Department of Economics, HU

1. CHAPTER ONE

INTRODUCTION TO MACROECONOMICS

Economics in general is the study of how societies use scarce resources to produce valuable
commodities and distribute them among different people. Behind this definition are two key
ideas: scarcity and efficiency. That is, resources are scarce and that society must use its
resources efficiently. Put differently, economics is the study of choice under conditions of
scarcity or economics is the study of choice with constraints.

Broadly speaking, economics has two components: microeconomics and macroeconomics.

Microeconomics (from the Greek word mikros, meaning “small”) fundamentally focuses in the
analyses of the behavior of individual economic actors (markets, households and business firms).
That is, it deals with how firms optimize profit and how households optimize their utility given
the respective constraints (such as income, technology, markets) they face. Macroeconomics
(from the Greek word makros, meaning “big”) on the other hand deals with issues relating to the
structure, performance and behavior of the economy as a whole.

The prime concern of macroeconomists is to analyze and attempt to understand the underlying
determinants of the main aggregate trends in the economy with respect to the total output of
goods and services (GDP), unemployment, inflation and international transactions. In particular,
the core of macroeconomic analysis seeks to explain the cause and impact of short-run
fluctuations in GDP (the business cycle), and the major determinants of the long-run path of
GDP (economic growth).

Macroeconomic Concerns

It is not uncommon to hear, in our everyday walk, people or the media mention and talk about
many macroeconomic issues. Such concerns include:

 Why are there recessions? Can the government do anything to combat recessions?
Should it?
 Why are so many countries, including Ethiopia, poor? What policies might help
them grow out of poverty?
 Why does the cost of living keep rising in Ethiopia in recent years or why
inflation has soared?
 why are millions of people unemployed even when the economy is registering
successive growth or why some new graduates from universities couldn’t find a
job?

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 Why do Ethiopia and other LDCs have such a huge trade deficit?
 What is the government budget deficit? How does it affect the economy?

Fig 1.1 Annual headline inflation rates of Ethiopia (1970-2011), measured as percentage
change in consumer price index

40

30

20
INFLATION
10

-10
1970 1975 1980 1985 1990 1995 2000 2005 2010 2011

Years

Source: data was taken from IMF’s World Economic Outlook online
As can be seen from the figure the Ethiopian economy has been regarded as one of the lowest
inflation economy. However, as of the year 2005, average annual inflation has risen consistently;
this has turned the major concern of the general public to this problem .

Figure 1.2 logarithm of real GDP per capita of Ethiopia from the year 1970- 2010
(In 2000’s constant Ethiopian Birr)

7.5

7.0

LRGDPC
6.5

6.0
1970 1975 1980 1985 1990 1995 2000 2005 2010
Years

Source: Data was taken from World Bank’s African Development Indicators

Why should we care about Macroeconomics?

Macroeconomic performance of a country is directly related to the lives and welfare of its
citizen. An economy that has successful macroeconomic management should experience low
unemployment and inflation, and steady and sustained economic growth. In contrast, in a country

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where there is macroeconomic mismanagement, we will observe an adverse impact on the living
standards and employment opportunities of the citizens of that country.

Because macroeconomic performance and policies are closely connected, the major
macroeconomic issues are also the subject of constant media attention and inevitably play a
central role in political debate.

1.1 Macroeconomic Tools: Theories and Models

Modern economics, systematically studies different agents’ economic behavior and economic
phenomena by a scientific studying method- observation theory observation- and through the
use of various analytical approaches. An economic theory consists of a set of assumptions and
conditions, an analytical framework, and conclusions (explanations and/or predications) that are
derived from the assumptions and the analytical framework.

Like any science, economics is concerned with the explanation of observed phenomena and also
makes economic predictions and assessments based on economic theories. Economic theories are
developed to explain the observed phenomena in terms of a set of basic assumptions and rules.

Macroeconomics makes heavy use of models. Economic models are simplified versions of a
more complex reality- in which irrelevant details are stripped away. Put differently, models are
simplified theories that show the key relationships among economic variables. A model relies on
both simplifying and critical assumptions. When analyzing a model, it is crucial to spell out the
assumptions underlying the model and realism may not a property of a good assumption. All
models have three aspects viz. the story, the mathematical expression and graphical
representation

Why we need economic models?

Economic models are used to show relationships between variables. Moreover, models are useful
to explain the economy’s behavior and devise policies to improve economic performance.
Economic models illustrate, often in mathematical terms, the relationships among economic
variables. Models have two kinds of variables: endogenous variables and exogenous variables.
Endogenous variables are those variables that a model tries to explain and exogenous variables
are those variables that a model takes as given

Exogenous variable Model

Endogenous

The most celebrated model in economics is the model of supply and demand
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E.g. The demand and supply of houses in Yirgalem

Qd = D (P, Y) Demand equation

- +

Qs = S (P, Pm) Supply equation

+ -

Qs = Qd Equilibrium market for houses

In the demand equation price and income are exogenous variables while quantity demanded is
endogenous variable. And the supply function tells us that, the quantity supplied (which is
endogenous) for houses is positively affected by the price of houses and inversely affected by the
price of inputs.

For each new model, you should keep track of, its assumptions, which variables are endogenous,
which are exogenous, the questions it can help us understand, and those it cannot

Flexible Versus Sticky Prices:

A key feature of a macroeconomic model is whether it assumes that prices are flexible or sticky.
Economists normally presume that the price of a good or a service moves quickly to bring
quantity supplied and quantity demanded into balance. This assumption is called market
clearing: an assumption that prices are flexible, adjust to equate supply and demand. However,
many wages and prices adjust slowly. For instance labor contracts often set wages for up to three
years. Many firms leave their product prices the same for long periods of time. Hence in the real
world some wages and prices are sticky- adjust sluggishly in response to changes in supply or
demand.

The economy’s behavior depends partly on whether prices are sticky or flexible. The assumption
of price flexibility is a good assumption for studying long-run issues, such as the growth in real
GDP that we observe from decade to decade. For studying short-run issues, such as year-to-year
fluctuations in real GDP and unemployment, the assumption of price flexibility is less plausible.
Therefore, most macroeconomists believe that price stickiness is a better assumption for studying
the short-run behavior of the economy.

1.2The State of Macroeconomics: Its Evolution and Developments

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The birth of modern macroeconomics as coherent and systematic approach to aggregate issues of
an economy is attributed to John Maynard Keynes and his General Theory of Employment,
Interest and Money published in 1936. Even if those issues that we consider them as
macroeconomic issues, such as unemployment and business cycles, were discussed by the then
economists, the idea of a separate subject that distinguishes macroeconomics from
microeconomics did not take shape until Keynes (before Keynes macroeconomics was called as
business cycle theory). Ever since its birth in modern form in the 1930s, macroeconomics has
witnessed considerable progress.

There are a wide variety of schools of thought in economics in general, and macroeconomics in
particular. These varied thoughts sometimes arise because our knowledge of the economy is
imperfect or because certain facts are in dispute.

Friedman- the founder of Monetarism- once emphasized that there are issues at which
macroeconomists consensually agreed but still there remains hotly contested and unresolved
ones. Accordingly, there is wide agreement among macroeconomists about the major goals of
economic policy: high employment, stable price and rapid growth. However there is least
agreement about the role that various instruments of policy can and should play in achieving the
several goals (Friedman, 1968 cited in Snowdon & Vane, 2005).

Mishkin (2012) outlined that there are six basic areas of disagreement among economists, viz. 1)
how flexible wages and prices are, 2) how long it takes to get to the long run, 3) the sources of
business cycle fluctuations, 4) whether stabilization policy is worthwhile, 5) how costly it is to
reduce inflation, and 6) how dangerous budget deficits are.

The fundamental question that underlies disagreements between economists however, rests on
matters of policy and practice, i.e. ‘what is the proper role of government in the economy?’ Put
succinctly, the real dividing issues between macroeconomists can be broadly stated as:

 Can the government influence the outcome of the economic process? and

 Should the government influence the economic process?

Different intellectual wisdoms answer these questions in varied manner. In mainstream (or
orthodox) economics, as contrasted to heterodox economics, we briefly distinguish:

 The Classical economists

 The Keynesians

 Neo-classical synthesis (a.k.a Neo-Keynesian synthesis)

 The Monetarists

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 The New classical economists and Real Business Cycle

 The Supply Siders

 The New Keynesians

These macroeconomic intellectual traditions are often broadly defined as the classical and
Keynesian approaches.

To preview the broad answers:

 “Keynesian economists” (broadly defined) generally answer “yes” to both questions

 “Classical economists” (broadly defined) generally answer “yes” to the first and “no” to
the second question

1. Classical Economists:

Names: Adam Smith, David Hume, David Ricardo, John Stuart Mill, Knut Wicksell and Irving
Fisher

For the classicals, there is no sharp distinction between microeconomics and macroeconomics.
The classical tradition asserted that:

 The economy is self regulating mechanism

 Wages, prices, and interest rates are flexible. That is markets always “clear”, or returns to
equilibrium, very quickly.

 Say’s law- the dictum, “supply creates its own demand”- holds true, so that insufficient
demand in the economy is unlikely.

 For the classical economists long run, full employment (vertical aggregate supply), was
the normal state of affairs.

Classical dichotomy: classicals distinguish between real (physical output) and nominal output,
which is expressed in the quantity theory of money. Money for classicals is neutral- i.e. for the
Classicals money is a veil which determines nominal price but does not affect real quantities and
relative prices. This theoretical separation of real & nominal variables is called Classical
dichotomy.

The policy implications of classical view is that of Laissez-faire-”leave it alone”- as the right and
sensible economic policy. Government intervention, in the form of activist stabilization policies,
would be neither necessary nor desirable.

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2. The Keynesians

Keynes’s legacy: “Great depression/Great crash”-a massive decline in aggregate demand.

Many people argue that Keynesian economics sprout up as a result of the Great crash of the 1929
to 1933- where major economies of the world experience massive unemployment and decline in
output- which until then the neoclassical belief was dominant.

Keynesian approach insisted on price and wage inflexibility and upward sloping supply curve
with the implication that, output can deviate from its potential for indefinitely long periods.
Keynes and his followers emphasised that, because wages and price are sticky (Keynesian
economics is usually regarded as short run economics, as Keynes himself stated “in the long run
we are all dead”1), there is no economic mechanism that will quickly restore full employment
and ensure that the economy produces at full capacity.

Policy implications: “Fine-tune the economy”

Active government intervention through fiscal policy can stimulate the economy and help
maintain high levels of output and employment. For Keynes, monetary policy, however, is
ineffective because the additional money will simply be absorbed by investors with no noticeable
effect on the interest rate.

3. Neo Classical Synthesis

Names: Intellectual titans in economics science that include Paul Samuelson, James Tobin,
Franco Modigliani, Robert Solow plus virtually all economists in 1950s and 1960s except Milton
Friedman

It was Samuelson who introduced the label ‘neoclassical synthesis’ into the literature and the
1960s was the heyday of neoclassical synthesizers. The neo classical synthesizers state that the
economy is “Keynesian” in the short run but “classical” in the long run, hence the name neo-
classical/neo-Keynesian synthesis. Neoclassical synthesizers believe that the long-run Aggregate
Supply curve is vertical, however, in the short run, nominal wages are rigid downwards and
expected price level is sticky. This opens up the possibility of unemployment and an upward
sloping short-run Aggregate Supply (AS-*) curve.

Policy view:
1
A fuller version of the quote: “This long run is a misleading guide to current affairs. In the
long run we are all dead. Economists set themselves too easy, too useless a task if in
tempestuous seasons they can only tell us that when the storm is long past the sea is flat
again” (taken from Krugman &Wells, macroeconomics, pp. 262)

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Both monetary and fiscal policy can affect the economy in the short run and presume the
government should pursue a counter-cyclical policy.

4. Monetarists

Names: Milton Friedman and his “Chicago boys”

The roots of monetarism emanated from the “quantity theory of money”

M = kPY

Where, M= is money supply, P= price level, Y = real output and 1/k = V is velocity of
circulation of money, which is assumed as stable

Monetarism holds that the money supply is the major determinant of short run movements in
nominal GDP and of long run movements in prices. 2 Moreover, Prices and wages are relatively
flexible and Philips curve (the inflation-unemployment tradeoffs) does not hold in the long run.

From these beliefs Friedman concluded in one of his famous dictum about inflation as: “inflation
is always and everywhere a monetary phenomenon.”

Policy Implications

For monetarists, fiscal policy is “irrelevant” because if V is stable, the only force that can affect
PY (nominal GDP) is M. Hence there is no fiscal policy variable that the policy maker can
influence. Monetary policy, however, is potent but policy makers make timing errors (“long and
variable lags”) and may exacerbate the cycle. Thus, there should be rather constant money
growth rule- set the growth of the money supply at a fixed rate and holds to that rate through all
economic conditions.

5. New Classical Economists

Names: Robert Lucas, Robert Barro, Thomas Sargent, Neil Wallace, Edward Prescott

They are also called “fresh water economists”- spearheaded by Robert Lucas- and distinctively
emerged during the 1970s. These economists are natural successors to the classical economists
and firmly back classical ideas. Central working assumptions of new classicals include: first
economic agents make optimal decisions, second expectations are rational- i.e. people use all
2
. Friedman and Schwartz took historical data of the United States in their “monetary history
of the United States, 1867-1960,” published in 1963 and conclude that economic
fluctuations including the Great Depression as purely caused by changes to the stock of
money supply.

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available information in their decision, hence the government cannot fool the people-, and third,
markets clear continuously. New Classicals claim that all the fluctuations that we observe in the
economy are due not to nominal rigidities as Keynesians claim but are due to rational agents
responding to the incentives as the observe them.

Policy Implications:

Policy ineffectiveness proposition (PIP) – “direct critique to monetarism”

The new classical school in particular supports the view that the authorities cannot, and therefore
should not; attempt to stabilize fluctuations in output and employment through the use of activist
demand management policies. This is because their analysis suggests that (i) an anticipated
increase in the money supply will raise the price level and have no effect on real output and
employment, and (ii) only unanticipated monetary surprises can temporarily affect real variables

Another breed of new classicals is Real Business Cycle theory–usually abbreviated as RBC (with
leading figures: Finn Kydland and Edward Prescott). They rely on rational expectations and
competitive markets but emphasizing on supply side shocks as causes to business cycle. They
assume that output is always at its natural level. That means all fluctuations in output are
movements of the natural level of output, as opposed to movements of output away from the
natural level of output. Accordingly business cycles are purely caused by real shocks-
equivalently supply side shocks- i.e. productivity shocks caused by due to improvement in
technology, the introduction of new management techniques, changes in the quality of
capital or labor, changes in the availability of raw materials or energy , unusually good or
unusually bad weather, changes in government regulations affecting production, and any
other factor affecting productivity. According to RBC economists, most economic booms result
from beneficial productivity shocks, and most recessions are caused by adverse productivity
shocks.

6. Supply Siders (Ultra-classicism, due to Samuelson)

Names: Arthur Laffer, Robert Mundell

They were radical conservatives with strong distrust of “the government” and emphasize on
distorting aspects of taxation. Major contribution of the supply siders was the so called Laffer
curve, which shows that high tax rates shrink the tax base because they reduce economic activity

President Reagan and Prime Minister Margaret Tacher loved the views of the supply siders and
even apply their policy advice but the result was huge budget deficit

Fig 1.3 the Laffer curve

The horizontal axis
depicts the tax rate levied
9 on labor (tl) and the
vertical axis shows tax
revenue (τ). If the tax rate
was lower, increasing the
Department of Economics, HU

Policy Advice:

Cut tax rates and then stimulate the economy. They argued that there was no need to cut
government spending, tax cut would pay for itself.

7. New Keynesian Economists

Names: Edmund Phelps, Stanley Fischer, John Taylor, Olivier-Jean Blanchard, Greg Mankiw,
Lawrence summers, George Akerlof, David Romer, Janet Yellen, Ben Bernanke, Joseph
Stiglitz…

They are also called ‘Saltwater’ economists. These economists derive their inspiration from John
Maynard Keynes. They assume that markets are prone to fail or to be incomplete hence stressed
in the existence of nominal rigidities, arising from, for example, multi-period nominal wage
contracts.

The most recent wave of new Keynesian economics is more micro based but they accept more or
less, the rational expectations hypothesis. The predominance of imperfect competition,
incomplete markets, coordination failures, and credit market imperfections- for example “credit
rationing model” of Stiglitz and Weiss- are stressed. Their policy advocacy is, the government
can and should intervene in the macro economy. But because new Keynesians believe in
rational expectations so that expectations can change rapidly, they recognize that designing
activist policies to stabilize the economy is far from easy. The effects of anticipated and
unanticipated policy will not be the same.

To recapitulate the developments in modern macroeconomics (Blanchard, macroeconomics

3rd Ed, 2003):

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 The history of modern macroeconomics starts in 1936, with the publication of Keynes’s
general theory of employment, money and interest. Keynes’s theory was formalized in
the IS-LM model of John Hicks and Alvin Hansen in the 1930s and early 1940s.
 The period from the early 1940s to early 1970s is called the golden age of
macroeconomics. Among the developments were the theory of consumption (by
Modigliani and Friedman independently), investment, money demand and portfolio
choice (James Tobin), the development of growth theory (Robert Solow), and the
development of large macro econometric models (Lawrence Klein).
 The main debate during the 1960s was between Keynesians and Monetarists. Keynesians
believed developments in macroeconomic theory allowed for better control of the
economy. Monetarists, led by Milton Friedman, were more skeptical of the ability of
governments to help stabilize the economy.
 In the 1970s, macroeconomics experienced a crisis for two reasons: one was the
appearance of stagflation- high unemployment coupled with high inflation- which came
as a surprise to most economists. The other was a theoretical attack led by Rob Lucas.
When rational expectations were introduced, 1) Keynesian models could not be used to
determine policy, 2) Keynesian models could not explain long lasting deviations of
output from its natural level, and 3) the theory of policy needed to be redesign using the
tools of game theory.
 Much of the 1970s and 1980s were spent integrating rational expectations in to
macroeconomics. Macroeconomists are now much more aware of the role of expectations
in determining the effects of shocks and policy, and the complexity of policy, than they
were two decades ago.
 Current research in macroeconomics is proceeding along three lines: new classical
economists are exploring the extent to which fluctuations can be explained in the natural
level of output, as opposed to movements away from the natural level of output. New
Keynesian economists are exploring more formally the role of market imperfections in
fluctuations. New growth theorists are exploring the role of R&D and the increasing
returns to scale in growth.
 Despite the controversies, there exist a set of propositions on which most
macroeconomists agree. Two of these propositions are 1) in the short run, shifts in
aggregate demand affect output; and 2) in the medium run, output returns to its natural
level

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