Debrebirhan University

College Business and Economics

Masters Program in
Deveolopment Economics
Advanced Macroeconomics (Econ 511)
Lecture Slides

By
Y.B

1
 LECTURE I: INTRODUCTION

1. General
2. Classical and Keynesian approaches
3. Neoclassical Synthesis

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Lecture I: INTRODUCTION

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1.1 GENERAL
1.1 .1 What Is Economics?

• Economics is the study of the choices

made by persons (Natural or Legal)
who/which are faced with scarcity.

• Scarcity is a situation in which resources

are limited and can be used in different
ways.

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1.1.2 Society’s Choices

• Having a limited amount of resources

means that we must sacrifice one thing
in order to obtain another.

• The decisions of producers,

consumers, and government &
environment determine how an
economic system answers three
fundamental questions:

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 Society’s Choices
• What goods and services do we
produce?
– If we devote more resources to the
production of one good, we have fewer
resources for the production of another.
• How do we produce these goods and
services?
– How do we organize production and
what methods and techniques should
we use?
• For whom do we produce the output?
– How should we distribute the output
produced among members of society?
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1.1.3 Factors of Production

Factors of production, or productive

inputs, are the resources we use to
produce goods and services:

• Natural resources and environment

• Labor
• Physical capital (Plant, machinery, building, etc)
• Human capital (Education + Health)
• Entrepreneurship

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 Factors of Production

• Natural resources:
– The things created by acts of nature such as
land, water, mineral, oil and gas deposits;
renewable and nonrenewable resources.
• Labor:
– The human effort, physical and mental, used by
workers in the production of goods and services.
• Physical capital:
– All the machines, buildings, equipment, roads
and other objects made by human beings to
produce goods and services.
• Human capital:
– The knowledge and skills acquired by a worker
through education and experience in a healthy
situation.

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 Factors of Production

• Entrepreneurship:
– The effort to coordinate the
production and sale of goods and
services. Entrepreneurs take risk
and commit time and money to a
business without any guarantee of
profit.

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1.1.4 The Production Possibilities Frontier
(PPF)

• The PPF curve is a graphical illustration of

fundamental economic problems related to
our ability to produce goods and services.

• The PPF curve shows the possible

combinations of goods and services available
to an economy, when resources are fully and
efficiently employed.

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The Production Possibilities
Frontier (PPF) Curve

• When the economy is

at point i, resources
are not fully employed
and/or they are not
used efficiently.

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The Production Possibilities
Frontier (PPF) Curve

• Point h is desirable
because it yields
more of both goods,
but not attainable
given the amount of
resources available.

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The Production Possibilities
Frontier (PPF) Curve

• Point e is one of the

possible combinations
of goods produced
when resources are
fully and efficiently
employed.

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The Production Possibilities
Frontier (PPF) Curve
• At point e in this
example, resources
are devoted to the
production of four
space missions and
380,000 computers.

• To increase the
number of space
missions by one,
80,000 computers
will have to be
sacrificed.

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The Production Possibilities
Frontier (PPF) Curve

• To increase the
production of one good
without decreasing the
production of the other,
the PPF curve must
shift outward.
 From point f, an additional
150 thousand computers or
two more space missions
are now possible.

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The Production Possibilities
Frontier (PPF) Curve

• Resources are not

perfectly adaptable.
– The PPF curve has a
concave shape because
resources are not
perfectly adaptable in
production. As we
increase the production
of one good, we sacrifice
progressively more of
the other.

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1.1.5 Microeconomics

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 Microeconomics

• Microeconomics gives you the tools

to analyze the impact of:
– Environmental regulations, taxes,
imports, gender discrimination, labor
unions, competition, patterns of
production and consumption, and
other decisions made by individual
economic units.

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1.1.6 Macroeconomics
Macroeconomics is the study of the nation’s
economy as a whole.

Macroeconomic analysis can be used to:

• Understand how a national economy works.
• Understand the grand debates over
economic policy.
• Make informed business decisions.
• Provides thorough understanding of macro
economics variables & their interaction such
as unemployment, inflation, interest rates,
exchange rates, the standard of living, the
federal budget, consumption, and saving
patterns.
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 1.1.6.1 Some Macroeconomics Concepts
• Aggregate Supply (AS) is production of firms in the
economy. 2 factors affect supply a) level of input & b) level of
technology.
• Supply of and demand for labor
– Direct r/ship b/n Ls & wager rate (w) w
– Inverse r/ship b/n LD & w LS

– Real wage = nominal wage adjusted

for price change (W/P) LD
QL
• Aggregate demand (AD)
– It is an inverse function
– It is viewed in terms of expenditure (spending) on goods
and services
– Its major components are:
– Consumption expenditure
– Private investment
– Government expenditure, and
– Net export
– Thus, Qd = C +I + G + (X-M)
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Aggregate Output (Supply)
Aggregate output can be measured by GDP, constant P
GDP measured in 3 ways:
• Sum of final output, Q
• Sum of factor income, Y
• Sum of final expenditure, E
Equilibrium Demand, Supply & Price
AS1
P
AS2
P1

P2

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AD1

AD2
0 Q
Q1
Q2
Fig: Equilibrium Output & Price Levels
• Circular Flow of Income

Market for
factors of
Income Factors payment
production

Household saving Financial

Markets

Gov’t deficit

Taxes Firms
Households Government

Government
purchases Investment

Consumption Market for goods Firm revenue

and services

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1.1.6.2 Simple theory of income & employment
 The theory of income and employment is an
aggregative theory which groups all markets for
goods and services into a single product market, all
financial markets into a money market, and all
markets for factor services into labor market.

Let’s focus on the product market for a moment

 The sum total of the production of final goods and
services (defined as output that is not resold in any
form during the accounting period) when valued at
market prices is the Gross Domestic Product (GDP).

 Assume GDP = GNP

 The deduction of a capital consumption allowance

for the replacement of capital equipment that was
used up during the course of producing current
output reduces this total to the Net Domestic
Product (NDP).
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When NNP is deflated by an index of prices in
order to obtain constant dollar values, we get
real NNP (often referred to as just income)
The level of income may be broken down into
several components. Typically, we divide the
economy into sectors and examine the
determinants of spending and the income
receipts of each sector.

A complete analysis would include a

household sector (C), a business sector (I), a
government sector (G), and a foreign sector (X-
M).
Hence, Y = C + I + G + X-M
 Where Y = Income, C = consumption, I = Investment,
G = Government Expenditure, X = Export, M =
Import.

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1.2. CLASSICAL & KEYNESIAN APPROACHES

1.2.1 Macroeconomic Schools of Thought

• No agreement among economists w.r.t:
» Q, P, and employment equilibrium adjustment
» Source of economic fluctuatuations

• Two important schools of thought:

» Classical school of thought, and
» Keynesian school of thoutht

• Classical approach is a term coined by John Maynard

Keynes to reflect ideas of economists prior to him
• Prominent classical economists (non-marginalist-
Surplus Value & dist.) are Adam smith, David Ricardo,
Thomas Malthus, Karl Marx and John Stuart Mill
• Prominent Keynesian economists are James Tobin,
Lawrence Klein, Robert Solow, James Meade, John
Hicks & Paul Samuelson
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• Neoclassical economists – Marginalist
:includes: Stanley Jevons, Karl monger, Leon
Walras, and J.B. Say.

– This school of thought suggests that

economic fluctuations can be explained
while maintaining classical assumptions of
free market with little gov’t intervention and
endorsement of classical ‘price and wage
flexibility’.

• New Keynesian economics (Gregory Mankiw,

Romer)
– Wages and prices adjust slowly to shocks. As a
result, fluctuations in aggregate demand cause
short-run fluctuations in output and employment.

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1.2.2 Differences in the 2 School of Thought
• Three bases for their differences:
1st the relative role played by DD and SS in
determination of output, employment & prices
2nd the flexibility of prices and wage rate in the
economy
3rd The dichotomy b/n real sector and monetary
sector
• The mainstay of classical economists has been
the assumption that “SS creates its own DD”.
Walras’ law (General equilibrium) & Say’s law
(AD = AS, i.e. economic agents supply goods and
services only if, and b/c, they demand other
goods and services)
• In Keynesians view “ DD creates its own SS” so
long as unemployment exists in the economy.
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• Classical economists
– Believe in free trade and minimum intervention by
the gov’t in economic activities.
– Suggest “laissez-faire” (French for ‘leave us alone’)
& gov’t be confined to law, defense and governance.
– Market force will determine real variable such as
output, employment and prices and this will be
made possible by flexibility of price and wage levels.
– Believe that AS curve is vertical so that no change in
equilibrium level of output and employment.
– A market economy is self-equilibrating, it
adjusts so that the supply of and demand for
labor are equated, and sustained states of
involuntary unemployment – where people
wish to work at the existing wage rate but
cannot find a job – cannot occur.

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– Classical macroeconomics was thus hardly a
separate branch of the subject.
– It had a theory of price determination, the
quantity theory of money, and a theory of the
determination of real wages in the labor
market.
– But, it had very little to say about aggregate
demand, it perceived no problem of
unemployment and it envisaged no role for
any form of macro policy other than control
of money supply to prevent inflation.
– The essential reason for all this was that
classical economics concentrated, at least in
its more formal and rigorous analysis, on the
long-term development of the economy, and
it produced no clear-cut agreed explanation
of short-run fluctuations in economic activity.

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• New Classical Macroeconomics
– Developed in the 1970s and remained influential
in the 1980s, led by Robert Lucas, Thomas
Sargent, Robert Barro, Edward Prescott and Neil
Wallace.
– It sees the world as one in which individuals act
rationally in their self-interest in markets that
adjust rapidly to changing conditions.
– It argues that the government is only likely to
make things worse by intervening.

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• John Maynard Keynes (1883-1946)
– He was the Cambridge (UK) economist, whose
work has produced a revolution in
macroeconomics (The Keynesian Revolution in
Macroeconomics – with his famous book ’The
General Theory of Employment, Interest & Money’
– His work can be regarded as its first kind in the
modern macroeconomics.
– Keynes’s answers to the two basic questions of
macroeconomics were:
1. The economy is not self-equilibrating, and
sustained states of involuntary unemployment
may occur,
2. The government can do something to reduce
and/or prevent unemployment, by making
appropriate use of monetary and fiscal policy.
 He thus provided a justification for a policy of
macroeconomic intervention, in contrast to the
laissez-faire principles of the classical
economists who proceded him.
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”Keynesian” thus refers to the work of
those economists who saw themselves as
following in Keynes’s footsteps.

In contrast to the classical economics,

Keynes was very concerned to develop a
theory of the demand for output as a whole
and hence a model of the (short-run)
determination of national income.

The simplest of such models is the

Keynesian cross model (Equilibrium
occurs where aggregate supply is equal to
aggregate demand for goods and
services).

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• New Keynesian Macroeconomics
– The New Keynesians emerged in the 1980s
through the works of George Akerlof, Janet
Yellen, David Romer, Oliver Blanchard, Greg
Mankiw, Larry Summers and Ben Bernanke).
– This group does not believe that markets clear
all the time but seeks to understand and explain
exactly why markets can fail.
– They argue that markets sometimes do not clear
even when individuals are looking out for their
own interests.
• Sluggishly adjusting, with slowly responding
prices, poor information, costs of changing price
and social customs impeding the rapid clearing
of markets, which help cause macroeconomic
fluctuations in output and employment.
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Keynesians Vs Neoclassicals
Keynes’s General Theory led to a lively debate in
the 1940s and 1950s between those economists
who saw themselves as his followers and
Neoclassical economists (or neoclassicals).
Neoclassicals felt closer to pre-Keynesian classical
economics but were prepared to use Keynes’s
analytical framework with its emphasis on
aggregate demand in arguing against Keynes and
his followers. Eg. The Hicks pave for the synthesis
of clasical and Keynesians ideas on real and
nominal macro-economic variables, popularly
known as IS-LM model as well as the Solow
analysis of long-run growth model.

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1.3. Keynesian Cross Model (KCM)
 The key characteristics of the KCM is that
aggregate supply responds passively to
aggregate demand and national income is
therefore determined by aggregate demand.
Yet, aggregate demand is partly autonomous
and partly positively related to income, with a
marginal propensity to spend (on all forms of
demand) less than unity.
This means that aggregate demand depends
on income: at low levels of income aggregate
demand is greater than income, and at high
levels of income it is less.
Aggregate supply or output is simply equal to
national income, as a result of the way both
aggregates are defined and measured in terms
of the value added in production (which
corresponds to the factor incomes (rent,
wages, interest and profit) generated.
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 1.3.1 Consumption Expenditure &
Saving

• For households the personal disposable

income (i.e., income after payment of tax
& adding transfer payments) is allocated
on either consumption expenditure (C) or
saving (S). Thus, Y = C + S
• It is crystal true that C is the major head of
spending by HHs and depends upon
personal Yd. However, to survive there
always exist minimum spending even Yd is
zero (from borrowing or previous saving)
or any other means

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 The consumption function would be:
C
450 line
C2 C function
Ct  C  cYt ; C1
C C
APC  is average propensity consumption
Y 0 Y Y
Y
1 2
ΔC
c   slope of the C fun. & called marginal proponsity to consume
ΔY

The saving function would be:

S

St  S  sYt ; where 0  s 1
S2
S
APS  is average propensity save S2
Y Y1 Y2 Y

Remmber MPC & MPS  1 S

ΔS
s   slope of the S fun. & called marginal proponsity to save
ΔY

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 1.3.2 Fixed Price Keynesian Model
• Classicals suggest free trade with little intervention by gov’t, as
it would be ineffective
• Keynes advocate intervention by the gov’t to correct
disequilibrium in the economy as price is assumed rigid and
adjustment should take through changes in output level
• For equilibrium, AD = AS. Let AS is GDP, x-axis & AD =
C+I+G, y-axis

AD 450 line
C+I+G
C
C’+I+G
• The Fig. shows adjustment process whenCprice is fixed (Keynesian
C’ model)
0
• I & G are exogenous variables for their levels do not depend
AS on the level
of output or income
• Equilibrium Y is the line C+I+G cross the 45 0 line (a line where AD = AS)
• We observe AD changes if there is change in C, I, or G. Therefore,
increase in I or G will increase AD & thus equilibrium output will
increase & vise versa.

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 1.3.3 Investment Multiplier
• We have seen that AD is seen in the context of aggregate spending in
the economy
• In circular flow we also observe one economic agent spending causes
an increase in the income of another economic agent by the same
amount
• Based on this logic, Kahn developed the theory of multiplier often
called investment multiplier
• Let gov’t issue a bond Birr 100million in the market to spend the
money. This increase gov’t expenditure to HHs by the same amount
• Let HHs spends 65m on bread purchase (i.e., MPC is 0.65) .
• Income of bread sellers ↑ by 65m. Let these spend 42m. This ↑ the
income of another person by 42m. The sequence will continue and
the amount will further shrinks.
• The initial spending of Birr 100m by the gov’t has replicated in the
economy & generate income of Bir100 + 65+42+…In summary, if c is
MPC, then 100+c1100+c2100+c3100+… = 100*1/1-c and 1/1-c is called
“investment multiplier” since AD ↑ by this multiplier for an initial
spending by the gov’t.
• In the example, the increase in AD would be Birr100*1/1-.65 ≈
Birr286
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1.3.4 Key results of the KCM

• Income can in principle be at any level,

depending on aggregate demand, and there
is nothing that makes it tend towards the
full employment level of income.
• In principle the government can do
something to bring this level of income
closer to full employment level, by varying
its own expenditure G or by varying tax
revenue T.
• G directly affects aggregate demand, and T
affects aggregate demand indirectly via its
influence on disposable income and hence
consumption.

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1.3.5 Three defects of the KC model

• It includes no money and no interest rate,

or more technically no ”monetary sector”.
• It implicitly assumes an exogenously fixed
price level, which does not vary when
output and income vary.
• It incorporates no analysis of the labor
market and implicitly assumes an
exogenously fixed wage level.

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 1.4. NEOCLASSICAL SYNTHESIS
1.4.1 Introduction
• In the previous section we have seen classical and Keynesian views
on the determination of output and prices in an economy
• Classical economists say SS creates its own DD and full employment
prevails through adjustments in prices and wage rate.
• The Keynesian view assumes that P level and wage rate are sticky in
an economy due to factors such as labor contracts & labor laws so
that adjustment to demand shocks takes place not through
adjustments in prices and wage rate but through changes in output
and employment levels. Then, Keynesians say that DD creates its
own SS so long as unemployment exists in the economy
• The differences in the two views is due to primarily to the time
horizon considered. In Keynesian view in the long run price level &
wage rate will adjust to equilibrium levels, but not in short run (P &
w stickiness).
• The neoclassicals, particularly Sir John Hicks, have attempted to
combine the ideas contained in both the schools and to bring a
synthesis b/n the real and the money sectors .

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1.4.2 Synthesis of Real and Monetary Sectors
• Combining the IS and LM curves gives a unique
combination of r & Y, which represents
equilibrium in both real market and money market
• Assume price if fixed for simplicity
• In this model it is not necessary that equilibrium
income and interest rate guarantee full
employment. In such a case the gov’t needs to
intervene [fiscal policy (tax & expense of gov’t )
and monetary policy (change in money SS by
central bank policies)].
• Gov’t expenditure (investment) makes IS curve
shift outward.
• Money SS leads to decrease in rate of interest (r).

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 R

LM
LM1

r3
IS31

IS3

r2 IS21

IS2
r1
IS11
r0
IS1
Y (income)
0 Y1 Y2 Y3
IS-LM Model
r0 = liquidity trap
Y1 = LM is assumed infinitely elastic. No increase in interest rate as there is sufficient balance in
the economy
Y3 = is the other extreme, when the economy is operating at income level Y3, gov’t expenditure shift
IS3 to IS31, the LM curve is perfectly inelastic, rate of interest is very high.
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 1.5 Sum-up
• In this chapter we have seen some of the basic concepts such
as Ad, AS & Circular flow of income. We also seen the two
school of thought.
• The classical economists assumed flexibility in price and wage
so that the possibility of unemployment in the economy was
ruled out. The economy adjusted to DD shocks through
changes in price level so that economic fluctuations were not
there. There was no need for gov’t intervention in the
classical model as supply was inelastic at full employment
level.
• Great Depression demolished the classical beliefs, as there was
widespread unemployment associated with declining P & Q
• Keynesian economics suggested that deficiency in AD could
trigger a recession and the remedy is to increase AD. Keynes
advocated increased gov’t spending so that AD would increase
simultaneously giving income & employment to people.
• C & S functions & investment multiplier are important
concepts of Keynesian economics.
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