CHAPTER SIX

Fundamentals of macroeconomics
Introduction

The purpose of an economic activity is the satisfaction of human wants. To this end, society
produces various goods and services. The money value of all goods and services produced in the
economy constitutes total national income. The National Income and Product Accounts
frequently referred to as NIA are the official measurements of the flow of product and income in
the economy. Many of the economic aggregates, such as consumer expenditure, business
investment, and so on, which this unit deals with, are defined in the accounts, which also provide
a framework for analyzing the level of economic activity. Therefore, in this unit we will look at
the different measures of national income, the concepts of GNP, GDP other points of the national
income accounts, and the consumer price index, or CPI, which measures the level of prices.
This unit is comprised of three sections. The first section deals with the basic principles of the
National Income Account; the second section elaborates on measuring the value economic
activity: Gross Domestic Product; and the third section deals with the consumer price index
measuring the cost of living for a given basket of goods. As I tried to mention in the module
introduction part, this unit will also contain summary and checklist parts. After that there will be
a self-assessment questions prepared from all subunits included in the unit try by yourself and
cross check your result with the answer key provided at the end of the module.
Unit Objectives
After successfully completing this Unit, you will be able to:
 Know the fundamental principles of the National Income-Product Account
 Measure the value of an economic activity
 Express the circular flow of the national income and output
 Calculate Real GDP and Nominal GDP of an economic activity
 Measure the cost of living through the Consumer Price Index
6.1. The Fundamental Concerns (Scope) of Macroeconomics
The scope of aggregative economic analysis or the fundamental concerns of macroeconomics
can be summarized as follows:
 National Income: Macroeconomics deals with national income. It includes the
study of the concepts of national income, product, and expenditure and the methods
of measurement of aggregates and sub-aggregates of national income and output.
 Employment: Macroeconomics is also concerned with the determination of the
level of employment in the whole system and variations in it. It deals with
aggregate demand, aggregate supply, consumption, savings, and investment
functions which determine the level of employment in an economy.
 Money and Banking: Macroeconomics deals with monetary theory, which further
deals with the demand and supply of money, central banking, commercial banking,
monetary policy, and the impact of monetary changes upon the general level of
economic activity.
  General Price Level: Macroeconomics concentrates upon the general level of
prices. It explains the inflationary and deflationary movements in the system and
the impact of these movements upon the general level of economic activity.
 Business Cycles: The theories of business cycles and policies to control cyclical
fluctuations come within the sphere of macroeconomics.
 Economic Growth: Economic growth is a long-run process. It depends upon
complex economic, sociological, institutional and technical factors.
Macroeconomics analyses the actions and interactions of these factors.
 Macrodistribution: Macrodistribution theories deal with the distribution of
income among various factors. An analytical study of these theories helps in
achieving equitable distribution of income and constitutes a part of
macroeconomics.
 International Trade: International Trade and International Finance (or
International Economics): Macroeconomics deals with the theories of international
trade, problems related to tariff and non-tariff barriers upon trade, balance of
payments, foreign exchange, international capital flows, and international economic

Figure 6.1: Fundamental Concerns of Macroeconomics

General Objectives of Macroeconomic Policy
We know that macroeconomic analysis deals with the behaviour of the economy as a whole with
respect to output, income, employment, general price level and other aggregate economic
variables. With a view to bringing about desirable changes in such variables, nations (developed
as well as developing) need to adopt various macroeconomic policies. These policies vary from
one economy to another and according to the prevailing economic conditions within a specific
economy.
The general objectives of a macroeconomic policy are to achieve:
  maximum feasible output
 high rate of economic growth
 full employment
 price stability
 equality in the distribution of income and wealth, and
 a healthy balance of payments.
To achieve these objectives, normally three types of macro-economic policies – fiscal policy,
monetary policy, and income policy – are adopted. We shall discuss these policies in detail in a
later unit.
6.2. National Income Accounting
National income is often considered as the most comprehensive measure of how well an
economy is performing. It is necessary and important, therefore, to measure the national income
of a country so as to have an idea of the performance of the economy. Measuring national
income is an extremely complicated large task. However, economists have devised various ways
of estimating national income. In fact, national income estimates are made in every country these
days. In Ethiopia, the task of estimating national income is entrusted with the Central Statistical
Organisation (CSO), that works in collaboration with ministry of finance. In this unit we discuss
the various concepts related to national income accounting and the methods of measuring
national income. National income is an essential element in the study of macroeconomics. It is
broadly defined as the aggregate monetary value of all the final goods and services produced in a
country during a year. Based on this definition, we can identify the following main features of
national income:
National income is counted for a period of one accounting year,
National income is a flow concept. National income is a measure of the flow of goods and
services during a year,
We include only final goods and services in the calculation of national income. Intermediate
goods are not included in the calculation of national income, National income is expressed in
terms of monetary value of goods and services.
Note that national income is also defined as the sum of factor incomes in a country in a year’s
time and is sometimes expressed in terms of aggregate expenditure of a country in a year’s time
Importance of National Income Accounting
National income accounting is a method of preparing and presenting national income accounts
based on the principle of double entry system of business accounting.
Preparation of national income accounts is important for the formulation of economic policies
and also as a measure of economic growth. Moreover, national income accounts reveal
information about production activities in the different producing sectors of an economy. We list
below some reasons for which national income accounts are important:
 Indicator of Economic Progress: Particularly in underdeveloped economies, the
State has to actively participate in various programs of development, and for that it
has to formulate economic policies. For the formulation of plans and determination
of priorities, it has to estimate national income data. In economic planning, it is also
essential to collect information about the national income, savings.
  Investment, consumption, employment, etc: All these estimates require data
relating to national income. National accounts are also helpful in the assessment of
various programs of development.
 Significance in Business Policy Making: National income data are also needed for
formulation of policies in different businesses. Individual firms are always
interested to know the contribution to national income by the particular industry to
which they belong. National income statistics also provide information to business
firms about the nature and extent of demand of various products in the market.
 Significance for Trade Unions: National income accounts are of great use to trade
unions and labour organisations. National income data provide information about
the contribution of the labour force to the gross national product and the wages and
salaries received by the workers.
 Measure of Economic Growth: National income accounts are used to measure the
rate of economic growth. These accounts reveal the trend of output, income,
consumption and capital formation during a given period of time.
 Comparison with other Countries: National income accounts help in
international comparisons. On the basis of national income, one can easily say
whether a country is developed or underdeveloped. By analysing the national
income statistics of the developed countries, the developing countries may change
their strategy of development.
 Knowledge of Structural Changes: National income accounts reveal the
structural changes taking place in an economy. It gives information about the
relative importance of different sectors of the economy and shows the distribution
of income among various producing sectors.
 Significance for Economic Analysis: National income is an important concept of
economic theory. Study of national income accounts is essential to identifying
interrelationships between different sectors of an economy.
6.2.1. Approaches to Measuring GDP
There are three different phases in circular flow of national income: production, income and
expenditure. Production of goods and services is the result of combined efforts of factors of
production (land, labour, capital and enterprenuers). The net output emerging from the
production process gets distributed in the form of money income (rent, wages, interest and profit)
among factors of production. With this income factors of production we purchase goods and
services for final consumption and investment. In this way income creates expenditure.
Expenditure in turn gives rise to further production. This leads to continuous circular movement
of production, income and expenditure.
 Figure 6.1: Circular Flow of Production, Income and Expenditure
We can look at national income from three angles – as a flow of goods and services, as a flow of
income or as a flow of expenditure. Accordingly, there are three methods of measuring national
income as shown below in Figure 6.2

Figure 6.2: Methods of measuring national income

I. Production Method (Value Added Method)
In this method two approaches – ‘Final Product Approach’ and ‘Value Added Approach’ – are
adopted.
i. Final Product Approach: According to this approach, in the estimation of GDP, we
include the market value of all final goods and services produced in a country. For
example, if we manufacture thread from cotton, cloth from thread and shirts from
cloth, here shirts are the final good. Hence, we should include the value of shirts only
in the calculation of national income.
Thus, GDP is calculated by multiplying all the final goods and services produced in a country
with their respective market prices GDPMP = P (Q) + P (S)
Where, P = Market price
Q = Quantity of goods
S = Quantity of services
Problem of Double Counting in the Final Product Approach: The final product approach
cannot be used in actual practice because production is a continuous process and in this process it
is difficult to know the final product. It gives rise to the problem of double counting. What is the
problem of double counting? Counting the value of a commodity more than once in the
measurement of national income is called double counting. So far as an individual enterprise is
concerned, it considers its output as final product. For example, for a farmer, cotton is a final
product, for a spinning mill, thread is a final product, for a cloth-mill, cloth is a final product, and
for a garment manufacturer, shirts are a final product. All these enterprises take the sale value of
their products as the value of their final output. When we take into account the sum total of the
value of output of all these individual enterprises in the estimation of national income, it suffers
the problem of double counting. This leads to overestimation of the value of goods and services
produced.
To overcome the difficulty of double counting, the value added approach is used.
ii. Value Added Approach: The value added approach measures the value added
(contribution) by each producing enterprise in the production process in the domestic
territory of a country in an accounting year. Value added is defined as the difference
between total value of the output of a firm and the value of inputs bought from other
firms. Clearly, the value added approach measures the contribution of each producing
unit in the domestic economy without any possibility of double counting.
The following steps are involved in estimating national income by the value added
approach:

Identifying all the producing units in the domestic economy and classifying them
into three economic sectors: primary, secondary and territory sectors. (The primary
sector exploits natural resources, the secondary sector transforms one type of
commodity into another, and the tertiary sector renders services.),
 Estimating the value added by each producing unit. (By deducting intermediate
consumption, from value of output, we get the value added.),
 Estimating the value added of each economic sector by summing up the value
added of all producing units falling in each industrial sector,
 Computing GDPMP by adding up the value added of all economic sectors.
 Estimating net factor income from abroad, which is added to GDPMP to obtain
GNPMP.
Example: GDP by final product approach.
The final productions of a hypothetical nation is given by the following table. The table shows
how GDP is calculated using final product and current prices.
 II. Income Method
The income method measures national income from the side of payments made to the primary
factors of production in the form of rent, wages, interest, and profit for their productive services
in an accounting year. Since the income of factors of production is cost to their employers, so
factor income and factor cost are the same. Thus if the factor incomes of all the producing units
generated within the domestic economy are added up, the resulting total will be the domestic
income at factor cost. If we add the value of depreciation and indirect taxes to this, we get
GDPMP. Adding further net factor income from abroad gives us GNPMP.
Remarks:
Depreciation means loss of the value of fixed capital assets during production. In other words,
depreciation is the value of existing capital stock that has been consumed (used up) in the
process of producing output. Fall in the value of fixed assets due to normal wear and tear and to
expected obsolescence is called consumption of fixed capital or depreciation.
Taxes which are levied by the government on production and sale of commodities are called
indirect taxes — for example, excise duty, sales tax, custom duty, etc. The buyer of a taxed
commodity pays the tax indirectly because the tax is included in the price which the buyer pays
The effect of indirect tax is that it increases the price of a commodity.
The following steps are involved in estimating national income by the income method.
Identifying enterprises which employ factors of production (land, labour, capital and
enterprenurship),
 Classifying various types of factor payments like rent, wages, interest and profit,
 Estimating the amount of factor payments made by each enterprise,
 Summing up of all factor payments made within the domestic territory to get the
domestic income at factor cost,
 Adding the value of depreciation and indirect taxes to domestic income at factor
cost to get GDPMP,
 Estimating net factor income from abroad, which is added to GDPMP to obtain
GNPMP.
To correctly compute national income by the income method, the following precautions need to
be taken.
Only factor incomes which are earned by rendering productive services are
included. All types of transfer income are not included.
 Imputed rent of owner-occupied dwellings and the value of production for self-
consumption are included, but the value of self-consumed services is not included.
 Income from illegal activities like smuggling, black marketing, etc., as well as
windfall gains from lotteries, etc., are not included.
Example: GDP at market price measured by income approach, of a hypothetical nation.
 III. Expenditure Method
The expenditure method gives us the value of GDP at MP when measured at the point of
expenditure. From the expenditure point of view, GDP is gross expenditure on the final use of
domestically produced goods and services during a period of account. Basically the final use of
goods and services is for two purposes: consumption purposes for direct satisfaction of wants,
and investment purposes, for expanding productive capacity. And expenditure on them is called
final consumption expenditure and final investment expenditure. They are further subdivided
into five components as shown below. Total final expenditure is equal to GDP at MP.
GDPMP = Private final consumption expenditure + government final consumption expenditure +
gross fixed capital formation + change in stocks + net exports
Example: Calculating GDP by expenditure approach

We discuss briefly each of these components:

Private final consumption expenditure: It measures the money value of goods and services
purchased by households for current use during a time period. In this category we include
consumption expenditure by consumer households on all types of consumer goods (i.e., durable,
semi-durable, and nondurable goods and services).
 Government final consumption expenditure: It is defined as “Current expenditure
on goods and services incurred in providing services of government administrative
departments less sales.” It is incurred by general government to satisfy collective needs
of the people. For example, government expenditure on health, education, general
administration, law and order, etc. belongs to this category.
Gross fixed capital formation: Expenditure on it consists of mainly two items
 Construction, and
 Machinery and equipment.
Change in stocks: This refers to the physical change in stocks of inventories like raw
material, semi-finished goods and finished goods lying with the producers for smooth working of
production processes. It is the difference between the stocks in the beginning of and at the end of
the accounting year. (inventories or unsold outputs)
Net exports (exports less imports): This refers to the difference between the value of exports
and value of imports. Note that exports and imports include both material goods as well as
services.
We may thus sum up as follows:
GDPMP = C + Ig + G + (X – M)
Where, C = Consumption expenditure by households
Ig = Gross Investment expenditure by firms
G = Government expenditure on goods and services
X – M = Net exports
Also, GNPMP = GDPMP + NFI
The following precautions need to be taken to correctly estimate national income by the
expenditure method:
To avoid double counting, expenditure on all intermediate goods and services is excluded.
Government expenditure on all transfer payments, such as scholarships, unemployment
allowances, old age pensions, etc., is excluded because non-productive services are rendered by
the recipients in exchange.
Expenditure on purchase of second-hand goods is excluded from national income because this
type of expenditure is not on currently produced goods.
Expenditure on purchase of old shares/bonds or new shares/bonds etc. is excluded because it is
not payment for goods or services currently produced. It shows mere transfer of property from
one person to another.
6.2.2. Other Measures of National Income Accounting
The national income accounts include other measures of income that differ slightly in definition
from GDP. It is important to be aware of the various measures, because economists and the press
often refer to them.
To see how the alternative measures of income relate to one another, we start with GDP and add
or subtract various quantities. To obtain Gross National Product (GNP), we add receipts of
factor income (wages, profit, and rent) from the rest of the world and subtract payments of factor
income to the rest of the world:
GNP = GDP + Factor Payments from Abroad − Factor Payments to Abroad.
Whereas GDP measures the total income produced domestically, GNP measures the total income
earned by nationals (residents of a nation). For instance, if a Japanese resident owns an
apartment in Addis, the rental income he earns is part of Ethiopia’s GDP because it is earned in
Ethiopia. But because this rental income is a factor payment to abroad, it is not part of Ethiopia’s
GNP.
To obtain net national product (NNP), we subtract the depreciation of capital— the amount of
the economy’s stock of plants, equipment, and residential structures that wears out during the
year:
NNP = GNP − Depreciation.
In the national income accounts, depreciation is called the consumption of fixed capital.
Because the depreciation of capital is a cost of producing the output of the economy, subtracting
depreciation shows the net result of economic activity.
The next adjustment in the national income accounts is for indirect business taxes, such as sales
taxes. These taxes, place a wedge between the price that consumers pay for a good and the price
that firms receive. Because firms never receive this tax wedge, it is not part of their income.
Once we subtract indirect business taxes from NNP, we obtain a measure called national
income:
National Income = NNP − Indirect Business Taxes.
National income measures how much everyone in the economy has earned.
The national income accounts divide national income into five components, depending on the
way the income is earned. The five categories are;
 Compensation of employees: The wages and fringe benefits earned by workers.
 Proprietors’ income: The income of non-corporate businesses, such as small farms and
law partnerships.
 Rental income: The income that landlords receive, including the imputed rent that
homeowners “pay’’ to themselves, less expenses, such as depreciation.
 Corporate profits: The income of corporations after payments to their workers and
creditors.
 Net interest: The interest domestic businesses pay minus the interest they receive, plus
interest earned from foreigners.
A series of adjustments takes us from national income to personal income, the amount of income
that households and non-corporate businesses receive. Three of these adjustments are most
important.
First, we reduce national income by the amount that corporations earn but do not pay out, either
because the corporations are retaining earnings or because they are paying taxes to the
government. This adjustment is made by subtracting corporate profits (which equals the sum of
corporate taxes, dividends, and retained earnings) and adding back dividends.
Second, we increase national income by the net amount the government pays out in transfer
payments. This adjustment equals government transfers to individuals minus social insurance
contributions paid to the government.
Third, we adjust national income to include the interest that households earn rather than the
interest that businesses pay. This adjustment is made by adding personal interest income and
subtracting net interest. Thus, personal income is;

 Personal Income = National Income - Corporate Profits - Social Insurance Contributions -

Net Interest + Dividends + Government Transfers to Individuals + Personal Interest Income.

Next, if we subtract personal tax payments and certain nontax payments to the government (such
as parking tickets), we obtain disposable personal income:
 Disposable Personal Income = Personal Income − Personal Tax and Nontax Payments.
We are interested in disposable personal income because it is the amount households and non-
corporate businesses have available to spend after satisfying their tax obligations to the
government.
6.3. Real GDP versus Nominal GDP
Dear learners, can you describe how GDP is a good measure of economic well-being?
Economists use the rules just described to compute GDP, which values the economy’s total
output of goods and services. But is GDP a good measure of economic well-being? Consider
once again the economy that produces only apples and oranges. In this economy GDP is the sum
of the value of all the apples produced and the value of all the oranges produced. That is,

GDP = (Price of Apples × Quantity of Apples) + (Price of Oranges × Quantity of Oranges).

Notice that GDP can increase either because prices rise or because quantities rise.
It is easy to see that GDP computed in this way is not a good gauge of economic well-being.
That is, this measure does not accurately reflect how well the economy can satisfy the demands
of households, firms, and the government. If all prices doubled without any change in quantities,
GDP would double. Yet it would be misleading to say that the economy’s ability to satisfy
demands has doubled, because the quantity of every good produced remains the same.
Economists call the value of goods and services measured at current prices as “nominal GDP”.

A better measure of economic well-being would tally the economy’s output of goods and
services and would not be influenced by changes in prices. For this purpose, economists use
“real GDP”, which is the value of goods and services measured using a constant set of prices,
which is commonly called the “Base Price”. That is, real GDP shows what would have
happened to expenditure on output if quantities had changed but prices had not.

To see how real GDP is computed, imagine we wanted to compare output in 2002 and output in
2003 in our apple-and-orange economy. We could begin by choosing a set of prices, called base-
year prices, such as the prices that prevailed in 2002. Goods and services are then added up
using these base-year prices to value the different goods in both years.
Real GDP for 2002 would be;
Real GDP = (2002 Price of Apples × 2002 Quantity of Apples) + (2002 Price of Oranges × 2002
Quantity of Oranges).
Similarly, real GDP in 2003 would be;
Real GDP = (2002 Price of Apples × 2003 Quantity of Apples) + (2002 Price of Oranges × 2003
Quantity of Oranges).
And real GDP in 2004 would be;
 Real GDP = (2002 Price of Apples × 2004 Quantity of Apples) + (2002 Price of Oranges
× 2004 Quantity of Oranges).
Notice that the 2002 prices are used to compute real GDP for all three years. Because the prices
are held constant, real GDP varies from year to year only if the quantities produced vary.
Because a society’s ability to provide economic satisfaction for its members ultimately depends
on the quantities of goods and services produced, real GDP provides a better measure of
economic well-being than nominal GDP.
6.4. The GDP Deflator and Consumer Price Index (CPI)
6.4.1. The GDP Deflator
From nominal GDP and real GDP we can compute a third statistic: the GDP deflator.
The GDP deflator, also called the implicit price deflator for GDP, is defined as the ratio of
nominal GDP to real GDP:

GDP Deflator =
The GDP deflator reflects what’s happening to the overall level of prices in the economy.

To better understand this, consider again an economy with only one good, bread. If Pb is the
current price of bread and Qb is the quantity sold, and then nominal GDP is the total number of
dollars spent on bread in that year, Pb × Qb. Real GDP is the number of loaves of bread produced
in that year times the price of bread in some base year, Pbase × Q. The GDP deflator is the price of
bread in that year relative to the price of bread in the base year, Pb/Pbase.

The definition of the GDP deflator allows us to separate nominal GDP into two parts: one part
measures quantities (real GDP) and the other measures prices (the GDP deflator). That is,
Nominal GDP = Real GDP × GDP Deflator.
Nominal GDP measures the current dollar value of the output of the economy. Real GDP
measures output valued at constant prices. The GDP deflator measures the price of output
relative to its price in the base year. We can also write this equation as

Real GDP =
In this form, you can see how the deflator earns its name: it is used to deflate (that is, take
inflation out of) nominal GDP to yield real GDP.
6.4.2. The Consumer Price Index (CPI)
Measuring the Cost of Living: The Consumer Price Index
Dear learners, can you describe how the changes in the cost of living should be measured?
A Birr today doesn’t buy as much as it did 20 years ago. The cost of almost everything has gone
up. This increase in the overall level of prices is called inflation, and it is one of the primary
concerns of economists and policymakers. In later chapters we examine in detail the causes and
effects of inflation. Here we discuss how economists measure changes in the cost of living.
The Price of a Basket of Goods
The most commonly used measure of the level of prices is the consumer price index (CPI). It
begins by collecting the prices of thousands of goods and services. Just as GDP turns the
quantities of many goods and services into a single number measuring the value of production,
the CPI turns the prices of many goods and services into a single index measuring the overall
level of prices.

How should economists aggregate the many prices in the economy into a single index that
reliably measures the price level? They could simply compute an average of all prices. Yet this
approach would treat all goods and services equally. Because people buy more chicken than
caviar, the price of chicken should have a greater weight in the CPI than the price of caviar. The
CPI is the price of this basket of goods and services purchased by a typical consumer relative to
the price of the same basket in some base year.
For example, 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

CPI =
In this CPI, 2002 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 cost to buy the same basket of fruit in 2002.
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
Dear learners, can you describe the difference between CPI and the GDP deflator in an
economy?
Earlier in this chapter we saw another measure of prices—the implicit price deflator for GDP,
which is the ratio of nominal GDP to real GDP. 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 this country affects the
CPI, because the Toyota is bought by consumers, 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 remain 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.
Economists call a price index with a fixed basket of goods a Laspeyres index and a price index
with a changing basket a Paasche index. Economic theorists have studied the properties of
these different types of price indices to determine which is a better measure of the cost of living.
The answer, it turns out, is that neither is clearly superior. When prices of different goods are
changing by different amounts, a Laspeyres (fixed basket) index tends to overstate the increase
in the cost of living because it does not take into account that consumers have the opportunity to
substitute less expensive goods for more expensive ones. By contrast, a Paasche (changing
basket) index tends to understate the increase in the cost of living. Although it accounts for the
substitution of alternative goods, it does not reflect the reduction in consumers’ welfare that may
result from such substitutions.

The example of the destroyed orange crop shows the problems with Laspeyres and Paasche price
indices. Because the CPI is a Laspeyres index, it overstates the impact of the increase in orange
prices on consumers: by using a fixed basket of goods, it ignores consumers’ ability to substitute
apples for oranges. By contrast, because the GDP deflator is a Paasche index, it understates the
impact on consumers: the GDP deflator shows no rise in prices, yet surely the higher price of
oranges makes consumers worse off.
6.5. Macroeconomic Problems
Macroeconomic problems will occur if the macroeconomic goals of the government are not
achieved. Therefore, the government should implement policies to ensure that this does not
happen. Here are some of the common macroeconomic problems of a given economy of a
nation.
1. The Business Cycle
Dear learners, can you describe how the business cycle shows fluctuations of aggregate
production?
The business cycle is the term used to describe the fluctuations in aggregate production as
measured by the ups and downs of the real GNP. The fluctuations, although not subject to easy
predictability regularity, can be readily identified. Figure 6-1 contains a stylized graph depicting
the recurrent business cycle that shows the periodic ups and downs of real GNP. The business
cycle is characterized by peaks & troughs and periods of contraction & expansion. The
fluctuations, of course, are not as regular as those illustrated in the stylized graph
Peak: the peak is highest level of real GNP in the business cycle. A peak is a point which marks
the end of economic expansion (rising aggregate output) and the beginning of a recession
(decline in economic activity). Each peak indicates an economy operating at close to full
capacity so that national product & national income correspond to a very high degree of
utilization of labor, factories & offices. During a peak of the cycle there are likely to be shortages
of labor, spare parts & materials in certain markets. On occasion the economy booms to such a
degree that factories and offices are utilized around the clock with two or more shifts of labor.

Figure 6.2: Business Cycle Phases

Contraction or Recession: A contraction is downward from peak economic activity during
which real GNP declines from the previous values. During contraction, real GNP falls and
therefore earnings also decline. Business profits also typically decline. As profitability falls, so
does business demand for investment goods.
Trough: a trough is the lowest level of real GNP observed over the business cycle. A trough
marks the end of a recession and the beginning of economic recovery. During this time, there is
an excessive amount of unemployment & idle productive capacity. Businesses are more likely to
fail because of low demand for their products. Although a trough is the pits, it’s also the point at
which thing start looking up. Once a trough is reached, things cannot get much worse and the
economic health of the nation begins to take a turn for the better.
Expansion or Recovery: an expansion is an upturn of economic activity between a trough and a
peak during which real GNP increases. During an expansion, demand for goods and services
increases & real GNP rises as firms expand production, hire more workers & begin to purchase
more investment goods. Employment opportunities increase during a period of expansion.

Despite common phases, business cycles vary greatly in duration & intensity. Some economists
prefer to talk of business fluctuations, rather than cycles, because cycles imply regularity while
fluctuations do not.
2. UNEMPLOYMENT
Dear learners, can you describe how unemployment is one of the macroeconomic problem?
In modern economics, we think of the population as having three components: those who are
employed, those who are unemployed, and the rest, who neither are working nor are seeking
work. The first two groups -- those who are employed and who are seeking work -- together
comprise the labor force:

The labor force: The labor force consists of all those persons who are willing to work at a
market equilibrium wage, and who either have jobs or are seeking work. To measure the
importance of unemployment in a nation's work force, we use unemployment rate:
Unemployment rate: The unemployment rate is a ratio, obtained by dividing the number of
unemployed persons by the number of persons in the labor force. Thus, the rate of
unemployment is a fraction, less than one. It is usually expressed as a percent.
Definition of Unemployment: Our second macroeconomic problem is unemployment. This
problem is highly correlated with recession, but is distinct, and we need to look at it in its own
terms. The concept of unemployment is one we get from our pessimistic old friend, Thomas
Malthus. It may seem strange to claim that someone "discovered" unemployment, but Thomas
Malthus seems to have been the first scholar to clearly distinguish unemployment from other
kinds of labor market problems, and to offer a theory of unemployment. Here is a modern
definition of unemployment:
Unemployed: A person is said to be "unemployed" if he or she is looking for work, is willing to
work at the prevailing wage, but is unable to find a job.
Unemployment: Unemployment refers to the condition of being unemployed, or to the number
or proportion of people in the working population who are unemployed.
Biases in Measurement of Unemployment: Counting those who are registered for
unemployment compensation, and considering them as the unemployed, makes sense and is
probably the best approximation we can get easily. But it really is an imperfect method, and it
leads to two kinds of biases -- biases that work in opposite directions and biases in
unemployment data:
Discouraged Workers: Discouraged workers are people who are willing to work at the going
wage, but have given up looking actively for work, because they do not expect to find a job.
They are not registered for unemployment compensation because they have been unemployed
too long to be eligible. Thus, they really unemployed but are not counted as unemployed.
"Andy Capps”: An "Andy Capp" is a person who is registered for unemployment compensation
but not willing to work at the going wage. He is only keeping up appearances in order to get the
unemployment money. (This is probably more common in European countries where the
programs are more generous than the American, especially with long-term unemployed males).
"Andy Capps" would be counted as unemployed although they are not really willing to work.
Unemployment as a Macroeconomic Problem፡ Economists are always concerned with
efficiency in the use of resources. Resources are used efficiently when they are devoted to their
most important or productive uses, broadly speaking. However, it is most clearly inefficient if
resources simply are unused and go to waste. The resource most likely to be underused (if any
resource is underused) is labor. "Unemployment" seems to be an instance of failure to use the
available labor. This is why many economists see unemployment as an economic problem.

This is quite controversial. Economists of the school of thought called "new classical" do not
regard unemployment as underuse of a resource, and regard the whole idea of underuse of
resources in a market economy as being confused. From their point of view, unemployment may
not be a problem at all, and if it is, it is a problem for other reasons.
The two major views on unemployment are:

The "Keynesian" view of Unemployment: Unemployment is an excess supply of labor

resulting from a failure of coordination in the market economy.
The "Classical" view of Unemployment: Unemployment is job search -- people engaged in
the productive work of looking for a better match between worker and employer.
In any case, the (possible) problem of unemployment is central to modern economics.
Kinds of Unemployment
Dear learners, can you list down and explain the three types of unemployment?
These definitions are the ones used in modern economics, which, of course, has refined the ideas
somewhat since Malthus' time. In fact, we shall need to pause and look at them more carefully,
because there is some vagueness in the idea of unemployment at its best. Modern economics
recognizes several categories of unemployment.
i. Frictional Unemployment
Suppose a person loses a job, perhaps because the work is finished. This could happen to a
construction craftsman or craftswoman, for example, when the construction job is finished; or it
could happen to an actor or actress when the show closes. It will ordinarily take some time
before that person finds another job. However, while construction craftsmen and entertainers can
ordinarily expect to face this problem from time to time, it is something that can happen to
anyone employed. People who are simply between jobs, in this sense, are said to be frictionally
unemployed. This is a particularly important category, since this category of unemployment can
never be eliminated or reduced to zero. Even in the best-functioning market economy, there will
be some people who are between jobs. The practical minimum proportion of the work force that
is between jobs in given circumstances will be called the frictional unemployment.
ii. Cyclical Unemployment
In recessions, we typically see increases in unemployment. Most modern economists would
interpret this in the following way: the decline in production in a recession is associated with a
decline in the demand for labor. The decline in the demand for labour leads (perhaps
temporarily) to an increase in unemployment, as measured by the standard statistics. This
increased unemployment is called cyclical unemployment. In the excess-supply interpretation,
cyclical unemployment in particular is thought of as excess supply of labor.
 iii. Structural Unemployment
Economists often use the term "structural unemployment" for employment problems that arise
because of a mismatch between the needs of employers and the skills and training of the labor
force. For example, if music schools were to educate many more X players than could get
positions playing the X, we might find that many of them would have to get jobs in other fields.
Lacking training for other skilled fields, some oboe players might be unable to get any jobs at all.
This would be an instance of structural unemployment.

Structural unemployment raises some questions. If an X player were offered a job as a disk
jockey, at very good pay, and refused the job because it was not the field for which he was
trained, what should we make of that? Is the X player really "willing to work at the going wage?"
Alternatively, should we consider the would-be X player as being out of the work force --
unwilling to work in the opportunities available to him?
On the other hand, people with little in the way of training suffer more than average
unemployment in most of the industrialized countries. This suggests that structural
unemployment is really quite an important problem in the industrialized countries at the end of
the twentieth century.
3. Inflation
Dear learners, can you describe what inflation is and how it affects people of a given nation?
The old saying tells us "if it isn't one darn thing, it's another," and that is true enough in
economics. Recessions and unemployment are trouble enough, but many people in the modern
world see a danger in too much prosperity. The danger is inflation.
Inflation is defined as an increase in the average price level in the economy. Thus, if the price of
each good or service in the economy were to rise by 5% from one year to the next, we could say
without hesitation that the average price level has risen by 5%, and there has been 5% inflation.
However, in general, prices do not all raise at the same rate -- some rise rapidly, some rise
slowly, and some prices even drop. Thus, we express the overall price level by a price index, that
is, an average of these different rising and falling prices. Nevertheless, a simple average will not
do.
Some prices are more important than others are. Instead, we use a weighted average with weights
that reflect the importance of the different products in production. Such a weighted index of
prices is known as a "price index. The best-known price index is the Consumer Price ("cost of
living") Index. The abbreviation CPI is often used for the Consumer Price Index. The consumer
price index measures the average price of goods consumed by urban wage- earners. That is, the
consumer price index is a weighted average in which the weights reflect the spending of urban
wage earners.
However, there are other price indices. Another important price index is the GDP deflator. The
GDP deflator measures the average price of all of the Gross Domestic Product. That is, the
weights for the GDP deflator reflect the share of each good in the Gross Domestic Product.
There could also be other price indices. Which is right? That depends on your purposes. If you
want to gauge the purchasing power of the worker's dollar, then the consumer price index is
probably best -- that is the purpose it was designed for.
However, if you need to estimate the purchasing power of the Birr for all sorts of goods and
services, including investment goods, the consumer price index does not do that, and the Gross
Domestic Product Deflator is probably your best choice. Inflation is measured as a percentage
change in the price index. Thus, 5% inflation this year means that a price index is 1.05 times as
large as last year.
Recession: A recession is defined as a period of two or more successive quarters of decreasing
production. A number of variables measures production. Real Gross Domestic Product is one
important measure. We will focus mainly on it.
The Great Depression, a period of about 10 years, 1929-1940, dominated by two recessions. The
first of those recessions was of unparalleled depth, and that was what caused people to refer to it
as a depression and as "The Great Depression." There is no general definition of a depression,
however, and until recently the decline of 1929-1940 was the only decline referred to as a
"depression."
Since the second World War price rise has been a universal phenomenon; however, the pattern
and degree of rise has been different in different countries. It is generally observed that prices do
rise during the process of economic development. It happens so because money supply
immediately increases, but corresponding to that, the national output does not increase. However,
if the prices go up much more than what they should have on account of development activities,
it is a cause of concern for the country and its economic planners. Such a situation is termed as
inflation.
Meaning of Inflation
Inflation, in general terms, is described as a situation characterised by a sustained increase in the
general price level. It may be noted thus:
 a small rise in prices or an irregular price rise cannot be called inflation. It is a
persistent and appreciable rise in prices which is called inflation.
 during inflation, all costs and prices do not rise together and in the same proportion.
It is an increase in the general level of prices measured by a price index, which is
an average of consumer or producer prices.
Causes of Inflation
Inflation cannot be attributed to a single factor. Rather, a mix of several factors is responsible for
it. Normally, these factors are divided into two broad types: Demand-Pull factors and Cost-Push
factors. Accordingly, we have the concepts of Demand-Pull inflation and Cost-Push inflation.
a) Demand-Pull Inflation
When the demand for goods and services exceeds the available supply at current prices, it is a
demand-pull inflation. The situation is described as “too much money chasing too few goods”.
For some reason people come into possession of more money or purchasing power, but there is
no corresponding expansion of the supply of goods and services. The expenditure increases, and
prices keep on rising continuously.
The various causes for demand-pull inflation include:
  An increase in government expenditure: This increases the demand for goods
and services, and hence, is responsible for price rise,
 An increase in money supply: Such a situation is followed by rises in prices.
Money represents purchasing power over goods and services,
 An increase in investment: When this is done by the private or public sector it
leads to a large demand for goods and services, which is followed by price rises,
 An increase in wages: particularly when this does not match a corresponding
increase in productivity, it increases the general price level,
 Black money: Such money, which is normally spent on non-essential goods and
services, plays an important role in pushing up the prices in a country.
 Deficit financing: This is an important factor for rises in money supply and
therefore for rises in price level,
 Credit Expansion: This is also a major cause of price rise. As a result of credit
expansion, people buy more goods, leading to increases in the demand for goods
and this leads to increase in the prices of goods.
b) Cost-Push Inflation
Inflation resulting from rising costs of production and slack resource utilisation is called cost-
push inflation. This is sometimes also known as supply-shocked inflation. Setbacks in
agricultural and industrial production due to various reasons –shortage of raw materials, power
breakdowns, strikes and lockouts, bad weather conditions, increase in input prices, etc. – lead to
a decreased supply of goods in comparison to their demand, which further leads to price rise.
Also, hoarding, both by firms and households, contributes to restricting the supply of goods and
services in the economy, which leads to a rise in price level. Firms are interested in speculative
dealings to earn large profits, whereas households hoard goods when they expect that prices will
rise in the future.
Remarks: Demand-pull and cost-push inflation go together in an economy. In both situations,
two common features exist:
 rise in the prices of factor inputs, and
 rise in the prices of final goods.
Therefore, demand-pull and cost-push inflation intermingle, and it may not be possible to
separate them.
Measuring Inflation
Inflation means a persistent or sustained rise in general price level. Thus measuring inflation
means a measurement of variations in general price level. To do this, various types of price index
numbers or simply price indexes, such as wholesale price index, consumer price index, etc. are
constructed. These price indexes are indicators of the overall or general price level. The
Consumer Price Index (CPI) is the most widely accepted index for measuring the rate of
inflation, since it measures the average price of goods and services bought by general consumers.
CPI measures the cost of a “market basket” of consumer goods and services relative to the cost
of that bundle during a particular base year. The base year is a reference year.
Rate of Inflation
Rate of inflation measures the extent of the increase in the general price level over time. It is usually
measured as the percentage change in the general price level from one year to the next.

4. Budget Deficit
Government budget is a forceful instrument of economic growth. In simple words, it is an
account of planned expenditures and expected receipts of the government, usually for a year.
When the receipts of the government are less than the expenditure, the government is said to
have a budget deficit. The government deficits or budget deficit is one of the major concerns of
macroeconomic policy of a country. With a view to have a better understanding of budget deficit
or the budgetary process itself, we discuss the major components of government budget and
some allied aspects.
Meaning of Budget
The budget provides details of the various sources through which money flows to the
government, and also the details of the various types of expenses on which money is spent by the
government. It is a useful tool to plan and control the fiscal affairs of the government. We may
say, a budget shows the details of the planned expenditures of the government program and the
expected revenues from tax and non-tax sources for a year. We need to specify, at this point, the
objectives, types and components (structure) of budget. We do this as follows.
Objectives of a Government Budget
The general objectives of a government budget are the following:
Economic Growth: to promote rapid economic growth so as to improve the living standard of
the people.
Reduction of Poverty and Unemployment: to eradicate mass poverty and unemployment by
creating maximum employment opportunities and providing maximum social benefits to the
poor. Social welfare is the single most important objective of the government.
Reallocation of Resources: to reallocate resources in line with social and economic objectives.
Reduction of Inequalities: to reduce inequalities of income and wealth through levying taxes
and granting subsidies. Equitable distribution of wealth and income is emphasised. Economic
progress in itself is not a sufficient goal but the goal, must be equitable progress.
Price Stability: to maintain price stability and correct business cycles involving depression
characterised by falling output, falling prices, and increasing unemployment.
Management of Public Enterprises: to manage public enterprises which are of the nature of
monopolies like railways, electricity, etc.
Types of Budget
As we now know, a budget shows the receipts and expenditures of the government. It is not
necessary that the receipts and expenditure should be equal. usually, it is not be so. There
may be a surplus or deficit in the budget. Accordingly, we have the following three types of
budget:
A Surplus Budget:
If the receipts of the government are more than its
expenditure, the government is said to have a surplus
budget.
A surplus budget implies that the government is pumping out more money from the
economic system than what it is pumping back in. When the government draws money from
the economic system, it has a contractionary effect. The level of economic activity falls. A
whole sequence of events may follow indicated in Figure 6.4. The economy will tend to
move backwards.
Balanced Budget:
 If the receipts of the government equal its expenditures, the government will be
said to have a balanced budget.
 A balanced budget will have a neutral effect on the level of economic activity. It
will have neither an expansionary effect nor a contractionary effect on the
economy.
Deficit Budget
If the receipts of the government are less than its expenditure, the government is said to have a
deficit budget.

Figure 2.4.Implication of budget surplus

A deficit budget implies that the government is pumping more money into the economic
system than it is pumping out. When it puts in more money into the economy, the level of
economic activity expands. The process works as shown in Figure 6.5.
 Figure 2.5: Implications of budget deficit
This will move the economy further on the growth path. Usually governments of developing
economies plan for a deficit budget.
Remarks: A deficit budget is financed by domestic borrowing, external borrowing, and the
printing of new currency.
Structure (or Components) of Budget
Usually, budget is divided into two parts: Revenue Budget and Expenditure Budget.
A Revenue Budget
This forecasts the total revenue collections of the government from tax and non-tax sources
In Ethiopia, it is classified into three parts:
i. Ordinary Revenue,
ii. External Assistance, and
iii. Capital Revenue.
i. Ordinary Revenue: The total of ordinary revenue is made up by tax revenue and
non-tax revenue. Tax revenue is further divided into three parts – direct tax, indirect
tax, and foreign trade tax.
A tax is generally defined as a compulsory payment that the citizens of a country have to make to
the government without a quid pro quo, i.e., the taxpayers cannot expect to get any direct benefit
in return for the tax paid by them.
Those who are liable to pay tax have to pay the tax; otherwise they can be prosecuted and
penalised by the state. Now, let us look at the three kinds of taxes.
1. Direct taxes: These are those taxes which are paid by the same persons on whom they have
been levied. The burden of the tax cannot be shifted onto anybody else. An example of this is
personal income tax. Income tax is levied on individual persons on the income earned by
them in a year. Every person who is liable to pay this tax has to bear the burden of this tax.
Other direct taxes imposed in Ethiopia include rental income tax, business income tax,
agricultural income tax, tax on dividend and lottery winning, and land-use fees and leases.
2. Indirect taxes: These taxes, on the other hand, are those taxes whose burden can be shifted.
Examples are excise duties and sales tax. These taxes are imposed on the producers and
sellers of goods and services. They are liable to pay the tax to the government. But the
producers (or sellers) can transfer the burden of this tax onto the consumers, collect the tax-
amount from them, and deposit the same with the government. Indirect taxes in Ethiopia
include excise and sales tax on domestically manufactured goods, services sales tax, stamps
and duty, and VAT.
Remarks: Direct taxes are normally imposed on income, wealth, and property, whereas
indirect taxes are levied on goods and services.
Foreign trade tax: This includes custom duty, excise tax and sales tax on imported goods.
Non-tax revenue is the revenue collected by the government from sources other than tax.
These include income of the government by way of sale of goods and services by
various departments of the government. Major constituents of non-tax revenue in
Ethiopia are charges, fees, fines, pension contribution, and investment revenue.
 ii. External Assistance: Grants received in cash, or some other form, from outside the
country are known as external assistance. These receipts form an important source of
financing the deficit budget of the government and play an active role in economic
development of the country. External assistance received from friendly countries is
called bilateral assistance; whereas assistance (grant) received from multilateral or
international institutions is known as multilateral assistance.
iii. Capital Revenue: Capital revenue is the third constituent of revenue budget. It
comprises the money received by the government from the sale of government assets,
collection of loans, counterpart fund and external loans.
Expenditure Budget
Expenditure budget is a forecast of the total expenditure by the government, in a year. In
Ethiopia, it is classified into two parts:
i Recurrent Expenditure, and
ii Capital Expenditure.
i. Recurrent Expenditure: Recurrent expenditure represents expenses made by the
government which are recurrent in nature, i.e., they are repeated. Normally, it is an expense
on consumables that facilitate productive activities, for example, salaries of civil servants,
purchase of raw materials, fuels and other factors of production. The recurrent expenditure is
classified in Ethiopia under four functional categories: Administrative and General Services;
Economic Services; Social Services; and Other Expenditures. All government bodies fall
under one of these categories. For instance, Administrative and General Services include
such activities as performed by political organs of the state such as council of representatives,
ministries, defence and so on. Economic Services include such activities as ones that come
under agricultural, industrial and service sectors. The Social Services include such activities
as health, education, and culture. Other Expenditures include pension payments, repayment
of public debts, provision of unforeseen expenses and similar items.
ii. Capital Expenditure: Capital expenditure represents expenses made by the government
for the implementation and expansion of development projects. These are in the nature of
acquisitions of fixed assets like buildings, machinery, equipment, etc. Government
expenditures on construction of infrastructure, industries, and research and development
programs are also part of capital expenditure. The capital expenditure is classified in Ethiopia
under three categories: Economic Development; Social Development and General
Development. Economic Development includes production activities in the agricultural and
industrial sectors and economic infrastructure in mining, roads, energy, commerce and
communication. Social Development includes such activities as education, health, urban
development and social welfare. General Development includes services in statistics,
cartography, and public and administrative buildings.
6.6. Macroeconomic Policy Instruments
We know that macroeconomic analysis deals with the behaviour of the economy as a whole with
respect to output, income, employment, general price level and other aggregate economic variables.
With a view to bringing about desirable changes in such variables, nations developed as well
developing need to adopt various macroeconomic policies. These policies and the instruments used
for their implementation vary from one economy to another and also according to the prevailing
economic conditions within a specific economy.
The general objectives of a macroeconomic policy are to achieve:
 maximum feasible output,
 high rate of economic growth,
 full employment,
 price stability,
 equality in the distribution of income and wealth, and
 a healthy balance of payments.
To achieve these objectives, normally three types of macroeconomic policies – fiscal policies,
monetary policy, and income policy – are adopted. We discuss below each of these types of
policies and their instruments.

6.6.1. Fiscal Policy

Fiscal policy is the expenditure and revenue (tax) policy of the government to achieve the
desired objectives. A fiscal policy can be of two types – expansionary or contractionary –
depending upon prevailing economic conditions.
i. Expansionary Fiscal Policy:
In a situation in which an economy is facing the problem of deficient demand, i.e., aggregate
demand falling short of output at full employment, there is a depression marked by
overproduction, a rise in unemployment, and a fall in prices and income. To increase the
aggregate demand and thereby total output and employment levels, expansionary fiscal policies
are adopted by governments.
Major instruments of expansionary fiscal policy are:
 Expenditure Policy (Increase expenditure): the objective of an expenditure policy
should be to pump more money in to the system in order to boost demand. During a
period of deficiency in demand, the government should make large investments in public
works like the construction of roads, bridges, buildings, railway lines, canals, etc., and
should provide free education and medical facilities, even though these activities might
enlarge budget deficits. The aim is to put more money in the hands of people so that they
would also spend more.

 Revenue Policy (Reduce tax rate): Taxes on personal incomes and taxes on
expenditures on buildings etc. should be reduced. If possible, taxes on lower income
groups should be abolished in order to increase their disposable income for spending. In
addition, subsidies, old age pensions, unemployment allowances and grants, interest-free
loans, should be given.

 Government (Public) borrowing: Borrowing should be discouraged.

ii. Contractionary Fiscal Policy:

When an economy’s, aggregate demand is for a level of output that is more than the full-
employment level of output, the demand is said to be an excess demand. In other words, excess
demand refers to the excess of aggregate demand over the available output at full employment.
This gap is called inflationary because it causes inflation (a continuous rise in prices) in the
economy. To control the situation of excess demand and thereby reduce the pressure of high
inflation, contractionary fiscal policies are adopted by governments.
Major instruments of contractionary fiscal policy, are:
 Expenditure Policy (Reduce expenditure): In a situation of excess demand, the
government should curtail its expenditures on public works such as roads, buildings, rural
electrification, irrigation work, etc., thereby reducing the money income of the people
and thus their demand for goods and services. In this way, the government would reduce
the budget deficit, which shows excess of expenditure over revenue.
 Revenue Policy (Increase taxes): During inflation, the government should raise rates of
all taxes, especially taxes on rich people, because taxation withdraws purchasing power
from the taxpayers and, to that extent, reduces effective demand. Care should be taken
that measures adopted to raise revenue should be disinflationary and at the same time
have no harmful effects on production and savings.
 Government (Public) borrowing: Government should resort to large-scale public
borrowing to absorb excess money from the public.
6.6.2. Monetary Policy
Monetary policy refers to the regulation of the money supply and the control of the cost and
availability of credit by the central bank of the country through the use of deliberate and
discretionary action for achieving desired objectives. As discussed in the case of fiscal policy, a
monetary policy can be expansionary or contractionary according to the situation of deficit
demand or excess demand, respectively.
i. Expansionary monetary policy
Major instruments of expansionary monetary policy, are:
 Bank Rate (Reduce it): Bank rate (also called discount rate) is the rate of interest at
which the central bank lends to the commercial banks. Those banks in turn increase or
decrease lending rates of interest accordingly. To check depression, the central bank
reduces the bank rate, thereby enabling the commercial banks to take more loans from it
and in turn to give more loans to producers at lower interest rates.
 Open Market Operation (Buy securities): These refer to the buying and selling of
government securities which influence money supply in the economy. During depression,
the central bank buys government bonds and securities from commercial banks, pay in
cash to increase their cash stock and lending capacity.
 Cash-Reserve Ratio (Reduce CRR): Every commercial bank is required to keep with
the central bank a particular percentage of its deposits or reserves in the form of cash.
This percentage is called the cash reserve ratio (CRR). During depression, the central
bank lowers the CRR, thereby increasing commercial banks’ capacity to give credit.
ii. Contractionary monetary policy
Major instruments of contractionary monetary policy, are:
 Bank Rate (Increase it): In a situation of excess demand leading to inflation, the
central bank raises the bank rate. This raises the cost of borrowing, which
discourages commercial banks from borrowing from the central bank. An increase
in the bank rate forces the commercial banks to increase their lending rates of
 interest, which makes credit costlier. As a result, the demand for loans falls. The
high rate of interest induces households to increase their savings by restricting
expenditure on consumption and discourages investment. Thus, expenditure on
investment and consumption is reduced, thereby reducing the aggregate demand.
 Open Market Operation (Sell securities): During inflation, the central bank sells
government securities to commercial banks, which lose an equivalent amount of
their cash reserves, thereby reducing their capacity to offer loans. This absorbs
liquidity from the system. As a result, there is a fall in investment and in aggregate
demand.
 Cash-Reserve Ratio (Increase CRR): During inflation, the central bank increases
the CRR, thereby curtailing the lending capacity of commercial banks.
6.6.3. Income Policy
In general terms, income policy is the government control of wages. Control of wages becomes
necessary when there is a situation of excess demand (inflation). Ceilings on wages keep
disposable income down, which checks the aggregate demand for goods and services.
However, the government has to devise an appropriate income policy. If an increase of
wages were to lead to an increase in productivity of labour, higher wages could be paid to
workers. But, a wage increase without improvement in productivity will add further
inflationary pressure in the situation of excess demand.

 Self-Assessment Question-Chapter six

Attempt all the following questions. Then check your answer against the answer key
provided at the end of the module.
1. Which one of the following is false about basic principles of national income & product?
A. Like expenditures or incomes should be aggregated together
B. Unlike expenditures should be separated
C. Expenditure and income stream comes from current production of goods and services
D. Transactions that transfer ownership of existing assets are included in GDP
2. Which one of the following is false about rules for computing Gross Domestic Product?
A. It is calculated based on market price
B. GDP measures only the value of currently produced goods and services
C. It includes the sale of used goods as part of GDP
D. Increases in inventory of goods is counted as expenditure by the firm owners
E. Adding the intermediate goods to the final goods would be double counting
3. A better measure of economic well-being would tally the economy’s output of goods and
services and would not be influenced by changes in prices is:
A. Real GDP B. Nominal GDP C. GDP Deflator D. CPI
4. Which one of the following is not the component/category of the national income accounts
(GDP) of spending
A. Consumption B. Investment C. Government Expenditure D. Net Exports E. None
5. The amount by which consumption changes when disposable income increases by one dollar
is
A. Marginal Propensity to Saving C. Consumer Price Index
B. Marginal Propensity to Consumption D. GDP Deflator E. None
6. Which one of the following is false about the measures of national income and product?
A. GNP = GDP - Factor Payments from Abroad − Factor Payments to Abroad
B. GNP = GDP + Factor Payments from Abroad − Factor Payments to Abroad
C. NNP = GNP − Depreciation
D. National Income = NNP − Indirect Business Taxes
E. Disposable Personal Income = Personal Income − Personal Tax and Nontax Payments
7. Many economists believe that, for a number of reasons, the CPI tends to overstate inflation.
Because;
A. It does not reflect the ability of consumers to substitute toward goods whose relative
prices have fallen
B. Introduction of the new goods to the market, which increases the real value of the dollar,
is not reflected in a lower CPI
C. 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.
D. All of the above
E. E. None of the above
Part II: Discussion Questions
1. List the two things that GDP measures. How can GDP measure two things at once?
2. A farmer grows a bushel of wheat and sells it to a miller for 1.00. The miller turns the wheat
into flour and then sells the flour to a baker for 3.00. The baker uses the flour to make bread
and sells the bread to an engineer for 6.00.The engineer eats the bread. What is the value
added by each person? What is GDP?
3. Suppose a woman marries her butler. After they are married, her husband continues to wait
on her as before, and she continues to support him as before (but as a husband rather than as
an employee). How does the marriage affect GDP? How should it affect GDP?
4. Consider an economy that produces and consumes bread and automobiles. In the following
table are data for two different years.

Category Year – 2000 Year – 2010

Price of an automobile $50,000 $60,000
Price of a loaf of bread $10 $20
Number of automobiles produced 100 200
Number of loaves of bread produced 500,000 400,000
 a) Using the year 2000 as base year, compute the following statistics for each year: nominal
GDP, real GDP, the implicit price deflator for GDP, and a fixed-weight price index such
as the CPI.
b) How much have prices risen between year 2000 and year 2010? Compare the answers
given by the Laspeyres and Paasche price indices. Explain the difference.
5. Abby consumes only apples. In year 1, red apples cost $1 each, green apples cost $2 each,
and Abby buys 10 red apples. In year 2, red apples cost $2, green apples cost $1, and Abby
buys 10 green apples.
a) Compute consumer price index for apples for each year. Assume that year 1 is the base
year in which the consumer basket is fixed. How does your index change from year 1 to
year 2?
b) Compute Abby’s nominal spending on apples in each year. How does it change from year
1 to year 2?
c) Using year 1 as the base year, compute Abby’s real spending on apples in each year. How
does it change from year 1 to year 2?
d) Defining the implicit price deflator as nominal spending divided by real spending;
compute the deflator for each year. How does the deflator change from year 1 to year 2?