CHAPTER 1

THE STATE OF MACROECONOMICS

 Economics is the study of the economy and the behavior of people in the
economy.
 Traditionally, economics is divided into microeconomics, which studies
the behavior of individuals and organizations (consumers, firms and the
like) at a disaggregated level, and macroeconomics, which studies the
overall or aggregate behavior of the economy.
 Focus area of macroeconomics
 The macroeconomics policy of any country focuses in achieve the
following three most important objectives. These are:
 Economic growth. This refers to the growth of output (GDP) in an
economy. Usually, letter Y represents output or GDP in
macroeconomic models.
 Stability of the economy. This refers to achieving low or stable
inflation (Л), interest rate (r), and exchange rate (USD to Birr ratio).
 Reducing or addressing unemployment, particularly the cyclical
unemployment, which is the outcome of poverty.
Macroeconomics is concerned with the behavior of
the economy as a whole- with booms and recessions,
the economy’s total output of goods and services and
the growth of output, the rate of inflation and
unemployment, the balance of payments, and
exchange rates.
Macroeconomics focuses on the economic behavior
and policies that affect consumption and investment,
trade balance, the determinants of changes in wages
and prices, monetary and fiscal policies, the money
stock, government budget, interest rate, and national
debt.
In other words, exogenous variables come from
outside the model and serve as the model’s input,
whereas endogenous variables are determined inside
the model and are the model’s output.
Macroeconomics goals and instruments
Macro economics goals
Economic growth. The ultimate measure of a
country’s economic success is its ability to generate a
high level of production of economic goods and
services for its population.
Reducing Unemployment: Reducing or addressing
unemployment, particularly the cyclical
unemployment, which is the outcome of poverty.
Poverty is the outcome of many factors. Some of the
factors include socio-economic backwardness, natural
hazards, war, and poor governance (administration) of
a nation and policies.
Frictional and structural unemployment, which are
caused due to poor or imperfect information and
change in technology respectively, can be addressed
easily. Therefore, their effect on an economy is
temporary.
As a result, economic policy makers give due attention
or emphasize to address the cyclical unemployment,
which could be permanent unless they are capable
using different macroeconomics instruments.
Stability of the economy: This refers to achieving
low or stable inflation, nominal interest rate (r), and
exchange rate (USD to Birr ratio). One of the stability
objectives is ensuring stable prices because Prices
stability denotes that the overall price level does not
rise or fall rapidly. Prices are a yardstick where by
economic values are measured.
When the economic yardstick changes quickly during
periods of rapidly changing prices, contracts and other
economic agreements become distorted, and the
price system tends to become less valuable.
 Foreign Economic Policy: The final goal of policy is
to promote a proper foreign economic policy.
This aim has become increasingly important, as the
nations of the globe have become more closely tied by
international trade and finance.
All economics are open. They import and export goods
and services, they borrow or lend money to foreigners;
they imitate foreign technologies or sell their
inventions abroad.
Declines in the costs of transportation and
communication have made these international
linkages even tighter than they were a generation ago.
Some economies today trade over half their national
output.
Nations also keep a close eye on their foreign
exchange rates, which represent the price of their
own currency in terms of the currencies of other
nations.
When a nation’s exchange rate rises, its exports
become more expensive and therefore less competitive
in world markets, causing exports to shrink relative to
imports. By contrast, when a nation’s exchange rate
falls, import prices rise and the inflation rate therefore
tends to increase. These and other impacts on the
economy make the exchange rate increasingly
important for all nations.
Macroeconomics instruments
To achieve the above objectives economic policy
makers of countries use mix of macroeconomics
instruments such as:
Fiscal Policy. It consists of setting the levels of
taxation and expenditure to affect macro economic
performance. Government expenditure affects the
overall level of spending in the economy and can
thereby affect the level of gross national product
(GNP).
In macroeconomics, taxation plays two key roles.
First, taxes reduce people’s incomes.
By leaving households with less spendable income,
higher taxes tend to reduce their consumption
spending, lowering aggregated demand and actual
GNP.
 In addition, taxes help determine the prices that
businesses and individuals face in markets and thereby
affect incentives and behavior
Monetary policy: this policy comprises the
management of a nation’s money, credit and banking
system by the nation’s central bank.
By speeding or slowing the growth of money supply,
the central bank makes interest rates lower or higher
and induces or retards investment in houses, plant,
equipment etc.
Income policy: it is more accurately denoted wage-
price policies. Income policies are government
actions that attempt to moderate inflation by direct
steps, whether by verbal persuasion or by legislated
wage and price controls.
The Foreign connection: As economies become more
and more open, their policy makers devote increasing
attention to managing their foreign economic policies.
The major tools fall in to two categories.
First, nations can affect their trade by trade policies.
These consist of tariffs, quotas, and other devices that
restrict or encourage imports and exports.
A second set of policies specifically aimed toward the
foreign sector is exchange market management.
There are a number of different systems whereby nations
can regulate their foreign exchange markets. Some
systems involve leaving exchange rates completely to the
market place (It’s called floating exchange rate).
 Others involve setting a fixed exchange with other
currencies.
 Economic thinking has begun since the birth of
1.3 Schools of thoughts in Macroeconomics
mankind. This is because archeological excavations
evidenced that our ancestors were having some
economic thinking such as saving due to scarcity of
resources and division of labor even when gathering
and hunting were their means of survival/basic
livelihood.
Further studies made in ancient civilizations of Egypt,
Babylon, Persia, Axum, China, India, Byzantine,
Greek, and Rome confirms that trade and tax were
the sources of their civilization.
The above findings, therefore, attest that people make
economic decision since birth at different age levels
(child, youth, adult, and old) to death whether
knowingly or unknowingly.
Available document suggest that economics is an old
science like Art, literature, Astronomy, Mathematics,
Physics, Medicine, and the like.
Plato and Aristotle were the two prominent ancient
Greek philosophers who produced enormous
economic articles on economics that served as
foundation/basis for further studies and advancement
of economics.
However, the studies of scholars conducted on
economic issues and theories developed up to the
industrial revolution of the 18th century focus only
on microeconomic issues.
Macroeconomics as a branch of economics was
emerged with the writing of Adam Smith “The wealth
of Nation” in 1776.
 Classical school of thought (1776 – 1870): In this
period the distinction between micro and macro was
not clear.
The dominant idea of this school of thought was the
invisible hand or lassies fair, which means leave the
market free (free market) advocated by Adam Smith.
The reason for their argument was that because supply
will create its own demand or price set by the private
sector alone will automatically correct/equilibrate
any imbalance or disequilibria created in the economy
both in the short run and the long run without
government intervention. This law is called the
“Says law”.
Adam Smith also described the government as evil
and hence advocated that the government should stay
away or refrain from intervening in the market.
For Adam Smith and his followers any government
policy is ineffective to correct economic disorder or
disequilibrium.
In other words, government intervention will distort
the market rather than stabilizing.
From the above arguments of the classical school of
thought concepts such as price, economy, and the
government are macro concepts. However, they did not
have clear vision of how the economy should operate.
Neo classical (1870 – 1936):
the neoclassical school is not different from them
classical school. The main distinction is the tool of
analysis, such as the marginal analysis and price
determination of goods and profit analysis.
The Keynesian macroeconomics (1936-1970s) :
Till 1930’s the classical line of thought dominated
macroeconomics.
It is behaved that always the economy function at the
full employment level and there was neither over
production nor underproduction.
An automatic functioning of the economic activity
was assumed by the classical writers.
A flexible price system was recommended by them
to maintain the general balance.
Classicalists gave importance to the supply side.
They believed in the say’s law of market “supply
creates its own demand”.
During the great depression of 1929, the mass
unemployment and over production disproved the
classical conclusions.
That is An American economist called Keynes
challenged the classical wisdoms of macroeconomics
based on the events or episodes during the great
economic depression of the early 1930’s (1929 to 1935).
The great depression was caused by excessive or
overproduction of wheat and coffee.
Due to excess production than demanded the price of
wheat and coffee goes down, implying supply fails to
create its demand as argued by the classical.
Keynes rejected the automatic equilibrium.
 He tried to examine the causes of unemployment,
depression and stagflation.
He argued that in a money using economy, supply
could not automatically create demand because the
income earners won’t spend their entire income.
They hold a part of it as idle cash balance this creates
deficiency of demand and difficulty to sell all that is
produced.
According to Keynes this is the basic cause of
unemployment. Because the amount of cash in the
economy is fixed, an individual can increase her cash
holding by spending less, but she does so only by
taking away cash that other people had been holding.
As a result income falls along with spending. I try to
accumulate cash by reducing my purchases from you,
and you try to accumulate cash by reducing your
purchases from me; the result is that both of our
incomes fall along with our spending, and neither of
us succeeds in increasing our cash holdings.
If we remain determined to hold more cash, we will
react to this disappointment by cutting our spending
still further, with the same disappointing result; and so
on and so on.
 Looking at the economy as a whole, you will see
factories closing, workers laid off, stores empty, as
firms and households throughout the economy cut
back on spending in a collectively vain effort to
accumulate more cash.
The end