in trade.
4. Trade only takes places when market-clearing prices have been
established in all markets.
5. Agents have stable expectation of government intervention.
 Keynesian School 1936 – 1970s

 Under classical school we have seen how full employment of resources are
determined under flexible price assumption and increase in general price
using Quantity theory of money.

 However, the classical market clearing (full employment) cannot handle the
1930’s great depression.

 From 1929 to 1932 there was collapse of industrial production and GDP of
major capitalist economies.
 Keynesian School (1936 – 1970s)…….

 Unemployment rises at alarming rate, commodity, and wholesale price

collapse.

 The market mechanism of classical could not restore full employment of

output.

 Reaction to the empirical observation of persistent mass unemployment as

well as decline in output and price level during the great depression gives rise
to the birth of Keynesian school.
 Keynesian School (1936 – 1970s)…….

 In the General theory Keynes discover that the national income of a given
economy determined by the amount of its employment which is determined
by the principle of effective demand.

 In other word according to Keynes’s (1936) theory, employment depends on

the economy wide demand for labor which in turn depends on effective
demand (the economy’s capacity to spend on goods and services).

 This effective demand consists of consumption and investment

expenditure.
 Keynesian School (1936 – 1970s)…….

 For Keynesians therefore, the Great depression of 1930’s was the result of
lack of effective aggregate demand compared to output supplied during the
time.

 In general theory of Keynes interest rate is purely a monetary phenomenon

determined by the liquidity preference (demand for money) of the public in
conjunction with the supply of money which is determined by monetary
authorities.
 Keynesian School (1936 – 1970s)…….

 For Keynesians, rise in the general price (inflation) is the result of increase in
nominal wage.

 An increase in wage causes an increase in aggregate demand. These will

cause excess demand over the amount of output supplied resulting in
inflationary condition.
 2. The New Classical School

 The new classical macroeconomics remained influential in the 1980s.

 This school of macroeconomics shares many policy views with Friedman.

 It sees the world as one in which individuals act rationally in their self-
interest in markets that adjust rapidly to changing conditions.

 The government, it is claimed, is likely only to make things worse by

intervening.

 The central working assumptions of the new classical school are three:
 2. The New Classical School…..

 Economic agents maximize. Households and firms make optimal

decisions given all available information in reaching decisions and that those
decisions are the best possible in the circumstances in which they find
themselves.

 Expectations are rational. This means they are statistically the best
predictions of 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 that it is not possible to fool most
 2. The New Classical School…..

Markets clear

 There is no reason why firms or workers would not adjust wages or prices if
that would make them better off.

 Accordingly prices and wages adjust in order to equate supply and demand; in
other words, market clear.

 For instance, any unemployed person who really wants a job will offer to cut
this or her wage until the wage is low enough to attract an offer from some
 3. The New Keynesians

 The new Keynesians argue that markets sometimes do not clear even when
individuals are looking out for their own interests.

 Both information problems and costs of changing prices lead to some price
rigidities, which help 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 windup with a poorer quality labour. Thus
they will be reluctant to cut wages.
 3. The New Keynesians

 All school of macroeconomics agree on the purpose of macro policy but they
disagree on how to achieve the macro objectives of higher output, lower level
of unemployment and inflation rate