UNIT ONE

INTRODUCTION
Why have some countries experienced rapid growth in incomes over the past century while others stay
stuck in poverty? Why do some countries have high rates of inflation while others maintain stable
price? Why all countries do experiences recession and depression- recurrent periods of falling incomes
and rising unemployment- and how can government policy reduce the frequency and severity of these
affair? These and other questions can be answered if we have the knowledge of macroeconomics.
1.1 Definition for Economics
Economics has no single definition; different scholars give different definition of economics let see
some of them;
Adam Smith defines Economics as “an inquiry in to the nature and cause of the wealth of nation.”
Alfred Marshall defines “Economics is the study of mankind in the ordinary business of life; it
examines that part of individual and social action which is most closely connected with the attainment
and with the use of the material requisites of well-being”
Paul A. Samuelson “ Economics is the study of how men and society choose, with or with out the use
of money, to employ the scarce productive resources which could have alternative uses, to produce
various commodities over time and distribute them for consumption now and in the future amongst
various people and groups of society”

But all of them have similar message about economics i.e., Economics is a subject which deals with
how human beings use the scarce (limited) resources in order to fulfill their unlimited wants.

Branches of Economics

Economics is divided in to two major branches: Microeconomics and Macroeconomics. These terms
connote the two different kinds of economics issues and economics studies, depending on whether a
part or the whole of economic system is covered under economic investigation.

When an economic study deals with economic behavior of an individual decision-making unit
(consumer and producer) or an economic variable (Price and quantity of a good) it is
Microeconomics. And, 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 is a policy-oriented part of economics. The subject matter of macro-

economics includes factors that determines both the level of macro economic variables such as:

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 total out put, aggregate price level, employment and unemployment, interest rates, wage rates
and foreign exchange rates and how the variables are change over time.
 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, the rate
of inflation and unemployment, the balance of payments, and exchange rates.
 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.
 In macroeconomics, we 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 prescriptions.
1.2 Schools of thoughts in Macroeconomics
Let us now see different school of thought in macroeconomics:
 Classical 1776 – 1870. In this period the distinction between micro and macro wasn‟t 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.
 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.
Macro-economists (school of thought in macro-economics) argue with regard to the government
intervention in the economy; parts of them believe the need for government involvement to the
economy while parts of them do not.
There have been two main intellectual traditions in macroeconomics. One school of thought believes
that government intervention can significantly improve the operation of the economy; the other
believes that markets work best if left to themselves. In the 1960s, the debate on these questions
involved Keynesians, including Franco Modigliani and James Tobin, on one side, and monetarists, led
by Milton Friedman, on the other. In the 1970s, the debate on much the same issues brought to the fore
a new group- the new classical macroeconomists, who by and large replaced the monetarists in
keeping up the argument against using active government policies to try to improve economic
performance. On the other side are the new Keynesians; they may not share many of the detailed belief
of Keynesians three or four decades ago, except the belief that government policy can help the
economy perform better.
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1. Keynesian’s View of the Economy
In a very simplified form we can present Keynes‟s theory of recessions. Imagine an economy that is
chugging along happily at full employment. Alongside the smoothly functioning „real‟ economy there
will be a smooth financial flows, as firms earn money from their sales, pay out their earnings in wages
and dividends, and household spend these receipts on new purchases from the firms.

But now suppose that for some reason each household and firm in this economy decides that it would
like to hold a little more cash. Keynes argued, in particular, this happens when businessmen lose
confidence and start to think of potential investments as risky, leading them to hesitate and accumulate
cash instead; today we might add the problem of nervous households who worry about their jobs and
cut back on purchases of big-ticket consumer items. 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.

But as Keynes pointed out, what works for an individual does not work for the economy as a whole,
because the amount of cash in the economy is fixed. An individual can increase her cash holding by
spending less, but she does so only by taking away cash that other people had been holding.
Obviously, not everybody can do this at the same time.
The question is what will happen when everyone tries to accumulate cash simultaneously? The answer
is that income falls along with spending. We try to accumulate cash by reducing my purchases from
you, and you try to accumulate cash by reducing your purchases from us; 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; and so on. Looking at the economy as a
whole, you will see factories closing, workers laid off, stores empty, as firms and households
throughout the economy cut back on spending in a collectively hopeless effort to accumulate more
cash. The process only reaches a limit when incomes are so wasted that the demand for cash falls to
equal the available supply.

Keynes and Economic Policy

For Keynes to do about recessions, the first and most obvious thing to do is to make it possible for
people to satisfy their demand for more cash without cutting their spending, preventing the downward
spiral of shrinking spending and shrinking income. The way to do this is simple to print more money,
and somehow get it into circulation.

So the usual and basic Keynesian answer to recessions is a monetary expansion. But Keynes worried
that even this might sometimes not be enough, particularly if a recession had been allowed to get out
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of hand and become a true depression. Once the economy is deeply depressed, households and
especially firms may be unwilling to increase spending 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 getting the economy moving again.

2. Monetarism
Monetarism, as advocates of free market, started challenging Keynes‟s theory in the 1970s. Milton
Friedman, the founder of monetarism, attacked Keynes idea of smoothing business cycle on the
ground that such active policy is not only unnecessary but actually harmful, worsening the very
economic instability that it is supposed to correct, and should be replaced by simple, mechanical
monetary rules. This is the doctrine that came to be known as “monetarism”.

Friedman began with a factual claim: 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. Rather, they occurred because of a fall
in the quantity of money in circulation.
Policy Rule under Monetarism
If economic slumps begin when people suddenly 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 slumps are always created by a fall in the quantity of money, then the monetary authority need
not monitor the economy; it need only make sure that the quantity of money doesn‟t slump. In other
words, a straightforward rule- “Keep the money supply stable”- is good enough, so that there is no
need for a “flexible” policy of the form, “Pump money in when your economic advisers think a
recession is coming up.”

3. 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:

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  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 of the people all the time or even most of the time.
 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.
4. The New Keynesians

The new classical group remains highly influential in today‟s macroeconomics. But a new generation
of scholars, the new Keynesians, mostly trained in the Keynesian tradition but moving beyond it,
emerged in the 1980s. 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. 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.
To sum up, 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.
1.3. Basic Concepts and Methods of Macroeconomic Analysis

The major macro-economic variables are: Output, unemployment, and inflation.

 Output: production of goods and services or the national income of the country.
 Unemployment: unemployment rate is the percent of the labour force that is not employed.
 Inflation: Is the general increase in the price level.

1.3.1 Measuring the value of economic activity

The national income measures the economic activity of a country. What is national income (Output)?
It includes:

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  The national income of a country in a year is the value, expressed in monetary terms of the net
contribution of the factors of production through the production units in the country and abroad
in the year.
 It is thus, the monetary expression of the current flow of net final good and services resulting
from the production activities of the normal residents of a country during the year.
 Concretely, national income is the net domestic product (or net domestic income) of a country
plus net income from abroad.
 If all the national income is in fact consumed the n the national income consists of consumer‟s
goods and services only. If only a part of the national income is consumed in the year then the
part that remains accumulate as a stock of goods or as capital stocks. National income then
would consist of consumer‟s goods and services plus increase in stocks of goods, i.e., of
consumption plus investment. Net investment includes increase in the stocks of fixed capital
goods and working of capital goods.
 If however, people consume more than the national income then it would probably mean that
the stock of capital goods has been eaten in to or that the people have received gifts from
abroad. Gifts from abroad refer to current transfer from abroad of consumer goods and
services.
 The national income is, thus the goods and services available to the normal residents in a
country, as a result of their production efforts in the year, to consume or to invest.

The significance of national income is that it is the value of the goods and services, which can be used
up in consumption by the residents of the country. It represents that part of the flow of goods and
services generated by the production process, which is produced in order to satisfy the wants of the
people.

In simple words, national income is the aggregate factor income (i.e., earning of labour and capital,
etc), which arises from the current production of goods and services by the nation‟s economy. The
nation‟s economy refers to the factor of production (labour and capital) supplied by the normal
residents of the national territory.

Now it is clear that the concept of national income has three types of interpretations:
 National income represents a receipt total,
 National income represents an expenditure total, and
 National income represents a total value of production.

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This three-fold interpretation takes place because of the fact that every expenditure is at the same time
a receipt, and if goods or services bought are valued at their sales prices, we have a three-fold identity
that the value received equals the value paid, equal the value of goods and services given in exchange.

A description of the above definition brings out three points. Firstly, national income refers to the
income of a country, say, Ethiopia. Secondly, its measurement refers to a specified period of time, say,
a year. Thirdly, national income includes all types of goods and services, which have an exchange
value, counting each one of them only once.

When we calculate the national income of a nation, we should remember that no commodity or service
should be counted twice; otherwise the results will not be accurate. For example, if raw cotton has
been evaluated in agricultural production, it should not be included while calculating the total value of
cotton textiles. In the same manner, the value of raw cotton shall have to be kept out while calculating
the total value of readymade garments, such as, bush-shirts and trousers made out of cotton textiles.

Generally, two statistical methods are used to avoid double counting or multiple counting in the
calculation of national income: Final products method, and Value-added method
Accord to the final products method:
 We add up the value of final products only. We first take the total value of the final consumer
goods produced in the country during the year.
 To this, we add the total value of durable producer goods, such as, machinery and plants, etc.
 This will provide us the aggregate value of all the final goods produced in the country during the
year.
 Collective and government services (evaluated at cost price) are also to be added to this aggregate
value of the final goods in order to arrive at the total product of the nation concerned.
According to the value-added method:
 We do not take in to account the value of the final goods and services produced in the country.
 On the contrary, we go on adding the values created at each stage in the manufacturing of a
commodity.
 Then all such values accruing at all processes in the manufacturing of all commodities are
added up together to arrive at the national income of the country.
Factors determining national income
There are a number of influences that determine the size of the national income in a country. It is on
account of these influences that one country may have a larger national income than another.
Following are the three main influences:
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1. Quantity and Quality Factors of production. The quantity and quality of a country‟s stocks
of the factors of production is one of the most important influences on its national income. The
quantity and quality of land, the climate, the rainfall etc., determine the quantity and quality of
agricultural production, and hence, the size of national income. The quantity of a labour has doubled
influences since labour is at the same time both a factor of production as well as the consumer of
what is produced. The quality of labour, depending upon inborn intelligence, education and training,
also influences the volume of industrial production. Capital may comprise simple, primitive tools or
the most modern type of industrial equipment. The quantity and quality of capital is one of the
greatest influences on total out put. Likewise, the quantity and quality of entrepreneurial ability is
also an important element to consider with in the determination of the size of national income of a
country.
2. The state of technical know-how: Another influence on output and national income is the
state of technical know-how in the country. A country with a poor technical knowledge cannot have a
large-sized national income, because it will not be in a position to make the best possible use of its
resources.
3. Political stability: Political stability is an essential prerequisite for maintaining production at
the highest level.
National Income Accounts
National income accounts are the instruments that help us to measure the national income of the
country. The various types of national income accounts helps us to measure the level of production in
the economy at some point of time, and explain the immediate causes of the level of performance. Let
us study the seven totals relating to national income accounts. They are:
1. Gross national product (GNP)
2. Net national product (NNP)
3. National income (NI) or net national income at factor cost (NNI at factor cost)
4. Net domestic product at factor cost (NDP at factor cost)
5. Personal income (PI)
6. Disposable personal income (DPI); and Real income (RI)
Thus instead of giving a single comprehensive estimate of national income, the economists use
different aggregates. The reasons for this are:
 There is disagreement among the economists over what should and what should not be counted
as national income. Instead of passing a judgement on this controversy, the statistics
department of the government gives some totals leaving it to each user to select the one he
prefers.
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  Another reason for this is that a certain total may be most useful for one purpose and a
different total for another purpose.

1. Gross National product (GNP)

 The gross national product is the basic social accounting measure. It is the most frequently
used national income aggregate in economic discussion.
 It is the nation‟s total production of goods and services (usually for one year) evaluated in
terms of the market prices of goods and services produced.
 It includes all the economic productions in the economy during one year.
 Strictly speaking, then the GNP is the money value of the total national production for any
given period.
Gross Domestic product (GDP)
Here we have also another national income accounts what we call Gross domestic product (GDP). The
single most important measure of overall economic performance is Gross Domestic Product (GDP).
The GDP is an attempt to summarize all economic activity over a period of time in terms of a single
number; it is a measure of the economy‟s total output and of total income. In other words GDP is the
value of all final goods and services produced in the economy in a given time period (note that GDP is
a flow not a stock).
GDP and GNP
There is a distinction between GDP and gross national product (GNP).
 GNP is the value of final goods and services produced by domestically owned factors of
production within a given period.
 While GDP is the value of final goods and services produced with in the country‟s territory with in
a given period, the factors of production used might not be domestically owned.
 The difference between GDP and GNP corresponds to the net income earned by foreigners. When
GDP exceeds GNP residents of a given country are earning less abroad than foreigners are earning
in that country. In Ethiopia, GDP has exceeded GNP since 1981 (based on the data available in
World Development Indicators CD-ROM, 2000) but the gap is well below 1% (0.75% to be exact)
during 1981 – 1998.
 In simple words, GDP is territorial while GNP is national.
Two points must be kept in mind while calculating the GNP or GDP of a country.
Firstly, we must take in to account the money value of the final goods (and services) produced in the
economy to avoid double or multiple counting. It should be remembered that final goods and services
are those, which are finally consumed by the consumers. Such goods and services do not enter in to

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the manufacture of other goods. As against this, intermediate goods and services are those goods and
services, which do enter in to the production of other goods and services (Bread, for example, is final
good, but flour is an intermediate good). Intermediate products are to be excluding from the GNP.

Secondly, we must take in to account the money value of only currently produced goods and services
while estimating the GNP of the country. This is due to the fact that the GNP is a measure of the
economy‟s productivity during a particular period of time.
There are two methods of estimating the GNP of a country. Both the methods lead to the same results.
The two methods are: Expenditure approach and Income approach.

Expenditure Approach to GNP: The GNP can be viewed as the nation‟s total expenditure on goods
and services produced during the year. Each unit of goods and services produced is matched by an
expenditure on that unit. The consumers buy most of the good and services produced in the country.
But there are some goods and services, which remains unsold. If the unsold goods and services were
regarded as having been bought by the producers who hold them as stocks or inventories, then the
monetary value of the total national production would be equal to the total national expenditure.
Under the expenditure approach to GNP, the total national expenditure can be broken down in to the
following categories:
A. Personal Consumption Expenditure (C). It includes the consumption expenditure made for both
durable goods (such as, motor-cars, radio-sets, etc., but not houses) and non-durable goods (such
as, food, drinks, clothing, etc.) produced in the country during the year. This sub-head also
includes expenditure on the purchase of a house is treated as investment rather than consumption
expenditure.

B. Gross Domestic Private Investment (I). This item includes private investment in „capital‟ or
„producer goods‟, such as, buildings, machinery, plant, equipment, etc; Business firms primarily
purchase such goods. Houses are also included in this category of expenditure, because they are
so durable that they represent, in fact, capital goods. Three points should be carefully noted here.

 Firstly, this sub-head includes capital or investment goods needed not only to replace the
existing depreciated capital goods, but also the capital goods require increasing the society‟s
production of goods and services.

 Secondly, the term „investment‟ here means real investment in the Keynesian sense rather
than financial investment. It means the purchase of real investment goods, such as, buildings,
machinery, plant, etc. Produced during the year. If a person buys 5-year old machinery, it is

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 not real investment, though it may be called financial investment, because that machinery
was included in the GNP five years ago when it was manufactured first.

 Thirdly, „investment‟ here does not include mere financial transfer, such as, the purchase of
existing stocks and shares on the stock exchange. The purchase of existing stocks and shares
does not represent new investment for purposes of the national income accounts. Since it
does not involve any production.
A. Governments’ Purchases of Goods and Services (G). The governments-central, state and local-
purchase from the market consumer goods, such as, paper, stationery, cloth, etc, as well as
investment goods, such as machinery, equipment, plant, etc, for their own enterprises. In addition,
the governments also purchase a number of different services-military, police, secretarial etc.
Governments do spend large amounts of money on what are called transfer payments (e.g.,
unemployment insurance and social security payments). Since these payments are not payments
for currently produced goods and services, the amount spent on transfer payments included in the
GNP of thee country.
B. Net Foreign Investment. As is well known, the entire production of a country is not sold within
the country. A part of it is the GNP of the country. At the same time, the country imports some
finished goods from other countries during the year. To make proper allowance for such exports
and imports, the value of imports should be deducted from the value of exports. If the balance is
positive, it should be added to the other items of expenditure. If it is negative, it should be
subtracted from the sum of the other expenditure items.

It is; thus, clear that if the entire production of a country is purchased at market prices, the amount so
spent will represent the GNP of the country. Therefore, to estimate the GNP, we have to add the above
four categories of expenditure.
Illustration
Gross National Product (GNP) = Personal consumption expenditure (C) Plus Gross domestic private
investment (I) Plus Government purchases of goods and services (G) Plus Net foreign Investment
(FI)
Symbolically: GNP= C +I + G + FI
We know the difference between GDP and GNP is the net factor income from abroad (NFIA) which is
the difference between income received from abroad from the citizen of the country (IRFA), and the
income paid to the foreigner (IPTA): NFIFA= IRFA - IPTA

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Gross domestic product, the market value of all final goods and services produced in the country
territory irrespective of citizenship, is the difference between GNP and net factor income from abroad.
Symbolically: GDP= GNP – NFIFA
As a result the above approach to calculate GNP also works to Calculate GDP. Therefore, we reach up
on GDP = C +I + G + FI +NFIFA
If there is no net factor income received from abroad: GDP=GNP= C +I + G + FI
C. Income Approach to GNP. The expenditure incurred on purchasing goods and services
produced in a country during the year also becomes the income of the various factors, which
collaborated in the production of those goods and services. We can group these factor-incomes
in the following categories:
A. Wages and salaries of the employees (or compensation to employees),
B. Incomes of non-company business
C. Rental incomes of persons
D. Corporate profits, and
E. Incomes from Interest
 The first category, as said above, includes the wages and salaries received by the employees
during the year plus certain supplements. These supplements are the contributions, which the
employers make to social security and other provident funds or pension funds of the workers.
 The second category includes the incomes earned by individual proprietors, parents and self-
employed persons.
 The third category comprises rental income earned by individuals on agricultural and non-
agricultural property.
 The fourth category includes corporate profits earned by business corporations before the
payment of corporate profit taxes or the payment of dividends to the shareholders. Thus, the
corporate profits, used in calculating the GNP, are equal to the sum of corporate profit taxes
plus dividends paid top the shareholders plus undistributed corporate profits.
 The fifth category contains net interest earned by individuals from sources other than the
organs of the government.
An aggregate of the above five categories of incomes will not be equal to the GNP as estimated by the
Expenditure Method. The reason is that a part of the total expenditure incurred by the community does
not become available to the other factors of production in the form of incomes. There are two such
leakages.
 First, indirect taxes levied by the government on goods and services; and
 Second, depreciation of machinery, plants and buildings.
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The expenditure incurred by the households (factors) on goods and services includes the indirect taxes
levied by the government. The income from these indirect taxes goes to the government and is not
available to the households (factors). Like wise, while calculating the GNP, we include the
depreciation (loss in value suffered by machinery, equipment, buildings etc.). Like the indirect taxes,
the payment on account of depreciation does not become available to the households (factors) in the
form of income. In other words depreciation is no part of the factor incomes. Therefore, while
estimating the GNP by the Income Method, we have to add indirect taxes and depreciation charges to
the factor incomes.
Illustration
GNP in the Income Method can be calculated as follows:
Gross national product (GNP):
Equals
Wages and salaries of employees (W/S) Plus Income of non-company business (I)
Plus Rental incomes of persons (R) Plus Corporate profits (Π) Plus Income from net interest (r)
Plus Indirect taxes (IT) Plus Depreciation of capital goods (D)
Symbolically: GNP= W/S +I + R + Π + r + IT + D
Therefore, GDP= W/S +I + R + Π + r +IT+ D -NFIFA
Or
GDP= GNP –NFIFA
GDP and GNP are the most frequently used national income concepts. They have their own merits and
demerits.
Merits
 They are better index, than any other concept, of the actual conditions of production and
employment in a country during a specified period.
 They are also statistically simpler concepts, as it takes no account of depreciation and
replacement problems.
Demerits
 They are not a net measure of the nation‟s economic performance, for they are, as the term
states, a gross measure.
 They don‟t include the cost for environmental protection
 Since they are the measure of the market value of all final goods and service they don‟t
incorporate the non-market activities i.e., Under ground Economy

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2. Net National Product (NNP) and Net Domestic Products NDP)
Net national product is defined as the net production of goods and services produced by citizens of a
country during a year and net domestic product is defined as the net production of goods and services
produced in a country territory during a year.
As we know, in the course of a year‟s production, part of the physical plant that was on hand at the
beginning of the year is worn out, or it may depreciate in value as it becomes outdated. Building
gradually deteriorate, machinery wears out or becomes obsolete, and so on for others. No sooner or
later, if depreciated capital is not replaced, the income of the nation will decline, and the economy as a
whole will become poorer. If we want to measure the level of income that can be sustained therefore,
we must deduct from gross output (GNP or GDP) the depreciation of capital during the period
concerned. What is left after this deduction is the net national product. Thus,
NNP= GNP – Depreciation
NDP= GDP - Depreciation
Net products are better concepts than gross products, because it makes proper allowance for the
depreciation suffered by capital goods during the period under consideration. These concepts give a
proper idea of the net increase in total production of a country. They are, therefore, used in analyzing
the long-period problems of maintaining and increasing the supply of capital goods in the country.

In spite of this fact that for some purposes of economic growth NNP is much more important than
GNP, it is more difficult to measure statistically, because we have no accurate record of the amount of
depreciation for various capital goods, such as, buildings, equipments, plants etc. The result is that the
deduction that has to be made from GNP to arrive at NNP is a matter of judgement, rather than of
exact measurement. Because of this difficulty, this concept of NNP is not fairly used.
3. Net National Income at Factor Cost (NNI)
National Income at factor cost means the sum of all incomes earned by resource suppliers for their
contribution of land, labour, capital and entrepreneurship during the year‟s net production. In other
words, national income at factor cost shows how much it costs society in terms of economic resources
to produce that net out put. Some times, we simply call it national income.
Both GNP and NNP measure the values of goods produced in industry at the prices that those goods
actually bring in the market. Here the difficulty is that when we buy these goods at market prices, then
the prices include the respective taxes on these goods levied by the government. Hence, not all of the
payment made for goods goes to the people who produced them. Some part of it goes to the
government. It does not constitute a part of the true cost of producing the goods concerned. This
violates the basic identity that the value of goods produced is equal to the sum of the money incomes

14
received by the producers. In other words, the GNP will exceed the sum money incomes received by
people of the country (resource suppliers). The excess is explained by the fact that we have included in
GNP the entire out put of government services, but we have also included part of the payments made
for these services in the prices of the products (in terms of sales tax). In other words, a part of the cost
of government has been counted twice. In order to get rid of this double counting, we may introduce
the concept of net national income at factor cost. It is equal to net national product minus indirect tax
plus subsidies.
To put it differently: NI= NNP-Indirect taxes +Subsidies
The concept of national income at factor cost occupies an important place in economics. It indicates
the nature of distribution of wealth among various factor inputs. This concept is more satisfactory than
the concept of GNP and NNP, because it eliminates the element of double counting inherent in those
two concepts. It accords with the basic principle of economic theory, that the payments received by the
factor suppliers equal the value of the goods produced. Further, the components of national income (at
factor cost) are very useful in dealing with certain economic problems. Changing relative shares of
different elements in the population from time to time have an important bearing on the fluctuations of
economic activity, and on the personal inequality of incomes, which has much to do with economic
welfare.
4. Net Domestic product at Factor Cost (NDP): Net domestic product at factor cost is defined as
that national production which is made by the domestic factors of a country during the period of a
year. In other words, we can get net domestic product (at factor cost) if we deduct net income
received from abroad from the net national product at factor cost. Thus,
NDP at Factor Cost= NNP at Factor Cost – Net Income from Abroad
5. Personal Income (PI)
Personal income is the sum of all incomes actually received by all individuals or households during a
given year. National income (i.e, total income earned during a year) is different from personal income
(i.e, the income actually received by households). We know that all, which is produced by industry
and government, must necessarily belong to someone, and hence can be regarded as national income
received or accrued by the people (of the country), but not all of the value of this product is paid to
them as money income. Part of the net earnings of business firms are taken away from them by
government in the form of corporate income taxes, excess profits taxes, and the like, before being paid
to the owners of the business firms. These are direct taxes that do not enter into the prices of
commodities. Further, many firms retain part of their earnings in the business, to make addition to
their plants or as a reserve for future emergencies, instead of distributing the entire profits to their
shareholders. Therefore, these earnings are not allowed to receive in money all of the salaries or wages
15
that they earn. The government charges a withholding tax, which is used to finance social security
payments to the aged, the unemployed and certain other persons. Similarly, the government make
some other transfer payments to people of the country.
All these things create a difference between the total incomes received by individuals and the total
social income produced. We subtract from national income all undistributed corporate profits,
corporate income taxes and social security withholding taxes and then add transfer payments from
government and business firms directly to persons; the resulting figure will be the personal income.
Thus,
Personal Income (PI) = Net National Income – undivided corporate Profits – Corporate Income
Tax- Social Security Contribution + Transfer payments.
The above concept of personal income is useful for certain special purposes. For example, it shows the
ability of people to pay taxes. The personal income data are available on monthly basis whereas the
data for national product and national income are not published so frequently and, therefore, the
accurate idea cannot be drawn. This is the reason that personal income data are used for analysing
current changes in the economy.
6. Disposable Income (DI)
The main drawback of personal income is that they do not tell us how much is actually at the
disposable of people for their personal expenditure. For this we use the concept of disposable income.
After a good part of personal income is paid to government in the form of personal taxes (such as
income tax, property tax etc.), what remains of personal income is called Disposable Income. Thus,
Disposable Income (DI) = Personal Income – Personal Taxes
Disposable income data are useful for studying the purchasing power of the consumers. Since
disposable income can either be consumed or it can be saved; with its help we may study of
consumption and saving that individuals make in the economy.
7. Real Income (RI)
When the national income is expressed in terms of the base year‟s price index, it is known as Real
Income. Net National Income is the money value of the goods and services produced during a given
year at the current prices. This figure does not indicate the real situation of the economy. Due to an
increase in the prices of goods and services, the figure for net national income may be high but real
production is not much. The reverse is also possible. To avoid this deficiency we make use of the
concept of real income. It is calculated by the following formula:

NetNatioanlIncome
Re alNatioanlIncome   100
Pr iceIndexForthatyear
16
Income- Expenditure Approach
A Simple Economy Model
Assume an economy in which there is no government and foreign trade. In such a case national
income accounts divide total expenditure into two categories (Note that in the simplest form of a
circular flow, output is equals to income that in turn equals to expenditure.): Consumption (C) and
investment spending (I).
 The first key identity is that between output produced and sold.
 Output sold can be written in terms of the components of demand as the sum of consumption
and investment spending.
 Accordingly, we can write the identity of output produced and output sold:
Y  C + I---------------------------------- [1]
Since there is no government and external sector in our economy (by assumption), the private sector
receives the whole of the disposable income (Y). The income will be partly spent on consumption and
partly will be saved. Thus we can write
Y  C + S-------------------------------- [2)
Identity (2) tells us that the whole of income is allocated to either consumption or saving. Next,
identity (1) and (2) can be combined to give us
C + I  Y  C + S-------------------------- [3]
The left-hand side of identity (3) shows the components of demand, and the right-hand sides show the
allocation of income. Identity (3) can be reformulated to let us look at the relationship between saving
and investment. Subtracting consumption from each part of identity (3), we have
I  Y - C  S-------------------------------- [4)
Identity (4) shows that in this simple economy investment is identically equals savings.
An Economy with Government and Foreign Trade
We denote the government purchases of all goods and services by (G) and its tax receipt by (TA). The
government also makes transfer to the private sector (TR). The foreign sector is composed on imports
(M) and exports (X). Net exports (exports minus imports) are denoted by NX.

With government and foreign trade, identity (1) can be rewritten by adding G and NX- i.e.
Y  C+I+G+NX---------------------------- [5]
Now we have to recognize that part of income is spent on taxes and that the private sector receives net
transfers (TR) in addition to national income. Disposable income (YD) is thus equal to income plus
transfers less taxes:
YD  Y+TR-TA----------------------------- [6]
17
Disposable income, in turn, is allocated to consumption and saving:
YD  C+S------------------------------------ [7]
Combining (6) and (7), se have:
C+S YD Y+TR-TA--------------------- [8]
Or
C YD-S Y+TR-TA-S------------------- [8a]
Identity (8a) states that consumption is disposable income less saving or, alternatively, that
consumption is equal to income plus transfers less taxes and saving.
Substituting the right hand side of (8a) into (5) and rearranging, we get
S-I (G+TA-TR) + NX--------------------- [9]
The first term on the right-hand side (G+TR-TR) is the government budget deficit- i.e. the excess of
government spending over its receipts. The second term on the right-hand side is the excess of exports
over imports, or net exports.
 Thus, identity (9) states that the excess of saving over investment (S – I) of the private sector is
equal to the government budget deficit Plus the trade surplus
 The identity suggests that there are important relations among the excess of private saving over
investment (S –I), the government budget (G+TR-TA), and the external sector.
 For instance, if, for the private sector, saving is equal to investment, then the government‟s budget
deficit (surplus) is reflected in an equal external deficit (surplus).
In the 1980s there was much discussion of the twin deficit- the budget deficit and the trade deficit.
Identity (9) is helpful is seeing that budget deficit must have a counterpart: if the government spends
more than it receives in revenue, then it has to borrow, either at home (private saving exceeds
investment) or abroad (imports exceeded exports). The identity makes it clear that budget deficits need
not be matched one-for-one by negative net exports.
Thus, there is no inevitable one-to-one link between the two deficits.
1.3. 2. Measuring the Cost of living
Price of a Basket of Goods
One birr today doesn‟t buy as much as it did 10 or 5 years ago. The cost of almost everything has gone
up. This increase in the over all level of prices is called Inflation, and it is one of the primary concerns
of economists and policy makers.

The most commonly used measure of the level of prices is the consumer price index (CPI). The
Statistical Authority has a job of computing the CPI. It begins by collecting the prices of thousands of
goods and services. Just as GDP turns the quantities of many goods and services in to a single number

18
measuring the value of production, the CPI turns the prices of many goods and services in to a single
index measuring the overall level of prices.

But how should economists aggregate the many prices in the economy in to a single price index that
reliably measure the price level? They could simply compute an average of all prices. Yet this
approach would treat all goods and services equally. Because people might buy more of product X
than product Y. Product X should have a greater weight in the CPI than the price of Y. The statistical
authority weights different items by computing the price of a basket of goods and services purchased
by a typical consumer. The CPI is the price of this basket of goods and services relative to the price of
the same basket in some base year.
Illustration
Suppose that the typical consumer buys 5 apples and 2 oranges every month. Then the basket of goods
consists of 5 apples and 2 oranges, and the CPI is

(5  CurrentpriceofApples)  (2  CurrentpriceofOranges )
CPI 
(5  2006Pr iceofApples )  (2  2006Pr iceofOranges)
In this CPI, 2006 is the base year. The index tells us how much it costs now to buy 5 apples and 2
oranges relative to how much it costs to buy the same basket of fruit in 2006.
The consumer price index is the most closely watched index of prices, but it is not the only such index.
Another is the producer price index, which measures the price of a typical basket of goods bought by
firms rather than consumers.
The CPI versus the GDP Deflator
Another measure of price is GDP Deflator that is the implicit price deflator for GDP, which can be
calculated as the ratio of nominal GDP to real GDP. The GDP deflator is a measure of the general
price level.
Nominal GDP
GDP Deflator 
Real GDP
Real GDP versus Nominal GDP
 Valuing goods at their market price allows us to add different goods into a composite measure, but
also means we might be misled into thinking we are producing more if prices are rising. Thus, it is
important to correct for changes in prices. To do this, economists value goods at the prices at
which they sold at in some given year. For example, in Ethiopia, we mostly measure GDP at
1980/81 prices. This is known as real GDP.
 GDP measured at current prices is known as nominal GDP.
19
The GDP Deflator and the CPI give somewhat different information about what‟s happening to the
overall level of prices in the economy. There are three key differences between the two measures
 The first difference is that the GDP deflator measures the prices of all goods and services
produced, whereas the CPI measures the prices of only the goods and services bought by
consumers. Thus, an increase in the price of goods bought by firms or the government will show
up in the GDP deflator but not in the CPI.
 The second difference is that the GDP deflator includes only those goods produced domestically.
Imported goods are not part of GDP and do not show up in the GDP deflator. Hence, an increase in
the price of a Toyota made in Japan and sold in Ethiopia affects the CPI, because consumers buy
the Toyota, but it does not affect the GDP deflator.
 The third and most subtle difference results from the way the two measures aggregate the many
prices in the economy. The CPI assigns fixed weights to the prices of different goods, whereas the
GDP deflator assigns changing weights. In other words, the CPI is computed using a fixed basket
of goods, whereas the GDP deflator allows the basket of goods to change over time as the
composition of GDP changes.
The following example shows how these approaches differ. Suppose that major frosts destroy the
nation‟s orange crop. The quantity of oranges produced falls to zero, and the price of the few
oranges that remains on grocers‟ shelves is driven sky-high. Because oranges are no longer part of
GDP, the increase in the price of oranges does not show up in the GDP deflator. But because the
CPI is computed with a fixed basket of goods that includes oranges, the increase in the price of
oranges causes a substantial rise in the CPI.
The consumer price index is a closely watched measure of inflation. Policymakers in the Federal
Reserve monitor the CPI when choosing monetary policy. In addition, many laws and private
contracts have cost-of-living allowances, called COLAS, which use the CPI to adjust for changes
in the price level. For instance, social security benefits are adjusted automatically every year so
that inflation will not erode the living standard of the elderly.
Many economists believe that CPI tends to overstate inflation; the reasons are:
 Because the CPI measures the price of a fixed basket of goods, it does not reflect the ability of
consumers to substitute toward goods whose relative prices have fallen. Thus, when relative
prices change, the true cost of living rises less rapidly than the CPI.
 A second problem is the introduction of new goods. When a new good is introduced in to the
marketplace, consumers are better off, because they have more products from which to choose.
In effect, the introduction of new goods increases the real value of the dollar. Yet this increase
in the purchasing power of the dollar is not reflected in a lower CPI.
20
  A third problem is unmeasured changes in quality. When a firm changes the quality of a good
it sells, not all of the good‟s price change reflects a change in the cost of living. Many changes
in quality, such as comfort or safety, are hard to measure. If unmeasured quality improvement
(rather than unmeasured quality deterioration) is typical, then the measured CPI rises faster
than it should.
1.4. Measuring Unemployment Rate
One aspect of economic performance is how well an economy uses its resources. Because an
economy‟s workers are its chief resource, keeping workers employed is a dominant concern of
economic policy makers.
Unemployed: A person who is willing to have a job and seeking it but couldn‟t find the job.
Employed: A person who have a job and actively participate at a paid job
Then unemployment rate is the statistic that measures the percentage of those people wanting to work
who do not have jobs.
Numberofunemployed
UnemploymentRate   100
Labourforce

The labour force is defined as the sum of the employed and unemployed, and the unemployment rate
is defined as the percentage of the labour force that is unemployed.
LabourForce  NumberofEmployed  NumberofUnemployed

A related statistics is the Labour-force-participation Rate, the percentage of the adult population that is
in the labour force:
LabourForce
Labour  ForceParticiaptionRate   100
AdultPopulation
1.5. Relationship between Macro Economic Variables

The Business Cycle and the Output Gap

Inflation, growth, and unemployment are related through the business cycle. The business cycle is the
more or less regular pattern of expansion (recovery) and contraction (recession) in economic activity
around the path of trend growth. At a cyclical peak, economic activity is high relative to trend; and at a
cyclical trough, the low point in economic activity is reached. Inflation, growth, and unemployment all
have clear cyclical patterns.

21
Figure 1:1 Business cycle The trend path of GDP is the
path GDP would take if factors
Output Peak
of production were fully
Trend
employed.

Trough
0 Time

Over time, real GDP changes for the two reasons.

 First, more resources become available which allows the economy to produce more goods and
services, resulting in a rising trend level of output.
 Second, factors are not fully employed all the time. Thus, increasing capacity utilization can
increase output.
Output is not always at its trend level, that is, the level corresponding to full employment of the factors
of production. Rather output fluctuates around the trend level. During expansion (or recovery) the
employment of factors of production increased, and that is a source of increased production.
Conversely, during recession unemployment increases and less output are produced than can in fact be
produced with the existing resources and technology. Deviations of output from trend are referred to
as the output gap.
The output gap measures the gap between actual output and the output the economy could produce at
full employment given the existing resources. Full employment output is also called potential output.
Output gap  potential output – actual output
When looking at the business cycle fluctuation, one question that naturally arises is whether
expansions give way inevitably to old age, or whether they are instead brought to an end by policy
mistakes. Often a long expansion reduces unemployment too much; causes inflationary pressures, and
therefore triggers policies to fight inflation- and such policies usually create recessions.
Because employed workers help to produce goods and services and unemployed workers do not,
increases in the unemployment rate should be associated with decreases in real GDP. This negative
relationship between unemployment and GDP is called Okun’s Law.
Okun’s Law

22
A relationship between real growth and changes in the unemployment rate is known as Okun’s law,
named after its discoverer, Arthur Okun. Okun‟s law says that the unemployment rate declines when
growth is above the trend rate.
u = -x (ya – yt)
Where u is change in unemployment, x the magnitude in which unemployment declines due to a
percentage point growth, ya actual growth rate of output, and yt is trend output growth rate. The figure
below shows the Okun‟s law relationship between unemployment and growth in output.

Growth and Unemployment Dynamics

12
Percentage change in real GDP

0
-3 -2 -1 0 1 2 3

-3
Change in unemployment rate

Fig1.2 Growth and Unemployment Dynamics

Inflation –Unemployment Dynamics
The Phillips curve describes the empirical relationship between inflation and unemployment: the
higher the rate of unemployment, the lower the rate of inflation. The curve suggests that less
unemployment can always be attained by incurring more inflation and that the inflation rate can
always be reduced by incurring the costs of more unemployment. In other words the curve suggests
there is a trade-off between inflation and unemployment.
Fig 1.3 Phillips curve
Inflation Rate

0
Unemployment rate

23
UNIT TWO
AGGREGATE DEMAND ANALYSIS
INTRODUCTION
The model of aggregate demand developed in this chapter, called the IS-LM model is the leading
interpretation of Keynes‟s theory. The goal of the model is to show what determines national income
for any given price level. We can view the IS-LM model as showing what causes income to change in
the short run when the price level is fixed or can be viewed the model as showing what causes the
aggregate demand curve to shift.

The two parts of the IS-LM model are, the IS curve and the LM curve. IS stands for „investment‟
and „saving‟, and the IS curve represents what‟s going on in the market for goods and services. LM
stands for „liquidity‟ and „money‟, and the LM curve represents what‟s happening to the supply and
demand for money. Because the interest rate influences both investment and money demand, it is the
variable that links the two halves of the IS-LM model. The model shows how interactions between
these markets determine the position and slope of the aggregate demand curve and, therefore, the level
of national income in the short run.
The Goods Market and the IS Curve
2.1.1. Construction of the IS curve
The IS curve/schedule is one that shows the combination of the interest rate and income that reflects
equilibrium condition in the goods market. The product market equilibrium condition is obtained at a
point where planned aggregate demand is equal to output/income, i.e.
Y = C + I + G……………………………………. (1)
And Y = C + S + T…………………………………… (2)
 C+S+T=C+I+G
S + T = I + G……………………. (3)
To find the set of interest rate and income level combinations that produces equilibrium for the
product market, a simplified and more general case is considered.
The simplified case
The government sector is neglected, i.e. G = T = O, then equation (3) can be written as
I(r) = S(y) …………………………………. (4)
Where; the prevailing market interest rate and that of saving by the level of income determine the level
of investment. So, while investment is plotted as a negative function of interest rate, saving is plotted
against income, with a positive MPS slope. The level of interest rate and the level of income that
equates equation (4) will give us the IS curve, the label of which is obtained from this simple version.

24
 r r

r2 A r2 A

r4 B r4 B
r1 C I”(r) r1 C IS’’
r0 D r0 D
I(r) IS
I’(r) IS’
I2 I0 I1 I4 Y2 Y0 Y1 Y4
S(Y) S(Y) = I(r) S(Y) S(Y)
S4 S4

S1 S1
S0 S0

S2 S2

450
I2 I0 I1 I4 I(r) Y2 Y0 Y1 Y4

Figure 2.1: The Derivation of the IS-curve

If the investment schedule is given by I(r) curve and the saving function is given by S(Y), the IS curve
can be derived by taking different values of the interest rates. Take the interest rate r 1, the
corresponding investment level, which is determined by the investment schedule at point C in the
upper left diagram, is I1. If the goods market is in equilibrium, the economy will exhibit a condition
that can be explained by the 45o line, i.e. I1 = S1. It means that for the I1 level of saving the goods
market will become equilibrium at S1 level of saving. S1 level of saving is attained at Y1 level of
income, which is located in the lower right diagram. Point C in the north-east corner of the diagram is
the combination of Y1 level of income and r1 interest rate. Thus, Y1 is the equilibrium level of output
when the interest rate is r1.
If the interest rate rises from r1 to r2, the level of investment will decline to I2, which is located at point
A in the northwest diagram. The level of saving that equilibrates the goods market is given by the 450
lines, i.e. S2. In order to save S2 level of saving the economy needs to have an income level of Y2. The
combination of r2 and Y2 gives rise to point A in the upper right diagram. The equilibrium level of
output decreases from Y1 to Y2 when the interest rate rises from r1 to r2. The curve thus formed
represents the negatively sloped IS curve.

25
2.1.2. What determines the slope of the IS curve?
The steepness of the IS curve depends upon, at a progressively falling interest rate, the income level
requirement of the product market equilibrium. The income level requires much higher income levels
when the slope of the IS curve is relatively flat and slightly increased ones when the curve is steep.
The slope thus is determined by
1) The slope of the investment function: - When the slope of the investment schedule is steep
(flat), where investment is not very sensitive (more sensitive) to movements in the interest rate,
the interest elasticity of investment demand is low (high). In the former case, investment is
relatively insensitive to changes in the interest rate, I is small consequently S and Y are
very small. The IS curve will be kept steep, and vice versa. When the investment function is
steep, I‟(r), the IS curve will bear a steep curve which is given by IS‟ in the r-Y plane. When
the investment function is flat, I”(r), the IS curve will have a flat shape, IS”.
2) The slope of the saving function: - The slope, which is given by the value of the MPS, will be
steeper, the higher the value of the MPS. If the slope of the investment schedule is unchanged,
a given decline of the interest rate leads to a given increase in investment. Thus saving must
increase by this same amount to maintain the product market equilibrium. The increase in
income that generates this new saving increment will be lower because of high MPS value.
Thus the IS curve will become relatively steeper.
2.1.3. What factors shift the IS schedule?
Let us consider the general case where the government sector is included to make the economy a
closed one. The equilibrium condition in the product market is thus given by
I(r) + G = S(Y-T) + T………………………………….. (5)
 Saving function is now given as a function of disposable income, Yd=Y-T
 Because of the introduction of the variable G, the level of spending, I(r) + G, is a schedule
that represents the aggregate demand and lies to the right of I(r) schedule by the fixed
amount of G
 The saving plus tax schedule, S(Y-T) + T, represents the national income and lies above
the saving function by a fixed amount of T, which is exogenously determined.
The IS curve will shift because of
A. Changes in government spending: - when the government spending increases, the IS curve
shifts outward.
Initially,
 The government spending was G0, and at r0 interest rate government spending and
investment spending was I0+G0
26
  The income level of Y0 generates saving plus tax equivalent with I0+G0 (S0+T=I0+G0)
 IS0 was the product equilibrium schedule at r0 and Y0 levels

r r

IS0 IS1

r1 r1
 1 
G 
1 c 

r0 r0
I(r) +G1
I(r) +G0
I1+G0 I1+G1 I0+G0 I0+G1 y0 y2 y1 y3

S+T S(Y) +T= I(r) +G S+T S(Y-T) +T

S3+T S3+T

S1+T S1+T

S2+T S2+T

S0+T S0+T

I1+G0 I1+G1 I0+G0 I0+G1 y0 y2 y1 y3

Figure .2. 2: The Effect of Government Spending on the IS curve

When the government spending increases from G0 to G1

 At a given r investment will be unchanged but the investment plus government
I1+G0 I1+G1 I0+G0 I0+G1
spending schedule shifts to the right and the sum of the spending will be higher by the
increase in government spending
G=G1-G0
 The product market equilibrium equates this higher level of I0+G1 with higher level of
saving plus taxes, S3+T, which is generated through the higher level of income,Y3.
 A given interest rate, r0, together with a higher level of income, Y3, will form the
product market equilibrium schedule, IS1 (shifts to the right of IS0)
 An increase in the government spending shifts the IS schedule to the right

27
 B. Changes in Taxes

r r

IS0

 c 
r1 r1 T  
1 c 

r0 r0 B A

I(r) +G0 IS1

I1+G0 I0+G0 y3 y1 y2 y0

S+T S(Y)+T= I(r)+G S+T S1(Y-T1) +T1

S0+T S0+T

S1+T S1+T
S0(Y-T0)+T0

I1+G0 I0+G0 y3 y1 y2 y0

Figure 2.3: The Effect of Tax change in the IS curve

Initially, Taxes equal to T0

 At the
I1+Gr00,I1the
+G1 level
I0+G0 of government
I0+G1 and investment spending along the I(r) + G schedule is at
I0+G0, which is equated with the saving plus taxes level, S0+T, at the product market
equilibrium (the 450 line). This requires the income level of Y0
 The corresponding level of r0 and Y0 in the IS schedule is plotted at point A
When taxes increase from T0 to T1
 At a given interest rate, r0, the product market equilibrium needs the level of income at
which the total saving plus taxes remains unchanged because I0+G0 is not changed
 Higher level of taxes should be offset by a reduction in saving and hence in the level of
income to maintain the unchanged equality. The corresponding equilibrium level of income
Y2 and interest rate r0 is plotted at point B in the IS curve (the curve shifts inwards to IS1)
 An increase in taxes shifts the IS curve to the left

28
 C. Autonomous Changes in Investment
A favorable expectation about the future profitability of investment projects increases the level
of investment demand corresponding to each interest rate. Consequently, it lease to shifting the
I(r) schedule upward. Shifting the investment plus government spending schedule to the right
by the amount of autonomous investment increase. Thus the increase in autonomous
investment spending shits the IS curve rightward
The General Case for Taxes
When taxes are partly collected on the basis of direct incomes, taxes become a function of income
written as: T=T(Y)…………………………………….(6)
In this case, the slope of the S(Y-T) +T(Y) schedule changes in accordance with the multiplier of the
MPS. The resulting IS curve will be reliant on the slope of the former schedule.

Mathematical Representation of the IS Curve

(1) The slope of the IS schedule

Using equations (5) and (6) the product market equilibrium condition of the IS curve is

 Is negatively sloped
 Is steeper when the MPS, given by (1  c(1  t )) , is higher or when the interest
elasticity of investment is relatively insensitive
 Is steeper when marginal tax revenue, t‟, is higher

29
 I (r )  G  S (Y  T (Y ))  T (Y )......... .......... .......... .......... .......... ....( 7)
and the consumption functionis proposedas
C  a  cYd .......... .......... .......... .......... .......... .......... ....(8)
a  the effect on consumption of var iablesotherthatnincome
c  MPC , theincreasein consumerexp enditure per unit increasein Yd
o  c 1
Yd  disposableincome, income net tax payments
Yd  Y  T .......... .......... .......... .......... .......... .......... .....( 9)
accordingto the definitionof naionalincome
Y  C  S  T .......... .......... .......... .......... .......... .........(10)
from (9) and (10)
Yd  Y  T  C  S .......... .......... .......... .......... .......... ..(11)
from(8) and (11)
S  a  (1  c)Yd .......... .......... .......... .......... .......... .....(12)
0  1 c  1
1  c is the m arg inal propensityto save
S  a  (1  c)(Y  T (Y )).................. .......... .......... ....(13)
U sin g (7) and (13)
I (r )  G  S (Y  T (Y ))  T (Y )
I (r )  G  a  (1  c)(Y  T (Y ))  T (Y )......... .......... .......... ...(14)
by takingthetotal differentiation
i dr  dy  t dy  c(dy  t dy)  t dy
i dr  (1  c(1  t ))dy
dr (1  c(1  t ))
 0
dy i
(2) Factors that shift the IS curve
By equation (14) we have
I (r )  G  a  (1  c)(Y  T (Y ))  T (Y )
And if I(r) and T(Y) have autonomous (exogenous) components given as
I (r )  I  i(r )
T (Y )  T  tY
Where I and T are exogenous/ autonomouscomponents
I  i (r )  G  a  (1  c)Y  (1  c)[T  tY ]  [T  tY ]
(1  c)Y  a  I  G  i (r )  (1  c)[T  tY ]  [T  tY ]
(1  c)Y  a  I  G  c(T  tY )  i (r )

Y
1
1 c

a  I  G  cT  c(tY ) 
1
1 c
i (r ) 

30
Thus the magnitude of the IS curve shift is given as follows. For the change in the autonomous
spending of consumption a, government spending, G, and investment I and, the IS curve shifts to the
right. The effect is identical and the magnitude is given by
dy dy dy 1
   0
da dg dI 1  c
For the change in exogenous taxes, the effect on IS schedule is given by
dy c
 0
dT 1  c
The IS schedule shifts leftward. But if we re-specify the investment function and tax functions as
I (r )  I  br
T (Y )  tY
We can rewrite(14) as
I  br  G   a  (1  c)(Y  tY )  tY
a  I  G  br  [(1  c)(1  t )  t ]Y
 [(1  t )  c(1  t )  t ]Y
 [1  c(1  t )]Y

Y 
1
1  c(1  t )
a  I  G  br 
if A  a  I  G and

1

1  c(1  t )
Y   [ A  br ]
2.2. The Keynesian Cross
We have seen from the above that the IS curve plots the relationship between the interest rate and the
level of income that arises in the market for goods and services. We can also develop this relationship
by another method below; we start with a basic model called the Keynesian Cross. This model is the
simplest interpretation of Keynes‟s theory of national income and is a building block for the more
complex and realistic IS-LM model.
Keynes proposed that an economy‟s total income was, in the short run, determined largely by the
desire to spend by households, firms, and the government. The more people want to spend, the more
goods and services firms can sell. The more firms can sell, the more output they will choose to
produce and the more workers they will choose to hire. Thus, the problem during recession and
depression, according to Keynes, was inadequate spending.

31
To derive the Keynesian cross, we begin by looking at a distinction between actual and planed
expenditure.
 Actual expenditure is the amount households, firms and the government spend on goods and
services and it is equal to GDP.
 Planned expenditure (or planned aggregate demand) is the amount of households, firms, and
the government plan to spend on goods and services.
The difference between actual and planned expenditure is unplanned inventory investment. When
firms sell less of their product than planned, their stock of inventories automatically rises.
Now consider the determinants of planned expenditure. Assuming that the economy is closed, so that
net exports are zero, we write planned aggregate demand (or planned expenditure) AD as the sum of
consumption (C), planned investment (I), and government purchases G:
AD = C+I+G------------------------------------ [1]
The above equation states that consumption depends on disposable income (Y-T), which is total
income Y minus taxes T.
C=C (Y-T) --------------------------------------- [2]
To keep things simple, for now we take planned investment as exogenously fixed.

I  I . --------------------------------- (3)
And that the levels of government purchases and taxes are also fixed.
G  G , -------------------------------- (4)
T  T . ---------------------------------- (5)
Combining these equations, we obtain
AD  C(Y  T)  I  G . ------------------------ (6)
Equation [6] states that planned aggregate demand (planned expenditure) is a function of income Y,
the exogenous level of planned investment I , and the exogenous fiscal policy variables G and T .
AD Figure .2.4. Planned expenditure a function of
AD  C(Y  T)  I  G income:
Planned expenditure as a function of the level of
income since the other variables are fixed.
The line slopes upward because higher income leads to
higher consumption and thus higher planned
MPC
expenditure.
The slope of this line is the marginal propensity to
0 Y consume, the MPC: it shows how much planned
expenditure increases when income rises by one unit.
Income, output

32
Proof: AD  C(Y  T)  I  G

d ( AD ) dC (Y  T ) d I d G
  
dY dY dY dY
Since the T, G and I are constants
d ( AD ) dC (Y )
MPC=  ; which is the marginal propensity to consume.
dY dY

The Economy in Equilibrium

The economy is in equilibrium when actual aggregate demand equals planned aggregate demand.
Total output of the economy Y equals not only total income but also actual aggregate demand. This
assumption is based on the idea that when people‟s plans have been realized, they have no reason to
change what they are doing. We can write the equilibrium condition as
Actual aggregate demand = Planned aggregate demand (Y= AD)
Figure. 2. 5 Keynesian Cross-
AD
In figure 2.5 the 45o line serves as a
Y=AD
Y1 AD=C+I+G reference line that translates any
horizontal distance into an equal
AD1 A
AD2 vertical distance.
Y2 Thus, anywhere on the 45o line, the
level of AD is equal to the level of
45o Y output. At point A, both output and
0
Income, output aggregate demand are equal.

In this model, inventories play an important role in the adjustment process. The equilibrium output
would be achieved through inventory adjustment. Unplanned changes in inventories induce firms to
change production levels, which in turn changes income and expenditure.
For example, suppose GDP is at a level greater than equilibrium level, such as level Y1 in figure 2.5
because of the miscalculation of firms about the aggregate demand. In this case, planned aggregate
demand AD1 is less than production (Y1). Firms are selling less than they produce. Firms add the
unsold goods to their stock of inventories. This unplanned rise in inventories induces firms to lay off
workers and reduce production, which reduce GDP. This process of unintended inventory
accumulation and falling income continues until income falls to the equilibrium level. At the
equilibrium, income equals planned aggregate demand.

33
Similarly, suppose GDP is at a level lower than the equilibrium level, such as the level Y 2. In this case,
planned aggregate demand is AD2, which is more than output Y2. Because planned aggregate demand
exceeds production, firms are selling more than they are producing. As firms see their stock of
inventories fall, they hire more workers and increase production. This process continues until income
equals planned aggregate demand.
In summary, the Keynesian cross shows how income Y is determined for given levels of planned
investment (I) and fiscal policy G and T. We can use this model to show how income changes when
one of these exogenous variables changes.
2.2.1 Fiscal Policy and the Multiplier: Government Purchases
Since government purchases are one component of expenditure, high government purchases imply, for
any given level of income, higher planned aggregate demand. If government purchases rise by G,
then the planned aggregate demand schedule shifts upward by G, as shown in the figure below.
Fig .2.6. An increase in Government Purchase in the Keynesian Cross
AD Y=AD
AD2 The graph shows that an increase in
B
AD2=Y2 government purchases leads to an even
Y G AD1 greater increase in income. That is, Y >
G. The ratio Y/G is called the
AD1=Y1 A government purchase multiplier; and it tells
how much income rises in response to a
one-unit increase in government purchases.
An implication of the Keynesian cross is
AD1=Y1 AD2=Y2 that the government purchases multiplier is
larger than
According to the consumption function, higher income causes one. consumption. Because an
higher
increase in government purchases raises income, it also raises consumption, which further raises
consumption, and so on. Therefore, in this model, an increase in government purchases causes a
greater increase in income.
G Y C Y C…

The process of the multiplier begins:

 When expenditure rises by G, which implies that income rises by G as well.
 This increase in income in turn raises consumption by MPC  G.
 This increase in consumption raises AD and income once again.
 This second increase in income of MPC  G again raises consumption by MPC  (MPC 
G), which again raises aggregate demand and income, and so on.
34
We can thus write this process compactly as
Y= G + MPC  G + MPC2  G + MPC3  G + …
= (1 + MPC + MPC2 + MPC3 +…)  G
The government purchase multiplies is
Y/G = 1 + MPC + MPC2 + MPC3 +…
This expression for the multiplier is an example of an infinite geometric series. A result from algebra
allows us to write the multiplies as
1
Y/G = .
1 - MPC

We can also derive the multiplier from our national income identity
Y = C (Y-T) + I +G-------------------------- [1]
Assuming T and I are constant and totally differentiating [1], we would get
dY = C‟ (dY) + dG--------------------------[2)
By a simple rearrangement of [2],
dG = dY – C‟ (dY)
dG/dY = 1 – C‟
Taking the inverse of the above expression
1
dY/dG = ; Where C’ = dC/dY –i.e. MPC.
1 - C'
2.2.2. Fiscal Policy Multiplier: Taxes
Let us now consider how changes in taxes affect equilibrium income.

Actual expenditure A decrease in taxes of T immediately

AD Planned expenditure
raises disposable income Y-T by T
B MPC x T and, therefore, consumption by MPC 
AD2=Y2
Y T. For any level of income Y,
aggregate demand is now higher. As
A
AD1=Y1 shown in the figure below, the
aggregate demand curve shifts upward
Income, output, Y by MPC  T. The equilibrium of the
AD1=Y1 AD2=Y2
economy moves from point A to point
Fig 2.7. A decline in tax in the Keynesian Cross B and income rises from Y1 to Y2.

35
An increase in government purchases has a multiplied effect on income; so does a decrease in taxes
(i.e., it have multiplier impact). Starting with the national income identity
Y= C (Y-T) + I + G
Assuming I and G to be constant, and differentiating the above expression we obtain
dY = C‟ (dY – dT),
dY (1-C‟) = -C‟ dTs
And then rearranging to find
dY C'
 <0
dT 1  C'
Since C‟ is MPC we can rewrite the tax multiplier as follows;
Y MPC

T 1  MPC

The multiplier implies that taxes and income are inversely related and a unit change in taxes increase
income by more than proportionately.

2.2.3. The Interest rate, Investment and the IS Curve

The Keynesian cross is useful because it shows what determines the economy‟s income for any given
level of planned investment. Yet it makes the unrealistic assumption that the level of planned
investment is fixed. However, planned investment depends negatively on the interest rate.
The transition from the Keynesian cross model to the IS curve is achieved by noting that if the real
interest rate changes, this changes planned investment. The Keynesian cross analysis tells us that
change in planned investment change GDP. Thus, for example, if interest rates increase, planned
investment falls, and so does output. Thus higher levels of the interest rate are associated with lower
level of output.

To add the relationship between the interest rate and investment, we write the level of planned
investment as

I = I(r).

Thus, we can write equation [1] as

Y = C (Y-T) +I(r) +G

36
 Y=AD
AD
AD=C(Y-T) +I (r1) +G
AD=C(Y-T) +I (r2) + G

We can now use the investment

function and the Keynesian cross
diagram to determine how income
changes when the r changes.
Because I is inversely related to r,
0 Y2 Y1 Y
an increase in r from r1 to r2 reduces
the quality of I form
r
I (r1) to I (r2).

r2 The reduction in planned

investment, in turn, shifts the
expenditure function downward as
r1
shown in the upper panel of the
IS figure above. The shift in the
expenditure function leads to a
0 Y2 Y1 Y
lower level of income. Hence, an
Fig.2.8. Deriving the IS curve increase in the interest rate lowers
income.

The IS curve summarizes the relationship between the interest rate and the level of income that results
from the investment function and the Keynesian cross. The higher the interest rate; the lower the level
of planned investment; and thus the lower level of income. For this reason the IS curve slopes
downward.
Definition: IS- curve represents the negative relationship between the Interest rate and the level of
income that arises from equilibrium in the market for goods and services.
Alternative Derivation of the IS Curve
We can also derive the IS curve using the national income accounts identity- i.e.
Y-C-G=I---------------------------- (1)
S=I.
The identity states that saving equals to investment. The saving here represents the supply of loan able
funds, and investment represents the demand for these funds.

37
To see how the market for loan able funds produces the IS curve, substitute the consumption function
for C and the investment function for I:
Y-C (Y-T)-G = I(r) ----------------- (2)
The left-hand side of this equation states that the supply of loan able funds depends on income and
fiscal policy (T and G). The right-hand side states that the demand for loan able funds depends on the
interest rate. The interest rate adjusts to equilibrate the supply and demand for loans.
Using the identity [2] we can reach to the IS curve relationship which shows an inverse relationship
between interest rate and output.
Re-writing [2] as
Y = C (Y-T) +I(r) + G ----------------------- [2.a]
Taking the total differential of [2.a] we obtain
dY =C‟ (dY – dT) + I‟ (dr) + dG
Assuming taxes and government spending to be constant, we get
dY= C‟dY + I‟dr
Rearranging the above expression to obtain
dr 1  C'
 < 0; Where C‟ is dC/dY (MPC) and I‟ is dI/dr.
dY I'
The above expression is less than zero because 0<C‟<1 and I‟ <0.

R S (Y1) S (Y2)

r1

r2

I(r)

IS
R

r1

r2

IS

Y1 Y2 Y
Figure 2.9: Derivation of IS curve

38
How Fiscal Policy Shifts the IS Curve

The IS curve shows us, for any given interest rate, the level of income that brings the goods market in
to equilibrium. As we learned from the Keynesian cross, the level of income also depends on fiscal
policy. The IS curve is drawn for a given fiscal policy; that is, the IS curve holds G and T fixed. When
fiscal policy changes, the IS curve shifts.

IS: Y=C(Y-T) + I(r) + G

dY = C‟ (dY – dT) +I‟dr + dG
Assuming that dT = dr = 0
dY = C‟dY + dG
dY/dG = 1/ (1-C‟); where C‟ is MPC and thus 1/1-C‟ is greater than zero.

This shows that for a given interest and tax rate, an increase in government spending will lead to a
higher level of output. This can be shown as a shift in the IS curve.

IS2
IS1
Y
Y1 Y2
Fig.2.10. Shift of IS curve

In summary, the IS curve shows the relationship between the interest rate and the level of income that
arises form the market for goods and services. The IS curve is drawn for a given fiscal policy.
Changes in fiscal policy that raise the demand for goods and services shift the IS curve to the right.
Changes in fiscal policy that reduce the demand for goods and services (such as an increase in tax)
shift the IS curve to the left.

2.3. The Money Market and the LM Curve

The second link in the chain, which proposes that the change in the money stock affects the aggregate
demand and income by changing the interest rate, deals with the relationship between the quantity of
money (money stock) and the rate of interest. The money stock includes such assets as money and

39
other deposits, bonds and stocks. The markets in which these assets are traded form the asset (money)
markets.
For macroeconomic analysis purpose these financial assets are classified into:
 money (currency and deposits on which checks can be drawn - demand deposits, travellers‟
check and other checkable deposits); and
 bonds (all other money assets – bonds and equities (stock)
The analysis begins by some simplifying assumptions
1. Based on this grouping of the financial assets, all money pays no interest
2. Bonds are homogeneous and perpetuities/ consol (with no repayment of principal)
R
V  Where; v --The present value of the bond
i
i – The interest rate
R – The interest paid per year
Bond is a promise by a borrower to pay a lender a certain amount (the principal) at a specified date
(the maturity date) and to pay a given amount of interest per specified time period in the meantime.
Governments, municipalities and corporations, can issue it with the interest rate reflecting the risk of
default.
How does an individual have to decide how to allocate his financial assets/wealth between alternative
types of assets? Such a decision is referred to as a portfolio decision
Wh= B+ M where; Bond holding (B) bears interest
Money holding (M) enables purchasing
The decision depends upon the equilibrium interest rate on bonds which is the rate at which the
demand for bond= the existing stock of bonds. What factors determine the equilibrium interest rate of
bonds?
The equilibrium interest rate can either be described as
 The rate at which the supply and the demand for bond (B) are equated,
 The rate that equates the demand for with the supply of money (M)
Assume that
 The supply of money and bonds are exogenously determined, i.e. the supply of money is
determined by the policies of central banks while that of bonds are by the investment decisions
of borrowers. The supply curve for B refers to the outstanding stocks
 The demand for M and B refer to the stock of money and the stock of B at a given point in time
If we aggregate the demand for money and bonds of individuals and use the above assumption, there
are two equivalent ways of depicting the equilibrium interest rate.
40
 r Md1 Ms r Bs Bd1
Md Bd

8% 8%

6% 6%

M B
Figure. 2.11 Equilibrium interest rate

A person who is satisfied with the level of holding money relative to total wealth is satisfied with the
bond holdings, i.e. (s) he is at the optimal split of fixed wealth between M and B at 6% interest rate. If
there exists an excess demand for M at this rate of interest, in the aggregate, the public tries to raise the
proportion of their money holding. They, then, become willing to supply an equivalent worth of B to
the bond market. The bond supply becomes excess, which together with the fixed supply of bonds,
leads to a fall in the price of bonds. This raises the interest rates because of the relationship that
R R
V   r
r V
Now as a result of the fall in the price of bonds the demand for bond for the existing bonds increases
and hence the demand function for bonds shifts up to Bd1 at a higher rate of interest until the bond
market clears. When it clears so does the money market at this higher interest rate at which the
demand for money = the supply of money. Thus, equilibrium in one market implies equilibrium in
another. For the purpose of macroeconomic analysis the money market where the equilibrium interest
rate is related with the monetary factors is chosen. According to this market the equilibrium rate of
interest is determined by factors affecting the supply of money and the demand for money.
 The supply of money is determined by the policies of the central bank
 The demand for money is determined by factors explained by the theory of money demand
2.3.1. The Theory of Money Demand
The demand for holding money relies on three motives: transaction, precautionary and speculative
motives.
(1) Transaction Demand
Individuals and firms hold money for use in transactions. As a medium of exchange, money bridges
the time gap between the receipt of income (monthly) and payments for expenditure (daily). As the
41
volume of transactions, for which income is a good measure, changes so does the amount of money
held for such purpose positively. In addition to this expected expenditure transaction, individuals also
hold money for unexpected expenditure. The money demand for such motives is termed as
precautionary demand for money. Both the transaction an precautionary demand for money, being
determined by income, are subsumed under the transaction demand for money, of which function is
given by
Transaction demand  k(y)
And k(y)>0
(2) Speculative Demand
Why should an individual hold any money above that needed for the transaction and the precautionary
motives? Even though bonds pay interest and money does not, there are times during which
individuals prefer to hold money rather than bonds. This usually happens when the individual believes
that future rates of interest will be above the current market interest rates, he has a reason for keeping
actual liquid cash rather than holding bonds.

The desire for holding speculative balances that arise from securing profit from unexpected future
capital losses on bonds depends on the rate of interest expected in future. How does expected future
interest rate affect current decision of speculative demand for money? At the time an individual makes
a decision whether to buy a bond or to hold money, he makes also expectations about future interest
rate, and i.e. he might expect that the interest rate will rise, fall or remain the same.
Case 1
If he expects that the rate of interest, as compared to its current rate, falls. Then he expects that the
R
expected future bond price, Ve  .......... .......... .......... .......... .......... .......... ..(1) will rise above its current bond
re
R
price, V  .......... .......... .......... .......... .......... .......... ..( 2) And he expects a capital gain,
r
R R
G  Ve  V   .......... .......... .......... .......... (3)
re r
If capital gain is expressed as a percentage of its current value,
R R
V V re r r
g e    1.......... .......... .( 4)
V R re
r

42
If this expected capital gain is added to the interest payments the individual will receive after a year,
the expected net profit of bond holding will be
r
erg r  1.......... .......... .......... ........( 5)
re
Since for this individual whose expectation is formed on the falling interest rate the expected earning
is positive (e>0). He will decide to invest all his wealth in bonds.

Case 2
Suppose the individual expects that future interest rate rises in comparison to the current rate, then
what will be his decision? This expectation leads to the expectation that future expected bond price
will fall according to the relationship given by (1). Then he expects a capital loss,
r
(g)  1  0
re
If this expected capital loss outweighs the interest earnings on bond holdings, r, i.e.
(g)>r  e<0
The individual expects a net loss no any bond he buys, then he will decide to hold his all wealth in the
form of money.
We can conclude that given the rate of interest the individual expects, he will desire to hold only
money when the current rate of interest is low and only bonds when the rate is high.
No loss no gain, if the capital loss is equal to the interest earning (r + g)=0, the individual will be
indifferent in bond and money holdings. This point is termed the critical interest rate. It is described
as;
r It is possible to conclude that when;
e  (r  g )  r  (  1)  0 e>0, r>rc, capital gain is expected
re
The proportion of wealth held in the form of money is zero
1
r (1  )  1 e<0, r<rc, capital loss expected and outweigh the interest rate
re The proportion of wealth held in the form of money is unity all the
1
r assets held in money
re  1 e=0, r=rc, both money and bond yield zero net return.
rd
re
rc  .......... .......... .......... .......... ..( 6)
1  re

43
Graphically, the individual‟s speculative demand for money can be given by the step function, ABCD.

r A r A r

B
r cA C rcA
B
r cB C rcB

D D
MA MB MA MA+MB
A’s Speculative dd for M B’s speculative dd for MB total speculative dd for M
Figure .2.12. Demand for money

In aggregate the speculative balances will be smooth and continuous as we add the individual
speculative demand for money curves horizontally. Keynes assumed that different wealth holders have
different expected rates of interest and therefore different critical rates of interest. As a result of this
difference it becomes possible to draw the liquidity preference function for the economy as a smooth
curve. At a relatively high interest rate, only a few wealth holders have higher critical interest rates.
Speculative demand for money  l(r)
l(r)<0
Liquidity Trap
At a very low interest rate there is a general expectation of capital losses on bonds that substantially
outweigh the interest earnings. Bond prices are so high that wealth holders become indifferent
between holding bonds and holding money. Bonds and money become perfect substitutes. The
liquidity preference function is therefore in the liquidity trap.

M=l(r)

Speculative demand for money

Figure 2.13 Liquidity trap

44
The Total Money Demand
The transaction and precautionary demand for money vary positively with income while the
speculative demand for money is negatively related with the interest rate. Then, by putting them
together, we can write the total demand for money as
Md=L(Y,r)
Md=l(r) +k(y)………………………………..(7)
With l <0 and k<0
NB: Both components of the total money demand, transaction and speculative, should be divided
by price to arrive at the demand for real balances

r r TB(y0) TB(y1) TB(y2) r

SB
r1 r1 r1

r2 r2 r2
r3 r3 r3

Md(y0)
Md(y1)
Md(y2)
Speculative dd Transaction dd money dd function

2.3.2. Money Supply

The amount of currency and demand deposit that constitutes the money supply of the economy is
exogenously determined by the central bank‟s policies. So the money supply is assumed to be a
controlled policy variable and taken as given at the level M . Given the price level P , the real money
supply is fixed at the level M P .
Now by putting the money demand and money supply functions, we will form the money market
equilibrium condition as follows:
d
M M
  l (r )  k ( y )......... .......... .......... .......... .......... ...(8)
P P

45
 M M 
r    
 P 0  P 1

Excess supply

r0

r1

Md(y0)
M/P
Quantity of Money

Figure. 2.13. Money supply

Using the above diagram let‟s consider the case when the fixed money stock shifts to the right
(increases). This, at the initial equilibrium interest rate, r0, results in the excess supply of money. The
resulting new money holding encourages people to buy bonds, whereby they reduce their money
holdings. The excess supply of money in the money market is changed into excess demand for bonds
in the bond market and pushes the price of bonds. Thus this causes to lower the rate of interest at
which suppliers of bonds or borrowers offer to sell their bonds until a new equilibrium interest rate is
reached a r1, where the demand for money rises from (M/P)0 to (M/P)1

2.3.3. The LM Curve

1. The Construction of the LM Curve
According to the Keynesian model, the money demand is a positive function of income, due to the
transactions demand, and a negative function of rate of interest, due to the speculative demand for
money. This relationship for real balances can be described as given above in (7).

Along with the demand function for real balances, the money market assumes the exogenously
determined and independent of the interest rate money supply function. It is considered as a fixed
stock of money and has a vertical shape. In addition to this, if we assume the general price level is
fixed, then the real money supply is given by M/P. The equilibrium condition in the money market is
given by the level of interest rate at which the demand function and the fixed supply function equates
as in (8)

46
 r r

LM

r2 r2
r1 r1
r0 r0
L(y2)
L(y1)
L(y0)
M/P Y
M/P Y0 Y1 Y2

Figure 2.14 Derivation of LM curve

As income level increases, say from Y0 to Y1 and to Y2, the money demand function shifts to the right
when plotted against the interest rate, say from L(Y0) to L(Y1) and to L(Y2). The value of the fixed
money stock being given at M P , the points of intersection in the money market show the resulting
increase in the interest rate say from r0 to r1 and then to r2, that maintains equilibrium in the money
market.
For each level of income, Y0, Y1 and Y2, it is possible to find the corresponding interest rates, r0, r1
and r2, at which the money market is in equilibrium. When these income-interest rate combinations,
(Y0,r0), (Y1,r1) and (Y2,r2) are plotted separately, the money market equilibrium, LM, schedule will be
constructed as shown above. Thus LM schedule can be defined as a schedule that represents the pairs
of interest rate and income level that maintain the money market equilibrium at a given level of money
supply and price level.

The LM schedule is positively sloped, or upward to the right. It means that at higher levels of income,
equilibrium in the money market occurs at higher interest rates. The reason for such a result lies in that
the increase in income increases money demand at a given interest rate, because the transactions
demand for money varies positively with income. But, since the money stock is fixedly supplied, the
money demand has to be restored to the equilibrium level by raising the interest rate. This results in a
lower speculative demand for money corresponding to the higher level of income. The interest rate
must rise until the fall in the speculative demand for money is just equal to initial income- induced
increase in transactions demand.

47
2. Factors Determining the Slope of the LM Schedule
The slope of the LM curve can be derived using (8) above, which states that
M
 l (r )  k ( y )
P
by takingtotal differentiation
M  dl(r ) dk ( y )
d     dr   dy
 P  dr dy
M
0  l dr  k dy d   0
 P

dr  k  income elasticityof money demand
  .......... .......... ....( 9)
dy l int erestelasticityof money demand
Since k   0 and l   0, dr dy  0

From (9) it is easy to see that the higher the value of k, the responsiveness of money demand to
income, and the lower the value of l, the responsiveness on money demand to the interest rate, the
steeper will be the LM curve. (In other words, the higher the value of k, the larger the increase in
money demands per unit increase in income M Y  , and hence the larger upward adjustment in the
interest rate required to restore the money market equilibrium at higher level of interest rate.) In order
to maintain the slope of the money demand function at the level of the fixed supply u of money stock
the interest rate will have to rise by enough to offset the income – induced increase in money demand.
(for transaction purpose).

However, for a given income-induced increase in money demand (for a given k) the amount by which
the interest rate has to rise to offset this increase to restore equilibrium of the money market depends
on the interest elasticity of money demand or sensitivity of money demand to interest rate. The lower
the interest elasticity on money demand, the steeper the LM curve will be and the lesser will be the
response of the demand for money to a given change in the interest rate. As income increases from Y0
to Y1 and then to Y2 money demand schedule will shift to the right resulting from the increases in the
transactions demand for money.

Because a given increase in the interest rate will not reduce money demand by much, the interest rate
will have to rise by large amount to reduce money demand back to the fixed money supply level. The
LM curve will be steeper.

48
 M
r r LM
P

r2 r2

r1 r1

r0 r0
L(Y2)
L(Y1)
L(Y0)
M y0 y1 y2 Y

When the money demand is highly interest – elastic, the money demand curve will become very flat.
This leads to the case where as the interest rate drops in a small amount, money demand increases
significantly. As income increases from Y0 to Y1 and from Y1 toY2, the income – induce increase in
money demand will be L(Y), L(Y1) and L(Y2).But, to restore the money market equilibrium, the
interest rate is required to rise by a relatively small amount that will offset the income- induced
increase in transactions balances. Consequently, the LM curve has relatively become flat.

M
r r
P

LM
r2 r2

r1 L(Y2) r1
r0 L(Y1) r0

L(Y0)
M y0 y1 y2 Y

3. Factors that Shift the LM Schedule

A policy action changing the policy instrument to a new level by increasing the money stock creates
an excess supply of money at the initial level of income and interest rate. Point A on the initial LN 0
curve represents the point of money market equilibrium for an interest rate r0 an income level Y0 that
are derived from the money market where the initial money supply Mo/P is equated with Ld (Y0)
schedules.

49
An increase in the real money supply from M0/P to M1/P reduces the equilibrium interest rate from r0
to r1 to restore the money market equilibrium at Y0 level of income. With income fixed, for the new
higher real money supply to be equal to money demand, the interest rate must be lower to increase the
speculative demand for money. The combination of the given income level and the new, lower interest
rate that equilibrates the new real money supply with the money demand forms the new LM schedule
which lies below the initial LM0 curve, as shown at point B on the graph. In short, at a given level of
income the equilibrium interest rate has to be lower to induce people to hold the larger real quantity of
money for speculative purpose.

M0 M1
r r LM0
P P
LM1

r0 r0 A C

r1 r1 B
Ld(Y1)
Ld(Y0)

M Y
y0 y1

Alternatively, the new LM curve can be traced again by increasing the level of income for a given
interest real, when the real money supply changes likewise. To maintain the money market
equilibrium, income would have to be higher to Y1, and hence for the given level of interest rate r0.
Through the transaction demand, the money demand schedule will shift out to Ld (Y1) to absorb the
higher real money supply. It is shown at point C on the new LM curve, LM1, which shifts rightward.

In short, an increase in the real money supply shits the LM schedule downward and to the right.
Reversing the increase in the real money supply, for example increasing P, produces symmetrically
opposite result in the LM schedule that will shift upward and to the left.

50
Mathematically, we can derive the relationship as follows:
The money market equilibrium condition is
M
 m  l (r )  k ( y )
P
M
d  dm  l dr  k dy
P
l dr  dm  k dy
dm k dy
dr  
l l
dr 1
 0
dm l 
In general LM curve:
 It is the curve giving the combinations of values of income and the interest rate that produce
equilibrium in the money market
 It slopes upward to the right
 It will be relatively flat (steep) if the interest elasticity of money demand is relatively high ( low)
 It will shift downward (upward) to the right (left) with an increase (decrease) in the quantity of money
Positions of the LM Curve
Consider the equilibrium point A, if we assume an increase in income from Y0 to Y1, then the demand
for money shifts from L (Y0) to L (Y1) at the initial interest rate r0. This turns out to be an excess
demand for money at point D.

M
r r M
P

Excess supply Excess supply

r1 C B r1 C B

r0 A D r0 A D
Excess demand Excess demand
L(Y1)
L(Y0) L
M Y
y0 y1

More generally, any point below and to the right of the LM schedule represents a disequilibrium ones
and excess demand for money. If excess supply of money exists in the money market, like at point C,
then correspondingly we have an excess supply of money in the LM schedule, where a disequilibrium
point C indicates this case. More generally, any point above and to the left of the LM schedule
indicates a disequilibrium point for excess supply of money.

51
 LM curve and Liquidity preferences
The theory of liquidity preference explains how the supply and demand for real money balance
determines the interest rate. To develop this theory, we begin with the supply of real money balances.
The theory of liquidity preference assumes there is a fixed supply of real balance.
That is, (M/P)s = M/ P
The money supply M is an exogenous (external variable) policy variable chosen by the central bank.
The price level P is also an exogenous variable in this model. (We take the price level as given
because the IS-LM model considers the short run when the price level is fixed).
These assumptions imply that the supply of real balances is fixed and, in particular, does not depend
on the interest rate as shown in the figure below.

R
Money Supply

M/ P M/P=real money balance

Fig.2.15. Money supply

Next, consider the demand for real money balances. People hold money because it is a “liquid”
asset- that is, because it is easily used to make transactions. The theory of liquidity preference
postulates that the quantity of real money balances demanded depends on the interest rate. The
interest rate is the opportunity cost of holding money. When the interest rate rises, people want to
hold less of their wealth in the form of money.

We can write the demand for real money balances as:

(M/P)d = L(r),
Where the function L (r) shows that the liquidity of money demanded depends on the interest rate.
This equation states that the quantity of real balances demanded is a function of the interest rate.
This inverse relationship between money demand and interest rate can be shown as a downward
sloping demand curve.
52
 R

L(r)
M/P
Fig.2.16. Money demand

To obtain the theory of the interest rate, we combine the supply and the demand for real money
balances. According to the theory of liquidity preference, the interest rate adjusts to equilibrate the
money market. At the equilibrium interest rate, the quantity of real balances demanded equals the
quantity supplied. The equilibrium condition is shown in the figure below.

R
Equilibrium interest rate

r*

L(r)
M/ P M/P

Fig.2.17. Theory of liquidity preference

The adjustment of the interest rate to this equilibrium of money supply and money demand occurs
because people try to adjust their portfolios of assets if the interest rate is not at the equilibrium level.
 If the interest rate is too high, the quantity of real balances supplied exceeds the quantity
demanded. Banks and other financial institutes respond to this excess supply of money by
lowering the interest rates they offer.
 Conversely, if the interest rate is too low, so that the quantity of money demanded exceeds the
quantity supplied, individuals try to obtain money by making bank withdrawals, which drives
the interest rate up.
 At the equilibrium interest rate people are content with their portfolios of monetary and non-
monetary assets.

53
The theory of liquidity preference implies that decreases in the money supply raise the interest rate and
that increases in the money supply lower the interest rate. Suppose there is a reduction in money
supply. A reduction in M reduces M/P, since P is fixed in the model. The supply of real balances shift
to the left, as shown in the figure below. The equilibrium interest rate rises from r1 to r2. The higher
interest rate induces people to hold a smaller quantity of real money balances.
The opposite would occur if the central bank had suddenly increased the money supply. Thus,
according to the theory of liquidity preference, a decrease in the money supply raises the interest rate,
and an increase in the money supply lowers the interest rate.

Fig. 2. 18. A reduction in the money supply in the theory of liquidity preference
R

r1
r2

L(r)
M2/P M1/P M/P (Real Money Balance)

2.4.1. Income, Money Demand, and the LM Curve

So far we have assumed that only the interest rate influences the quantity of real balances demanded.
More realistically, the level of income Y also affects money demand. When income is high,
expenditure is high, so people engage in more transactions that require the use of money. Thus, greater
income implies greater money demand. Write the money demand function as (M/P) d = L(r, Y).
The quantity of real money balances demanded is negatively related to the interest rate and positively
related to income. Using the theory of liquidity preference, we can see what happens to the interest
rate when the level of income changes. For example, consider what happens when income increases
from Y1 to Y2.
R R LM
Fig.2.19.
r2 r2
Deriving the LM
L(r, Y2)
Curve
r1 r1
L(r, Y1)

M/ P M/PY1 Y2 Y

54
As the above figure shows the increase in income shifts the money demand curve outward. To
equilibrate (to get equilibrium) the market for real money balances, the interest rate must rise from r1
to r2. Therefore, higher income leads to a higher interest rate. The LM curve plots this relationship
between the level of income and the interest rate. The higher the level of income, the higher the
demand for real money balances and the higher the equilibrium interest rate. For this reason the LM
curve slopes upward as illustrated above.

Definition: The LM curve represents a positive relationship between the interest rate and the level of
income that arises from equilibrium in the market for real money balance

How Monetary Policy Shifts the LM Curve

The LM curve tells us the interest rate that equilibrates the money market for any given level of
income. The theory of liquidity preference shows that the equilibrium interest rate depends on the
supply of real balances. The LM curve is drawn for a given supply of real money balances. If real
balances change, the LM curve will shift.

Suppose that the money supply is decreased from M1 to M2, which causes the supply of real balances
to fall from M1/P to M2/P. Holding constant the amount of income and thus the demand curve for real
balances, a reduction in the supply of real balances raises the interest rate that equilibrates the money
market. Hence, a decrease in real balances shifts the LM curve upward.
LM2
R
LM1
r2 r2

r1 L(r, Y ) r1

M2/P M1/P M/P Y

Fig. 2.20. Shift of LM because of reduction in the money supply
In summary, the LM curve shows the relationship between the interest rate and the level of income
that arises in the market for real money balances. The LM curve is drawn for a given supply of real
money balances. Decreases in the supply of real money balances shift the LM curve upward. Increases
in the supply of real money balances shift the LM curve downward.

55
2.5. The Short-Run Equilibrium
We now have all the components of the IS-LM model. The two equations of this model are
Y= C (Y-T) + I(r) +G ---------IS
M/P = L(r, Y) ---------------------LM
The model takes fiscal policy, G and T, monetary policy M, and the price level P as exogenous. Given
these exogenous variables:
 The IS curve provides the combination of r and Y that satisfy the equation representing the
goods market, and
 The LM curve provides the combinations of r and Y that satisfy the equation representing the
money market.
These two curves are shown together in the figure below.
The equilibrium of the economy is
R LM the point at which the IS curve and
Equilibrium
Interest rate the LM curve cross.
E This point gives the r* and the level
r* of income Y* that satisfy both the
Equilibrium level of income
goods market and the money
IS market equilibrium condition.
In other words, at this intersection,
Income, output, Y
Y* actual expenditure equals planned
Fig.2.21. the IS-LM Model: Interaction of IS and LM curves expenditure, and the demand for
real money balances equals the
supply.

2.5.1. Monetary and Fiscal Policy Analysis

The intersection of the IS curve and the LM curve determines the level of national income. National
income fluctuates when one of these curves shifts, changing the short-run equilibrium of the economy.
2.5.1.1 Change in Fiscal Policy
Suppose that we start in equilibrium and that government spending is increased by G. Then the IS
curve shifts to the right. The increased spending increases income and, through the multiplier effects
from the circular flow, also increases consumption; income increases further. (Recall that the
rightward shift of the IS curve equals G/(1-MPC).) If we only had to worry about the goods market,
this would be the end of the story. But the increase in income, in turn, increases the demand for money
for transaction purposes (for purchasing of goods and services). This increased demand for money
forces up the interest rate, leading, in turn, to a decline in investment. Thus we observe short-run
crowding out:
56
  The increase in GDP is less than the simple Keynesian cross model would have predicted
because that model omits changes in the interest rate.
 A decline in taxes, like an increase in government spending, shifts the IS curve out, causing
interest rates and GDP to rise.
Mathematical derivation of the impact of Fiscal policy
IS: Y= C(Y-T) + i(r) + G----------------- [1]
LM: M/P = kY + Lr ---------------------- [2]

Differentiating [1] and [2], we obtain

dY = C‟ (dY – dT) +i‟dr + dG
Assuming the tax rate is fixed

dY = C’dY + i’dr + dG----------------[1.a]

Or
dY (1-C’) = i’dr + dG
From [2] we get
dm dp
 m 2 = Ldr + kdY
p p
dm dp k
dr = m  dY ------------------[2.a]
LP LP 2 L
Substituting [2.a] into [1.a]

i ' dm dP
dY  C ' dY  (  m 2  kdY )  dG
L p P
1 i' dm i' mdP
dY  (   dG) ------------------- (3)
i' k L' P L ' P 2
(1  C '  )
L
dY 1
 >0
dG i' k
1  C' 
L
i' k
1-C’ >0 and > 0 since both the numerator and denominator are negative.
L
Thus, government expenditure has expansionary impact.

57
2.5.1.2 Changes in Monetary Policy
Consider the effects of an increase in the money supply. This shifts the LM curve out. The increased
money supply causes interest rates to fall in order to bring the demand for money in line with the new
higher supply. This fall in interest rates encourages investment, leading ultimately to an increase in
GDP. Thus interest rates are lower and GDP is higher. The linkage from a change in the money supply
to GDP is known as the monetary transmission mechanism.

Mathematical derivation of the impact of monetary policy

The impact of the monetary policy can also be derived from equation [3] above.
1 i' dm i' mdP
dY  (   dG)
i' k L' P L' P 2
(1  C '  )
L
i'
dY L' P > 0 since both the denominator and the numerator are positive.

dM i' k
1  C '
L
This shows that an increase in money supply raises the level of income. The transmission mechanism
in the context of the IS-LM model is that an increase in the money supply lowers the interest rate,
which stimulates investment and thereby expands the demand for goods and services.

2.5.1.3 Interaction between Monetary and Fiscal Policy

When analysing any change in monetary or fiscal policy, it is important to note that these policies may
not be independent of each other. A change in one may influence the other. This interdependence may
alter the impact of a policy change.

Suppose that the fiscal authorities increase taxes. Other things equal, this would reduce output and
interest rate in the short run (Case 1). If the monetary authority is trying to keep interest rates stable,
however, it would respond to this change by decreasing the money supply. The result would be a
larger decrease in output (Case 2). Alternatively, the monetary authorities might be trying to keep
output stable, in which case it would increase the money supply, driving interest rates down further
(Case 3). The basic issue is that the ultimate effects on the economy depend upon the combinations of
policies chosen by the monetary and fiscal authorities.

58
R LM2 LM1
LM LM2
LM1

IS1
IS1 IS1
IS2 IS2 IS2
Y Y
Case 1 Case 2 Case 3

Central bank hold money central bank hold Central bank hold
Supply constant interest rate constant Income constant

Fig.2.22. Fiscal and Monetary policy on IS-LM Model

2.6. Aggregate Demand and the ISLM

We have been using IS-LM model to explain national income in the short run when the price level is
fixed. Now we examine what happens in the IS-LM model if the price level is allowed to change.
We now consider how the ISLM model can also be viewed as a theory of aggregate demand. We
defined the IS and LM curves in terms of equilibrium in the goods and money markets, respectively.
Aggregate demand summarizes equilibrium in both of these markets.
Recall that the ISLM model is constructed on the basis of a fixed price level. For a given value of the
price level and the nominal money supply, the position of the LM curve is fixed. The real money
supply changes if either the nominal money supply or the price level changes. Thus we can see that
changes in the price level are associated with changes in the equilibrium level of output and interest
rates. This is the relationship that is summarized by the aggregate demand curve i.e. aggregate demand
describes a relationship between the price level and the level of national income.

If the price level is high, other things equal, the real money supply is low. This implies high interest
rates, and thus low investment and output. If the price level falls, then the real money supply increases.
Equilibrium in the money market implies that interest rates must fall. Equilibrium in the goods market
thus implies that output must rise, since investment rises. Thus we find that the aggregate demand
curve is downward sloping; high values of the price level are associated with low level of output, and
vice versa. Notice that the reason this curve slopes downward is not easy to describe; it is not like the
regular microeconomic demand curve for a good.

59
 LM (P2)
R r
LM (P1)

IS IS

M/P2 M/P1 M/P Y2 Y1 Y

P2

P1
AD

Y1 Y2

Fig.2. 23. Deriving the aggregate Demand curve with the IS-LM model
The aggregate demand curve can also be derived either from equation [3] above or the quantity theory.
1 i' dm i' mdP
dY  (   dG)
i' k L' P L' P 2
(1  C '  )
L
 i' m
dY L' P 2 < 0; since – i‟ > 0 and L‟ < 0, and hence the numerator is negative. And the

dP i' k
1  C '
L
denominator is positive. Thus, dY/dP will be negative.
Alternatively, we can use the quantity theory to derive the above relationship. Consider the quantity
theory
MV = PY
Y= MV/P
dY  MV
 0
dP P2
How Monetary and Fiscal policy shift the aggregate demand curve?
What causes the aggregate demand curve to shift?
Because the aggregate demand curve summarizes the results of the ISLM
Model, shocks that sift the IS curve or the LM curve cause the aggregate demand curve to shift.
 For instance, an increase in the money supply raises income in the IS-LM model for any given
price level; it thus shifts the aggregate demand curve to the right, as shown in Fig. 15. A.
60
  Similarly, an increase in government purchases or a decrease in taxes raises income in the IS-
LM model for a given price level; it also shifts the aggregate demand curve to the right, as
shown in Fig. 15. B.
 Conversely, a decrease in money supply, a decrease in government purchases, or an in crease
in taxes lowers income in the IS-LM model and shifts the aggregate demand curve to the left.
Thus, the result can be summarized as follows:
 A change in income in the ISLM model resulting from a change in the price level represents a
movement along the aggregate demand curve.
 A change in income in the ISLM model for a fixed price level represents a shift in the
aggregate demand curve.

LM1 (P=P1)
R LM (P=P1)
LM2 (P=P1)

IS 2
IS1
Y
Y1 Y2 Y1 Y2 Y
P
AD1 P
AD2
AD2 AD1

Y1 Y2 Y=income Y1 Y2 Y

Fig.2.24. A. Expansionary Fig.2.24. B. Expansionary

Monetary policy Fiscal policy

The ISLM Model in the short-run and Long Run

The IS-LM model is designed to explain the economy in the short run when the price level is fixed.
Yet, now that we have seen how a change in the price level influences the equilibrium in the IS-LM
model, we can also use the model to describe the economy in the long run when the price level adjusts
to ensure that the economy produces at its natural rate. By using the IS-LM model to describe the long

61
run, we can show clearly how the Keynesian model of income determination differs from the classical
model.
We can also analyze the transition to the long run in the ISLM model. If the economy is not at full
employment, then the price level adjusts. In terms of the AD-AS diagram, the economy moves along
the AD curve. In terms of the ISLM diagram, the LM curve shifts. Thus we can see that the process of
adjustment to equilibrium has subtle economic forces lying behind it. If, for example, we start in
recession, then over time prices fall. This increases the real money balance, pushing down interest
rates and encouraging investment. This increase in investment, in turn, leads to higher spending and
higher output.

LRAS LRAS
LM (P1) P
R

LM (P2P)1 SRAS1
K
C SRAS2
P2
K
IS
C AD
Y Y Y Y
(A)The IS-LM model (B) the Model of Aggregate Supply
Aggregate Demand
Fig.2.25. the short run and long-run Equilibrium

In the above figure 2.25.A the three curves that are necessary for understanding the short-run and long
run equilibria: the IS curve, the LM curve, and the vertical line representing the natural rate of out
put Y . The LM curve is, as always; drown for a fixed price level, P1. The short-run equilibrium of the
economy is point K, where the IS curve crosses the LM curve. Notice that in this short-run
equilibrium, the economy‟s income is less than its natural rate.

Figure 2.25.B shows the same situation in the diagram of aggregate supply and aggregate demand. At
the price level P1, the quantity of output demanded is below the natural rate. In other words, at the
existing price level, there is insufficient demand for goods and services to keep the economy
producing at its potential.
In these two diagrams we can examine the short-run equilibrium at which the economy finds itself and
the long-run equilibrium toward which the economy gravitates. Point K describes the short run
62
equilibrium, because it assumes that the price level is stuck at P1. Eventually, the low demand for
goods and services causes prices to fall, and the economy moves back towards its natural rate. When
the price level reaches P2, the economy is at point C, the long-run equilibrium. The diagram of
aggregate supply and aggregate demand shows that at point C, the quantity of goods and services
demanded equals the natural rate of output. This long-run equilibrium is achieved in the IS-LM
diagram by a shift in the LM curve: the fall in the price level raises real money balances and therefore
shifts the LM curve to the right.
We can see the key difference between Keynesian and classical approaches to the determination of
national income. The Keynesian assumption (represented by point K) is that the price level is stuck.
Depending on monetary policy, fiscal policy, and the other determinants of aggregate demand, output
may deviate from the natural rate. The classical assumption (represented by point C) is that the price
level is fully flexible. The price level adjusts to ensure that national income is always at the natural
rate.
To make the same point somewhat differently, we can think of the economy as being described by the
equations. The first two are the IS and LM equation:

Y= C (Y-T) + I (r) + G-----------------------IS

M/P= L (r, Y) ------------------------------------LM
The IS equation describes the goods market, and the LM equation describes the money market. These
two equations contain three endogenous variables: Y, P, and r. The Keynesian approach is to complete
the model with the assumption of fixed prices, so the Keynesian third equation is P=P1
This assumption implies that r and y must adjust to satisfy the IS and LM equations. The classical
approach is to complete the model with the assumption that output reaches the natural rate, so the
classical third equation is Y= Y

This assumption also implies that r and p must adjust to satisfy the IS and LM equation:
The classical assumption best describes the long run. Hence, our long-run analysis of national income
and price assumes that out put equals the natural rate. The Keynesian assumption best describe the
short run. There fore, our analysis of economic fluctuations relies on the assumption of a fixed price
level.
We can also explain the IS-LM in the long run and short-run in the following ways:
In the long run output is equals to its potential level –i.e. Y= Y . Thus, the IS equation will be

IS dY (1-C‟) = i‟dr + dG, but dY=0 thus

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 -i’dr = dG---------------------------------- [1]
And the LM equation will be

dm dp
LM  m 2 = Ldr + kdY, but dY = 0. Thus,
p p
dm dp dm dp
Ldr =  m 2  dr=  m 2 --------- [2]
p p Lp Lp
Substituting the [2] into [1] and rearranging to obtain
LP 2 i'
dP  (dG  dm)
i' m LP This implies that in the long run, a proportionate change in price is
dP P dP dm
  
dm m P m
equals to the proportional change in the money stock.

The second element of our theory is the money market. The equilibrium in the money market is

M/P = L (i, Y) = L (r, Y)

Where M is the amount of currency supplied to the public by the central bank. Note that, in the
Keynesian theory the price level is fixed so that we can assume that there is no difference between the
nominal and the real interest rate (i.e. r and i are equal). The central bank affects the level of interest
rates by choosing the amount of currency by open market operations the equilibrium in the money
market is determined at the point where the real money supply M/P is equal to the real money demand
L.

We can now express this equilibrium in the money market as a new relation between the real interest
rate r and real output Y, given values of M and P; we will call this relation the LM curve. We derive
this relation in much the same way we did for the IS curve. Start with supply and demand for money
for a given initial value of Y.

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UNIT THREE
AGGREGATE SUPPLY ANALYSIS
INTRODUCTION
In the previous chapter we examined aggregate demand in some detail. The IS-LM model shows how
changes in monetary and fiscal policy and shocks to the money and goods market shift the aggregate
demand curve. In this chapter, we turn our attention to aggregate supply and develop theories that
explain the position and slope of the aggregate supply curve.

Aggregate Supply
Definition: Aggregate supply (AS) is the relationship between the quantity of goods and services
supplied and the price level.
The aggregate demand and aggregate supply curves together pin down the economy‟s price level and
quantity of output.
Most macroeconomists believe that the key difference between the short run and the long run is the
behavior of prices.
 In the long run, prices are flexible and can respond to change in supply or demand.
 In the short run, many prices are sticky at some predetermined level. Because prices behave
differently in the short-run than in the long run, economic policies have different effects over
different time horizons.
The long run: The vertical aggregate supply curve
Because the classical model describes how the economy behaves in the long run, we derive the long
run aggregate supply curve from the classical model. To show this, we write
Y= F ( K , L )
=Y
According to the classical model, out put does not depend on the price level. To show that output is
the same for all price levels, we draw a vertical aggregate supply curve, in the figure 3.1. The
intersection of the aggregate demand curve with this vertical aggregate supply curve determines the
price level.

65
 LRAS, long run aggregate supply
Price (P)

0 Y Output =Y
Figure .3.1. The long run aggregate supply curve

If the aggregate supply is vertical, then changes in aggregate demand affects prices but not out put. For
example, if the money supply falls, the aggregate demand curves shifts down ward, as in figure 3.2.
The economy moves from the old intersection of aggregate supply and aggregate demand, point A to
the new intersection, point B. The shift in aggregate demand affects only prices.

The vertical aggregate supply curve satisfies the classical dichotomy, because it implies that the level
of out put is independent of the money supply. This long run level of out put, Y , is called the full
employment or natural level of out put. It is the level of output at which the economy‟s resources are
fully employed or, more realistically, at which unemployment is at its natural rate.
LRAS
Price
A
B AD1

AD2
0 Y Income=output=Y
Figure 3.2 Shifts in Aggregate Demand in the long run

The short run: the Horizontal aggregate supply curve

The classical model and the vertical aggregate supply curve apply only on the long –run. In the short-
run, some prices are sticky and, therefore, do not adjust to changes in demand. Because of this price
stickiness, the short run aggregate supply curve is not vertical.

66
As an extreme example, suppose that all firms have issued price catalogs and that it costly for them to
issue new ones. Thus, all prices are stuck at predetermined levels. At these prices, firms are willing to
sell as much as their customers are willing to buy, and they hire just enough labour to produce the
amount demanded. Because the price level is fixed, we represent this situation in figure 3.3 below with
a horizontal aggregate supply curve.
Price, P

short run aggregate supply, SRAS

0 Income=output=Y
Figure 3.3.The short-run Aggregate supply

The short-run equilibrium of the economy is the intersection of the aggregate demand curve and this
horizontal short-run supply curve. In this case, changes in aggregate demand do affect the level of
output. For example, if the central bank suddenly reduces the money supply, the aggregate demand
curve shifts inward, as in figure 3.4. The economy moves from the old intersection of aggregate
demand and aggregate supply, point A, to the new intersection, point B. The movement from point A
to point B represents a decline in output at a fixed price level.

Thus, a fall in aggregate demand reduces output in the short-run because prices do not adjust instantly.
After the sudden fall in aggregate demand, firms are stuck with prices that are too high. With demand
low and prices high, firms sell less of their product, so they reduce production and lay off workers.
The economy experiences a recession.
P

B A SRAS

AD1 AD2 Income=output=Y

Figure .3.4. Shifts in Aggregate Demand in the short-run

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3.2 Models of Aggregate supply
We have three models of aggregate supply:
 Sticky-wage model
 The imperfect-information Model
 Sticky-price model
In all the models, some market imperfection (that is, some type of friction) causes the output of the
economy to deviate from the classical target. As a result, the short-run aggregate supply curve is
upward sloping, rather than vertical, and shifts in the aggregate demand curve causes the level of
output to deviate temporarily from the natural rate. These temporary deviations represent the booms
and busts of the business cycle.
Although each of the three models takes us down a different theoretical route, each route ends up in
the same place. That final destination is a short-run aggregate supply equation of the form

,  >0
Y  Y   (P  P e )

Pe Where Y is output, Y is the natural rate of output, P is the price level, and is the expected
price level. This equation states that output deviates from its natural rate when the price level deviates
from the expected price level. The parameter  indicates how much output responds to unexpected
changes in the price level; 1/  is the slope of the aggregate supply curve.

3.2.1 The Sticky-Wage Model

To explain why the short-run aggregate supply curve is upward sloping, many economists stress the
sluggish adjustment of nominal wages. In many industries, nominal wages are set by long-term
contracts, so wages cannot adjust quickly when economic conditions change. Even in industries not
covered by formal contracts, implicit agreements between workers and firms may limit wage changes.
Wages may also depend on social norms and notions of fairness that evolve slowly. For these reasons,
many economists believe that nominal wages are sticky in the short run.

The sticky-wage model shows what a sticky nominal wage implies for aggregate supply. To preview
the model, consider what happens to the amount of output produced when the price level rises:
 When the nominal wage is stuck, a rise in the price level lowers the real wage, making labour
cheaper.
 The lower real wage induces firms to hire more labour
 The additional labour hired produces more output

68
This positive relationship between the price level and the amount of output means that the aggregate
supply curve slopes upward during the time when the nominal wage can not adjust.
To develop this story of aggregate supply more formally, assume that workers and firms bargain over
and agree on the nominal wage before they know what the price level will be when their agreement
takes effect. The bargaining parties the workers and the firms have in mind a target real wage. The
target many be the real wage that equilibrate labor supply and demand. More likely, the target real
wage is higher than the equilibrium real wage.
The workers and firms set the nominal wage W based on the target real wage w and on their
expectation of the price level P e . The nominal wage they set is
W= w  Pe
Nominal wage = Target Real Wage  Expected price level
After the nominal wage has been set and before labor has been hired, firms learn the actual price level
P. The real wage turns out to be
W/P = w  ( P e /P)
Expectedpricelevel
Real Wage= Target real Wage 
Actuaklpricelevel
This equation shows that the real wage deviates from its target if the actual price level differs from the
expected price level. When the actual price level is greater than expected, the real wage is less than its
target; when the actual price level is less than expected, the real wage is greater than its target.
The final assumption of the sticky-wage model is that employment is determined by the quantity of
labour that firms demand. In other words, the bargain between the workers and the firms does not
determine the level of employment in advance; instead, the workers agree to provide as much labour
as the firms wish to buy at the predetermined wage. We describe the firm‟s hiring decisions by the
labour demand function
L= Ld (W/P),
This states that the lower the real wage, the more labour firms hire. The labour demand curve is shown
in figure 3.5A. Out put is determined by the production function
Y= F (L),
Which states that the more labour is hired, the more output is produced. This is shown in figure 3.5B
and figure 3.5C shows the resulting aggregate supply curve. Because the nominal wage is sticky, an
unexpected change in the price level moves the real wage away from the target real wage, and this
change in the real wage influences the amounts of labour hired and output produced. The aggregate

supply curve can be written as

Y  Y   (P  P e )
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 Output deviates from its natural level when, the price level deviates from the expected price level.

Real wage,
W/P Income,Y

Y2 Y=F (L)
W/P1 (A) Labour Demand

W/p2 L=Ld (W/P) Y1 (B) Production

Function

0 L1 L2 Labour, L 0 L1 L2 Labour, L

Price level
Y  Y   (P  P e )
P2
(C) Aggregate supply
Figure. 3.5. Sticky-wage model P1

0 Y1 Y2 Output, Y

3.2.2 The imperfect-Information Model

The second explanation for the upward slope of the short-run aggregate supply curve is called the
imperfect-information model. Unlike the sticky-wage model, this model assumes that markets clear-
that is, all wages and prices are free to adjust to balance supply and demand. In this model, the short-
run and long run aggregate supply curve differs because of temporary misperception about prices.

The imperfect-information model assumes that each supplier in the economy produces a single good
and consumes many goods. Because the number of goods is so large, suppliers cannot observe all
prices at all times. They monitor closely the prices of what they produce but less closely the prices of
all the goods they consume. Because of imperfect information, they sometimes confuse changes in the
overall level of prices with changes in relative prices. This confusion influences decisions about how
much to supply, and it leads to a positive relationship between the price level and out put in the short
run.

70
Consider the decision facing a single supplier-a wheat farmer, for instance. Because the farmer earn
income from selling wheat and uses this income to buy goods and services, the amount of wheat she
choose to produce depends on the price of wheat relative to the prices of other goods and services in
the economy. If the relative price of wheat is high, the farmer is motivated to work hard and produce
more wheat, because the reward is great. If the relative price of wheat is low, she prefers to enjoy more
leisure and produce less wheat.
Unfortunately, when the farmer makes her production decision, she does not know the relative price of
wheat. As a wheat producer, she monitors the wheat market closely and always knows the nominal
price of wheat. But she does not know prices of all the other goods in the economy. She must
therefore, estimate the relative price of wheat using the nominal price of wheat and her expectation of
the overall price level.
Consider how the framer responds if all prices in the economy, including the price of wheat, increase:
 One possibility is the she expected this change in prices. When she observes an increase in the
price of wheat, her estimate of its relative price is unchanged. She does not work any harder.
 The other possibility is that the framer did not expect the price level to increase (or to increase
by this much). When she observes the increase in the price of wheat, she is not sure whether
other prices have risen (in which case wheat‟s relative price is unchanged) or whether only the
price of wheat has risen (in which case its relative price is higher). The rational inference is
that some of each has happened. In other words, the farmer infers from the increase in the
nominal price of wheat that its relative price has risen some what. She worked harder and
produces more.
Our wheat farmer is not unique. When the price level rises unexpectedly, all suppliers in the economy
observes increase in the price of the goods they produce. They all infer, rationally but mistakenly, that
the relative prices of the goods they produce have risen. They work harder and produce more.

To sum up, the imperfect-information model says that when actual prices exceed expected prices,
suppliers raise their output. The model implies an aggregate supply curve that is now familiar:

.
Y  Y   (P  P e )
Output deviates from the natural rate when the price level deviates from the expected price level.
3.2.3. Sticky Price Model
The sticky price model emphasizes that firms do not instantly adjust the prices they charge in response
to changes in demand. Sometimes prices are set by long-term contracts between firms and customers.
Even without formal agreements, firms may hold prices stable in order not to aggravate their regular
71
customers with frequent price changes. Some prices are sticky because of the way markets are
structured: once a firm has printed and distributed its catalogue or price list, it is costly to alter prices.
To see how sticky prices can help explain an up-ward –sloping aggregate supply curve, we first
consider the pricing decisions of individuals firms and then add to whole. In the previous discussions
we have thought of firms‟ choosing how much output to produce, taking as given the price at which
they can sell their output. If we really want to explain why prices may be sticky, we have to think
about who actually sets prices and on what basis. In reality, firms generally set the prices at which they
want to sell their output. To analyze this situation properly, we need models of imperfect competition
in which firms have some monopoly power.
Consider the pricing decision facing a typical firm. The firm‟s desired price p depends on tow
macroeconomic variables:
 The overall price P. A higher price level implies that the firm‟s costs are higher. Hence, the
higher the overall price level, the more the firm would like to charge for its product.
 The level of aggregate income Y. A higher level of income raises the demand for the firm‟s
product. Because marginal cost increases at higher levels of production, the greater the
demand, the higher the firm‟s desired price.
We write the firm‟s desired price as

p= P  a(Y  Y )
This equation says that the desired price p depends on the overall level of prices P and on the level of
aggregate output relative to the natural rate Y- Y . The parameter a (a > 0) measures how much the
firm‟s desired price responds to the level of aggregate output.

Now assume that there are two types of firms. Some have flexible prices: they always set their prices
according to this equation. Others have sticky prices: they announce their prices in advance based on
what they expect economic conditions to be. Firms with sticky prices set prices according to

p= P e  a(Y e  Y e )
For simplicity assume that these firms expect output to be at its natural rate, so the last

term, a(Y e  Y e ) , is zero. Then these firms set price as

p= P e .
That is, firms with sticky prices set their prices based on what they expect others firms to charge.
If s is the fraction of firms with sticky prices and 1 – s the fraction with flexible prices, then the overall
price level is
P  sPe  (1  s)[P  a(Y  Y )]
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The first term is the price of the sticky-price firms weighted by their fraction in the economy, and the
second term is the price of the flexible-price firms weighted by their fraction. Now subtract (1-s) P
from both sides of this equation to obtain
P  P  sP  sPe  P  a(Y  Y )  sP  sa(Y  Y )  P  sP

sP  sPe  a(Y  Y )  Sa(Y  Y )

sP  sPe  a(1 s)[Y  Y ]

Dividing both sides by s to solve for the overall price level:
a (1  s )
P  Pe  [Y  Y ]
s
The two terms in this equation are explained as follows:
 When firms expect a high price level, they expect high costs. Those firms that fix prices in
advance set their prices high. These high prices cause the other firms to set high prices also.
Hence, a high-expected price level leads to a high actual price level P.
 When output is high, the demand for goods is high. Those firms with flexible prices set their
prices high, which leads to a high price level. The effect of output on the price level depends
on the proportion of firms with flexible prices.
Hence, the overall price level depends on the expected price level and on the level of output.

From the price equation above, we can derive the aggregate supply equation using some algebraic
manipulation.
a (1  s )
Letting to be n, the price equation above can be written as
s

P  P e  n[Y  Y ] , And we can solve for Y- i.e.

nY  nY  P  P e
1
Y  Y  (P  P e )
n
1
Letting to be equalsto 
n
Y  Y   (P  P e )
The sticky-price model says that the deviation of output from the natural rate is positively associated
with the deviation of the price level from the expected price level.

73
3.3. Aggregate demand and aggregate supply in long and short run

P AS2

C
P3=Pe3
AS1
P2 B
P1=P1e=p2e A
AD2
AD1

Y
Y1=Y3= Y

Figure .3.6. Aggregate Demand and Aggregate Supply

In the short run, the equilibrium moves from point A to B. the increase in aggregate demand raises the
actual price level from P1 to P2. Because people did not expect this increase in the price level, the
expected price level remains at Pe2, and output rises from Y1 to Y2, which is above the natural rate Y .
Thus, the unexpected expansion in aggregate demand causes the economy to boom.

Yet the boom does not last forever. In the long run, the expected price level rises to catch up with
reality, causing the SR aggregate supply curve to shift upward. As the expected price level rises from
Pe2 to Pe3, the equilibrium of the economy moves from point B to point C. The actual price level rises
from P2 to P3, and output falls from Y2 to Y3 = Y . In other words, the economy returns to the natural
level of output in the long run, but at a much higher price level.

74
UNIT FOUR

UNEMPLOYMENT RATE, OKUN'S LAW, INFLATION, AND THE PHILLIPS CURVE.

INTRODUCTION
Unemployment is the macroeconomic problem that affects people most directly and severely. For
most people, the loss of a job means a reduced living standard and psychological distress. It is no
surprise that unemployment is a frequent topic and political debate and that politician often claim that
their proposed policies would help crate job.
Inflation, an increase in the general price level and unemployment are the main social problem. If you
asked why inflation is a social problem, you might answer it is because it makes you poorer. You
remember in 1998 E.C. there was an increase in salary for civil servants but immediately following the
rise in salary the price of each consumption bundle is increasing. The implicit assumption inn this
statement is that if there were no inflation, you would get the same raise and be able to buy more
goods.
Unemployment, GDP and Okun's Law
The labor force is the sum of employed and unemployed:
Labor Force = Number of Employed + Number of Unemployed
L = N + UN

The Unemployment Rate is defined as the percentage of the labor force that is unemployed:

U (Unemployment Rate) = Number of Unemployed / Labor Force  100

U = UN / L  100
Okun's Law: The relation between the growth rate of GDP and changes in the unemployment rate.
Since employed workers contribute to the production of goods while unemployed workers do not,
increases in the unemployment rate should be associated with decreases in the growth rate of GDP.
This negative relation between changes in the unemployment rate and GDP growth is called Okun's
Law.
Types of Unemployment

 Frictional unemployment: The unemployment caused by the time it takes workers to search
for a job. In fact, workers have different preferences and abilities, and jobs have different
attributes. Furthermore, the flow of information about job candidates and job vacancies is
imperfect, and the geographic mobility of workers is not instantaneous. For all these reason,
searching for an appropriate job takes time and effort, and this tends to reduce the rate of job
75
 finding. Indeed, because different jobs require different skill and pay different wages,
unemployed workers may not accept the first job offer they receive.
 Structural unemployment: The unemployment resulting from wage rigidity and job
rationing. Workers are unemployed not because they are actively searching for the jobs that
best suit their individual skills but because, at the going wage, the supply of labor exceeds the
demand. These workers are simply waiting for jobs to become available.

4.2. Inflation, its cause and costs

Inflation is always and everywhere a monetary phenomenon. Inflation implies the rise in the general
price level. As we have discussed above inflation is a cost to the society.

Two causes of rising and falling inflation

 Demand –pull inflation: we know that the relation ship between inflation and unemployment
is negative. Low unemployment pulls inflation rate up. Inflation caused because of high
aggregate demand is responsible for such type of inflation. For example, an increase in demand
for the products makes supplier to raise the price of the product in order to control the supply
limitation, which will come later.
 Cost-push inflation: Inflation also rises and falls because of supply shocks. An adverse supply
shock, such as the rise in world oil prices in the 1970s, implies arise in inflation. The supply
shocks are typically events that push up the sots of production.

Costs of inflation

 One cost is the distortion of the inflation tax on the amount of money people hold. A higher
inflation rate leads to a higher nominal interest rate, which in turn leads to lower real money
balances.
 A second cost of inflation arises because high inflation induces firms to change their posted
prices more often. Changing prices is some times costly: for example, it may require printing
and distributing a new catalog. These costs are called menu costs, because the higher the rate
of inflation, the more often restaurant have to print new menus.
 A third cost of inflation arises because firms facing menu costs change prices infrequently;
therefore, the higher the rate of inflation, the greater the variability in relative prices. For
example, suppose a firm issues a new catalog every January. If there is no inflation, then the
firm‟s prices relative to the over all price level are constant over the year. Yet inflation is 1
76
 percent per month, then from the beginning to the end of the year the firm‟s relative price fall
by 12 percent. Sales from this catalog will tend to be low early in the year (when its prices are
relatively high) and high later in the year (when its prices are relatively low).
 A fourth cost of inflation results from the tax laws. Many provisions to the tax code do not take
in to account the effect of inflation. Inflation can alter individual tax liability, often in ways
that lawmakers did not intend.
 A fifth cost of inflation is the inconvenience of living in a world with a changing in price level.
Money is the yardstick with which we measure economic transactions. When there is inflation,
that yardstick is changing in length.

4.3 Inflation, Unemployment, and the Phillips curve

Two goals of economic policy makers are low inflation and low unemployment, but often these goals
conflict. Suppose, for instance, that policymakers were to use monetary or fiscal policy to expand
aggregate demand. This policy would move the economy along the short-run aggregate supply curve
to point of higher out put and a higher price level. As we can see from figure 5.1 higher out put means
lower unemployment, because firms need more workers when they produce more. A higher price
level, given the previous year‟s price level means higher inflation

AS2

C
P3= P e 3
B AS1

P2 A AD2

P1= P e 1= P e 2 AD1

Y1=Y3= Y Y2

Figure. 4.1. Short run fluctuation because of shift in aggregate demand

Thus, when policymakers move the economy up along the short-run aggregate supply curve, they reduce the
unemployment rate and raise the inflation rate. Conversely, when they contract aggregate demand and move
the economy down the short-run aggregate supply curve, unemployment rises and inflation falls. This trade
off between inflation and unemployment, called Phillips curve.

77
 Deriving the Phillips curve from the aggregate supply curve.

The Phillips curve is a reflection of the short-run aggregate supply curve: as policy makers move the
economy along the short-run aggregate supply curve, unemployment and inflation move in opposite
direction. The Phillips curve is a useful way to express aggregate supply because inflation and
unemployment are such important measures of economic performance.

The Phillips curve in its modern from states that the inflation rate depends on three forces:
 Expected inflation
 The deviation of unemployment from the natural rate, called the Cyclical unemployment;
 Supply shocks

These three forces are expressed in the following equation:

 = e -  (u-un) + v

Inflation = Expected - (  Cyclical + Supply shock

Inflation Unemployment)

Where; , is a parameter measuring the response of inflation to cyclical unemployment. Notice that
there is a minus sign before the cyclical unemployment term: high unemployment tends to reduce
inflation. This equation summarizes the relationship between inflation and unemployment.

Although it may not seem familiar, we can derive it from our equation for aggregate supply. To see
how, you remember in chapter three the aggregate supply equation is:

p= P e  1 / a(Y  Y )

With one addition, one subtraction, and one substitution, we can manipulate this equation to yield a
relationship between inflation and unemployment.

The three steps are:

 First, add to the right-hand side of the equation a supply shock v to represent exogenous events
(such as a change in world oil price) that alter the price level and shift the short run aggregate
supply curve: p= P e  1 / a(Y  Y ) + v

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  The second is to go from price level to inflation rates, subtract lat year‟s price level P-1 from
both sides of the equation to obtain

(P – P-1)= ( P e  P  1)  1 / a(Y  Y )  v
The term on the left-hand side, P-P-1, is the difference between the current price level and last year‟s
price level, which is inflation i.e. . The term on the right-hand side, Pe – P-1, is the difference
between the expected price level and the last year‟s price level, which is expected inflation i.e. e.
Therefore, we can replace P –P-1 with  and Pe –P-1 with e:

= e + (1/) (Y- Y ) + v
 The third is, to go from out put to unemployment, remember the Okun‟s law sates that the
deviation of output from its natural rate is inversely related to the deviation of unemployment
from its natural rate; that is, when out put is higher than the natural rate of output,
unemployment is lower than the natural rate of unemployment. We can write this as
1 / a(Y  Y )   u  u n).

Using this OKun‟s law relationship, we can substitute - (u-un) for 1 / a(Y  Y ) in the previous
equation to obtain
 = e -  (u-un)+ v.
Thus, we can derive the Phillips curve equation from the aggregate supply equation.
All this algebra is meant to show one thing: the Phillips curve equation and the short-run aggregate
supply equation represent essentially the same macro-economic ideas. According to the Philips curve
equation, unemployment is related to unexpected movements in the inflation rate. The aggregate
supply curve is more convenient when we are studying out put and the price level, whereas the Phillips
curve is more convenient when we are studying unemployment and inflation. But we should not lose
sight of the fact that Phillips curve and the aggregate supply curve are two sides of the coin.
4.5 The short-run trade off between inflation and unemployment
Consider the options the Phillips curve gives to a policymaker who can influence aggregate demand
with monetary or fiscal policy. At any moment, expected inflation and supply shocks are beyond the
policymaker‟s immediate control. Yet, by changing aggregate demand, the policy maker can alter
output, unemployment, and inflation. The policymaker can expand aggregate demand to lower
unemployment and raise inflation. Or the policy maker can depress aggregate demand to raise
unemployment and lower inflation.
Figure 4.2 below plots the Phillips curve equation and shows the short-run trade off between inflation
and unemployment. When unemployment is at its natural rate (u=un), inflation depends on expected

79
inflation and the supply shock (=e + v). The parameter  determines the slope of the trade off
between inflation and unemployment. In the short-run, for a given level of expected inflation,
policymakers can manipulate aggregate demand to choose a combination of inflation and
unemployment on this curve, called the short-run Phillips curve.
Inflation, 

e + v 1

0 un Unemployment, u
Figure. 4.2. Short-run trade off between inflation and unemployment: Phillips curve
Notice that the position of short-run Phillips curve depends on the expected rate of inflation. If
expected inflation rises, the curve shifts up ward, and the policy maker‟s trade off becomes less
favorable: inflation is higher for any level of unemployment. Figure 5.3 shows how trade off
depends on expected inflation.
Because people adjust their expectations of inflation overtime, the trade off between inflation and
unemployment holds only in the short run. The policymaker cannot keep inflation above expected
inflation (and thus unemployment below its natural rate) forever. Eventually, expectations adapt to
whatever inflation rate the policymaker has chosen.
Inflation, 

High-expected inflation
Low expected inflation

un Unemployment, u
Figure .4.3. Shifts in the short-run trade off

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UNIT FIVE
FOREIGN EXCHANGE: OPEN ECONOMY
5.1. Introduction to Open Economy
The open economy macroeconomics deals with the international transaction that involves the import
and export of merchandises and services. Such a transaction is recorded in the current account of the
balance of payments while the other side of the balance of payments, capital account, records the
transaction of capital flow. Along with the transaction, the kind of exchange rate put in place also
affects the balance of payments. It is now time to complete our macro-economic analysis by
recognizing the linkages among nations.
Any country is linked to the rest of the world through two channels:
1. Trade, and
2. Finance

1. The trade linkage arises from the factor that some of country‟s production is exported to
foreign countries, (e.g., coffee export from Ethiopia to Germany) while some good that are
consumed or invested at home are produced abroad and imported (e.g., fuel is imported). It is
worth while nothing here how trade linkages affect domestic prices and the demand for our
goods. Foreign prices matter in two respects:
A. The price of commodities or raw materials, which are inputs in production, and an
element of producer‟s costs are heavily affected by worldwide supply and demand
conditions. E.g. oil price rise
B. The prices of foreign manufactured goods affect the demand for domestically produced
goods. A decline in the dollar prices of US competitors relative to the prices at which
US firms sell shifts demand away from US goods toward goods produced abroad, and
vice versa.

2. There are also strong international links in the area of finance. US residents, whether
households, Banks, or Corporations can hold US assets such as treasury bills or corporate
bonds, or they can hold Assets in foreign countries, say in Canada.

International investors seeking the best return on their assets link asset markets here and abroad
together, and their actions have fundamental effects on the determination of income, exchange
rates, and the ability of monetary policy to affect interest rates.

81
 What does Balance of Payment mean?
 The balance of payment is systematic statement of all economic transactions between a
country and the rest of the world.
 Because the balance of payments is calculated over the course of a one-year period (Or one
quarter), it is interpreted as a flow concept.
 An international transaction refers to the exchange of goods, services, and assets between
residents of one country and those abroad.

But what is meant by the term Resident? Resident includes business, individuals and government
agencies that make the country in question their legal dwelling. Although a corporation is considered
to be a residents of the country in which it is incorporated, its overseas branch or subsidiary is not.
Military personnel, government diplomats, tourists, and workers who emigrate temporarily are
considered residents of the country in which they hold citizenship.

There are two main accounts in the balance of payments:

1. Balance on current account: The totality of merchandise or trade, services, investments
income and unilateral transfers (e.g. remittances, gifts and grants.) The goods and services
component of the current account shows the monetary value of all of the goods and services a
nation exports or imports.
2. Balance on Capital Account: The capital account recorded purchases and sales of assets, such
as stocks, bonds and land. The capital account includes both the private sector and official
(central bank) transactions.

The simple rule for balance of payments accounting is that any transaction that gives rise to
payments by a country‟s residents is a deficit item in that country‟s balance of payments. Example,
imports of cars, use of foreign shipping, gifts to foreigners, purchases of land abroad or making a
deposit in other countries making international payments. As noted any transaction that gives rise
to payment by local residents to foreigners is a deficit item. An overall deficit in the balance of
payments- The sum of the current and capital accounts- means, therefore, that the US residents are
making more payments to foreigner than they are receiving from foreigners. Since foreigners want
to be paid in their own currencies, the question of how these payments are to be made arises.

82
 When the overall balance of payments is in deficit, residents have to pay more foreign currency to
foreigners than is received. The Federal and foreign central banks provide the foreign currency to
make payments to foreigners and the net amount supplies is „official reserve transactions‟.
When the country‟s (USA) balance of payments is in surplus, foreigners have to get the dollars
with which to pay for the excess of their payments to the USA over their receipts from sales to
USA.

5.2. Foreign Exchange Market

What exchange rate market mean?
 The foreign exchange market refers to the organizational setting with in which individuals;
business, governments and banks buy and sell foreign currencies and other debt instruments.
Only a small fraction of daily transactions in foreign exchange actually involve trading of
currency; most foreign exchange transactions involve the transfer of bank deposits.
 Unlike stock or commodity exchanges, the foreign exchange market is not an organized
structure. It has no centralized meeting place and no formal requirements for participation.
Nor is the foreign exchange market limited to any one country. For any currency, such as the
U.S.dollar, the foreign exchange market consists of all locations where dollars are exchanged
for other national currencies.

Three of the largest foreign exchange markets in the world are located in London, New York and
Tokyo. A dozen or so other market centres also exist around the world, such as Paris and Zurich.
Because foreign exchange dealers are in constant telephone and computer contact, the market is very
competitive; in effect, it functions no differently from a centralized market.
A typical foreign exchange market functions at three levels:
1. In transactions between commercial banks and their commercial customers, who are the
ultimate demanders and suppliers of foreign exchange
2. In the domestic inter-bank market conducted through brokers, and
3. In active trading in foreign exchange with banks overseas.
Exporters, importers, investors and tourists buy and sell foreign exchange from and to commercial
banks rather than each other. As an example, consider the import of U.S.A automobile by Ethiopian
dealer. The dealer is billed for each car it imports at the rate of 50,000 U.S dollar per car. The
Ethiopian dealer cannot write a check for this amount because it does not have a checking account
denominated in U.S dollar. Instead, the dealer goes to the foreign exchange department of, say,
Commercial Bank of Ethiopia to arrange the payment. If the exchange rate is 1$=8 birr, the
83
automobile dealer writes a check to Commercial Bank of Ethiopia for 400,000 birr (50,000  8) per
car. Commercial Bank of Ethiopia then pay the US manufacturer 50,000 U.S. dollar per car in U.S.A.
Commercial Bank of Ethiopia is able to do this because it has a checking deposit in U.S. dollar at it
branch in U.S.A.

Foreign Exchange Rates

Foreign trade involves the use of different national currencies. The relative price of two currencies is
called the foreign exchange rate, which measures the price of one unit of domestic currency in terms
of foreign currency.

The foreign exchange rate is determined in the foreign exchange markets where different currencies
are traded. The foreign exchange rate is an important determinant of international trade because it has
a large effect on the relative prices of the goods of different countries.

To see how the foreign exchange rate affects foreign trade, take wine as an example. The relative
prices of US wine and French wine will depend up on the foreign exchange rate. Say that California
chardonnay wines sell for $ 6per bottle, while the equivalent French Chardonnay sells for 40 French
Francs. Then, at the 1984 exchange rate of 10 French Frances to the dollar, French wine sells at $4 per
bottle while California wine sells at $6, giving an advantage to the imported variety. Say that by 1996
the foreign exchange rate of the dollar fell (or depreciated) to 5 Frances. Then with unchanged
domestic prices, the French wine would sell $8 as compared to $6 for the California wine. The fall in
the exchange rate on the dollar had the effect of making imports less „competitive‟ by turning relative
prices against imports and in favor of domestic products. If the dollar‟s price had risen, relative prices
would have moved in favor of imports and against domestic production.
Types of foreign Exchange Transaction
When conducting purchases and sales of foreign currencies, banks promise to pay a stipulated amount
of currency to another bank or customer on an agreed up-on date. Banks typically engaged in three
types of foreign exchange transaction: Spot, Forward and Swap.

 Spot Transaction: Spot transactions refer to outright purchase and sales of foreign currency
for cash settlement not more than two business days after the date the transactions are recorded
as spot deals. The two-day period, known as immediate delivery, allows time fore the two
parties to forward instructions to debit and credit bank accounts at home and abroad.

84
  Forward transaction: In many case, a business or financial institution knows it will be
receiving or paying an amount of foreign currency on a specific date in the future. Forward
transactions differ from spot transactions in that their maturity date is more than two business
days in the future. A forward exchange contract‟s maturity date can be a few months, or even
years, in the future. The exchange rate is fixed when the contract is initially made.

 Swaps transaction: Swaps transaction entails the conversion of one currency to another
currency at one point, with an agreement to reconvert it back to the original currency at some
point in the future. The rates of both exchanges are agreed to in advance. Swaps provide an
efficient mechanism through which banks can meet their foreign exchange needs over a period
of time. Banks are able to use a currency for a period in exchange for another currency that is
not needed during that time.

5.3. Foreign Exchange Regimes

There are two major exchange rate regimes
1. Flexible Exchange Rate regimes: One basic system occurs when exchange rates move purely
under the influence of market supply and demand. This system, known as flexible exchange
rates, is one where governments neither announce an exchange rate nor take steps to enforce
one. Thus, in a flexible- exchange rate system, the relative prices of currencies are determined
in the market place through the buying and selling of household and businesses.
The flexible exchange rate is also known as floating rate. There are clean and dirty flexible rates:

 In a system of clean flexible rates, the exchange rate is determined by supply and
demand without central bank intervention. (Note that intervention is the buying or
selling of foreign exchange by the central bank). What determines the amount of
intervention that a central bank has to do in a fixed exchange rate system? The balance
of payments measures the amount of foreign exchange intervention needed from the
central banks. So long as the central bank has the necessary reserves, it can continue to
intervene in the foreign exchange markets to keep the exchange market constant.
 However if a country persistently runs deficits in the balance of payments, the central
bank eventually will run out of reserve of foreign exchange and will be unable to
continue its intervention. Before that point is reached, the central bank is likely to
decide that it can no longer maintain the exchange rate, and will devaluate the
currency.
85
What devaluation means?
 Devaluation means decrease the value of a domestic currency in terms of foreign currency or
 Increase the value of foreign currency in terms of domestic currency.
Country‟s use devaluation in order adjusts the balance of payments deficit because devaluation
encourages country‟s export while discourage imports. But all countries might not benefit by
devaluing their currency particularly for less developed countries like Ethiopia devaluation fail to
improve the balance of payments deficit this is because:

 Even if devaluation encourage export there is a supply rigidity or limitation to cover the
increase in demand of goods or services by foreigners
 All most all of the exporting items for less developed countries especially Ethiopia are primary
products but such products are less competitive in the world market. Moreover, the price for
primary products is highly fluctuated.
 The summation of import and export elasticity is less than one (  m   x  1 ) as a result
devaluation does not improve the balance of payments disequilibria for such countries.
2. Fixed Exchange Rate regimes: The other major system is fixed exchange rates, where
governments determine the rate at which their currency will be converted in to other
currencies. In a fixed exchange rate system, foreign central banks stand ready to buy and sell
their currencies at a fixed price in terms of dollars. In a fixed rate system, the central banks
have to finance any balance of payments surplus or deficit that arises at the official exchange
rate. They do that simply by buying or selling all the foreign currency that is not supplied in
private transaction. Example; if the US were running a deficit in the balance of payments Vis-
à-vis Germany so that the demand for marks in exchange for dollars is greater than the supply
of marks in exchange for dollars, the bank would buy the excess dollars paying for them with
marks.
Fixed exchange rates thus operate like any other price support scheme, such as those in agricultural
markets. Given market demand and supply, the price fixer has to make up the excess demand or
take up the excess supply. In order to be able to ensure that the price (exchange rate) says fixed, it
is obviously necessary to hold an inventory of foreign currencies, or foreign exchange that can be
provided in exchange for the domestic currency.
What country‟s reserve entailing?
 Foreign central banks held reserves, inventories of dollars and gold that could be sold for
dollars that they would sell in the market when there was an excess demand for dollars and that
they would buy up the dollars when there was an excess supply of dollars.
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  When the over all balance of payment is in deficit, residents have to pay more foreign currency
to foreigners than is received.
 Flexible exchange rate system: the relative prices of currencies are determined in the market
place through the buying and selling of households and business.
 Fixed exchange rate system: Governments specify the rate at which their currency will be
converted in to other currencies.
Fiscal and Monetary policy in open economy
Here we consider monetary and fiscal policy in an open economy model. There are several alternatives
open economy macroeconomic frameworks. The one used here is the Mundell-Fleming Model
(named after its developer, Robert Mundell and Marcus Fleming) for open economy macroeconomics.

In an open economy gross domestic product (GDP) differs from that of a closed economy because
there is an additional injection- export expenditure, which represents foreign expenditure on
domestically-, produced goods. There is also an additional leakage; expenditure on imports which
represents domestic expenditure on foreign goods and which raises foreign national income. The
identity for an open economy is given by:
Y = C + I +G +X – M; Where X –M = net export

You remember our discussion in the previous chapters about IS-LM Model i.e., the integration of
money, interest and income in to a general equilibrium model of product and money markets.
The IS curve is the locus of those combinations of income and rate of interest at which aggregate
saving equals aggregate investment i.e. saving equals investment, showing that aggregate supply
equals the aggregate demand. Consequently, the IS curve shows the equilibrium of the real sector of
the economy.

The LM curve is the locus of those combinations or pairs of money income and the rate of interest at
which the money market is in equilibrium in the sense that there is equilibrium between the total
demand for and the total supply of money. Each point on the LM curve shows a particular level of
money income and the rate of interest against this income level at which the total demand for money
equals the total supply of money.

87
The Mundell-Fleming Model
This model is an open economy version of the IS-LM model considered previously.

The closed economy IS-LM model consists of the following two equations:
M= L (Y, r) ------------------------- (1) Money Market Equation
S (y) +T = I (r) +G------------------------- (2)  Goods Market Equation

The equation for the IS schedule is derived from the goods market equilibrium condition for a closed
economy:

C+S+T = Y= C +I + G ------------------- (3)

When C is subtracted from both sides
S+ T = I + G------------------------------ (4)
If we add imports (M) and exports (X) to the model, (3) above is replaced by
C+S+T  Y=C+I+G+X-M------------------ (5)
And the IS equation becomes
S+T= I+G+X-M--------------------------- (6)
Where (X-M), net exports, is the foreign sector‟s contribution to aggregate demand. If we bring
imports over to the left-hand side and indicated the variables up on which each elements in the
equation depends.
The open economy IS equation can be written as
S (y) +T +M (y, e) = I (r) +G +X (Yf, e) ------------ (7)
 Imports depend positively on income. Import demand also depends negatively on exchange
rate (e). A rise in the exchange rate will make foreign goods more expensive and causes
imports to fall.
 Our exports are other countries‟ imports and thus depend positively on foreign income (Yf) and
exchange rate. The latter relationship follows because a rise in the exchange rate lowers the
cost of birr measured in terms of the foreign currency and makes Ethiopian goods cheaper for
foreign residents.
Therefore, If r   M
e   M

If Yf  X
e X
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In constructing the open economy LM-schedule in Fig 5.1 below we hold four variables constant: the
level of taxes and government spending, income, and the exchange rate. Because; these are variables
that shift the curve.

Interest LM
Rate
BP

IS

0
0 Income

Fig 5.1 Open economy IS-LM Model

Expansionary Shocks: such as an increase in government spending, a cut in taxes, an increase in

foreign income or a rise in the exchange rate, shift the IS curve to the right.
A rise in foreign income is expansionary because it increases demand for our exports. A rise in the
exchange rate (e) is expansionary because it increases exports and reduce import demand for a given
level of income, it shifts demand from foreign to domestic products. An autonomous fall in import
demand is expansionary for the same reason. Changes in the opposite direction in these variables shifts
the IS curve to the left.
In addition to the IS and LM curves, our open economy model will contain a balance of payment
equilibrium curve, the BP curve as we can see in Fig 5.1 above. This curve plots all the interest rate-
income combinations that results in balance of payments equilibrium at a given exchange rate.
Balance of payments equilibrium means that official reserve transaction balance is zero.
The equation for the BP curve can be written as:
X (Yf, e) – M (Y, E) + F(r- rf) = 0--------------------- (8)
Where; X-M= trade balance (net export)
F= Net capital inflow (the surplus or deficit in the
Capital account in the balance of payments)
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The value of F depends positively on the domestic interest rate minus the foreign interest rate (r-rf). A
rise in Ethiopian interest rate relative to the foreign interest rate leads an increase in the demand for
Ethiopian financial assets (e.g., bonds) at the expense of foreign assets; the net capital inflow increase.
A rise in the foreign interest rate has the opposite effect. The foreign interest rate is assumed to be
exogenous.
The BP curve is positively slopped as shown above, as the level of income rises; import demand
increases where as export demand does not. To maintain balance of payments equilibrium, the capital
inflow must increases, which will happen id the interest rate is higher. Now consider factors that will
shift BP curve:
 An increase in e will shift the curve horizontally to the right.
 For a given level of the interest rate, which fixes the capital follow, at a higher exchange rate a
higher level of income will be required for balance of payment equilibrium. The reason is that
the higher exchange rate encourages exports and discourages imports; thus a higher level of
income that will stimulate import demand is needed for balance of payments equilibrium.
 Similarly an exogenous rise in export demand (due to rise in r f) or fall in import demand will
shift the BP curve to the right.
 If exports rise, for example, a given interest rate that again fixes the capital flow, a higher level
of income and therefore of imports is required to restore balance of payments equilibrium. The
BP curve shifts to the right.
 A fall in the foreign interest rate would also shift the BP curve to the right; at a given domestic
interest rate (r), the fall in the foreign interest rate increases the capital inflow, for equilibrium
in the balance of payments, imports and therefore income must be higher.
Note that the BP curve will also up ward sloping for the case of what is called imperfect capital
mobility.
 For this case, domestic and foreign assets (e.g., bonds) are substitutes, but they are not perfect
ones.
 If domestic and foreign assets were perfect substitutes, the case of perfect capital mobility,
investors would move to equalize interest rates among countries.
 If one type of asset had a slightly higher interest rate temporarily, investors would switch to
that asset until its rate was driven back down to restore equality.
If assets are less than perfect substitute, then their interest rates need not be equal. Factor that might
make assets in foreign countries less than perfect substitute for Ethiopian assets (for example) include
differential risk on the assets of different countries, risks due to exchange rate changes, transaction
costs, and lack of information on properties of foreign assets.
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UNIT SIX
CONSUMPTION AND SAVING
INTRODUCTION IN CONSUMPTIN AND SAVING
In the previous chapter we have seen that the level of national income in an economy depends up on
consumption expenditure, investment and government expenditure. Now let us introduce you some
points about consumption functions and theories of consumption.
Definition:
 The term consumption means the use of a good rather than the expenditure on the good in any
one period.
 Consumption expenditure on the other hand is the expenditure on consumer goods in a given
period.
In a simple language, all unconsumed disposable income (Income after tax) is known as Savings.
C= a + cY
The above equation implies consumption is an increasing function of income. Note that a saving
function is directly related to the consumption function. With an increase in the disposable income of
an economy, the personal savings of the recipients of this income and hence the aggregate savings of
the economy also grow.
 The proportion of each increment in the level of disposable income that will be saved is the
Marginal Propensity to Save (MPS). That is MPS is the increment to saving per unit increase
in disposable income.
 Like wise, the value of the increment to consumer expenditure per unit increment to income is
termed the Marginal Propensity to Consume (MPC).
 Thus, the MPS plus the MPC must be one (MPC + MPS = 1)

You should note that the consumer expenditure is the largest component of aggregate demand. This is
why consumption plays a central role in the macroeconomics.

John Maynard Keynes believes that the level of consumer expenditure was stable function of
disposable income (Yd). Keynes did not deny that variable other than income affect consumption, but
he believed that income was the dominant factor determining consumption. The specific from of the
consumption-income relationship, i.e. the consumption function, proposed by Keynes was as follows:

C= a + bYD where; a and b are constants

YD is disposable income
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As can be seen from the above Keynesian function, when disposable income (YD) is zero, then the
value of consumption function will be equal to the intercept term a (autonomous consumption). Thus,
as such, a can be thought of as a measure of the effect on consumption of variables other than income,
variables not explicitly included in this simple model (e.g., dissaiving, borrowing, etc). The parameter
b (which is the slope of the function) gives the increase in consumer expenditure per unit increase in
disposable income.
C
Thus in notation, b= where; the Greek letter delta  , indicate the
Yd
Change in the variable it precedes.

Thus, b is the marginal propensity to consume

(MPC)
The Keynesian assumption is that consumption will increase with an increase in disposable income
(b  0) but that the increase in consumption will be less than the increase in disposable income (b  1).

Thus, Keynesians assume that b is between 0 and 1. I.e., 0  b  1.

From the definition of National income we know that

Y  C +S +T  Aggregate supply
YD  Y –T  C +S
This implies that disposable income is, by definition, consumption plus saving. I.e., YD= C +S
Now we can replace C by a +bYD. Then we can get:

YD= a +bYD +S
 S= YD - a – bYD
 S= -a + (1-b) YD

Note that if a one-unit increase in disposable income leads to an increase of b units in consumption,
then the remainder of the one unit increase, i.e., (1-b), is the increase in savings:
C
Therefore, = 1- b
Yd
This increment to savings per unit increase in disposable income (1 –b) is the marginal propensity to
save (MPS). Note also that the MPS and the MPC add up to one. This is because the one unit
increment in disposable income is divided in to consumption and savings.

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6.1. The Basic Model of Consumer Behaviour

Irving Fisher‟s Model based on Micro-foundations Optimising Consumption: A Two-Period Case

Starting from a single consumer with a utility function
U = U (c0,……, ct, ………cT)
Where lifetime utility U is a function of his real consumption c in all time periods up to T, the instant
before he dies. The consumer will try to maximize his utility subject to the constraint that the present
value of his total consumption in life cannot exceed the present value of his total income in life; that is,
T T
ct y
0 (1  r ) t 0 (1  tr ) t


Where; T is the individual‟s expected lifetime. This constraint says that the consumer can allocate his
income stream to a consumption stream by borrowing and lending, but the present value of
consumption is limited by the present value of income. For this restriction to hold as a strict equality,
we assume that if the person receives an inheritance, he passes on a bequest of an equal amount.
An Inter-temporal Model of Consumption
To make the above utility maximization problem analytically tractable, we will take as an example a
particular form of the utility function. Let us assume first that the underlying utility function is
logarithmic, that is,
U(c) = ln c.
This utility function has the usual properties that marginal utility is positive, u‟(c) = 1/c, and
diminishing in consumption, u‟‟(c) = -1/c2 . Second, we will assume that the utility function is
additively separable over time. This means that each period‟s marginal utility is independent of the
consumption in all other periods. Third, we assume that future utilities are discounted at the subjective
rate δ. These three assumptions give us the particular specification of utility function of equation (1)
below
ln c1 ln ct ln cT
u  ln c0   ....   ... 
1  (1   ) t
(1   ) T
T
ln ct
[1] 
0 (1   ) t

The constraint on the consumer‟s choices in this many-period case comes from total resources
available: current plus all future income. With no bequests, the inter-temporal budget constraint over
the remaining T years of life, in more compact notation, is

93
 T T
ct yt
[2]  (1  r )   (1  r )
0
t
0
t

The consumer faces the problem of maximizing the utility function given by [1], subject to the
constraint given by [2]. This is usually written in the form:
T
ln ct
max  ,
ct
0 (1   ) t

Subject to the constraint that

T T
ct y
0 (1  r ) t 0 (1  tr ) t


To solve this problem and obtain the maximizing stream of consumption c0…cT, we will use the
method of Lagrange multipliers. We incorporate the constraint and the objective together into one
expression:
T
ln ct T yt T
ct 
max L        t 
ct ,
0 (1   ) t
 0 (1  r )
t
0 (1  r ) 

The Lagrange multiplier λ is a positive constant that will turn out to measure the marginal utility of an
additional unit of wealth.
The first order conditions of the above expression are given as:
L 1
[3a]   0
c0 c0
L 1 1 
[3b]  .  0
 ct (1   ) ct (1  r ) t
t

.......... .......... .......... .......... .......... .

L 1 1 
[3c]  *  0
 cT (1   ) cT (1  r ) T
T

L T yt T
ct
[3d ]    0
 0 (1  r ) t
0 (1  r )
t

There will be T marginal conditions like [3a] – [3c], one for each c in (c0,……, ct, ………cT).
Equation [3d] just gives us back the budget constraint.

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First, we will compare time 0 consumption c0 to time t consumption, which represents any of the
future periods. If we move the terms in λ to the right-hand sides of [3a] and [3b], we get

ct  1  r 
t

[4]  
c0  1   
And in general for any to adjacent periods we would have

ct 1  r  1 r 
[5]  , or ct   ct 1
ct 1 1   1  

These inter-temporal consumption relations have some interesting implications. First from [4] and [5]
we see that whether consumption rises or falls over time depends on whether the market rate of return
is larger or smaller than the individual‟s discount rate, that is, whether r >or < δ. From the technical
solutions we see that if r> δ, the consumption path would be rising over time. The market interest rate
r measures the return in additional saving, whereas the discount rate δ gives the individual‟s loss from
waiting to consume. If r > δ, it pays to save to consume later; if r< δ, it pays to consume more now,
less lately. This gives us the time profiles of consumption as shown in the figure below.
Ct

r>δ

r=δ

r< δ

0 T Time
Figure. 6.1.

A consumption path that begins high because r < δ must cross one that begins low because r > δ. Their
integral must equal the same constraint.

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6.2. Franco Modigliani and the Life- Cycle Hypothesis

In a series of papers written in the 1950s, Franco Modigliani and his collaborators Albert Ando and
Richard Brumberg used Fisher‟s model of consumer behaviour to study the consumption function.
One of their goals was to solve the consumption puzzle- that is, to explain the apparently conflicting
pieces of evidence that came to light when Keynes‟s consumption function was brought to the data.
According to Fisher‟s model, consumption depends on a person‟s lifetime income. Modigliani
emphasized that income varies systematically over people‟s lives and that saving allows consumers to
move income from those times in life when income is high to those times when it is low. This
interpretation of consumer behaviour formed the basis of his life-cycle hypothesis.

According to this hypothesis, the typical individual has an income stream that is relatively low at the
beginning and end of a person‟s life. This typical income stream is shown as the y curve in the figure
below where T is expected lifetime.

T
Figure .6.2.

On the other hand, the individual might be expected to maintain a more or less constant, or perhaps
slightly increasing, level of consumption, shown as the c line in the above figure, through out his life.
This corresponds to the r > δ path in figure 6.1. The constraint on this consumption stream is that the
present value of his total consumption does not exceed the present value of his total income.

Now if the life-cycle hypothesis is correct, if one is to undertake a budget study by selecting a sample
of the population at random and classifying the sample by income level, the high-income groups will
contain a higher-than-average proportion of persons who are at high-income levels because they are in
the middle years of life, and thus have a relatively low c/y ratio. Similarly, the low-income groups will
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include relatively more persons whose incomes are low because they are at the ends of the age
distribution, and thus have a high c/y ratio. Thus, if the life cycle theory is true, a cross-sectional study
will show c/y falling as income rises, explaining the cross-sectional budget studies showing MPC <
APC or APC falls with a rise in income.
There are some remaining notes in this part that you are supposed to refer Branson, 1989.

c0  k 1   (T  1)y0L  ka0
C X

kat

0 yL

Figure .6.3.

Over time we may observe a set of points such as those along the line OX, which shows a constant
consumption-income ratio along trend as the economy grows. This constancy of the trend c/y ratio can
be derived from the Ando-Modigliani function as follows.

yL
 k 1   (T  1) t  k t
ct a
yt yt yt
If the c/y ratio given by this equation is constant as income grows along rend, then the line OX, which
yL
gives the APC c/y, will go through the origin. The c/y ratio will be constant if i.e. the labour share
y
in total income and a/y (the ratio of assets, or capital, to output) are roughly constant as the economy
grows along trend.

Thus, the Ando-Modigliani model of consumption behavior explains all three of the observed
consumption phenomena. It explains the MPC < APC result of cross-sectional budget studies by; the
life-cycle hypothesis: it provides an explanation for the cyclical behavior of consumption with the
consumption-income ratio inversely related to income along a short-run function, and it also explains

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the long-run constancy of the c/y ratio. In addition, it explicitly includes assets as an explanatory
variable in the consumption function.

The Ando-Modigliani model is attractive because it remains close to the original Fisherian formulation
of inter-temporal optimization. It brings out the importance of demographics for trends in aggregate
consumption patters. For example, with no bequest, no trend in economic growth, and a static
population, the life-cycle hypothesis implies that net aggregate saving is zero. The dissaving of the
young and the old exactly offsets the saving by the middle-aged. If, in contrast, the population is
aging, on average, with many middle-aged high earners now, then the savings rate will be positive.
Likewise in a growing economy, because younger cohorts live during a richer era, their savings are
greater than the dissavings from the poorer old folks, and again aggregate savings are positive. On the
other hand, an increase in prospective government retirement (social security) benefits may reduce
gross private sector savings now, matched by an equal reduction in gross private dissavings when
current savers retire. Such fairly stable features of societies help explain why the Japanese save twice
as much, in proportional terms, as Americans do.
6.3. The Friedman Approach: Permanent Income

In a book published in 1957, Milton Friedman proposed the permanent income hypothesis to explain
consumer behavior. Friedman‟s permanent income hypothesis complements Modigliani‟s life-cycle
hypothesis: both use Irving Fisher‟s theory of the consumer to argue the consumption should not
depend on current income alone. But unlike the life-cycle hypothesis, which emphasizes the income
follows a regular pattern over a person‟s lifetime; the permanent-income hypothesis emphasizes that
people experience random and temporary changes in their incomes from year to year.

Friedman suggested that we view current income Y as the sum of two components, permanent
income Yp and transitory income YT. That is,

Y Y P  Y T .
Permanent income is the part of income that people expect to persist into the future. Transitory income
is the part of income that people do not expect to persist. Put differently, permanent income is average
income, and transitory income is the random deviation from that average. Consumption can also be
classified in the same way as income as permanent and transitory- i.e. C = Cp + CT .

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Assumptions:

1. Permanent and transitory income are uncorrelated

2. There is no relationship between permanent and transitory consumption.
3. There is no relationship between transitory income and transitory consumption.

The last assumption states that a sudden increase in income, due to transitory fluctuation, will not
contribute immediately to an individual‟s consumption. This assumption is intuitively less obvious
than the other ones, but it seems fairly reasonable, because we are dealing with consumption as
opposed to consumer expenditure. Consumption includes, in addition to purchases of nondurable
goods and services, only the “use” of durables- measured by depreciation and interest cost- rather than
expenditure on durables. This means that if a transitory or windfall income is used to purchase a
durable good, this would not appreciably affect current consumption. Thus, Friedman assumes that the
covariance of CT and YT is zero.
Thus, Friedman reasoned that consumption should depend primarily on permanent income, because
consumers use saving and borrowing to smooth consumption response to transitory changes in
income. Friedman concluded that we should view the consumption function as approximately

C   Y P , Where α is a constant.
The permanent income hypothesis, as expressed by this equation, states that consumption is
proportional to permanent income. This expression is similar to the life-cycle hypothesis if we view
transitory income as changes in wealth and permanent income as changes in income. The marginal
propensity to consume out of transitory income (wealth) is low; the marginal propensity to consume
out of (permanent) income is high.

The permanent-income hypothesis solves the consumption puzzle by suggesting that the standard
Keynesian consumption function uses the wrong variable. According to the permanent income
hypothesis, consumption depends on permanent income; yet many studies of the consumption function
try to relate consumption to current income. Friedman argued that this errors-in-variables problem
explains the seemingly contradictory findings.

Dividing both sides of the Friedman‟s consumption equation by Y to obtain the APC

APC = C/Y = ΑYP/Y.

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According to the permanent income hypothesis, the average propensity to consume depends on the
ratio of permanent income to current income. When current income temporarily rises above permanent
income, the APC temporarily falls; when current income temporarily falls below permanent income,
the APC temporarily rises.

Consider the studies of household data. Friedman reasoned that these data reflect a combination of
permanent and transitory income. Households with high permanent income would have
proportionately higher consumption. If all variation in current income came from permanent
component, one would not observe differences in the average propensity to consume across
households. But some of the variation in income comes from the transitory component, and
households with high transitory income would not have higher consumption. Therefore, researchers
would find that high-income households had, on average, lower average propensities to consume.

Similarly consider the studies of time-series data. Friedman reasoned that year-to-year fluctuations in
income are dominated by transitory income. Therefore, years of high income should be years of low
APC. But over long periods of time- say, from decade to decade- the variation in income comes from
the permanent component. Hence, in long time-series, one should observe a constant APC.

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