CHAPTER ONE
THE STATE OF
MACROECONOMICS

1.1 What macroeconomics is about?
• Economics is divided in to two major branches:
Microeconomics and Macroeconomics.
• Microeconomics
– Deals with economic behavior of an individual
decision-making unit (consumer and producer) or
an economic variable (Price and quantity of a
good)

Cont.…
Macroeconomics
• Macroeconomics, branch of economics concerned with
the aggregate, or overall, economy.
• Macroeconomics deals with economic factors such as
total national output and income, unemployment,
balance of payments, and the rate of inflation.
• Is the study of the behaviour of the economy as a whole.
It concerns the business cycles that lead to
unemployment and inflation, as well as the longer-term
trends in output and living standards.

Cont..
• The state of macroeconomics affects everyone’s life;
they play a central role in political debate.
• Countries fix their relation with the others based on
their macroeconomic policies.
• It is also the base for the regional economic
integration. example, Europe has moved towards a
common currency, COMESA set a tax exemption
region among the member countries etc.

Cont.…
Macroeconomics is a young and imperfect science
 Macroeconomists were not generally successful in
predicting the global economic crisis of 2008
 Even after the crisis, they were unable to agree on
what should be done to deal with the crisis
Nevertheless, the importance of the subject is
clearer than ever

1.2 Method of macroeconomics
analysis
• Macroeconomics is the study of the economy as
a whole
• Macroeconomists collect data on incomes, price
levels, interest rates, unemployment, and many
other macroeconomic variables from different
time periods and different countries
• They then try to build general theories to
explain the data that history gives them

Cont..
• Economic Model: is a theory that summarises,
often in mathematical terms, relationships
among economic variables.
• Theory: is a system of ideas explaining
something, especially one based on general
principles independent of the particular things
to be explained. Or,
• An economic theory is a generalisation based
on a few principles that enables us to
understand and predict the economic choices
made by people.

Cont..
• Exogenous Variables: are determined outside
of the model.
• Endogenous Variables: are determined within
the model. And do capture the decisions
made by people in which we are primarily
interested in learning about.
• In building economic models economists tend
to assume two general principles about how
people and the societies in which they exist
behave in trying to understand the decisions
made by people:

Cont..
• Optimisation Principle-people are motivated
by self-interest, or equivalently, that people try
and do the best they can.
• Equilibrium Principle-that people’s actions
tend to become consistent with each other. In
the limit the economic forces are so balanced
that there is no tendency for people’s
behaviour to change.

1.3 Macro goals Continues…
–Full employment
–High living standards
–Price stability
–Reduction of economic inequality
–Rapid economic growth
–Steady foreign exchange position

Policy Instruments
• Fiscal Policy
• Monetary Policy
• Other, employment, international trade, price
& income policy

Cont.
• Fiscal Policy
–concerned with the use of taxes and
government expenditures.
–Government has to meet various
expenditures like salaries, defense expenses,
infrastructure development, etc
– All these expenses leave a positive effect on
the overall economy

Cont…
– The other part of the fiscal policy is generation of
revenues for the government.
– Taxes are the main source of revenue for any
government.
– Taxes affect the economy and the individuals in two
ways.
• bring down the disposable income in the hands of
the consumers. This reduces the spending in the
economy.
• Second, the taxes levied on goods and services
make them costlier. This discourages the firm to
invest in capital goods.

Monetary Policy
– is the second most widely used macroeconomic
policy instrument.
– helps government, managing the nation’s money,
credit, and banking system.
– There are various entities that are part of the
monetary system of an economy.
– Central bank regulates the monetary system, and
other entities like banks, insurance companies are
also a part of the monetary system.
– In Ethiopia, National Bank of Ethiopia is the
custodian of the monetary system of the economy.

Cont.
• Central bank brings changes in the interest rates, reserve
requirements, etc. These changes make significant impact on the
overall functioning of the economy.
• For example, the lowering of interest rates on housing loans
helped the growth of the housing sector. As a result of low
rate of interest, it became easier to avail a housing loan and
to own a house.
Employment Policy
– adopted by government in order to increase the
employment level in the country.
Price and Incomes Policy
– This policy aims at regulating the prices in the market
and also to ensure the minimum wages to the workers.

Cont.…
• International Trade Policy
– Globalization has given a big push to the
international trade. This has resulted in framing of
specific polices by many countries to cope with
the new challenges. International trade policy
addresses issues like tariff and non tariff barriers.

1.4 Evolution of macroeconomics
• Economic thinking has begun since the cradle of mankind
• Since today’s knowledge of the economics evolves over
time based on preexisting knowledge and some historical
events. To do so, we have to look different schools of
thought of macroeconomics.
 Classical 1776-1936
 Keynesian 1936- 1970
 After 1970 there is no dominant school of thought in
macroeconomics .there are different schools of thought
with different ideas (Monetarism, new classical, new
Keynesians, institutional and others).

1.4.1 Classical school of thought
• It is a macroeconomics idea of 1776-1936 periods. During this
time, there was no unified or formalized theory of aggregate
employment and origin of business cycle.
• Classical economists : Adam Smith, J.B. Say, David Ricardo,
John Stuart Mill, Thomas Malthus, A.C. Pigou, and others—
wrote from the 1770s to the 1930s
• The ruling principle was the invisible hand coined by Alfred
Marshall.
Major Assumption
• All markets including labor market always clear (the economy
always operates at equilibrium and at equilibrium all resources
are fully employed).
• No government intervention is needed in the form of stabilization
policies, it is neither desirable nor necessary to achieve full
employment.

Cont.…
• Economic agents (firms and households) are rational
and aim to maximize their profit or utility.
• All markets are perfectly competitive so that agents
decide how much to buy and sell on the basis of a
given set of prices which are perfectly flexible.
• All agents have perfect knowledge of market
conditions and prices before engaging in trade.
• Trade only takes places when market –clearing prices
have been established in all markets.
• Agents have stable expectation.

Cont..
• Classical macroeconomists explain the determination of
crucial macro variables by dividing the economy in to
two sectors: the real sector and monetary sector. This
is usually known as classical dichotomy. They should
be studied separately.
• Demand-side policies mainly affect nominal variables
such as interest rate and prices while supply side
polices affect real variables such as real wage,
employment and output.

Cont..
• Classical used short run production function to explain
the determinants of real output. At micro level
production function shows the relationship between the
maximum outputs levels produced from a given amount
of inputs.
• The more input, labor and capital that a firm uses, the
greater will be the output produced. When we consider
the economy as whole the quantity of total output
(GDP) will also depends on the amount of input used
and how efficiently they are used.
• Where; Y - real output, L-amount labor used, K-capital
used, and
• Y= f A(K,L)

Cont.....
Classical & Neo-classical Macroeconomics
Basic Assumptions:
Flexible wages and prices.
Supply creates its own demand, Say’s Law.
Forward-looking agents with perfect foresight.
The price level is proportional to the money stock
in the long run.
Main argument:
No need for government intervention as the
economy has a self-correction mechanism.
Inflation is caused by excessive growth in money
stock.
 No distinction b/n macro- & micro-economics.

Cont..
1.4.2 Keynesian Macroeconomics
 The birth of modern macroeconomics is linked to
the Great Depression (period of high unemp’t &
stagnant production) & Keynes.
 The market adjustment concept of classicals &
neoclassicals didn’t work during 1929-1933.
 Basic Assumptions:
 Economy is unstable due to shifts in AD.
 Nominal wages & prices are inflexible, esp.
downwards.
 Large multiplier effect for changes in
government spending & tax rates.
 Keynes emphasized “effective demand” or AD, and
proposed expansionary policies.

Cont...
These Policies are fiscal & monetary:
1. Increasing government expenditure (G):
G  AD  Y (production).
Y (output/income)  C (Consumption) 
AD  Y ... – the multiplier effect.
2. Increasing money supply (M):
M  r (interest rate)  I (investment) 
AD  Y ... – the multiplier effect.
But, all the M may be absorbed at the existing r
(esp. when recession is deep) – the economy is in
liquidity trap!
With liquidity trap, the Classical model is
incapable of producing equilibrium – Keynes.
 Keynes preferred fiscal to monetary policy.

1.5 The State of Macroeconomics: Evolution & Recent
Developments
1.5.1 New Classicals
 In the 1970s, the debate on active policy brought
to the fore new groups – new classicals & new
Keynesians.
 New classicals attached great importance to the
role of expectation in influencing macro-economic
equilibrium.
 They introduced macroeconomic analysis from
micro foundations.
 Expansionary fiscal policy tends to increase
inflationary expectations, shifting AS, causing real
GDP to fall & the price level to rise.
 Many of them supported supply-side policies
meant to raise growth rate of potential GDP.

Cont.
1.5.2 New Keynesians
 They gave micro foundation for Keynesian
thoughts.
 Markets sometimes do not clear even when
individuals are rationally looking out for their own
interests.
 Emphasize imperfections in various markets
(labor, credit, product).
 Information problems & costs of changing prices
may lead to price rigidities, causing
macroeconomic fluctuations in output & emp’t.

Cont....
 Their central working assumptions are:
 forward looking economic agents with rational
expectations.
 Markets clear.
 AS is responsive to changes in expectations
about inflation.
 Incentives to produce, work & save are affected
by government policies which influence
marginal tax rates and subsidize households
and businesses.
 The self-correction mechanism is based on shifts in
AS caused by changes in expectations of inflation.

1.2 The State of Macroeconomics: Evolution &
Recent Developments
1. New Keynesians
 They gave micro foundation for Keynesian
thoughts.
 Markets sometimes do not clear even when
individuals are rationally looking out for
their own interests.
 Emphasize imperfections in various
markets (labor, credit, product).
 Information problems & costs of changing
prices may lead to price rigidities, causing
macroeconomic fluctuations in output &
emp’t.