CHAPTER-ONE

1.Introduction to
Macroeconomics
 1.1. Concepts and Definition of Macroeconomics

• Economics is the study of the production,

consumption and distribution of goods and
services or it is the study of how to allocate
scarce resource among competing activities.
• The two main branches of economics are
microeconomics and Macroeconomics.
• Microeconomics is the study of how households
and firms make decisions and how these decision
makers interact in the marketplace.
 Con...
• In microeconomics, households choose their purchases
to maximize their level of satisfaction, which
economists call utility, and firms make production
decisions to maximize their profits.
• Macroeconomics means big or large and it is focusing
economic picture. It is studies how the overall national
economic perform.
• Macroeconomics is the study of aggregate economic
behaviors such as unemployment, inflation, gdp,
national income and its growth, national consumption,
monetary policies and fiscal policies, general price
level etc.
 The major goals of macroeconomic policies

• Low Unemployment
• Price stability
• Rapid Economic growth and raise of living of
citizens
• Fair distribution of income among the citizens
of the country.
• Less fluctuation of income activities
• The avoidance of balance of payments
 Con...
• The macroeconomist, not only study about the
current performance of the economy, but also
predict the future course of economic events.
• The main concerns of Macroeconomics are:
1.It is concerned with aggregate output.
2.It is concerned with the aggregate price level.
3. It is concerned with total employment.
4. The relationship between the domestic economy
and the rest of the world is considered.
 The Origin of Macroeconomics

• Economists started to study macroeconomics

since 1750s and this was the origin of
macroeconomics.
• Modern macroeconomics did not emerge until
“The Great depression”, a decade (1929-39)
of high unemployment and stagnant
production in the world economy.
• Modern macroeconomics emerged with the
publication in 1936 of John Maynard Keynes
“The General Theory of Unemployment,
Interest & Money”.
 Con...
• John Maynard Keynes proposed that the
government must involve and must influence the
economy through fiscal and monetary policies. .
Because, he showed that the market failed to
adjust itself.
• Now a day, there are two kinds of economic
thought. These are the Classical (new Classical)
and Keynesian (new Keynesian) school of
thoughts.
 1.2. Key elements of macroeconomics

• Gross Domestic Product (GDP): is the market

monetary value of all goods and services produced in
one year within the boundary of a given country, i.e.
whether by the Ethiopians or foreign supplied
resources. This can be obtained by aggregating the
values of goods and services produced in different
sectors of the economy.
• Inflation: represents a rise in general price level.
During inflation, average prices of all goods and
services become high. Inflation can also be defined as
a decline in the value or purchasing power of dollar.
 Con...

• An increase in money supply can be a reason of

inflation.
• If the demand for goods and services
continuously rises faster than their supply, prices
of goods and services shall rise too this is called
demand-pull inflation.
• On the other hand, a continuous fall in supply of
goods and services or a continuous rise in cost of
production pushes up the general price level this
is called cost-push inflation.
 Con...
• Unemployment: occurs when a person is
available and willing to work but currently
without work.
• The prevalence of unemployment is usually
measured using the unemployment rate, which is
defined as the percentage of those in the labor
force who are unemployed.
• Total money supply: is the sum of total
currencies in circulation. The amount or size of
money supply is controlled to the appropriate level
by Central Bank of the country.
 Con…
• Government expenditure: is the amount of
resources that the government sector of a country
spends in a given fiscal year (budget year). This
expenditure includes both consumption
expenditure and investment expenditure in such
activities as construction of roads, schools,
clinics and hospitals, water supply, electrification
and others.
• Trade Balance: is the net inflow of foreign
exchange from trade (export and import).Total
export value (X) minus total import value (M).
 Con…
• Balance of Payment (BOP): is the net inflow of
resources to a given country/economy from the rest of
the world.
 BOP includes,
-the flow of resources from foreign investment,
- borrowings from the rest of the world (short
term, medium term, and long term), and
repayments of such borrowings.
• Exchange rate: refers to the rate at which domestic
currency is exchanged for foreign currency.
 Con…
• Consumer price Index (CPI): is the measure
of weighted average of prices of goods and
services used by consumers. It is the measure of
cost of living. It measures prices of several
goods and services into a single price.
• Per capita Income (PCI): is the measure of
average output of a country per person. It is the
ratio of the total output, Gross Domestic
Product (GDP) to total population (N) of the
country.
 1.3. Macroeconomic school of thoughts

• There are different macroeconomic schools of

thoughts. The common ones are classical,
neoclassical, Keynesian, new classical and new
Keynesian.
• 1.3.1.Classical and neo-classical school of thought
• The Classical School of thought was developed
about 1750 and lasted as the mainstream of
economic thought until the late 1800’s.
• Its major developers include Adam Smith, Jean-
Baptiste Say, David Ricardo, Thomas Malthus and
John Stuart Mill.
 con…

• Adam Smith's Wealth of Nations, published in

1776 can be used as the formal beginning of
Classical Economics.
• Adam Smith [1723-1790] is recognized as the
originator of Classical Economics.
• John Stuart Mill [1806-1873] is often regarded as
the synthesizer of the school.
 CON….

Classical Economies Principles

 Unemployment is a natural part of business cycle
 Economics is self-corrected
 No need of Government intervention like fiscal and
monetary policies.
 Early economic thinkers believe that it was
necessary to study consumers and producers in the
market to understand the economy as a whole.
o This classical economists did not work after great
depression:
•
 Con...
oThe distinction between micro and macro was not very
clear.
oThey believed that by maximizing individuals’ wealth
one can maximize country’s wealth. This idea was based
on the assumptions that individuals are rational and
markets are efficient.
oThe main idea and the ruling principle is “invisible
hand”. The most effective market system is the market
without government intervention and the outcome will be
efficient.
oThe ‘invisible hand’ refers to the unobservable market
force that helps the demand and supply of goods in a free
market reach full employment of resources.
 Con...
• Classical economics, especially as directed
toward macroeconomics, relies on three key
assumptions. These are flexible prices, Say's law,
and saving-investment equality.
1. Flexible Prices: Price flexibility means that
markets are able to adjust quickly and
efficiently to equilibrium. While this assumption
does not mean that every market in the economy
is in equilibrium at all times, any
imbalance(shortage or surplus) is short lived.
 Con...
• Moreover, the adjust to equilibrium is
accomplished automatically through the market
forces of demand and supply without the need for
government action.
• The most important macroeconomic dimension of
this assumption applies to resource markets,
especially labor markets.
• If wages are flexible as the classical economists
argue, then a decrease in wages does allow firms
to hire more workers. Only those who are
reluctant to work for lower wages would then
remain unemployed.
 Con...
2. Say's Law: The second assumption of classical
economics states that “supply creates its own
demand" which means that the income derived
from producing certain goods by some, allows
them to purchase goods produced by others.
o Since all people have a need to purchase goods,
they will seek to produce some goods to derive
income and buy whatever they want.
o Thus, the product markets will always
necessarily be in equilibrium.
 Con...
• The law actually applies to aggregate supply and
demand.
• A more accurate phrase is "aggregate supply
creates its own aggregate demand."
• This law, first and foremost, directed attention to
the production or supply-side of the economy.
That is, focus on production and the rest of the
economy will fall in line.
 3. Saving-Investment Equality

• The last assumption of classical economics is that

saving by the household sector exactly matches
investment expenditures on capital goods by the
business sector.
• A potential problem with Say's law is that not all
income generated by the household sector spend
on consumption i.e. some income is saved.
• A match between saving and investment is
assured in classical economics through flexible
prices.
 Con...
• However, in this case price flexibility applies to
interest rates.
• In particular, if saving exceeds investment, then
interest rates fall, which stimulates investment and
restricts saving until the two are once again equal.
• Neoclassical school of thought (1870 – 1936)
• Neoclassical economics focuses on how
individuals operate within an economy. As such,
the neoclassical school emphasizes the exchange
of goods and services as the key focus of
economic analysis.
 Con...
• Neoclassical economics assumes that people
have rational expectations and strive to maximize
their utility.
• This school presumes that people act
independently on the basis of all the information
they can attain.
• Neoclassical economists believe the market is
always in equilibrium, macroeconomics focuses
on the growth of supply factors and the influence
of money supply on price levels.
1.3.2. Keynesian’s school of thoughts (1936 – 1970s)
• Keynesian economics is a macroeconomic theory
based on the ideas of 20th century British
economist John Maynard Keynes.
• Keynesian economics advocates a mixed
economy.
• The macroeconomic study of Keynesian
economics relies on three key assumptions.
These are rigid prices, effective demand, and
savings-investment determinants.
 CON….
Macroeconomics was not formally born until the
Great Depression (1929 – 1933), a decade of
high unemployment and stagnant production.
The market adjustment concept of the classical
and neoclassical schools didn’t work at the
period, and it was as a result of this failure that
Keynes developed expansionary policies.
The expansionary policies consist of two
elements.
– Increasing money supply
– Increasing government expenditure
 Con...
1. Rigid Prices: Prices are inflexible or rigid,
especially in the downward direction.
o If prices, especially wages, do not decline, then
the resulting labor market surplus means
unemployment.
2. Effective Demand: Effective demand means that
people spend the income that they actually have
not the income that they could have under other
circumstances.
o This assumption means that changes in income,
especially disposable income, are the prime
influence on consumption expenditures.
 Con...
• If the household sector has more income because
the economy is expanding, then they increase
consumption expenditures.
• If the household sector has less income because
the economy is contracting and a large group of
workers is unemployed, then they decrease
consumption expenditures.
3. Saving and Investment Determinants: The
third important Keynesian assumption is that
saving and investment are influenced by factors
other than the interest rate.
 Con...
• These other factors can prevent the equality
between saving and investment.
• The lack of equality between saving and
investment can lead to declining production and
income.
• The most important non-interest-rate determinant
of business investment is expectations, especially
expectations of future production and
profitability.
 Con...
• Keynes asserted that economy is subject to failure as
markets are not efficient and economy may not achieve
full employment level. He believed that government
intervention is inevitable.
• He also suggested that quantity of money is not so
important especially during depression. But, the most
important factors are investment level, fiscal factors and
export level. His theory is also known as ‘Theory of
Recession.
• According to Keynesian economics, government
intervention is necessary to moderate the booms and
busts in economic activity, otherwise known as the
business cycle.
 1.3.3. New classical and New Keynesians

• New Classical economics (1970s – present)

• The central working assumptions of the new
classical school are three:
1. Economic agents are maximizes: 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.
2. Expectations are rational: which means they are
statistically the best predictions of the future that
can be made using the available information.
 Con...
o 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.
3. Markets clear: The economy is always adjusted
into equilibrium.
o It means market is efficient enough to adjust supply
with demand in each and every market.
 Many of the new classical economists support
supply-side policies designed to increase the growth
 New Keynesian economics (1970s – present)

• They do not believe that markets clear all the

time.
• The new Keynesians argue that markets
sometimes do not clear even when individuals
are looking out for their own interests.
• According to them, both information problems
and costs of changing prices lead to some price
rigidities, which help cause macroeconomic
fluctuations in output and employment.
 Con...
 Prices and Wages are not flexible ( sticky,”) as opposed
to the classical economists’ position owing to the
following major reasons: Imperfect information and
Long-term contract(strong trade union).
 New Keynesians generally argue that the government
needs to take an active role, through the use of fiscal
policy (government spending or tax cuts) or monetary
policy (lower interest rates, change in money supply,
and so on), whenever economic conditions start to
deteriorate (e.g., falling employment or rising inflation).
 Con...
A large majority of economists now believe that
o Both monetary and fiscal policies have powerful
effects on the economy.
o Stabilization policies are likely to affect interest
rates and foreign exchange rates and to influence
the incentives of both households and businesses to
make purchases.
o Policies encouraging the long term growth of
potential real GDP are likely to raise the future
living standards of households.
o There is no single school that best describes an
economy.