February, 20 23Arba Minch, Ethiopia

❖ Inflation occurs when there is a sustained increase in the overall level of prices, and ismeasured more commonly by the consumer price index. If many people face a situation wherethe prices that they pay for food, shelter, and health care are rising much faster than the wagesthey receive for their labor, there will be widespread unhappiness as their standard of livingdeclines as their purchasing power declines. Besides, rapidly rising prices reduces businessexpectation and thereby investment. For such reasons, the objective of any nation and/ormacroeconomists is to keep the inflation rate as low as possible. Inflation rate of lower than5% is a major goal.❖ Equitable Distribution of Income: nations try to narrow the gap between the higher incomeand the lower income groups. This is to ensure that all people are equal in terms of standard ofliving. Taxation (progressive) is one of the methods of achieving equitable distribution ofincome.❖ Framework / Method of Macroeconomic AnalysisAs you learn in introductory economics, principal tools used by economists are theories andmodels. In microeconomics, we use theories of supply and demand; likewise, in macroeconomics,we use the theories and/or models of aggregate demand (AD) and aggregate supply (AS). Thereare two major perspectives on macroeconomics: the Classical and the Keynesian perspective, eachof which has its own version of AD and AS model. Based on the two perspectives,macroeconomists try to show what drives the macro economy.❖ Policy InstrumentsNational governments have two major policy instruments for influencing the macro economy orto achieve the macroeconomic goals. The first is monetary policy, which involves managing themoney supply and interest rates. The second is fiscal policy, which mainly involves changes ingovernment spending/purchases and taxes.In summary, we study macroeconomics from three different perspectives as shown in the structurebelow:1. What are the macroeconomic goals?2. What are the frameworks economists can use to analyze the macro-economy?3. What are the policy tools governments may use to manage the macro- economy?

➢ This chart shows what macroeconomics is about and how macroeconomists do with themacro-economy.

➢ Economic Growth➢ Low Unemployment➢ Low Inflation➢ Equitable Distributionof Income, etc.

➢ Aggregate Demand/Aggregate Supply➢ Keynesian Model➢ Classical Model

➢ Fiscal Policy➢ Monetary Policy➢ Income Policy

o With regard to the labor market, they contend that labor demand and labor supply are broughtinto equilibrium by the real wage. As a result, there is no involuntary unemployment.o With regard to the financial market, for Classical economists saving and investment arebrought into equilibrium by the interest rate and investment responds to the interest rate.o In the money market, money demand is simply a transaction demand and money has no anyeffect on the real economy and hence raising the money supply simply pushes up prices (i.inflationary). That is what we call Classical dichotomy: the quantity of money affect onlynominal variables (i. money wages, and nominal GNP), and have no influence whatsoeveron the real variables of the economy such as real GNP, level of employment and real wagerate.o In general, for classical economists, both Fiscal policy and monetary policy are useless.Because, for them;➢ Fiscal policy raises interest rate and crowds out investment.➢ Monetary policy raises prices and does nothing to “real” things.Implication: No need for macroeconomic policy.Government has no any role in the economy through its fiscal and monetary policy. As suchclassical economists are advocates of “laissez-faire” – free market system.Influential Classical Economists Include:✓ David Hume (1711-1776), Adam Smith (1723-90), Thomas Malthus (1766-1834), DavidRicardo (1772-1823), John Stuart Mill (1806-1873), Alfred Marshall (1842-1924) and ArthurPigou (1877-1959).

school. The main distinction is the tool of analysis, such as the marginal analysis. In the areaof growth theory, they gave us neoclassical growth models. Eg: Solow growth model.

Influential Keynesian Economists Include:✓ John Maynard Keynes (1883-1946), Paul Samuelson (1915-2009), James Tobin (1918-2002),and Franco Modigliani (1918- 2003).The main theme of the Keynesian stream is that the economy is subjected to failure so that it maynot achieve full employment level. Thus, government intervention is inevitable. This school viewsthe labor market in that workers and firms bargain for a money wage, not for real wage. Moneywages adjust slowly and workers resist any drop in the money wage, which is termed as Nominal

wage rigidity. Unlike the Classicals, for Keynesians saving and investment are brought intoequilibrium by changes in income. Investment is not influenced by a mere change in interest rate;rather it is affected by expectations of the future, which is uncertain. Money demand is affected bytransactions, but also by other things, in particular fear, which may lead to a “speculative demand”for high money balances. With regard to the role of the government, Keynes argued that thegovernment role was needed to preserve capitalism because without management, a moderncapitalist economy is so unstable that it may threaten the social compact that it rests on.❑ In short, for the Keynesian school:❖ The self-correcting feature of the market, which is of course the hallmark of classicaltheory, does not work. They believe that prices and especially wages respond slowly tochanges in supply and demand, resulting in shortages and surpluses,❖ AD is influenced by a host of economic decisions – both public and private.❖ Changes in AD, whether anticipated or unanticipated, has its greatest short-run impact onreal output and employment, not on prices.❖ Keynesians are more concerned about combating unemployment than about conqueringinflation.❖ Policy Implication✓ During recessions, government should satisfy peoples demand for more cash preventing thedownward spiral of shrinking income and shrinking spending via monetary expansion. ButKeynes worried that even this might sometimes not be enough, particularly if a recession hadbeen allowed to get out of hand and become a true depression. Once the economy is deeplydepressed, households and especially firms may be unwilling to increase spending no matterhow 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 asa “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 afiscal expansion can break the vicious circle of low spending and low incomes and getting theeconomy moving again.

The neo-Keynesian synthesis was developed by neoclassical economists who allowed theeconomy for a short run behavior with Keynesian properties and a long run with classical

was trying to increase its holdings of a fixed amount of money. Rather, they occurred because ofa fall in the quantity of money in circulation. With regard to the labor market, while not puttingforward his own theory of the labor market, Friedman argues that people do tend to think in realterms and not in nominal amounts. Friedman had a strong faith in the ability of the private sectorto produce growth and stability if it is not constrained by government. Friedman is a libertarian,opposed to government interference on principle.❖ Policy Rule under MonetarismIf economic slumps begin when people spontaneously decide to increase their money holdings,then the monetary authority must monitor the economy and pump money in when it finds a slumpis imminent. If such slumps are always created by a fall in the quantity of money, then the monetaryauthority need not monitor the economy; it need only make sure that the quantity of money doesn’tslump. In other words, a straightforward rule- “Keep the money supply steady”- is good enough,so that there is no need for a “discretionary” policy of the form, “Pump money in when youreconomic advisers think a recession is imminent.” Thus, for Monetarists, depressions were theconsequence of a temporary shortage of money and this implied that monetary policy was ofprime importance in determining the aggregate level of output and employment.

Influential New Classical Economists include:➢ Robert Lucas (1937-), Thomas Sargent (1943-), Edward Prescott (1940-), Robert Barro(1944-).The new classical macroeconomics remained influential in the 1980s. This school ofmacroeconomics shares many policy views with Friedman. It sees the world as one in whichindividuals act rationally in their self-interest in markets that adjust rapidly to changing conditions.The government is claimed, likely only to make things worse by intervening. The central workingassumptions of the new classical school are:

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, which 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. For instance, any unemployed person who really wants a job will offer to cut this or her wage until the wage is low enough to attract an offer from some employer. Similarly, anyone with an excess supply of goods on the shelf will cut prices so as to sell. The essence of the new classical approach is the assumption that markets are continuously in equilibrium.

Influential New Keynesians include:✓ Edmund Phelps (1933-), David Romer, Greg Mankiw (1958-), Stanley Fischer (1943-),✓ John B. Taylor (1946-), Olivier-Jean Blanchard (1948-).New Keynesian economics is the school of thought in modern macroeconomics that evolved fromthe ideas of John Maynard Keynes. Keynes wrote The General Theory of Employment, Interest,and Money in the thirties, and his influence among academics and policymakers increased throughthe sixties. In the seventies, however, new classical economists called into question many of theprinciples of the Keynesian revolution. The label "new Keynesian" describes those economistswho, in the eighties, responded to this new classical critique with adjustments to the originalKeynesian tenets.The new classical group remains highly influential in today’s macroeconomics. But a newgeneration of scholars, the new Keynesians, mostly trained in the Keynesian tradition but movingbeyond it, emerged in the 1980s. They do not believe that markets clear all the time but seek tounderstand and explain exactly why markets fail.The new Keynesians argue that markets sometimes do not clear even when individuals are lookingout for their own interests. Both information problems and costs of changing prices lead to someprice rigidities, which help cause macroeconomic fluctuations in output and employment.

effects that go beyond the firm and its customers. For instance, a price reduction by one firmbenefits other firms in the economy. When a firm lowers the price it charges, it lowers the averageprice level slightly and thereby raises real income. (Nominal income is determined by the moneysupply.) The stimulus from higher income, in turn, raises the demand for the products of all firms.This macroeconomic impact of one firm's price adjustment on the demand for all other firms'products is called an "aggregate-demand externality." Firms which do not lower their pricescauses real aggregate demand to be lower in recessions than it would be otherwise; if all firmswere to lower their prices together, real balances would rise and real demand for all firms’output would increase. Thus, aggregate demand externality due to firms’ inability to reduceprices explains fluctuations in aggregate output and employment.In the presence of this aggregate-demand externality, small menu costs can make prices sticky,and this stickiness can have a large cost to society. Suppose that General Motors announces itsprices and then, after a fall in the money supply, must decide whether to cut prices. If it did so, carbuyers would have a higher real income and would, therefore, buy more products from othercompanies as well. But the benefits to other companies are not what General Motors cares about.Therefore, General Motors would sometimes fail to pay the menu cost and cut its price, eventhough the price cut is socially desirable. This is an example in which sticky prices are undesirablefor the economy as a whole.B. The Staggering of PricesNew Keynesian explanations of sticky prices often emphasize that not everyone in the economysets prices at the same time. Instead, the adjustment of prices throughout the economy is staggered.Staggering complicates the setting of prices because firms care about their prices relative to thosecharged by other firms. Staggering can make the overall level of prices adjust slowly, even whenindividual prices change frequently.Consider the following example. Suppose, first, that price setting is synchronized: every firmadjusts its price on the first of every month. If the money supply and aggregate demand rise onMay 10, output will be higher from May 10 to June 1 because prices are fixed during this interval.But on June 1 all firms will raise their prices in response to the higher demand, ending the three-week boom.

Now suppose that price setting is staggered: Half the firms set prices on the first of each monthand half on the fifteenth. If the money supply rises on May 10, then half the firms can raise theirprices on May 15. Yet because half of the firms will not be changing their prices on the fifteenth,a price increase by any firm will raise that firm's relative price, which will cause it to losecustomers. Therefore, these firms will probably not raise their prices very much. (In contrast, if allfirms are synchronized, all firms can raise prices together, leaving relative prices unaffected.) Ifthe May 15 price setters make little adjustment in their prices, then the other firms will make littleadjustment when their turn comes on June 1, because they also want to avoid relative pricechanges. And so on. The price level rises slowly as the result of small price increases on the firstand the fifteenth of each month. Hence, staggering makes the price setting sluggish, because nofirm wishes to be the first to post a substantial price increase.C. Coordination FailureSome new Keynesian economists suggest that recessions result from a failure of coordination.Coordination problems can arise in the setting of wages and prices because those who set themmust anticipate the actions of other wage and price setters. Union leaders negotiating wages areconcerned about the concessions other unions will win. Firms setting prices are mindful of theprices other firms will charge. In the real world, coordination is often difficult because the numberof firms setting prices is large.D. Efficiency WagesAnother important part of new Keynesian economics has been the development of new theories ofunemployment. Persistent unemployment is a puzzle for economic theory. Normally, economistspresume that an excess supply of labor would exert a downward pressure on wages. A reductionin wages would, in turn, reduce unemployment by raising the quantity of labor demanded. Hence,according to standard economic theory unemployment is a self-correcting problem.However, New Keynesian economists often turn to theories of what they call efficiency wages toexplain why this market-clearing mechanism may fail. These theories hold that high wages makeworkers more productive. The influence of wages on worker efficiency may explain the failureof firms to cut wages despite an excess supply of labor. Even though a wage reduction wouldlower a firm's wage bill, it would also—if the theories are correct—cause worker productivity andthe firm's profits to decline.

National income is considered as the most comprehensive measure of how well an economy isperforming. To have an idea of the performance of the economy, measuring the national incomeof a country is extremely important. But measuring national income is an extremely complicatedlarge task. However, economists have devised various ways of estimating national income. In fact,national income estimates are made in every country these days. In this chapter, we will discussthe various concepts related to national income accounting and the methods of measuring nationalincome.What is National Income (Output)?✓ The national income of a country in a year is the value, expressed in monetary terms of thenet contribution of the factors of production through the production units in the country andabroad in the year.✓ It is thus, the monetary expression of the current flow of net final goods and servicesresulting 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 acountry plus net income from abroad.✓ If all the national income is in fact consumed then the national income consists ofconsumer’s goods and services only. If only a part of the national income is consumedin 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 stocksof goods, i., of consumption plus investment. Net investment includes increase in thestocks of fixed capital goods and working of capital goods.✓ If however, people consume more than the national income then it would probably mean thatthe stock of capital goods has been eaten in to or that the people have received gifts fromabroad. Gifts from abroad refer to current transfer from abroad of consumer goods andservices.✓ The national income is, thus the goods and services available to the normal residents in acountry, as a result of their production efforts in the year, to consume or to invest.

✓ The various types of national income accounts helps us to measure the level of production inthe economy at some point of time, and explain the immediate causes of the level ofperformance.Various aggregates and concepts concerning domestic and/or national income are used innational income accounting. The following are some of the most important totals relating tonational income accounts:➢ Gross national product (GNP)➢ Gross domestic product (GDP)➢ Net national product (NNP)➢ National income (NI) or net national income at factor cost➢ Personal income (PI)➢ Disposable personal income (DPI); and Real income (RI)Instead of giving a single comprehensive estimate of national income, economists use differentsuch aggregates. The reasons for this are:✓ There is disagreement among the economists over what should and what should not becounted as national income. Instead of passing a judgment on this controversy, the statisticsdepartment of the government gives some totals leaving it to each user to select the onehe/she prefers.✓ Another reason for this is that a certain total may be most useful for one purpose and adifferent total for another purpose.2 Basic Concepts of GDP and GNP