Module Macro@ABVM

AGRIBUSINESS MANAGEMENT (ABVM 211)
LT 3: MACROECONOMICS (4 ECTS)
Compiled by: Ebisa Deribie (MA) Negash Mulatu (MSc)
JULY, 2012
Agribusiness Management: Macroeconomics
Table of Contents
Contents
3.3 Macroeconomics .......................................................................................................................... ii 3.3.1 Introduction............................................................................................................................... ii 3.3.2 Objectives .................................................................................................................................. ii 3.3.3. Sections .................................................................................................................................... 1 3.3.3.1. Concepts and Theories of Macroeconomics ......................................................................... 1 Introduction........................................................................................................................................ 1 How to Approach the Study of Macroeconomics .............................................................................. 2 Basics of Aggregate Demand and Aggregate Supply .......................................................................... 5 Price Indexes .................................................................................................................................... 12 3.3.3.2. National Income Accounting ........................................................................................ 17
Concepts and Definition of GNP and GDP ........................................................................................ 17 Measuring GNP and GDP .................................................................................................................. 18 Approaches to Measure GNP ........................................................................................................... 18 3.3.3.3. Macroeconomic Problems............................................................................................ 22
Inflation ............................................................................................................................................ 22 Unemployment................................................................................................................................. 29 Tradeoffs between Inflation and Unemployment............................................................................ 33 3.3.3.4. Macroeconomic Policies ............................................................................................... 35
Fiscal Policy ....................................................................................................................................... 35 Monetary Policy ............................................................................................................................... 45 3.3.3.5. Economic Development Issues and Policies ................................................................. 52
Economic Development vs. Economic Growth ................................................................................ 52 Measurements of Economic Development ...................................................................................... 53 Characteristics of Underdeveloped Country .................................................................................... 54 3.3.3.6. Ethiopian Economy ....................................................................................................... 59
Brief Review of the Structure of the Ethiopian Economy ................................................................ 59 Macroeconomic Reforms and Development Plans .......................................................................... 59 3.3.4. Proof of Ability .................................................................................................................. 63
NICHE : Jimma, Haramaya, Hawassa, Ambo, Adama, Bahirdar, Semera and Wolaita Sodo Universities
3.3 Macroeconomics 3.3.1 Introduction

The aim of this learning task is to provide students with the basic concepts and theories of macroeconomics, national income accounting, macroeconomic problems like unemployment and inflation, and macroeconomic policies. The learning tasks ultimate target is to enable students to analyze aggregate economic variables, understand macroeconomic problems and the functioning of the national economic policies. The whole chapters in the module are interrelated and they clearly reveal the dynamics of the macroeconomics. Therefore, learners are expected to read and understand the module. Besides, learners are advised strongly to refer other books and relevant references. A number of questions are included in the module for the learners to exercise. By doing this learners could find studying the course simple and understandable.
3.3.2 Objectives
The major objectives of this learning task are: To provide learners with the general concept of the major theories and concepts with macroeconomics To equip learners with the contemporary macroeconomic issues To explain macroeconomic policies in relation to monetary policies, fiscal policies and income policies To reveal the relationships between concepts of economics of development and macroeconomic concepts To show some evidences of macroeconomic issues and policies from Ethiopias perspectives
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3.3.3. Sections 3.3.3.1. Concepts and Theories of Macroeconomics

Introduction
Dear student, before you start reading this section try to answer the next pre-test questions that would make your reading simple. What is economics? Can you explain what macroeconomics is? What makes it different from microeconomics? ___________________ __________________________________________________________________________ Economics is studied on various levels. We can study the decisions of individual households and firms; the interaction of households and firms in markets for specific goods and services; or the operation of the economy as a whole, which is just the sum of the activities of all decision makers in all markets. Economics is a subject matter that is concerned with the efficient utilization or management of limited productive resources for the purpose of attaining the maximum satisfaction of human material wants. As you might have learnt in microeconomics, economics is divided into two broad branches: microeconomics and macroeconomics. Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets, while macroeconomics is the branch of economics that deals with human behavior and choices as they relate to highly aggregate markets (e.g., the goods and services market) or the entire economy. In other words, it examines the economy as a whole and concerned with the combined or aggregate effects of choices/decisions of economic agents at economy or macro level. It deals with macroeconomic variables like, unemployment, general price levels, national income, economic growth, trade balance and balance of payments, foreign economic relations, fiscal and monetary policies of the government etc. The goal of macroeconomics is to explain the economic changes that affect many households, firms, and markets at once. Macroeconomics tries to address diverse questions such as: Why is average income high in some countries while it is low in others? What causes long run and short run economic fluctuations? Why do prices rise rapidly in some periods of time while they are more stable in other periods? What causes inflation? Why is the unemployment rate sometimes high and sometimes low? What, if anything, can the government do to promote rapid growth in incomes, low inflation, and stable employment? How does the economy work? Why do some national economies grow faster than other national economies? What might cause interest rates to be low one year and high the next? How do changes in the money supply, government spending and taxes affect the economy?
Macroeconomics and microeconomics are closely intertwined. Because changes in the overall economy arise from the decisions of millions of individuals, it is impossible to understand macroeconomic developments without considering the associated microeconomic decisions. For example, you might study the effect of a cut in the federal income tax on the overall production of goods and services. To analyze this issue, you must consider how the tax cut affects the decisions of households about how much to spend on goods and services. Despite the inherent link between microeconomics and macroeconomics, the two fields are distinct. Because microeconomics and macroeconomics address different questions, they sometimes take quite different approaches and are often taught in separate courses. How to Approach the Study of Macroeconomics Dear students, what kinds of macroeconomic problems do you know? __________________ __________________________________________________________________________ Before we begin our discussion of macroeconomic measurements, we need to take some time to discuss how best to approach the study of macroeconomics. As mentioned, macroeconomics is the branch of economics that deals with the entire economy. Most discussions in macroeconomics focus on one or more of the following issues: 1. Macroeconomic problems, 2. Macroeconomic theories, 3. Macroeconomic policies and 4. Different views of how the economy works Macroeconomic Problems: Dear student, you may list a number of macroeconomic problems. Here are a few macroeconomic problems: High inflation rate, High unemployment rate, High interest rates and Low economic growth. With regard to such problems, macroeconomics tries to inform us on two things: 1. What is the cause of the problem? and, 2. What needs to be done to end the problem? Macroeconomic Theories: When you encounter macroeconomic problems, certain questions naturally come to mind. For example, if interest rates are unusually high, you might wonder why interest rates are high sometimes but low at other times. If the inflation rate has recently gone up, you might wonder why the inflation rate went up now. Many of the questions you would ask do not have obvious answers. To answer these questions, then, we often build theories. For example, a macroeconomist might build a theory to try to understand why interest rates are high in one year but not high in some other year; he or she might build a theory to try to understand why the inflation rate is low in one year but high in another year. We will encounter a number of macroeconomic theories in our discussion of macroeconomics. Dear learner, in the coming topics of macroeconomics, we will come across theories that attempt to explain such things as changes in the price level, changes in
unemployment, changes in interest rates, and so on. In our discussion of the concept of macroeconomics, we have to keep in mind that not all macroeconomists agree on the causes of certain macroeconomic problems. Macroeconomic Policies: To solve certain macroeconomic problems, macroeconomists often propose certain types of policies. Specifically, a macroeconomist might propose cutting tax rates to revive economic growth or cutting back the growth rate in the money supply to lower prices. The two types of macroeconomic policy that we will discuss later include fiscal policy and monetary policy. Fiscal policy deals with changes in government expenditures and/or taxes. For example, a proposal to cut taxes is a fiscal policy measure. Monetary policy deals with changes in the money supply. For example, a proposal to decrease the rate of growth of the money supply is a monetary policy measure. Different Views of How the Economy Works: We are not at the stage in the history of macroeconomics where we can say that all macroeconomists agree as to how the economy works. For example, some economists believe that the economy is inherently stable and selfregulating. On the other hand, some economists do not believe the economy is selfregulating. They see it as inherently unstable. In other words, the economy has certain forces within it that can (and sometimes do) cause it to get ill on its own. There are three central issues on the research agenda in macroeconomics. How do we explain periods of high and persistent unemployment? Macroeconomic research focuses on persistent unemployment as a central question. There are many theories of why persistent high unemployment is. How do we explain inflation? What determines economic growth? The questions of whether the government can and should do something about each of these issues and what is best to do have been at the center of macroeconomics for a long time. These questions continue to divide the profession, and every generation develops its own debate, reinterpreting past events or experiences in various parts of the world. Moreover, there are questions about policy in the open economy: should governments fix exchange rates? Or should exchange rates be market-determined? To help you categorize what you learn in macroeconomics and to give you a better idea of what macroeconomics is about, we outline three macroeconomic organizational categories. We call these categories: The P-Q Category; Self-RegulatingEconomic Instability Category; and Effective-Ineffective Category The P-Q Category: Many of the topics discussed in macroeconomics relate directly or indirectly to the price level and Real GDP. The price level is the weighted average of the prices of all goods and services. Real GDP is the value of the entire output produced annually within a countrys borders, adjusted for price changes. We discuss both the price level and
Real GDP in depth later, but for now, you may simply want to view the price level as an average price and Real GDP as the quantity of output produced. The symbols we use for the price level is P; for Real GDP is Q. Thus, we can talk about the P-Q category. In macroeconomics, we have occasion to discuss numerous topics, such as inflation, deflation, unemployment, and so on. Many of these topics relate directly or indirectly to either P or Q. Here is a list of macroeconomic topics and how each relates to either price (P) or Real GDP (Q): Gross Domestic Product (GDP), that is P times Q; unemployment, changes in unemployment are related to changes in Q; inflation, that is a rising P; deflation, a falling P; economic growth, related to increasing Q; stagflation, a rising P combined with rising unemployment; business cycle, recurrent swings up and down in Q; inflationary gap, the condition of the economy when Q is above its natural level; recessionary gap, the condition of the economy when Q is below its natural level; fiscal policy, that is concerned with stabilizing P and increasing Q; and monetary policy, that is concerned with stabilizing P and increasing Q. The Self-RegulatingEconomic Instability Category: Consider the Great Depression of 19291933. During this period in U.S. history, unemployment skyrocketed, the production of goods and services plummeted (Q fell), prices fell (P fell), banks closed, savings were lost, and companies went bankrupt. What does this period indicate about the inherent properties of a market economy? Some observers argue that the Great Depression is proof of the inherent instability of a market (or capitalist) economy and demonstrates that natural economic forces, if left to themselves, may bring on human suffering. Other observers see things differently. They argue that left to itself, the economy would never have nosedived into the Great Depression. They argue that the economy is inherently stable or self-regulating. The Great Depression, they believe, was largely caused and made worse by government tampering with the self-regulating and wealth-producing properties of a market economy. Which came first? Did the market economy turn down under the weight of its own forces, producing massive unemployment, with government later stepping in to restrain the destructive market forces? Or was the market economy pushed into depression, and held there, by government economic tampering? The answer largely depends on how the inherent properties of a market economy are viewed. The Effective-Ineffective Category: Here the words effective and ineffective describe fiscal policy and monetary policy. Fiscal policy refers to changes in government expenditures and/or changes in taxes to achieve particular macroeconomic goals (e.g. low unemployment, stable prices). Monetary policy refers to changes in the money supply, or the rate of growth of the money supply, to achieve particular macroeconomic goals. Macroeconomists can take one of several positions with the effective-ineffective category. They can believe that fiscal and monetary policies are always effective (at meeting their goals), that both fiscal and monetary policies are ineffective, or that fiscal policy is effective and monetary policy is
ineffective, and so on. Often, a macroeconomists position on the effectivenessineffectiveness of a policy is implicit in his or her view of how the economy works. Basics of Aggregate Demand and Aggregate Supply Dear students, before starting the reading this section, please answer the next pretest question. List and describe the two sides of a market on the following blank space? __________________________________________________________________________ __________________________________________________________________________ Good! Now continue your reading. Just as there are two sides to a market, a buying side (demand) and a selling side (supply), there are two sides to an economy. There is a demand side and a supply side. The demand in an economy is referred to as aggregate demand (AD); the supply is referred to as aggregate supply (AS). The AD-AS framework has three parts: (1) aggregate demand (AD), (2) short-run aggregate supply (SRAS), and (3) long-run aggregate supply (LRAS). We begin with a discussion of aggregate demand. Aggregate Demand (AD) AD refers to the quantity demanded of all goods and services (Real GDP) at different price levels, ceteris paribus (we will discuss later on about Real GDP). In other words, it is the quantity demanded of goods and services by people, firms, government, or the quantity demanded of Real GDP, at various price levels, ceteris paribus. An aggregate demand (AD) curve is the graphical representation of aggregate demand. An AD curve is shown in figure 1.1. Notice that it is downward sloping, indicating an inverse relationship between the price level (P) and the quantity demanded of Real GDP (Q): As the price level rises, the quantity demanded of Real GDP falls, and as the price level falls, the quantity demanded of Real GDP rises, ceteris paribus.
Figure 1.1: Aggregate demand curve The AD curve slopes downward means there is an inverse relationship between the price level and the quantity demanded of Real GDP. This inverse relationship, and the resulting downward slope of the AD curve, is explained by the real balance effect, the interest rate effect, and the international trade effect. 1. Real balance effect: The real balance effect states that the inverse relationship between the price level and the quantity demanded of Real GDP is established through changes in the
value of monetary wealth, or money holdings. To illustrate, consider a person who has $50,000 in cash. Suppose the price level falls. As this happens, the purchasing power of the persons $50,000 rises. That is, the $50,000, which once could buy 100 television sets at $500 each, can now buy 125 sets at $400 each. An increase in the purchasing power of the persons $50,000 is identical to saying that his monetary wealth has increased. (After all, isnt the $50,000 more valuable when it can buy more than when it can buy less?) And as he becomes wealthier, he buys more goods. In summary, a fall in the price level causes purchasing power to rise, which increases a persons monetary wealth. As people become wealthier, the quantity demanded of Real GDP rises. Suppose the price level rises. As this happens, the purchasing power of the $50,000 falls. That is, the $50,000, which once could buy 100 television sets at $500 each, can now buy 80 sets at $625 each. A decrease in the purchasing power of the persons $50,000 is identical to saying that his monetary wealth has decreased. And as he becomes less wealthy, he buys fewer goods. In summary, a rise in the price level causes purchasing power to fall, which decreases a persons monetary wealth. As people become less wealthy, the quantity demanded of Real GDP falls.
Figure 1.2: Real balance effect 2. Interest rate effect: The interest rate effect states that the inverse relationship between the price level and the quantity demanded of Real GDP is established through changes in household and business spending that is sensitive to changes in interest rates. Lets consider a person who buys a fixed bundle of goods (food, clothing, and shelter) each week. Suppose the price level falls, increasing the purchasing power of the persons money. With more purchasing power (per dollar), she can purchase her fixed bundle of goods with less money. What does she do with (part of) this increase in her monetary wealth? She saves it. In terms of simple supply-and-demand analysis, the supply of credit increases. Subsequently, the price of credit, which is the interest rate, drops. As the interest rate drops, households and businesses borrow more, so they end up buying more goods. Thus, the quantity demanded of Real GDP rises.
Figure 1.3: Interest rate effect 3. International trade effect: The international trade effect states that the inverse relationship between the price level and the quantity demanded of Real GDP is established through foreign sector spending which includes spending on imports and exports. Suppose the price level in the United States falls. As this happens, U.S. goods become relatively cheaper than foreign goods. As a result, both Americans & foreigners buy more U.S. goods. The quantity demanded of (U.S.) Real GDP rises. Similarly, say the price level in the United States rises. As this happens, U.S. goods become relatively more expensive than foreign goods. As a result, both Americans and foreigners buy fewer U.S. goods. The quantity demanded of (U.S.) Real GDP falls.
Figure 1.4: International trade effect We explained that the aggregate demand curve is downward sloping because of the real balance, interest rate, and international trade effects. Keep in mind what caused these three effects: a change in the price level. In other words, when we were discussing, say, the interest rate effect, we were discussing the interest rate effect of a change in the price level. Why is this an important point? Because the interest rate can change due to things other than the price level changing, and not everything that change the interest rate leads to a movement from one point to another point on the AD curve. Some things that change the interest rate can lead to a shift in the AD curve instead.
Change in the Quantity Demanded of Real GDP Vs Change in Aggregate Demand Dear students, before starting your reading, please answer the next pretest question. What is the difference between change in demand and change in quantity demanded for good X? __________________________________________________________________________ __________________________________________________________________________ A change in the quantity demanded of Real GDP is brought about by a change in the price level. As the price level falls, the quantity demanded of Real GDP rises, ceteris paribus. In figure 1.5(a), a change in the quantity demanded of Real GDP is represented as a movement from one point (A) on AD1 to another point (B) on AD1. A change in aggregate demand is represented in panel (b) as a shift in the aggregate demand curve from AD1 to AD2. Notice that when the aggregate demand curve shifts, the quantity demanded of Real GDP changes even though the price level remains constant. For example, at a price level (index number) of 180, the quantity demanded of Real GDP on AD1 in panel (b) is $6.0 trillion. But at the same price level (180), the quantity demanded of Real GDP on AD2 is $6.5 trillion.
Figure 1.5: Change in quantity demanded and change in demand What can change aggregate demand? In other words, what can cause aggregate demand to rise and what can cause it to fall? The simple answer is that aggregate demand changes when the spending on the goods and services changes. If spending increases at a given price level, aggregate demand rises; if spending decreases at a given price level, aggregate demand falls. When individuals, firms, and governments want to buy more goods and services even though the prices of these goods have not changed, then we say that aggregate demand has increased. As a result, the AD curve shifts to the right. Of course, when individuals, firms, and governments want to buy fewer goods and services at a given price level, then we say that aggregate demand has decreased. As a result, the AD curve shifts to the left.
Short-Run Aggregate Supply (SRAS)

Aggregate demand is one side of the economy; aggregate supply is the other side. Aggregate supply refers to the quantity supplied of all goods and services (Real GDP) at various price levels, ceteris paribus. Aggregate supply includes both short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS). A short-run aggregate supply (SRAS) curve is illustrated in figure 1.6. It shows the quantity supplied of all goods and services (Real GDP or output) at different price levels, ceteris paribus. Notice that the SRAS curve is upward sloping: As the price level rises, firms increase the quantity supplied of goods and services; as the price level drops, firms decrease the quantity supplied of goods and services. Why is the SRAS curve upward sloping? Economists have put forth a few explanations for this, such as the stick wages and workers misperception.
Figure 1.6: The Short Run Aggregate Supply Curve What Puts the Short Run in SRAS? According to most macroeconomists, the SRAS curve slopes upward because of sticky wages or worker misperceptions. No matter which explanation of the upward-sloping SRAS curve we accept, things are likely to change over time. Wages will not be sticky forever (labor contracts will expire), and workers will figure out that they misperceived real wage changes. It is only for a period of timeidentified as the short runthat these issues are likely to be relevant. Changes in Short-Run Aggregate Supply A change in the quantity supplied of Real GDP is brought about by a change in the price level. A change in quantity supplied is a movement along the SRAS curve. But what can change short-run aggregate supply & shift the curve? The factors that can shift the SRAS curve include wage rates, prices of nonlabor inputs, productivity, and supply shocks. Wage Rates: Changes in wage rates have a major impact on the position of the SRAS curve because wage costs are usually a firms major cost item. Higher wage rates mean higher costs and, at constant prices, translate into lower profits and a reduction in the number of units (of a given good) managers of firms will want to produce. Lower wage rates mean lower costs and, at constant prices, translate into higher profits and an increase in the number of units (of a given good) managers will decide to produce.
Prices of Non-labor Inputs: There are other inputs to the production process besides labor. Changes in their prices affect the SRAS curve in the same way as changes in wage rates do. An increase in the price of a non-labor input (e.g., oil) shifts the SRAS curve leftward; a decrease in the price of a non-labor input shifts the SRAS curve rightward. Productivity: Productivity describes the output produced per unit of input employed over some period of time. Although various inputs can become more productive, lets consider the input labor. An increase in labor productivity means businesses will produce more output with the same amount of labor. This causes the SRAS curve to shift rightward. A decrease in labor productivity means businesses will produce less output with the same amount of labor. This causes the SRAS curve to shift leftward. A host of factors lead to increased labor productivity, including a more educated labor force, a larger stock of capital goods, and technological advancements. Supply Shocks: Major natural or institutional changes on the supply side of the economy that affect aggregate supply are referred to as supply shocks. Supply shocks are of two varieties. Adverse supply shocks (such as bad weather, major cutback in the supply of oil) shift the SRAS curve leftward, and beneficial supply shocks shift it rightward. Example: major oil discovery, unusually good weather. Putting AD & SRAS Together: Short-Run Equilibrium In this section, we put aggregate demand and short-run aggregate supply together to achieve short-run equilibrium in the economy. Aggregate demand and short-run aggregate supply determine the price level, Real GDP, and the unemployment rate in the short run. Figure 1.7 shows an aggregate demand (AD) curve and a short-run aggregate supply (SRAS) curve. We consider the quantity demanded of Real GDP and the quantity supplied of Real GDP at three different price levels: P1, P2, and PE. At P1, the quantity supplied of Real GDP (Q2) is greater than the quantity demanded (Q1). There is a surplus of goods. As a result, the price level drops, firms decrease output, and consumers increase consumption. Why do consumers increase consumption as the price level drops? At P2, the quantity supplied of Real GDP (Q1) is less than the quantity demanded (Q2). There is a shortage of goods. As a result, the price level rises, firms increase output, and consumers decrease consumption. In instances of both surplus and shortage, economic forces are moving the economy toward E, where the quantity demanded of Real GDP equals the (short-run) quantity supplied of Real GDP. This is the point of short-run equilibrium. PE is the short-run equilibrium price level; Q E is the short-run equilibrium Real GDP. A change in aggregate demand, short-run aggregate supply, or both will obviously affect the price level and/or Real GDP. For example, an increase in aggregate demand raises the equilibrium price level and, in the short run, Real GDP. An increase in short-run aggregate
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supply lowers the equilibrium price level and raises Real GDP. A decrease in short-run aggregate supply raises the equilibrium price level and lowers Real GDP.
Figure 1.7: Short run equilibrium Long-Run Aggregate Supply (LRAS) In this section, we discuss long-run aggregate supply and draw a long-run aggregate supply (LRAS) curve. We also discuss long-run equilibrium and explain how it differs from shortrun equilibrium. As an earlier section explains, economists give different reasons for an upward-sloping SRAS curve. It follows, then, that short-run equilibrium identifies the Real GDP the economy produces when either of these two conditions hold. In time, though, wages will become unstuck and misperceptions will turn into accurate perceptions. When this happens, the economy is said to be in the long run. In other words, in the long run, these two conditions do not hold. An important macroeconomic question is: Will the level of Real GDP the economy produces in the long run be the same as in the short run? Most economists say that it will not be. They argue that in the long run, the economy produces the full-employment Real GDP or the Natural Real GDP (QN). Natural Real GDP: is The Real GDP that is produced at the natural unemployment rate. It is the Real GDP that is produced when the economy is in long-run equilibrium. The aggregate supply curve that identifies the output the economy produces in the long run is the long-run aggregate supply curve. It is shown as the vertical line in as follows.
Figure 1.8: Long Run Aggregate Supply (LRAS) Curve

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It follows that long-run equilibrium identifies the level of Real GDP the economy produces when wages and prices have adjusted to their (final) equilibrium levels and there are no misperceptions on the part of workers. Graphically, this occurs at the intersection of the AD and LRAS curves. Furthermore, the level of Real GDP that the economy produces in long-run equilibrium is Natural Real GDP (QN). Generally, there are two equilibrium states in an economy: short-run equilibrium and longrun equilibrium. These two equilibrium states are graphically shown in figure 1.9. In panel (a) of the figure, the economy is at point 1, producing Q1 amount of Real GDP. Notice that at point 1, the quantity supplied of Real GDP (in the short run) is equal to the quantity demanded of Real GDP, and both are Q1. The economy is in short-run equilibrium. In panel (b) of the figure, the economy is at point 1, producing QN. In other words, it is producing Natural Real GDP. The economy is in long-run equilibrium when it produces QN. Notice that in both short-run and long-run equilibrium, the quantity supplied of Real GDP equals the quantity demanded. So what is the difference between short-run equilibrium and long-run equilibrium? In long-run equilibrium, quantity supplied and demanded of Real GDP equal Natural Real GDP [see panel (b)]. But in short-run equilibrium, quantity supplied and demanded of Real GDP are either more than or less than Natural Real GDP.
Figure 1.9: Equilibrium States of the Economy
Price Indexes
Earlier, we presented three distinct macroeconomic categories in which much of our macroeconomic discussion can be placed. In this section, we discuss the P of the P-Q category; the price level. We discuss how economists measure the price level. They measure the price level by constructing price indexes. There are three types of price indexes. They are: consumer price index (CPI), GDP deflator and the producer price index (PPI). I. Consumer Price Index (CPI) As stated earlier, the price level is a weighted average of the prices of all goods and services. The consumer price index (CPI) measures the cost of buying a fixed basket of goods and services representative of the purchases of urban consumers. The CPI is calculated from
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sampling of thousands of households and businesses. When a news report says that the cost of living increased by, say, 7 percent, it is usually referring to the CPI. The CPI is based on a representative group of goods and services purchased by a typical household. This representative group of goods is called the market basket. In the US, the market basket includes eight major categories of goods and services: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. Some examples of these goods and services are breakfast cereal, milk, coffee, bedroom furniture, mens shirts, womens dresses, jewelry, new vehicles, airline fares, gasoline, prescription drugs, cable television, sports equipment, college tuition, postage, and haircuts. To simplify our discussion, we assume the market basket includes only three goods instead of the many goods it actually contains. Our market basket consists of 10 pens, 5 shirts, and 3 pairs of shoes. To calculate the CPI, we must first calculate the total dollar expenditure on the market basket in two years: the current year and the base year. The base year is a benchmark year that serves as a basis of comparison for prices in other years. We multiply the quantity of each good in the market basket (column 1) by its current-year price (column 2) to compute the current-year expenditure on each good (column 3). By adding the dollar amounts in column 3, we obtain the total dollar expenditure on the market basket in the current year. This amount is $167. To find the total expenditure on the market basket in the base year, we multiply the quantity of each good in the market basket (column 1A) by its base-year price (column 2A) and then add these products (column 3A). This gives us $67. As shown in Exhibit 1.1, the CPI for our tiny economy is 249.To find the CPI, we use the formula:
Note that the CPI in the base year is 100. How do we know this? Well, look again at the formula for calculating the CPI. The numerator is the total dollar expenditure on market basket in current year and the denominator is the total dollar expenditure on market basket in base year. In the base year, the current year is the base year, so the numerator and denominator are the same.
Computing the Consumer Price Index: we use hypothetical data to show how the CPI is computed. To find the total dollar expenditure on market basket in current year, we multiply the quantities of goods in the market basket times their current-year prices and add these products. This gives us $167. To find the total dollar expenditure on market basket in base year, we multiply the quantities of goods in the market basket times their base-year prices and add these products. This gives us $67. We then divide $167 by $67 and multiply the quotient by 100.
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If we know the CPI for various years, we can compute the percentage change in prices. To find the percentage change in prices between any two years, we use the following formula:
For example, suppose that the CPI in 1990 was 130.7, and the CPI in 2005 was 195.3. What was the percentage change in prices over this period of time? It was 49.43 percent: [(195.3 130.7) 130.7] 100 = 49.43. This means that from 1990 to 2005, prices increased 49.43 percent. You can think of the percentage change in prices this way: What cost $1 in 1990 cost approximately $1.49 in 2005. II. The GDP Deflator The GDP deflator is the other important price index. The GDP deflator is the ratio of nominal GDP in a given year to real GDP of that year. The deflator measures the change in prices that has occurred between the base year and the current year. Since the GDP deflator is based on a calculation involving all the goods produced in the economy, it is a widely based price index that is frequently used to measure inflation. Example: we can get a measure of inflation between 2000 and 2004 by comparing the value of 2004 GNP in 2004 prices and 2000 prices. Assume the ratio of nominal to real GNP in 2004 is 1.22 (=21 million/17.2 million). In other words, output is 22 % higher in 2004 when it is valued using the higher prices of 2004 than valued in the lower prices of 2000. We ascribe the 22 % increase in the value of the output to price increases, or inflation, over the 2000-2004 periods. Therefore, in the period between 2000 and 2004, inflation rate was 22%. The GDP deflator, by contrast, uses the weights of the current period to calculate the price index. Let be the quantities of the different goods produced in the current year.
This is known as a Paasche, or current-weighted, price index.

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The following are the three main differences between CPI and GDP deflator: The deflator measures the prices of a much wider group of goods than the CPI does. CPI prices are measured by field-workers who go into shops and make phone calls to discuss the prices of the goods being sold by firms. The CPI measures the cost of a given basket of goods, which is the same from year to year. The basket of goods included in the GDP deflator, however, differs from year to year, depending on what is produced in the economy in each year. When corn crops are large, corn receives a relatively large weight in the computation of the GDP deflator. By contrast, the CPI measures the cost of a fixed basket of goods that does not vary over time. The CPI directly includes prices of imports, whereas the deflator includes only prices of goods produced in the country, say Ethiopia. III. The Producer Price Index (PPI) Now you understand what CPI is. So using your understanding of the CPI, try to explain what PPI is. ________________________________________________________________ __________________________________________________________________________ You did it? Well, now continue your reading. The producer price index (PPI) is the third price index that is widely used. Like the CPI, this is a measure of the cost of a given basket of goods. It differs from the CPI partly in its coverage, which includes, for example, raw materials and semi finished goods. It differs, too, in that it is designed to measure prices at an early stage of the distribution system. Whereas the CPI measures prices where urban households actually do their spendingthat is, at the retail levelthe PPI is constructed from prices at the level of the first significant commercial transaction. This makes the PPI a relatively flexible price index and one that generally signals changes in the general price level, or the CPI, some time before they actually materialize. For this reason the PPI and, more particularly, some of its sub-indexes, such as the index of "sensitive materials,'' serve as one of the business cycle indicators that are closely watched by policy makers. Both the PPI and CPI are price indexes that compare the current and base year cost of a basket of goods of fixed composition. If we denote the base year quantities of the various goods by and their base year prices by , the cost of the basket in the base year is the summation of , where the summation () is over all the goods in the basket. The cost of a basket of the same quantities but at today's prices is , where is today's price. The CPI or PPI is the ratio of today's cost to the base year cost, given by
This is a so-called Laspeyres, or base-weighted, price index.

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Comparing the above two formulas we see that they differ only in that , or the base year quantities, appears in both numerator and denominator of the CPI and PPI formula, whereas appears in the formula for the deflator. In practice, the CPI, PPI, and GDP deflator indexes differ also because they involve different collections of goods. Learning Activity 1.1 1. Form groups of two members each and discuss on the next question and report to your instructor. In microeconomics, we hope you have learnt the difference between change in demand and change in quantity demanded for a good. What kind of relationship you see with change in demand and change in quantity demanded for real GDP? 2. Again form group and discuss on how the CPI, PPI and GDP deflator are calculated and their use in understanding changes in price levels. Discuss also the use of a base year? 3. Answer the next question for yourself. You know that change in aggregate demand in the economy can be caused by a change in consumption, investment, government purchases, or net exports. But, what are the factors that can change consumption (C), investment (I), government purchases (G), and net export (NX) and therefore can change AD? 4. Convince also for yourself on how does wage stickiness and workers misperception cause SRAS upward sloping curve? 5. Assume the market basket contains 10X, 20Y, and 45Z. The current-year prices for goods X, Y, and Z are Birr 1, Birr 4, and Birr 6, respectively. The base-year prices are Birr 1, Birr 3, and Birr 5, respectively. What is the CPI in the current year? Discuss your answer with in the class to all the students.
Continuous Assessment
Explain the principles and/or theories of macroeconomics in decision making in agribusiness is the main performance criteria. The assessment methods for this criterion include individual assignment, group work and written test. The relation of this criterion with competencies is to explain and organize. Summary Macroeconomics deals with economic behavior at an aggregate level. Aggregate demand and aggregate supply at the economy level interact to determine the equilibrium level of output. Short-run equilibrium exists at the intersection of the AD and SRAS curves. A shift in either or both of these curves can change the price level and Real GDP. Long-run equilibrium exists at the intersection of the AD and LRAS curves. It is the condition that exists in the economy when all economy-wide adjustments have taken place and workers do not hold any (relevant) misperceptions. In long-run equilibrium, quantity demanded of Real GDP = quantity supplied of Real GDP = Natural Real GDP. Moreover, there are three price indexes that we can use to measure and understand movements in general price levels with in an economy. These indexes are consumer price index, producer price index and GDP deflator.
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3.3.3.2. National Income Accounting

Among the economic performance measurements one is the GNP. It is the most commonly known measuring tool of economic performance. However, there are also other measuring tools as well. Can you explain them? ____________________________________________ __________________________________________________________________________
Concepts and Definition of GNP and GDP

The names of the measures consist of one of the words "Gross" or "Net", followed by one of the words "National" or "Domestic", followed by one of the words "Product", "Income", or "Expenditure". All of these terms can be explained separately. "Gross" means total product, regardless of the use to which it is subsequently put. "Net" means "Gross" minus the amount that must be used to offset depreciation i.e. wear-and-tear or obsolescence of the nation's fixed capital assets. "Net" gives an indication of how much product is actually available for consumption or new investment. "Domestic" means the boundary is geographical: we are counting all goods and services produced within the country's borders, regardless of by whom. "National" means the boundary is defined by citizenship (nationality). We count all goods and services produced by the nationals of the country (or businesses owned by them) regardless of where that production physically takes place. "Product", "Income", and "Expenditure" refer to the three counting methodologies explained earlier: the product, income, and expenditure approaches. However the terms are used loosely. "Product" is the general term, often used when any of the three approaches was actually used. Sometimes the word "Product" is used and then some additional symbol or phrase to indicate the methodology; so, for instance, we get "Gross Domestic Product by income", "GDP (income)", "GDP (I)", and similar constructions."Income" specifically means that the income approach was used. "Expenditure" specifically means that the expenditure approach was used. Note that all three counting methods should in theory give the same final figure. However, in practice minor differences are obtained from the three methods for several reasons, including changes in inventory levels and errors in the statistics. One problem for instance is that goods
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in inventory have been produced (therefore included in Product), but not yet sold (therefore not yet included in Expenditure). Similar timing issues can also cause a slight discrepancy between the value of goods produced (Product) and the payments to the factors that produced the goods (Income), particularly if inputs are purchased on credit, and also because wages are collected often after a period of production. Gross domestic product (GDP) is defined as "the value of all final goods and services produced in a country in one year. Gross National Product (GNP) is defined as "the market value of all goods and services produced in one year by labor and property supplied by the residents of a country." NDP: Net domestic product is defined as "gross domestic product (GDP) minus depreciation of capital", similar to NNP. GDP per capita: Gross domestic product per capita is the mean value of the output produced per person, which is also the mean income.
Measuring GNP and GDP National Accounts

Arriving at a figure for the total production of goods and services in a large region like a country entails a large amount of data-collection and calculation. Although some attempts were made to estimate national incomes as long ago as the 17th century, the systematic keeping of national accounts, of which these figures are a part, only began in the 1930s, in the United States and some European countries. The impetus for that major statistical effort was the Great Depression and the rise of Keynesian economics, which prescribed a greater role for the government in managing an economy, and made it necessary for governments to obtain accurate information so that their interventions into the economy could proceed as much as possible from a basis of fact. In order to count a good or service it is necessary to assign some value to it. The value that the measures of national income and output assign to a good or service is its market value the price it fetches when bought or sold. The actual usefulness of a product (its use-value) is not measured assuming the use-value to be any different from its market value.
Approaches to Measure GNP The output approach

The output approach focuses on finding the total output of a nation by directly finding the total value of all goods and services a nation produces.
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Because of the complication of the multiple stages in the production of a good or service, only the final value of a good or service is included in total output. This avoids an issue often called 'double counting, wherein the total value of a good is included several times in national output, by counting it repeatedly in several stages of production. In the example of meat production, the value of the good from the farm may be $10, then $30 from the butchers, and then $60 from the supermarket. The value that should be included in final national output should be $60, not the sum of all those numbers, $100. The values added at each stage of production over the previous stage are respectively $10, $20, and $30. Their sum gives an alternative way of calculating the value of final output. Formulae: GDP (gross domestic product) at market price = value of output in an economy in a particular year - intermediate consumption NNP at factor cost = GDP at market price - depreciation + NFIA (net factor income from abroad) - net indirect taxes
The expenditure approach

The expenditure approach is basically an output accounting method. It focuses on finding the total output of a nation by finding the total amount of money spent. This is acceptable, because like income, the total value of all goods is equal to the total amount of money spent on goods. The basic formula for domestic output combines all the different areas in which money is spent within the region, and then combining them to find the total output. GDP = C + I + G + (X - M) Where: C = household consumption expenditures / personal consumption expenditures I = gross private domestic investment G = government consumption and gross investment expenditures X = gross exports of goods and services M = gross imports of goods and services
Note: (X - M) is often written as XN, which stands for "net exports"
The Income Approach

The income approach equates the total output of a nation to the total factor income received by residents of the nation. The main types of factor income are:

Employee compensation (= wages + cost of fringe benefits, including unemployment, health, and retirement benefits); Interest received net of interest paid; Rental income (mainly for the use of real estate) net of expenses of landlords; Royalties paid for the use of intellectual property and extractable natural resources.
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All remaining value added generated by firms is called the residual or profit. If a firm has stockholders, they own the residual, some of which they receive as dividends. Profit includes the income of the entrepreneur- the businessman who combines factor inputs to produce a good or service. NDP at factor cost = Compensation of employees + Net interest + Rental & royalty income + Profit of incorporated and unincorporated firms + Income from self-employment. National income = NDP at factor cost + NFIA (net factor income from abroad) GDP per capita (per person) is often used as a measure of a persons welfare. Countries with higher GDP may be more likely to also score highly on other measures of welfare, such a life expectancies. However, there are serious limitations to the usefulness of GDP as a measure of welfare:
Measures of GDP typically exclude unpaid economic activity, most importantly domestic work such as childcare. This leads to distortions; for example, a paid nanny's income contributes to GDP, but an unpaid parent's time spent caring for children will not, even though they are both carrying out the same economic activity. GDP takes no account of the inputs used to produce the output. For example, if everyone worked for twice the number of hours, then GDP might roughly double, but this does not necessarily mean that workers are better off as they would have less leisure time. Similarly, the impact of economic activity on the environment is not measured in calculating GDP. Comparison of GDP from one country to another may be distorted by movements in exchange rates. Measuring national income at purchasing power parity may overcome this problem at the risk of overvaluing basic goods and services, for example subsistence farming. GDP does not measure factors that affect quality of life, such as the quality of the environment (as distinct from the input value) and security from crime. This leads to distortions - for example, spending on cleaning up an oil spill is included in GDP, but the negative impact of the spill on well-being (e.g. loss of clean beaches) is not measured. GDP is the mean (average) wealth rather than median (middle-point) wealth. Countries with a skewed income distribution may have a relatively high per-capita GDP while the majority of its citizens have a relatively low level of income, due to concentration of wealth in the hands of a small fraction of the population.
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Summary - GDP, Gross domestic product is defined as "the value of all final goods and services produced in a country in one year. - Gross National Product (GNP) is defined as "the market value of all goods and services produced in one year by labor and property supplied by the residents of a country. - If for example Mr. X is Ethiopian and has a company from abroad, his goods monetary value will be counted in Ethiopia GNP but not in GDP. - The approaches used in the measure of GDP and GNP are output approach, the expenditure approach and the income approach. - The output approach focuses on finding the total output of a nation by directly finding the total value of all goods and services a nation produces. - The expenditure approach is basically an output accounting method. It focuses on finding the total output of a nation by finding the total amount of money spent. - The income approach equates the total output of a nation to the total factor income received by residents of the nation. Learning Activity 2.1 Form groups with members of two students and discuss on the following question. Can you mention the limitations of GNP as a measuring tool of economic performance? Continuous Assessment The major performance criterion is to explain the principles and/or theories of macroeconomics in making decisions. The method of assessment for this criterion includes individual assignment, group work, written test, rubrics and problem analysis. The relation of this criterion with competencies is to explain and organize.
Exercises: Fill in the blank space. 1. ___________is income receipts from abroad minus income payments to foreigners. 2. ___________is the difference between export and import. 3. ___________is factor cost plus indirect business tax (IBT). 4. ___________ are goods used to produce other goods. 5. ___________ is GNP per unit of the total population.
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3.3.3.3. Macroeconomic Problems

Dear students, now we turn to discuss the basic macroeconomic problems that every country in the world has been facing and is also facing. Particularly, today the world economy is going in crisis and facing the problems of unemployment and inflation. Even though there many and different forms of macroeconomics problems such as high inflation, unemployment, low economic growth, high interest rate, budget deficit, stagflation, and so on, we will only focus only on inflation and unemployment in this section. Dear learners, what do you understand by inflation and unemployment? Put your answers here. ______________________________________________________________________ __________________________________________________________________________ Did you try the question? Do not worry whether your answers are correct or not. Just try it.
Inflation
Inflation is a continual and ongoing rise in general or average price level on a specified period of time. The term inflation is usually used to indicate a rise in the general price level, though one can speak of inflationary movements in any single price or group of prices. A birr today doesnt buy as much as it did ten years ago. The cost of almost everything may go up. This increase in the overall level of prices is called inflation, and it is one of the primary concerns of economists and policymakers. Economists measure changes in the cost of living using the price indexes that we have discussed in the previous topics. The inflation rate measures how fast prices are rising. Macroeconomists study how these variables are determined, why they change over time, and how they interact with one another. Periods of falling prices, called deflation, were almost as common as periods of rising prices. The inflation rate is the positive percentage change in the price level on an annual basis. For example, the inflation rate for 2000 is the percentage change in prices from the end of December 1999 through the end of December 2000. The consumer price index (CPI) in December 1999 was 168.9, and the CPI in December 2000 was 174.6. This means the inflation rate in 2000 was approximately 3.4 percent. If you know the inflation rate, you can find out whether your income is (1) keeping up with, (2) not keeping up with, or (3) more than keeping up with inflation. How you are doing depends on whether your income is rising by (1) the same percentage as, (2) a smaller percentage than, or (3) a greater percentage than the inflation rate, respectively. Another way to look at this is to compute and compare your real income for different years. Real income is a persons nominal income (or money income) adjusted for any change in prices, given by
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Types of Inflation
The causes of rising general price level (inflation) are the ways by which types of inflation are categorized. There are four types of inflation with four different causes. 1. 2. 3. 4. Demand pull inflation Cost push inflation Pricing power inflation Sectoral inflation
1. Demand Pull Inflation It is also known as excess demand inflation. It occurs when the total demand for goods and services in an economy exceeds the available supply, so the prices for them rise in a market economy. Historically, this has been the most common type and at times the most serious. 2. Cost Push Inflation Since cost push inflation occurs due to factors that arise from the supply side, we call it supply side inflation. It occurs when the costs of production rise, for one reason or another, and force up the prices of finished goods and services. When cost increases, supply will decrease which lead a rise in price. Often a rise in wages and salaries in excess of any gains in labor productivity is what raises unit costs of production and thus raises prices. 3. Pricing Power Inflation Pricing power inflation is also known as administered price inflation or oligopolistic inflation since it occurs whenever businesses in general decide to boost their prices to increase their profit margins. This does not normally occur in recessions but when the economy is booming and sales are strong. Oligopolies have the power to set their own prices and raise them when they decide the time is ripe. Here you have to note that in order to say there is such inflation there should be a rise in the general price level, since there are possibilities of price movements in any single price or group of prices. 4. Sectoral Inflation The term applies whenever any of the other three factors hits a basic sector /industry/ causing inflation there, and if the industry hit is a major supplier of many other industries, as for example steel is, or oil is, that raises costs of the industries using say steel or oil, and forces up prices there also, then inflation becomes more widespread throughout the economy, although it originated in just one basic sector. In addition to the above types of inflation, there are also monetary and fiscal inflation. Monetary inflation was most famously seen in Weimar Germany during the 1920s, when the
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German government went crazy with the printing presses to the point where it took billions of marks to equal one dollar. This wiped out the savings of the middle class, most members of which were compensated with (worthless) million mark notes. Fiscal inflation is due to excess government spending, for which the budget deficit is a reasonably good proxy.
Inflation and Money

Dear student, what kind of relationship do you expect between inflation and growth of money with in an economy? ___________________________________________________ __________________________________________________________________________ From his empirical works Milton Friedman argued that inflation is always and everywhere a monetary phenomenon. The quantity theory of money leads us to agree that the growth in the quantity of money is the primary determinant of the inflation rate. Inflation is simply an increase in the average level of prices, and a price is the rate at which money is exchanged for a good or a service. To understand inflation, therefore, we must understand money: what it is, what affects its supply and demand, and what influence it has on the economy. What is Money? When we say that a person has a lot of money, we usually mean that he or she is wealthy. By contrast, economists use the term money in a more specialized way. To an economist, money does not refer to all wealth but only to one type of it: money is the stock of assets that can be readily used to make transactions. Roughly speaking, the dollars in the hands of the public make up the nations stock of money. Money has three important functions. It serves as a store of value, a unit of account, and a medium of exchange. A store of value: this means money is a way to transfer purchasing power from the present to the future. If I work today and earn $100, I can hold the money and spend it tomorrow, next week, or next month. Of course, money is an imperfect store of value: if prices are rising, the amount you can buy with any given quantity of money is falling. Even so, people hold money because they can trade it for goods and services at some time in the future. A unit of account: money provides the terms in which prices are quoted and debts are recorded. Microeconomics teaches us that resources are allocated according to relative pricesthe prices of goods relative to other goodsyet stores post their prices in dollars and cents. A car dealer tells you that a car costs $20,000, not 400 shirts (even though it may amount to the same thing). Similarly, most debts require the debtor to deliver a specified number of dollars in the future, not a specified amount of some commodity. Money is the yardstick with which we measure economic transactions. A medium of exchange: money is what we use to buy goods and services. This note is legal tender for all debts, public and private is printed on the U.S. dollar. Payable to the bearer on demand is also printed on Ethiopian birr. When we go into stores, we are
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confident that the shopkeepers will accept our money in exchange for the items they are selling. The ease with which an asset can be converted into the medium of exchange and used to buy other things - goods and services - is sometimes called the assets liquidity. Because money is the medium of exchange, it is the economys most liquid asset. Imagine an economy without money: a barter economy. In such a world, trade requires the double coincidence of wants - the unlikely happenstance of two people each having a good that the other wants at the right time and place to make an exchange. A barter economy permits only simple transactions. The quantity of money available in an economy is called the money supply. In a system of commodity money, the money supply is simply the quantity of that commodity. In an economy that uses fiat money, such as most economies today, the government controls the supply of money: legal restrictions give the government a monopoly on the printing of money. Just as the level of taxation and the level of government purchases are policy instruments of the government, so is the quantity of money. The governments control over the money supply is called monetary policy. With inflation as a consequence, what would ever induce a central bank to increase the money supply substantially? Here we examine one answer to this question. Lets start with an indisputable fact: all governments spend money, for example to buy goods and services (such as roads and police) and to provide transfer payments. There are three sources of government revenue: taxes, borrowing from the public by selling bonds and printing money. The revenue raised by printing of money is called seigniorage. Today this right belongs to the central government, and it is one source of revenue. When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax. At first it may not be obvious that inflation can be viewed as a tax. After all, no one receives a bill for this taxthe government merely prints the money it needs. Who, then, pays the inflation tax? The answer is the holders of money. As prices rise, the real value of the money in your wallet falls. Therefore, when the government prints new money for its use, it makes the old money in the hands of the public less valuable. Inflation is like a tax on holding money. Inflation and Interest rate What is interest rate? ________________________________________________________ Do you think there is relationship between inflation and interest rates with in an economy? If yes, what kind of relationship? _________________________________________________ __________________________________________________________________________
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Interest rates are among the most important macroeconomic variables. In essence, they are the prices that link the present and the future. Here we discuss the relationship between inflation and interest rates. There are two interest rates: real and nominal interest rates. Suppose you deposit your savings in a bank account that pays 8 percent interest annually. Next year, you withdraw your savings and the accumulated interest. Are you 8 percent richer than you were when you made the deposit a year earlier? The answer depends on what richer means. Certainly, you have 8 percent more dollars than you had before. But if prices have risen, each dollar buys less, and your purchasing power has not risen by 8 percent. If the inflation rate was 5 percent over the year, then the amount of goods you can buy has increased by only 3 percent. And if the inflation rate was 10 percent, then your purchasing power has fallen by 2 percent. The interest rate that the bank pays is called the nominal interest rate, and the increase in your purchasing power is called the real interest rate. If i denotes the nominal interest rate, r the real interest rate, and the rate of inflation, then the relationship among these three variables can be written as r = i . The real interest rate is the difference between the nominal interest rate and the rate of inflation. Moreover, there are two types of real interest rates: ex-ante and ex-post real interest rates. When a borrower and lender agree on a nominal interest rate, they do not know what the inflation rate over the term of the loan will be. Therefore, we must distinguish between two concepts of the real interest rate: the real interest rate that the borrower and lender expect when the loan is made, called the ex ante real interest rate, and the real interest rate that is actually realized, called the ex post real interest rate.
The Effects of Inflation on the Society

In the above topics, we tried to see some types and causes of inflation and its effects on purchasing power of money or income and interest rates. Now let us add some problems caused by inflation on the society. Before reading the next paragraph, dear students, can you list the possible effects of inflation on the society? ______________________________________________________________ __________________________________________________________________________ Did you try it? It is good. If you ask the average person why inflation is a social problem, he will probably answer that inflation makes him poorer. Each year my boss gives me a raise, but prices go up and that takes some of my raise away from me. The implicit assumption in this statement is that if there were no inflation, he would get the same raise and be able to buy more goods. This complaint about inflation is a common fallacy. As you know the purchasing power of labor - the real wage - depends on the marginal productivity of labor,
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not on how much money the government chooses to print. If the government reduced inflation by slowing the rate of money growth, workers would not see their real wage increasing more rapidly. Instead, when inflation slowed, firms would increase the prices of their products less each year and, as a result, would give their workers smaller raises. Why, then, is a persistent increase in the price level a social problem? It turns out that the costs of inflation are subtle. Indeed, economists disagree about the size of the social costs. To the surprise of many laymen, some economists argue that the costs of inflation are small - at least for the moderate rates of inflation that most countries have experienced in recent years. In the next few paragraphs, we will see the costs of expected and unexpected inflation. I. The Costs of Expected Inflation Suppose that every month the price level rose by 1 percent. What would be the social costs of such a steady and predictable 12-percent annual inflation? One cost is the distortion of the inflation tax on the amount of money people hold. As we have already discussed, a higher inflation rate leads to a higher nominal interest rate, which in turn leads to lower real money balances. If people are to hold lower money balances on average, they must make more frequent trips to the bank to withdraw moneyfor example, they might withdraw birr 100 twice a week rather than birr 200 once a week. The inconvenience of reducing money holding is metaphorically called the shoe-leather cost of inflation, because walking to the bank more often causes ones shoes to wear out more quickly. A second cost of inflation arises because high inflation induces firms to change their posted prices more often. Changing prices is sometimes costly: for example, it may require printing and distributing a new catalog. These costs are called menu costs, because the higher the rate of inflation, the more often restaurants have to print new menus. A third cost of inflation arises because firms facing menu costs change prices infrequently; therefore, the higher the rate of inflation, the greater the variability in relative prices. For example, suppose a firm issues a new catalog every January. If there is no inflation, then the firms prices relative to the overall price level are constant over the year. Yet if inflation is 1 percent per month, then from the beginning to the end of the year the firms relative prices fall by 12 percent. Sales from this catalog will tend to be low early in the year and high later in the year. Hence, when inflation induces variability in relative prices, it leads to microeconomic inefficiencies in the allocation of resources. A fourth cost of inflation may result from tax laws. Many provisions of tax code do not take into account the effects of inflation. Inflation can alter individuals tax liability, often in ways that lawmakers did not intend. One example of the failure of the tax code to deal with inflation is the tax treatment of capital gains. Suppose you buy some stock today and sell it a
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year from now at the same real price. It would seem reasonable for the government not to levy a tax, because you have earned no real income from this investment. Indeed, if there is no inflation, a zero tax liability would be the outcome. But suppose the rate of inflation is 12 percent and you initially paid birr 100 per share for the stock; for the real price to be the same a year later, you must sell the stock for birr 112 per share. In this case a tax code that ignores the effects of inflation, says that you have earned birr 12 per share in income, and the government taxes you on this capital gain. This means that the tax code measures income as the nominal rather than the real capital gain. In this example, and in many others, inflation distorts how taxes are levied. A fifth cost of inflation is the inconvenience of living in a world with a changing price level. Money is the yardstick with which we measure economic transactions. When there is inflation, that yardstick is changing in length. For example, a changing price level complicates personal financial planning. One important decision that all households face is how much of their income to consume today and how much to save for retirement. A dollar saved today and invested at a fixed nominal interest rate will yield a fixed dollar amount in the future. Yet the real value of that dollar amountwhich will determine the retirees living standarddepends on the future price level. Deciding how much to save would be much simpler if people could count on the price level in 30 years being similar to its level today. II. The Costs of Unexpected Inflation Unexpected inflation has an effect that is more pernicious than any of the costs of steady, anticipated inflation: it arbitrarily redistributes wealth among individuals. Let us it see using different cases. Firstly, consider long-term loans. Most loan agreements specify a nominal interest rate, which is based on the rate of inflation expected at the time of the agreement. If inflation turns out differently from what was expected, the ex post real return that the debtor pays to the creditor differs from what both parties anticipated. On the one hand, if inflation turns out to be higher than expected, the debtor wins and the creditor loses because the debtor repays the loan with less valuable dollars. On the other hand, if inflation turns out to be lower than expected, the creditor wins and the debtor loses because the repayment is worth more than the two parties anticipated. Secondly, unanticipated inflation also hurts individuals on fixed pensions. Workers and firms often agree on a fixed nominal pension when the worker retires (or even earlier). Because the pension is deferred earnings, the worker is essentially providing the firm a loan: the worker provides labor services to the firm while young but does not get fully paid until old age. Like any creditor, the worker is hurt when inflation is higher than anticipated. Like any debtor, the firm is hurt when inflation is lower than anticipated. These situations provide a clear argument against variable inflation. The more variable the rate of inflation, the greater the
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uncertainty that both debtors and creditors face. Because most people are risk averse (dislike uncertainty) the unpredictability caused by highly variable inflation hurts almost everyone.
Unemployment
Dear student, until now we discussed inflation. Now we turn to the second basic macroeconomic problem, unemployment. Unemployment is the macroeconomic problem that affects people most directly and severely. For most people, the loss of a job means a reduced living standard and psychological distress. It is no surprise that unemployment is a frequent topic of political debate and that politicians often claim that their proposed policies would help create jobs.
Measuring Unemployment
To understand how unemployment can be measured, let us take the case of the US. The total population of the United States can be divided into two broad groups. One group consists of persons who are (1) under 16 years of age, (2) in the armed forces, or (3) institutionalized that is, they are in a prison, mental institution, or home for the aged. The second group, which consists of all others in the total population, is called the civilian non-institutional population. The civilian non-institutional population, in turn, can be divided into two groups: persons not in the labor force and persons in the civilian labor force. (Economists often refer to the labor force instead of the civilian labor force.)
Persons not in the labor force are neither working nor looking for work. For example, people who are retired, who are engaged in own-home housework, or who choose not to work fall into this category. Persons in the civilian labor force fall into one of two categories: employed or unemployed. Civilian labor force = Employed persons + Unemployed persons According to the Bureau of Labor Statistics (BLS), employed persons consist of: All persons who did any work for pay or profit during the survey reference week. All persons who did at least 15 hours of unpaid work in a family-operated enterprise. Unemployed persons consist of: All persons who did not have jobs, made specific active efforts to find a job during the prior four weeks, and were available for work. All persons who were not working and were waiting to be called back to a job from which they had been temporarily laid off
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The unemployment rate is the percentage of the civilian labor force that is unemployed. It is equal to the number of unemployed persons divided by the civilian labor force.
The employment rate (sometimes referred to as the employment/population ratio) is the percentage of the civilian non-institutional population that is employed. It is equal to the number of employed persons divided by the civilian non-institutional population:
Finally, the labor force participation rate (LFPR) is the percentage of the civilian noninstitutional population that is in the civilian labor force.
The LFPR may sound like the employment rate, but it is different. Although the denominator in both is the same, the numerator in the employment rate is the number of employed persons, and the numerator in the LFPR is the civilian labor force (which consists of both employed persons and unemployed persons). For this reason, some economists say that while the employment rate gives us the percentage of the population that is working, the LFPR gives us the percentage of the population that is willing to work.
Reasons for and Types of Unemployment

Usually, we think of an unemployed person as someone who has been fired or laid off from his or her job. Certainly, some unemployed persons fit this description, but not all of them do. An unemployed person may fall into one of four categories. 1. Job loser: This is a person who was employed in the civilian labor force and was either fired or laid off. 2. Job leaver: This is a person employed in the civilian labor force who quits his or her job. If you quit your current job and are looking for a better job, then you are a job leaver. 3. Reentrant: This is a person who was previously employed, hasnt worked for some time, and is currently reentering the labor force. 4. New entrant: This is a person who has never held a full-time job for two weeks or longer and is now in the labor force looking for a job. Note: first, to be an unemployed person, you have to meet certain conditions, one of which is that you have to be actively looking for work; secondly, the unemployment rate can decline even if the number of unemployed persons has not declined. For example, if the number of unemployed persons rises by a smaller percentage than the civilian labor force, the unemployment rate will decline. Dear students, next we discuss few types of unemployment.
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I. Frictional Unemployment The unemployment owing to the natural friction of the economy, which is caused by changing market conditions and is represented by qualified individuals with transferable skills who change jobs, is called frictional unemployment. In fact, workers have different preferences and abilities, and jobs have different attributes. Furthermore, the flow of information about job candidates and job vacancies is imperfect, and the geographic mobility of workers is not instantaneous. For all these reasons, searching for an appropriate job takes time and effort, and this tends to reduce the rate of job finding. Indeed, because different jobs require different skills and pay different wages, unemployed workers may not accept the first job offer they receive. Such unemployment caused by the time it takes workers to search for a job is also frictional unemployment. II. Structural Unemployment This is unemployment due to structural changes in the economy that eliminate some jobs and create other jobs for which the unemployed are unqualified. Most economists argue that structural unemployment is largely the consequence of automation (laborsaving devices) and long-lasting shifts in demand. The major difference between the frictionally unemployed and the structurally unemployed is that the latter do not have transferable skills. Their choice is between prolonged unemployment and retraining. For example, suppose there is a pool of unemployed automobile workers and a rising demand for computer analysts. If the automobile workers do not currently have the skills necessary to become computer analysts, they are structurally unemployed. III. Natural Unemployment Adding the frictional unemployment rate and the structural unemployment rate gives the natural unemployment rate (or natural rate of unemployment). The natural rate of unemployment is the long-run average or steady state rate of unemployment. It depends on the rates of job separation and job finding. IV. Cyclical Unemployment The unemployment rate that exists in the economy is not always the natural rate. The difference between the existing unemployment rate and the natural unemployment rate is the cyclical unemployment rate (UC). Cyclical unemployment = Unemployment rate Natural unemployment rate When the unemployment rate (U) that exists in the economy is greater than the natural unemployment rate (UN), the cyclical unemployment rate (UC) is positive. For example, if U = 8 percent and UN = 5 percent, then UC = 3 percent. When the unemployment rate that exists in the economy is less than the natural unemployment rate, the cyclical unemployment rate is negative. For example, if U = 4 percent and UN = 5 percent, then UC = -1 percent.
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Job Loss, Job Finding, and the Natural Rate of Unemployment

Every day some workers lose or quit their jobs, and some unemployed workers are hired. This perpetual ebb and flow determines the fraction of the labor force that is unemployed. In this section we develop a model of labor-force dynamics that shows what determines the natural rate of unemployment. Let L denote the labor force, E the number of employed workers, and U the number of unemployed workers. Because every worker is either employed or unemployed, the labor force is the sum of the employed and the unemployed: L=E+U In this notation, the rate of unemployment is U/L.
To see what determines the unemployment rate, we assume that the labor force L is fixed and focus on the transition of individuals in the labor force between employment and unemployment. Let s denote the rate of job separation, the fraction of employed individuals who lose their job each month. Let f denote the rate of job finding, the fraction of unemployed individuals who find a job each month. Together, the rate of job separation s and the rate of job finding f determine the rate of unemployment. If the unemployment rate is neither rising nor fallingthat is, if the labor market is in a steady statethen the number of people finding jobs must equal the number of people losing jobs. The number of people finding jobs is fU and the number of people losing jobs is sE, so we can write the steady-state condition as fU = sE We can use this equation to find the steady-state unemployment rate. From an earlier equation, we know that E = L - U; that is, the number of employed equals the labor force minus the number of unemployed. If we substitute (L - U) for E in the steady-state condition, we find fU = s(L - U) To get closer to solving for the unemployment rate, divide both sides of this equation by L
Now we can solve for U/L to find
This equation shows that the steady-state rate of unemployment U/L depends on the rates of job separation (s) and job finding (f.) The higher the rate of job separation, the higher the unemployment rate. The higher the rate of job finding, the lower the unemployment rate. Example: Suppose that 1 percent of the employed lose their jobs each month (s = 0.01). Suppose further that about 20 percent of the unemployed find a job each month (f = 0.20), so that spells of unemployment last 5 months on average. Then the steady-state rate of
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unemployment is about 5 percent (= 0.01/(0.01+0.20) = 0.0476). From this we imply that any policy aimed at lowering the natural rate of unemployment must either reduce the rate of job separation (f) or increase the rate of job finding (f).
Tradeoffs between Inflation and Unemployment

Dear students, you should try this question first! What kind of relationship do you expect between inflation and unemployment with in an economy? __________________________________________________________________________ __________________________________________________________________________ The two goals of economic policymakers are low inflation and low unemployment, but often these goals conflict. Suppose, for instance, that policymakers were to use monetary or fiscal policy to expand aggregate demand. This policy would move the economy along the shortrun aggregate supply curve to a point of higher output and a higher price level. Higher output means lower unemployment, because firms need more workers when they produce more. A higher price level, given the previous years price level, means higher inflation. Thus, when policymakers move the economy up along the short-run aggregate supply curve, they reduce the unemployment rate and raise the inflation rate. Conversely, when they contract aggregate demand and move the economy down the short-run aggregate supply curve, unemployment rises and inflation falls. This tradeoff between inflation and unemployment, called the Phillips curve. The Phillips curve is a useful way to express aggregate supply because inflation and unemployment are such important measures of economic performance. It describes the empirical relationship between inflation and unemployment: the higher the rate of unemployment, the lower the rate of inflation. The curve suggests that less unemployment can always be attained by incurring more inflation and that the inflation rate can always be reduced by incurring the costs of more unemployment. In other words the curve suggests there is a trade-off between inflation and unemployment. The economy could register (1) high unemployment and low inflation or (2) low unemployment and high inflation. Also, economists noticed that the Phillips curve presented policy makers with a menu of choices. For example, policy makers could choose to move the economy to any of the points on the Phillips curve in figure 3.1. If they decided that a point like A, with high unemployment and low inflation, was preferable to a point like D, with low unemployment and high inflation, then so be it. It was simply a matter of reaching the right level of aggregate demand. To Keynesian economists, who were gaining a reputation for advocating fine-tuning the economy (i.e., using small-scale measures to counterbalance undesirable economic trends) this conclusion seemed consistent with their theories and policy proposals.
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Figure 3.1: The Phillips Curve Learning Activity 3.1 1. Analyse the causes, consequences and solutions of inflation and unemployment in the economy by taking into consideration the national realities. 2. You are expected to analyse bulletins and publications reporting about the recent trends of macroeconomic issues and challenges (e.g. inflation, unemployment, low interest rate, low economic growth) in light of the macroeconomic concepts, theories and frameworks you have learned. Your instructor will guide you. 3. What is the major difference between frictionally unemployment and structural unemployment? If the cyclical unemployment rate is positive, what does this imply? Continuous Assessment The main performance criterion is to explain the principles and/or theories of macroeconomics in making decisions in agribusiness. The method of assessment includes individual assignment, group work, written test, rubrics and problem analysis. The relation of this criterion with competencies is to explain and organize. Summary Inflation and unemployment are the two basic macroeconomic problems of every economy where policy makers always want to address. Low inflation and low unemployment are the two goals of economic policymakers, but often these goals conflict because of the tradeoff between them. There are four types of inflation with four different causes: demand pull, cost push, pricing power and sectoral inflation. Unemployment has also different forms with different causes such as frictional, structural and cyclical unemployment. Exercise: Workout and writing questions. 1. In year 1, your annual income is $45,000 and the CPI is 143.6; in year 2, your annual income is $51,232 and the CPI is 150.7. Has your real income risen, fallen, or remained constant? Explain your answer. 2. Suppose civilian non-institutional population is 200 million, number of employed persons is 126 million and number of unemployed persons is 8 million. Compute (a) the unemployment rate, (b) the employment rate, and (c) the labor force participation rate 3. Assume frictional unemployment rate is 2 %, natural unemployment rate is 5 %, civilian labor force is 100 million and number of employed persons is 82 million. Compute the structural unemployment rate and the cyclical unemployment rate. 3. What is disguised or hidden unemployment? Seasonal unemployment?
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3.3.3.4. Macroeconomic Policies

What is the impact of increasing government expenditure on the economy? How do you relate fiscal policy with monetary and income policies? ______________________________ __________________________________________________________________________
Fiscal Policy Fiscal Policy and Aggregate Demand

Fiscal policy involves the use of government spending, taxation and borrowing to influence both the pattern of economic activity and also the level and growth of aggregate demand, output and employment. It is important to realize that changes in fiscal policy affect both aggregate demand (AD) and aggregate supply (AS). Traditionally fiscal policy has been seen as an instrument of demand management. This means that changes in government spending, direct and indirect taxation and the budget balance can be used to help smooth out some of the volatility of real national output particularly when the economy has experienced an external shock. The Keynesian school argues that fiscal policy can have powerful effects on aggregate demand, output and employment when the economy is operating well below full capacity national output, and where there is a need to provide a demand-stimulus to the economy. Keynesians believe that there is a clear and justified role for the government to make active use of fiscal policy measures to manage the level of aggregate demand. Monetarist economists on the other hand believe that government spending and tax changes can only have a temporary effect on aggregate demand, output and jobs and that monetary policy is a more effective instrument for controlling demand and inflationary pressure. They are much more skeptical about the wisdom of relying on fiscal policy as a means of demand management. How does a change in fiscal policy feed through the economy to affect variables such as aggregate demand, national output, prices and employment? This simple flow-chart above identifies some of the possible channels involved with the fiscal policy transmission mechanism. The multiplier effects of an expansionary fiscal policy depend on how much spare productive capacity the economy has; how much of any increase in disposable income is spent rather than saved or spent on imports. And also the effects of fiscal policy on variables such as interest rates
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The fiscal policy transmission mechanism
Government spending
Spending by the public sector can be broken down into three main areas: Transfer Payments: Transfer payments are government welfare payments made available through the social security system including the Jobseekers Allowance, Child Benefit, the basic State Pension, Housing Benefit, Income Support and the Working Families Tax Credit. These transfer payments are not included in the national income accounts because they are not a payment for output produced directly by a factor of production. Neither are they included in general government spending on goods and services. The main aim of transfer payments is to provide a basic floor of income or minimum standard of living for low income households in our society. And they also provide a means by which the government can change the overall distribution of income in a country. Current Government Spending: i.e. spending on state-provided goods & services that are provided on a recurrent basis every week, month and year, for example salaries paid to people working and resources used in providing state education and defence. Current spending is recurring because these services have to be provided day to day throughout the country. Capital Spending: Capital spending would include infrastructural spending such as spending on new motorways and roads, hospitals, schools and prisons. This investment spending by the government adds to the economys capital stock and clearly can have important demand and supply side effects in the medium to long term. Government spending is justified on economic and social grounds including the desire to
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correct for perceived market failure when the market mechanism might fail to provide sufficient public and merit goods for social welfare to be maximized. Therefore we justify government spending on these grounds: To provide a socially efficient level of public goods and merit goods To provide a safety-net system of welfare benefits to supplement the incomes of the poorest in society this is also part of the process of redistributing income and wealth To provide necessary infrastructure via capital spending on transport, education and health facilities an important component of a countrys long run aggregate supply As a means of managing the level and growth of AD to meet the governments main macroeconomic policy objectives such as low inflation and high levels of employment
Automatic stabilizers and discretionary changes in fiscal policy

Discretionary fiscal changes are deliberate changes in direct and indirect taxation and government spending for example a decision by the government to increase total capital spending on the road building budget. Automatic stabilizers include those changes in tax revenues and government spending that come about automatically as the economy moves through different stages of the business cycle Tax revenues: When the economy is expanding rapidly the amount of tax revenue increases which takes money out of the circular flow of income and spending Welfare spending: A growing economy means that the government does not have to spend as much on means-tested welfare benefits such as income support and unemployment benefits Budget balance and the circular flow: A fast-growing economy tends to lead to a net outflow of money from the circular flow. Conversely during a slowdown or a recession, the government normally ends up running a larger budget deficit.
Taxation
We now turn to the revenue that flows into the governments accounts from taxation. There are so many different kinds of taxation and the tax system itself often appears to be horrendously complex! But one important distinction to make is between direct and indirect taxes. Direct taxation is levied on income, wealth and profit. Direct taxes include income tax, national insurance contributions, capital gains tax, and corporation tax. Indirect taxes are taxes on spending such as excise duties on fuel, cigarettes and alcohol and Value Added Tax (VAT) on many different goods and services
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Progressive, proportional and regressive taxes

With a progressive tax, the marginal rate of tax rises as income rises. I.e. as people earn more income, the rate of tax on each extra pound earned goes up. This causes a rise in the average rate of tax (the percentage of income paid in tax). The UK income tax system is progressive. Everyone is entitled to a tax-free income. Thereafter, as income grows, people pay the starting rate of tax (10%) before moving onto the basic tax rate (22%). Higher income earners pay the top rate of tax (40%) on each additional pound of income over the top rate tax limit. This is the highest rate of income tax applied. With a proportional tax, the marginal rate of tax is constant. For example, we might have an income tax system that applied a standard rate of tax of 25% across all income levels. If the marginal rate of tax is constant, the average rate of tax will also be constant. National insurance contributions are the closest example in the UK of a proportional tax, although low-income earners do not pay NICs below an income threshold, and NICs also do not rise for income earned above a top threshold. With a regressive tax, the rate of tax falls as incomes rise I.e. the average rate of tax is lower for people of higher incomes. In the UK, most examples of regressive taxes come from excise duties of items of spending such as cigarettes and alcohol. There is well-documented evidence that the heavy excise duty applied on tobacco has quite a regressive impact on the distribution of income in the UK. Learning Activity 4.1 Which types of taxation are functional in Ethiopia? Are the indirect taxes contributing much to the revenue of the government?
Fiscal Policy and Aggregate Supply

Changes to fiscal policy can affect the supply-side capacity of the economy and therefore contribute to long term economic growth. The effects tend to be longer term in nature. Labour market incentives: Cuts in income tax might be used to improve incentives for people to actively seek work and also as a strategy to boost labour productivity. Some economists argue that welfare benefit reforms are more important than tax cuts in improving incentives in particular to create a wedge or gap between the incomes of those people in work and those who are in voluntary unemployment. Capital spending. Government capital spending on the national infrastructure (e.g. improvements to our motorway network or an increase in the building programme for new schools and hospitals) contributes to an increase in investment across the whole economy. Lower rates of corporation tax and other business taxes might also be used as a policy to
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stimulate a higher level of business investment and attract inward investment from overseas Entrepreneurship and new business creation: Government spending might be used to fund an expansion in the rate of new small business start-ups Research and development and innovation: Government spending, tax credits and other tax allowances could be used to encourage an increase in private business sector research and development designed to improve the international competitiveness of domestic businesses and contribute to a faster pace of innovation and invention Human capital of the workforce: Higher government spending on education and training (designed to boost the human capital of the workforce) and increased investment in health and transport can also have important supply-side economic effects in the long run. An enhanced transport infrastructure is seen by many business organizations as absolutely essential if the UK is to remain competitive within the European and global economy Free market economists are normally skeptical of the effects of government spending in improving the supply-side of the economy. They argue that lower taxation and tight control of government spending and borrowing is required to allow the private sector of the economy to flourish. They believe in a smaller sized state sector so that in the long run, the overall burden of taxation can come down and thus allow the private sector of the economy to grow and flourish. However targeted government spending and tax decisions can have a positive impact even though fiscal policy reforms take a long time to feed through. The key is to help provide the right incentives for individuals and businesses for example the incentives to find work and incentives for businesses to increase employment and investment.
Fiscal policy effects

Fiscal policy decisions have a widespread effect on the everyday decisions and behaviour of individual households and businesses hence in this note we consider some of the microeconomic effects of fiscal policy before considering the links between fiscal policy and aggregate demand and key macroeconomic objectives. The microeconomic effects of fiscal policy Taxation and work incentives: Can changes in income taxes affect the incentive to work? This remains a controversial subject in the economic literature! Consider the impact of an increase in the basic income tax rate or an increase in the national insurance contributions rate. The rise in direct tax has the effect of reducing the post-tax income of those in work because for each hour of work taken the total net income is now lower. This might encourage the individual to work more hours to maintain his/her target income. Conversely, the effect
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might be to encourage less work since the higher tax might act as a disincentive to work. Of course many workers have little flexibility in the hours they work. They will be contracted to work a certain number of hours, and changes in direct tax rates will not alter that. The government has introduced a lower starting rate of income tax for lower income earners. This is designed to provide an incentive for people to work extra hours and keep more of what they earn. Changes to the tax and benefit system also seek to reduce the risk of the poverty trap where households on low incomes see little net financial benefit from supplying extra hours of their labour. If tax and benefit reforms can improve incentives and lead to an increase in the labour supply, this will help to reduce the equilibrium rate of unemployment (the NAIRU) and thereby increase the economys non-inflationary growth rate. Taxation and the Pattern of Demand: Changes to indirect taxes in particular can have an effect on the pattern of demand for goods and services. For example, the rising value of duty on cigarettes and alcohol is designed to cause a substitution effect among consumers and thereby reduce the demand for what are perceived as de-merit goods. In contrast, a government financial subsidy to producers has the effect of reducing their costs of production, lowering the market price and encouraging an expansion of demand. The use of indirect taxation and subsidies is often justified on the grounds of instances of market failure. But there might also be a justification based on achieving a more equitable allocation of resources e.g. providing basic state health care free at the point of use. Taxation and labour productivity: Some economists argue that taxes can have a significant effect on the intensity with which people work and their overall efficiency and productivity. But there is little substantive empirical evidence to support this view. Many factors contribute to improving productivity tax changes can play a role - but isolating the impact of tax cuts on productivity is extremely difficult. Taxation and business investment decisions: Lower rates of corporation tax and other business taxes can stimulate an increase in business fixed capital investment spending. If planned investment increases, the nations capital stock can rise and the capital stock per worker employed can rise. The government might also use tax allowances to stimulate increases in research and development and encourage more business start-ups. A favourable tax regime could also be attractive to inflows of foreign direct investment a stimulus to the economy that might benefit both aggregate demand and supply. The Irish economy is often touted as an example of how substantial cuts in the rate of corporation tax can act as a magnet for large amounts of inward investment. The very low rates of company tax have been influential although it is not the only factor that has underpinned the sensational rates of economic growth enjoyed by
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the Irish economy over the last fifteen years. Capital investment should not be seen solely in terms of the purchase of new machines. Changes to the tax system and specific areas of government spending might also be used to stimulate investment in technology, innovation, the skills of the labour force and social infrastructure. A good example of this might be a substantial increase in real spending on the transport infrastructure. Improvements in our transport system would add directly to aggregate demand, but would also provide a boost to productivity and competitiveness. Similarly increases in capital spending in education would have feedback effects in the long term on the supply-side of the economy. Measuring the fiscal stance: The fiscal stance is a term that is used to describe whether fiscal policy is being used to actively expand demand and output in the economy (a reflationary or expansionary fiscal stance) or conversely to take demand out of the circular flow (a deflationary fiscal stance). A neutral fiscal stance might be shown if the government runs with a balanced budget where government spending is equal to tax revenues. Adjusting for where the economy is in the economic cycle, a neutral fiscal stance means that policy has no impact on the level of economic activity. A reflationary fiscal stance happens when the government is running a large deficit budget (i.e. G>T). Loosening the fiscal stance means the government borrows money to inject funds into the economy so as to increase the level of aggregate demand and economic activity. A deflationary fiscal stance happens when the government runs a budget surplus (i.e. G<T). The government is injecting fewer funds into the economy than it is withdrawing through taxes. The level of aggregate demand and economic activity falls. The Keynesian school argues that fiscal policy can have powerful effects on aggregate demand, output and employment when the economy is operating well below full capacity national output, and where there is a need to provide a demand-stimulus to the economy. Keynesians believe that there is a clear and justified role for the government to make active use of fiscal policy measures to manage the level of aggregate demand. Monetarist economists on the other hand believe that government spending and tax changes can only have a temporary effect on aggregate demand, output and jobs and that monetary policy is a more effective instrument for controlling demand and inflationary pressure. They are much more skeptical about the wisdom of relying on fiscal policy as a means of demand management. We will consider below some of the criticisms of using fiscal policy as a tool of stabilising demand and output in the economy. The multiplier effects of an expansionary fiscal policy depend on how much spare productive capacity the economy has; how much of any increase in disposable income is spent rather than saved or spent on imports. And also the effects of fiscal policy on variables such as
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interest rates Problems with Fiscal Policy as an Instrument of Demand Management: In theory a positive or negative output gap can be relatively easily overcome by the fine-tuning of fiscal policy. However, in reality the situation is complex and many economists argue for ignoring fiscal policy as a tool for managing aggregate demand focusing instead on the role that monetary policy can play in stabilizing demand and output. Recognition lags and policy time lags: Inevitably, it takes time to for government policymakers to recognise that AD is growing either too quickly or too slowly and a need for some active discretionary changes in spending or taxation. It then takes time to implement an appropriate policy response government spending plans are subject to a three year spending review and cannot be changed immediately. Likewise the tax system is highly complex for example income tax can only normally be changed once a year at the time of the Budget. Indirect taxes can be changed more quickly but they have less of an effect on the level of aggregate demand. It then takes time for the change in fiscal policy to work, as the multiplier process on national income, output and employment is not instantaneous. Fiscal Crowding-Out: The crowding-out hypothesis became popular in the 1970s and 1980s when free market economists argued against the rising share of national income being taken by the public sector. The essence of the crowding out view is that a rapid growth of government spending leads to a transfer of scarce productive resources from the private sector to the public sector. For example, if the government seeks to reflate AD by reducing taxation, or by increasing government spending, then this may lead to a budget deficit. To finance the deficit the government will have to sell debt to the private sector. Attracting individuals and institutions to purchase the debt may require higher interest rates. A rise in interest rates may crowd out private investment and consumption, offsetting the fiscal stimulus. This type of crowding out is unlikely to make fiscal policy wholly ineffective but large budget deficits do require financing and in the long run, this requires a higher burden of taxation. Higher taxes affect both businesses and households neo-liberal economists believe that higher taxation acts as a drag on business investment, labour market incentives and productivity growth all of which can have a negative effect on economic growth potential in the long run. The Keynesian response to the crowding-out hypothesis is that the probability of 100% crowding-out is extremely remote, especially if the economy is operating well below its productive capacity and if there is a plentiful supply of savings available that the government can tap into when it needs to borrow money. There is no automatic relationship between the
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level of government borrowing and the level of short term and long term interest rates. We can see from the previous chart that there has been a downward trend in long term interest rates over the last tent to twelve years. Indeed in 2003 the yield (rate of interest) on ten year government bonds dipped below 4 per cent one of the lowest long term interest rates in recent history. Reaction to Tax Cuts Rational Expectations: According to a school of economic thought that believes in rational expectations, when the government sells debt to fund a tax cut or an increase in expenditure, then a rational individual will realize that at some future date he will face higher tax liabilities to pay for the interest repayments. Thus, he should increase his savings as there has been no increase in his permanent income. The implications are clear. Any change in fiscal policy will have no impact on the economy if all individuals are rational. Fiscal policy in these circumstances may become impotent. Partly because of the limitations of fiscal policy as a tool of demand management, many governments have switched the focus of fiscal policy towards using it to improve aggregate supply as a means of creating the conditions for sustainable economic growth. This is certainly the case with the current government. Government borrowing: The level of government borrowing is an important part of fiscal policy and management of aggregate demand in any economy. When the government is running a budget deficit, it means that in a given year, total government expenditure exceeds total tax revenue. As a result, the government has to borrow through the issue of debt such as Treasury Bills and long-term government Bonds. The issue of debt is done by the central bank and involves selling debt to the bond and bill markets. Does a budget deficit matter? There is a consensus that a persistently large budget deficit can be a problem for the government and the economy. Three of the reasons for this are as follows: Financing a deficit: A budget deficit has to be financed and day-today, the issue of new government debt to domestic or overseas investors can do this. In a world where financial capital flows freely between countries, it can be relatively easy to finance a deficit. But it may be that if the budget deficit rises to a high level, in the medium term the government may have to offer higher interest rates to attract sufficient buyers of government debt. This in turn will have a negative effect on economic growth A government debt mountain? In the long run, government borrowing adds to the accumulated National Debt. This means that the Government has to spend more each year in debt-interest payments to holders of government bonds and other securities. There is an opportunity cost involved here because this money might be used in more productive ways, for example an increase in spending on health services or extra investment in education. It also represents a transfer of income from people and businesses that pay taxes
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to those who hold government debt and cause a redistribution of income and wealth in the economy. Crowding-out - the need for higher interest rates and higher taxes. Eventually the budget deficit has to be reduced. This can be achieved by either by cutting back on public sector spending or by raising the burden of taxation. If a larger budget deficit leads to higher interest rates and taxation in the medium term and thereby has a negative effect on growth in consumption and investment spending, then a process of fiscal crowding-out is said to be occurring. Wasteful public spending: Neo-liberal economists are naturally opposed to a high level of government spending. They believe that a rising share of GDP taken by the state sector has a negative effect on the growth of the private sector of the economy. They are skeptical about the benefits of higher spending believing that the scale of waste in the public sector is high money that would be better off being used by the private sector. Potential benefits of a budget deficit: What are the main economic and social justifications for a higher level of government spending and borrowing? Two main arguments stand out: Government borrowing can benefit economic growth: A budget deficit can have positive macroeconomic effects in the long run if it is used to finance extra capital spending that leads to an increase in the stock of national assets. For example, spending on the transport infrastructure improves the supply-side capacity of the economy. And increased investment in health and education can bring positive effects on productivity and employment. The budget deficit as a tool of demand management: Keynesian economists would support the use of changing the level of government borrowing as a legitimate instrument of managing aggregate demand. An increase in borrowing can be a useful stimulus to demand when other sectors of the economy are suffering from weak or falling spending. The fiscal stimulus given to the British economy during 2002-2004 has been important in stabilizing demand and output at a time of global economic uncertainty. Perhaps Keynesian fiscal demand management has once more come back into fashion! The argument is that the government can and should use fiscal policy to keep real national output closer to potential GDP so that we avoid a large negative output gap. Effectiveness of Policies: When the economy is in a recession, monetary policy may be ineffective in increasing spending and income. In this case, fiscal policy might be more effective in stimulating demand. Other economists disagree they argue that changes in monetary policy can impact quite quickly and strongly on consumer and business behavior. However, there may be factors which make fiscal policy ineffective aside from the usual crowding out phenomena. Future-oriented consumption theories based round the concept of rational expectations hold that individuals undo government fiscal policy through changes
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in their own behavior for example, if government spending and borrowing rises, people may expect an increase in the tax burden in future years, and therefore increase their current savings in anticipation of this. Learning Activity 4.2 By forming groups either in the class or your home, discuss on the following questions. Discuss the problems and limitations of fiscal policy. Elaborate the policy implications of fiscal policy and examine the effectiveness of the fiscal policy in an economy. Compare and contrast the effectiveness of fiscal policy with monetary policy in the context of Ethiopias macroeconomic policy.
Monetary Policy
Fundamental concepts of money supply and income policy
Banks exist to receive deposits from individuals and businesses, and to lend these funds. Banks derive their revenue from the interest they charge on loans (as well as from fees for other services). Deposits, withdrawals and payments by check do not change the money stock, but loans do. A portion of deposits are held in reserves. Banks are private businesses, just as car manufacturers or retail stores. What they offer is a service. That service is making loans from the deposits they receive. For that service they receive an interest which is higher than the interest they have to pay for the deposits they receive from individuals. The difference provides them with profits and keeps them in business. When a check is drawn and a payment is made by check, the total money stock does not change, only the composition, or distribution of money in its different forms, changes. A payment by check results in a shifting of reserves from one bank to another when the check clears through the central bank. Money is created when a bank makes a loan: the bank accepts a promissory note from the borrower (which is not money) and gives the borrower the ability to make payments in the form of demand deposits up to the amount of the loan. When a loan is repaid money is canceled. In normal circumstances, the volume of new loans exceeds repayment of loans, and thus, the money supply keeps increasing. However, a bank can only loan up to its available excess reserves. When a loan is repaid money supply is decreased because the borrower must use demand deposits to make the repayment. This takes some cash or demand deposits out of circulation. Funds held by a bank in its vaults or in its account at the central bank, are its reserves. A proportion of its deposits must be kept in reserves, and only the excess are the excess
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reserves which can be lend out. The portion of reserves which must be kept by the bank are referred to as required reserves. (Reserves are never part of money supply. They are called "high powered money" because they can permit the creation a multiple of money stock). The initial purpose of required reserves when they were instituted was to make sure that banks would have on hand sufficient funds which depositors may withdraw, or at least an adequate proportion. This is no longer true because the required reserves need not be kept on hand. Thus, the purpose of the required reserves is now mostly for monetary policy. The proportion between required reserves and deposits is the required reserve ratio. There are actually several different ratios according to the degree of permanency of the deposits. The ratios vary from less than 2% to over 15%. They are occasionally changed by the central bank according to economic needs. When the proceeds of a loan are used to make a payment, the excess reserves of the first bank are transferred to a second bank. A portion of these funds must remain as required reserves, but the excess reserves can be lent out. Successive relending of the excess reserves cumulates in a total money creation which is several times the initial loan. This monetary multiplier is equal to the inverse of the required reserve ratio. Banks have a strong preference for government securities because of the safety (as well as liquidity) they offer as compared to loans to private businesses. Excess reserves are often held in government securities. When a bank buys a government security from an individual, the transaction is equivalent to a loan and increases money supply. The central bank holds a large stock of government securities and is responsible for their issuance and redemption. The U.S. Treasury Bills (or T.B.'s for short) are considered very safe and held by many U.S. and foreign entities. They are also very liquid: easy to convert into cash. Some of these T.B.'s are redeemed or rolled-over (at the option of the owner) every 90 days. Banks like this safe and liquid type of loan to the government. Income policies in economics are economy-wide wage and price controls, most commonly instituted as a response to inflation, and usually below market level. Incomes policies have often been resorted to during wartime. During the French Revolution, "The Law of the Maximum" imposed price controls (by penalty of death) in an unsuccessful attempt to curb inflation, and such measures were also attempted after World War II. Peacetime income policies were resorted to in the USA in August 1971 as a response to inflation. The wage and price controls were effective initially but were made less restrictive in January 1973, and later removed when they seemed to be having no effect on curbing inflation. Incomes policies were successful in the United Kingdom during World War II but less successful in the post-war era. Experience was mixed but somewhat more favorable in countries such as
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Australia and the Netherlands. One of the main reasons for governments to use a prices and incomes policy is to support other macroeconomic policies, and so achieve internal balance, (where economic growth rates lead to acceptable inflation and employment outcomes). Governments can use prices and income policies such as the Accords for a variety of purposes. i. Reduce unemployment and lower the inflation rate: An organised system of wage determination can remove the problem that occurs in the free market, where workers with greater bargaining power are often able to gain excessive wage increases. This may cause a flow-on effect to other industries that cannot afford the wage increases. Cost-push inflation and higher levels of unemployment can result, as these less competitive industries increase prices and reduce their labour forces in attempts to remain profitable. ii. Increase international competitiveness: One of the main economic reasons for the introduction of the Accords by the Hawke Labor government in 1983 was to restrain wages growth and reduce industrial disputation. Reduced labour costs and improved reliability of production have since helped substantially in bettering Australias international competitiveness. iii. Reduce the number of industrial disputes: The government needs an effective system to resolve any conflict between employees and employers. Strikes and prolonged industrial action are costly to the economy and can affect our standing in the international community. iv. Create a more equitable distribution of income: As previously outlined, wage earners in industries with greater bargaining power can gain larger increases than those with less influence. Inequality may occur between workers who are doing the same or similar work, but in different industries. This is the principle of comparative wage justice. v. As part of macroeconomic policy: A prices and incomes policy can also be used to support fiscal and monetary policy, keeping budget outcomes, inflation, unemployment and interest rates at targeted levels. Learning Activity 4.3 Prove that money is created when banks issue loans. Go through daily operations of banks and confirm your proof. Monetary policy instruments The tools of monetary policy are those available to the central bank to control the excess reserves of banks. They include open market operations, changes in required reserve ratios and changes in the discount rate. Changes in required reserve ratios affect reserves directly but are too authoritarian and not used often. Changes in the discount rate make bank
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borrowing from the central bank more or less difficult, but the volume of bank borrowing is very small. It is normal to believe that control over the physical printing of bank notes is the essence of monetary policy, but that is not entirely correct. Since the monetary multiplier shows that banks have the ability to create most of the money, control over reserves which banks can lend, is the real focus of monetary policy. Open market operations Open market operations consist of buying and selling of government securities by the central bank. It is the most common and most potent tool of monetary policy because it is flexible, subtle and effective. Discount rate The discount rate is the interest charged by the central bank on loans to member banks. The amount of such loans is very small. When a change in the discount rate occurs it is most often a reflection of changing conditions rather than an intended monetary policy action. However, such change contains a strong message about the direction of monetary policy. Tight money policy A tight money policy consists in reducing the excess reserves of banks and, thus, their money creation ability. This is done by selling government securities to banks in the open free market for government securities. Banks are eager to put some of their excess reserves in government securities because of their safety. Tight money policy can also be carried out by increasing the required reserve ratios or the discount rate. Easy money policy An easy money policy is intended to increase the excess reserves of banks and, thus, make money creation by banks more possible. This is accomplished by purchasing government securities from banks (since banks commonly hold a large portion of them). An easy money policy can also be carried out by lowering the required reserve ratios or the discount rate. Minor monetary policy instruments In addition to open market operations, changes in required reserves ratios and the discount rate, the central bank may also affect the money supply by changing margin requirements (the proportion which must be present in a securities dealer account for transactions), consumer credit terms such as the down payment or the length of car loans. Another, less common, method is to persuade banks to adopt some desirable conduct; this is called moral
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suasion. In many countries of the world, monetary policy is carried out by direct contact between the central bank and the banking community (i.e. moral suasion, as it is known in the U.S.). For instance, this is true in Canada where there are seven major banking institutions only. Such process is not possible in the United States, because of the large number of private banks. Monetary policy controversy The purpose of this topic is to look at the two alternative explanations of how monetary policy affects economic activity. In Keynesian view, a link exists through interest rates and investment. In monetarist view, the money stock affects the level of purchases directly. The opposing views lead to different recommendations for the appropriate policy to use. Keynesian view of monetary policy In Keynesian view, the effect of easy money policy is an increase in money supply which causes the interest rate (or cost of borrowing) to decrease. The lower interest rate makes more investment possible. The increase in investment is an increase in aggregate expenditure which has a multiplier effect. The tight money policy works in the opposite direction. Monetary policy shortcomings: In Keynesian view, monetary policy may be very ineffective. Some of the shortcomings come from the asymmetry of the policy, changes in velocity (which may frustrate policies), and the uncertainty of investment to be undertaken (especially if not interest sensitive). In addition, a feedback exists in interest rates because interest rates are also costs and affect inflation which decreases wealth and, therefore, consumption. In most countries of the world, it is generally accepted that monetary policy is adequate for controlling inflation, but is inadequate for economic stimulation. Fiscal policy is considered the appropriate tool for control of economic activity. Monetary policy asymmetry: The major shortcoming of monetary policy is its asymmetry. That is, a tight money policy is very effective in preventing new loans because excess reserves are reduced, but easy money policy is likely to be ineffective because the additional excess reserves will not be lent out by banks in fear of potential bankruptcies of borrowers during periods of recession. Thus, the recommendation is not to use monetary policy, but fiscal policy instead. During the great depression of the 1930's, interest rates dropped below 1%. At this low interest rate, one would think that many businesses would have taken out loans. But this did not happen: the volume of loans also decreased considerably. The reason was that businesses had difficulties staying in business, and banks were afraid to lend them money. Monetary policy dilemma: Monetary policy may be used to either control the money supply
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or the interest rate. But, both cannot be controlled at the same time. Thus the dilemma. In the past, the dilemma was especially important because the central bank was often responsible for facilitating government borrowing by keeping interest rates low. Such policy would normally be contrary to the goal of inflation control, a major responsibility of the central bank. The choice between control over interest rates and control of money supply was especially difficult right after World War II. As a result of the war, the government had a large debt and was urging the central bank to keep interest rates low. But the low interest rate policy ran contrary to the need to tighten the money supply and keep inflation down. Monetarist view of monetary policy In the view of monetarists, an easy money policy increases the money balances of individuals encouraging them to spend more because individuals maintain a stable relationship between their desired money balances and spending. A tight money policy reduces money balances and curtails spending directly. In monetarist view there is no need for the investment linkage of the Keynesian view presented above. If the money stock increases, it means that there is more money in checking deposits, which are the largest component of money. If individuals have more money in their checking accounts, they will feel wealthier and will be more willing to spend. Summary Fiscal policy involves the use of government spending, taxation and borrowing to influence both the pattern of economic activity and also the level and growth of aggregate demand, output and employment. Keynesians believe that there is a clear and justified role for the government to make active use of fiscal policy measures to manage the level of aggregate demand. Monetarist economists on the other hand believe that government spending and tax changes can only have a temporary effect on aggregate demand, output and jobs and that monetary policy is a more effective instrument for controlling demand and inflationary pressure. When the economy is in a recession, monetary policy may be ineffective in increasing spending and income. In this case, fiscal policy might be more effective in stimulating demand. Other economists disagree they argue that changes in monetary policy can impact quite quickly and strongly on consumer and business behavior. Continuous Assessment Methods The major performance criterion is to explain the principles and/or theories of macroeconomics in decision making in agribusiness. The method of assessment for this criterion includes individual assignment, group work, written test, rubrics and problem analysis. The relation of this criterion with competencies is to explain and organize.
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Exercises: Multiple choices 1. Which of the following is NOT a method proposed to reduce budget deficits? A. increasing taxes, B. constitutional amendment C. cutting imports, D. cutting spending
2. A contractionary fiscal policy consists of
A. decrease in T, B. increase in G, C. decrease in G D. increase in G and decrease in T E. decrease in G and increase in T 3. Government spending is a form of leakage. A. True
B. False
4. The purpose of the required reserve ratio is to control lending by banks. A. True B. False 5. Which of the following is not part of the normal operations of a commercial bank?
A. receive deposits B. issue stocks C. makes loans D. safe custody of valuables
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3.3.3.5. Economic Development Issues and Policies

How do you differentiate economic development from economic growth? What do you think are the major issues that should be dealt in economic development? __________________________________________________________________________ __________________________________________________________________________ Economic Development vs. Economic Growth Dear students, can you define the following phrases in your own ways? Economic development; Economic growth These terms do not have any relationship with the type f economic system that the nation follows. The difference between the two relates to the nature and causes of change. Schumpeter defines development as a continuous and spontaneous change in the stationary state which forever alters and displaces the equilibrium state previously existing while growth is a gradual by a gradual increase in the long run which comes about by a gradual increase in the rate of saving. This view of Schumpeter has been widely accepted and elaborated by the major of economists. - Kindleberger, economic growth means more output while economic development implies both more output and changes in the technical and institutional arrangement by which it is produced and distributed. - Friedman defines growth as an expansion of the system in one or more dimensions without a change in its leading to the structural transformation of social system. The concept of development should embrace the major economic and social objectives and values that society strives for. Goulet distinguished three basic values of development, as, life sustenance (ability to meet basic needs), self respect and freedom from the evils of want and ignorance. Generally, economic growth is related to a quantitative sustained increase in the country's per capita output or income accompanied by expansion in its labor force consumption, capital and volume of trade. On the other hand, economic development is wider concepts than economic growth. It is taken to mean growth plus change. It is related to qualitative change in economic wants, institutions or the upward movement of the entire social system. It describes the underlining determinants of growth such as technological and structural changes.
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Measurements of Economic Development Economic growth is measured in four ways: 1. GNP- Gross National Product: refers to the country's total output of final goods and services. GNP does not reveal the changes in growth of population. It does not reveal -the costs to society of environmental pollution. It tells us nothing about the distribution of income in the economy. GNP makes no effort in including the non marketable products (bringing up children, production of home materials, home bakery, etc).Another difficulty in calculating GNP is of double counting which arises from the failure to distinguish properly between final and intermediate products. There always exists the fear of a good or a service being included more than once. If it so happens the GNP would work out to be many times the actual. 2. GNP per capita-it is the GNP divided by the total population of the country. The real GNP per capita fails to take problems associated with basic needs like nutrition, health, sanitation, housing, water and education. The improvement in living standards by providing basic needs cannot be measured by increase in GNP per capita. The real GNP per capita is the most widely used measure of economic development. 3. Welfare- economic development IS regarded as a process whereby there is an increase in the consumption of goods and services of individual. Welfare as measurement of development is not free from limitations like the difficulty in the valuation of the output. This measure is the secular improvement in material well being. 4. Social Indicators- economists include a wide variety of items in social indicators some are input such as nutritional standards or number of hospital based or doctors per head of population while others may be output corresponding to these input such as improvements in health in terms of infant "mortality rates, sickness rates etc, social indicators are often referred to as the basic needs for development. It should be known that the merit of social indicators is that they are concerned with ends being human development. The social indicators include health, food, water, sanitation, housing and the like. Human Development Index (HDI) Since 1990, the UNDP has been presenting the measurement of human development in terms of a Human Development Index (HDI) in its annual human development report. The HDI is a composite index of three social indicators: life expectancy, adult literacy and years of schooling and real GDP per capita. Thus, the HDI is a composite index of achievement in three fundamental dimensions: a long and healthy life, knowledge and a decent standard of living. The HDI value of a country is measured by taking three indicators:- Longevity: as measured by life expectancy at birth the range is 25 to 85 years
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- Education attainment as measured by a combination of adult literacy (2/3 weight) and combined primary, secondary and tertiary enrollment ratios (1/3 weight), the range for both is 0% to 100% - Standard of living as measured by real GDP per capita based on Purchasing Power Parity (PPP), the range is between $100 to $40,000. - For any component of the HDI, the individual indices can be computed according to the general formula: Index = Actual value-Minimum value Maximum Value- Minimum value The HDI is not free from certain limitations such as: the three indicators are not the only indicators of human development, the attachment of weights to each of these items is arbitrary and others. Example: life expectancy at birth for country X is given to be 58 years. The combined primary secondary and tertiary education attainment is given to be 50%, for the same country the real per capita GDP is $900.The adult literacy is given to be 30%.Calculate, a) Life expectancy index b) Education index c) GDP index d) HDI Solution: A) Life Expectancy Index= 58-25 = 0.55 85-25 B) Education index = 2/3 (30-0/100-0) + 1/3 (50-0) = 0.37 (100-0) C) GDP index = log 900- log 100 = 0.52 log 40, 000-log100 D) HDI = 1/3(0.55) + 1/3(0.37) + 1/3(0.52) = 0.48 HDI takes the range from 0 to 1. Countries with an HDI value below 0.5 are considered to have a low level of human development those between 0.5 to 0.8 a medium level and those above 0.8 a high level. In the HDI, countries are also ranked by their GDP per capita.
Characteristics of Underdeveloped Country

A. General poverty An underdeveloped country is poverty ridden. Poverty is reflected in low GNP per capita. According to the World Development Report, 59.60/0 of the world population in 1998 living in low- income economies has GNP per capita of $760 or less, 25.4~) in middle income economies had $761 to $9,360, and 150/0 in high income economies had $9,361 or more. The extremely low GNP per capita of low Income economics reflects the extent of poverty in them.
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It is not relative poverty but absolute poverty that is more important in assessing underdeveloped countries. Absolute -poverty is measured not only by low income but also by malnutrition, poor health, clothing, shelter, and lack of education. Thus, absolute poverty is reflected in low living standards of the people. In such countries, food is the major item of consumption and about 80% of the income is spent on it as compared with 200/0 in advanced countries. The vast majority of the people in LDCs are ill fed, ill-clothed, ill-housed and ill educated. B. Agriculture, the main occupation In underdeveloped countries two-thirds or more of the people live in rural areas and their main occupation is agriculture. There are large times as many people occupied in agriculture in some underdeveloped countries as there are in advanced countries. This heavy concentration in agriculture is a symptom of poverty. Agriculture, as the main occupation, is mostly unproductive. It is carried on in an old fashion with obsolete and outdated methods of production. C. A dualistic economy Almost all underdeveloped countries have a dualistic economy. One is the market economy which is modern and the other subsistence economy which is backward and mainly agriculture-oriented. Dualism is also characterized by the existence of an advanced industrial system and an indigenous backward agricultural system. There is also financial dualism consisting of the unorganized money market charging very high interest rates on loans and the organized money market with low interest and abundant credit facilities. D. Underdeveloped natural resources The natural resources of an underdeveloped country are underdeveloped in the sense that they are either unutilized or underutilized. A country may by deficient in natural resource, but it cannot be so in the absolute sense. Although a country may be poor in resources, it is just possible that in the future it may become rich in resources as a result of the discovery of presently unknown resources or because new uses may be found for the known resources. E. Demographic features One common feature in underdeveloped countries is a rapidly increasing population which adds a substantial number to the total population every year. Almost all the underdeveloped countries possess high population growth potential characterized by high birth rate and high but declining death rate. The advancement made by medical science has resulted in the discovery of marvelous drugs and the introduction of better methods of public health and save reduced mortality and increased fertility. An important consequence of high birth-rate is that a larger proportion of the total population is in young age groups. A large percentage of children in the population entail a heavy burden on the economy which implies a large
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number of dependents who do not produce at all but do consume. With many dependents to support, it becomes difficult for the workers to save for purposes of investment in capital equipment. It is also a problem for them to provide their children with the education and basic necessities of life that are essential for the country's economic and social progress in the long run. F. Unemployment and Disguised Unemployment In underdeveloped countries there is vast open unemployment and disguised unemployment. The unemployment is spreading with urbanization and the spread of education. But the industrial sector has failed to expand along with the growth of labor force thereby increasing urban unemployment. Then there are the educated unemployed who fail to get jobs due to structural rigidities and the lack of manpower planning. Under employment or disguised unemployment is a notable feature of underdeveloped countries. A person is said to be disguised unemployed if his contribution to output is less than what he can produce by working for normal hours per day. G. Economic Backwardness In under developed countries particular manifestations of economic backwardness are low labor efficiency, factor immobility, and limited specialization in occupation and in trade, economic ignorance, values and social structure that minimize the incentive for economic change. H. Lack of enterprise and initiative Entrepreneurial ability is inhibited by the social system which denies opportunities for creative facilities. The force of custom, the rigidity of status and the distrust of new ideas and of the exercise of intellectual curiosity, combine to create an atmosphere inimical to experiment and innovation. The small size of the market, lack of capital, absence of private property, absence of freedom of contract and of law and order hamper enterprise and initiative. I. Insufficient capital equipment Underdeveloped countries are characterized as capital poor or low saving and low-investing economies. There is not only an extremely small capital stock but the current rate of capital formation is also very low. In most under developed countries gross investment is only (5-6) % of GNP where as in advanced countries it is about (15-20) %. J. Technological Backwardness Their technological backwardness is reflected in the high average cost of production despite low money wages, also it is reflected in the predominance of unskilled and untrained workers and others.
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K. Foreign Trade Orientation Underdeveloped economies are generally foreign trade oriented. This orientation is reflected in exports of primary products and imports of consumer goods and machinery. The percentage share of fuels, minerals, metals, and other primary products in the merchandise exports of the majority of LDCs is on the average about 80 percent as revealed by the recent World Bank data. Summary Economic growth is related to a quantitative sustained increase in the country's per capita output or income accompanied by expansion in its labor force consumption, capital and volume of trade. On the other hand, economic development is wider concepts than economic growth. It is taken to mean growth plus change. It is related to qualitative change in economic wants, institutions or the upward movement of the entire social system. Economic growth is measured in four ways: GNP, GNP per capita, welfare and variety of items in social indicators. An underdeveloped economy is characterized by: Low GDP per capita (perhaps less than $2,000 a year), low levels of infrastructure education, transport and health care, low levels of human development. E.g. low levels of Literacy, low life expectancy, high rate of unemployment, political instability, lack of good road network and lack of health facilities etc. Learning Activity 5.1 How do you characterize underdeveloped country? It is obvious that poverty is one of the manifestations of the developing nations. However; poverty in developed countries and those of LDCs is different. How do you explain this paradox? Continuous Assessment Methods The main performance criterion is to explain the principles and/or theories of macroeconomics in making decisions. The method of assessment for this criterion includes individual assignment, written test, rubrics and problem analysis. The relation of this criterion with competencies is to explain and organize.
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Exercises I. Say True or False ________ 1. Economic development is related to a quantitative increase in the country's output. ________ 2. HDI is the best measure of economic performance that indicates standard of living. ________3.Economic growth is the qualitative improvement in the economic performance. ________4.Relative poverty is the common feature of LDCs. ________5. Foreign exchange earnings are excess in the developing nations. ________6. The problem of inflation and unemployment are chronic in LDCs. ________7. A considerable debt burden is the feature of underdeveloped economy only.
Long question 1. Life expectancy at birth for country A is given to be 46 years. The combined primary secondary and tertiary education attainment is given to be 50%, for the same country the real per capita GDP is $1200.The adult literacy is given to be 40%.Calculate, a) Life expectancy index b) Education index c) GDP index d) HDI
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3.3.3.6. Ethiopian Economy

Brief Review of the Structure of the Ethiopian Economy
Learners, try this question. What is the nature of the Ethiopian economy? Which sector dominates historically? _______________________________________________________ __________________________________________________________________________ The Ethiopian economy is based on agriculture, which accounts for about 45% of GDP and 85% of employment. Ethiopian agriculture is predominantly rain-fed subsistence agriculture, troubled by recurrent droughts. Agricultural commodities also dominate the export sector, mainly coffee, qat, and hides and skins. Agriculture plays a significant and decisive role in the social and economic development of the country. However, owing to natural and manmade causes the country has not properly benefited from its abundant natural resources conducive to agricultural development, and consequently failed to register the desired economic development that would enable its people pull out of the quagmires of poverty. The major impediments to agricultural development are the predominance of subsistence agriculture and lack and /or absence of more business/market-oriented agriculture; adverse climatic changes; failure to use agricultural land according to appropriate land use management plan and resource base; limitation in information base; lack of provision of supply and dissemination of appropriate technology; failure to integrate relevant activities; and lack of adequate implementation capacity. Industrial development in Ethiopia is still in its infancy and has a narrow base. Its linkage with the agricultural sector is also weak. The integration between the agricultural and industrial sectors plays a key role to accelerate the country's economic development and to bring about socio-economic transformation. The agricultural sector plays a major role in supplying inputs to the industrial sector as well as creating the market for outputs of the industrial sector. The linkages between the agricultural and industrial sector also provides the opportunity for the expansion of the service sectors. Ethiopia possesses substantial untapped water resources that could play significant role in reducing poverty and accelerating growth, if utilized properly. The country has also good potential for tourism and mining. However, the country is not realizing these potentials.
Macroeconomic Reforms and Development Plans

Before you go to the next section, list some of the macroeconomic reforms and development plans that have been undertaken in Ethiopia since the current government takes power? __________________________________________________________________________ __________________________________________________________________________ __________________________________________________________________________
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Economic reforms may go even beyond the economic sphere, and bring up the nation under a comprehensive structure of reforms which includes not only an efficient and transparent system in public expenditure management and tax system, but also a fair and effective legal and regulatory framework, political accountability in free and fair elections and observance of fundamental freedom and rights of human beings. It also requires a clear separation of powers of executive, legislature and the judiciary, as well as recognition of the role of an independent press and media. Economic reforms, therefore, have a wide scope - inseparable from the political and social sphere - and must be seen in this way for its better functioning in any economy. There is no doubt that economic reform policies have brought new prosperity to the world economy. Experiences of many countries show that economic reforms influence economic growth and development. However, the success or failure lies in how comprehensive the economic reforms are. Concerning Ethiopia, a number of macroeconomic reforms have been taken in different sectors and institutions in the country such as in the financial sector, civil service system, justice system, telecommunication, governance and so on. Moreover, we will see the two development plans that have been developed and implemented in recent years in the country: the Plan for Accelerated and Sustained Development to End Poverty (PASDEP) and the Growth and Transformation Plan (GTP). I. The Plan for Accelerated and Sustained Development to End Poverty (PASDEP) PASDEP was Ethiopias guiding strategic framework for the five-year period 2005/062009/10. It represents the second phase of the Poverty Reduction Strategy Program (PRSP) process, which has begun under the Sustainable Development and Poverty Reduction Program (SDPRP), which covered the three years, 2002/03-2004/05. The PASDEP carries forward important strategic directions pursued under the Sustainable Development and Poverty Reduction Program (SDPRP) - related to infrastructure human development, rural development, food security, and capacity-building - but also embodies some bold new directions. Foremost among them was a major focus on continuing growth with a particular emphasis on greater commercialization of agriculture and enhancing private sector development, industry, urban development and a scaling-up of efforts to achieve the Millennium Development Goals (MDGs). PASDSEPs objectives were ensuring accelerated, sustained and broad based economic development as well as preparing the ground for the full achievement of Ethiopias MDG targets by 2015. To achieve these objectives the PASDEP was built on the following eight strategic pillars. 1. 2. 3. 4. 5. Building all-inclusive implementation capacity, A massive push to accelerate economic growth, Creating the balance between economic development and population growth, Unleashing the potentials of Ethiopias women, Strengthening the infrastructure backbone of the country,
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6. Strengthening human resource development, 7. Managing risk and volatility, and 8. Creating employment opportunities. Generally, during the PASDEP period, Ethiopia has built on the development strategies pursued under SDPRP (expanding education, strengthening health service provision, fighting HIV/AIDS, Food Security Program, capacity-building as well as decentralization). It was also continued to pursue on the Agricultural Development Led Industrialization (ADLI) strategy, but with important enhancements to capture the private initiative of farmers and support the shifts to diversification and commercialization of agriculture. II. The Growth and Transformation Plan (GTP) The government has formulated the five year Growth and Transformation Plan (GTP) (2010/11-2014/15) to carry forward the important strategic directions pursued in the PASDEP. In the GTP plan special emphasis is given to agricultural and rural development, industry, infrastructure, social and human development, good governance and democratization. The GTP takes in to account two alternative economic growth scenarios: a base case and a high case: the base case scenario assumes that the previous five years average annual GDP growth rate will be maintained; the high case scenario assumes that the GDP and the agricultural value added achieved in 2009/10 will be doubled by the end of the GTP period, 2014/15. The countrys vision, the achievements of PASDEP, and the lessons drawn from its implementation, were the basis for formulation of the five year GTP plan. Ethiopias vision which guides the GTP is: to become a country where democratic rule, good-governance and social justice reign, upon the involvement and free will its peoples, and once extricating itself from poverty to reach the level of a middle-income economy as of 2020-2023. Moreover, the countrys vision specifically on economic sector includes: building an economy which has a modern and productive agricultural sector with enhanced technology and an industrial sector that plays a leading role in the economy, sustaining economic development and securing social justice and increasing per capita income of the citizens so as to reach the level of those middle-income countries. The Growth and Transformation Plan (GTP) has the following major objectives: Maintaining at least an average real GDP growth rate of 11% and attain MDGs; Expand and ensure the qualities of education and health services and achieve MDGs in the social sector; Establish suitable conditions for sustainable nation building through the creation of a stable democratic and developmental state; and Ensure the sustainability of growth by realizing all the above objectives within a stable macroeconomic framework.
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Additionally, the GTP has the following 8 strategic pillars: 1. 2. 3. 4. 5. 6. 7. Sustaining rapid and equitable economic growth, Maintaining agriculture as major source of economic growth, Creating conditions for the industry to play key role in the economy, Enhancing expansion and quality of infrastructure development Enhancing expansion and quality of social development Building capacity and deepen good governance, and Promote gender and youth empowerment and equity.
Learning Activity 6.2 Students should form groups with four members each and work on one of the following questions and submit to the instructor. What are the 8 Millennium Development Goals (MDGs) and their targets? Which one of the MDGs Ethiopia is recording good progress? Write down the structure, current performance and prospects and challenges of the Ethiopian agricultural sector. Write down the structure, current performance and prospects and challenges of the Ethiopian industrial sector. Write down the structure, current performance and prospects and challenges of the Ethiopian service sector. What is ADLI? What do you understand by backward and forward linkages between agriculture and industrial sectors? What is the role of such linkages in Ethiopian economy context? Continuous Assessment The major performance criterion is to explain the principles and/or theories of macroeconomics in making decisions. The method of assessment for this criterion includes group work, written test and problem analysis. The relation of this criterion with competencies is to explain and organize. Summary The Ethiopian economy is highly rooted on the rain-fed agricultural sector. The Economys GDP, employment and export commodities are mainly contributed by this sector. In order to eradicate poverty and accelerate economic growth, the government has been developing and adopting different types of development plans, policies and strategies. Among them are the Growth and Transformation Plan (GTP), the Plan for Accelerated and Sustained Development to End Poverty (PASDEP), the Sustainable Development and Poverty
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Reduction Program (SDPRP), the Poverty Reduction Strategy Program (PRSP), and the Agricultural Development Led Industrialization (ADLI) strategy.
3.3.4. Proof of Ability

The instructor/s and other individuals who have assumed the responsibility to assess students are expected to provide students assignments, activities, responsibilities or challenges that require students to meet proof of ability. The assessors are expected, for example, to assess whether the knowledge and skills the students have gained from this learning task are aligned to the practical situation. The purpose of proof of ability is to assess whether the students have acquired the necessary knowledge, skills, attitudes and values that form the professional foundation of agribusiness manager. Assessment methods that are used for the proof of ability of this learning task are task-based interview, rubrics, written tests, individual assignments and case studies. Assessments will be carried out at the end of the learning process and upon completion of the learning task. There are two situations for doing the assignment for proof of ability. One is in university classroom settings and the second is in and around actual agribusiness firms where students are made to get direct access to and observe realities in work environment. In both cases, emphasis will be given to applications of knowledge and skills. The percentage of the final mark for the proof of ability is 50%.
References: Mankiw, N. G., 2002. Macroeconomics. 5th edition, Worth Publishers. Mankiw, N.G., 2008. Principles of Macroeconomics. 5th edition, Cengage Learning. R.A. Arnold, 2008. Macroeconomics. 9th edition, Cengage Learning. Dornbusch R. and Fischer S, Macroeconomics, 6th edition, Tata McGraw-Hill Publishing Company Limited. Meier, G.M. and J.E. Rauch. Leading Issues in Economic Development. (New York and Oxford: Oxford University Press) eighth edition, 2005. Todaro, M.P. and S.C. Smith .Economic Development. (London: Pearson,) tenth edition, 2008. MoFED, 2006. A Plan for Accelerated and Sustained Development to End Poverty, volume1. Addis Ababa, Ethiopia. MoFED, 2010. Growth and Transformation Plan, volume I. Addis Ababa, Ethiopia.
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AGRIBUSINESS MANAGEMENT (ABVM 211)

Compiled by: Ebisa Deribie (MA) Negash Mulatu (MSc)

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

3.3 Macroeconomics 3.3.1 Introduction

Agribusiness Management: Macroeconomics

3.3.3. Sections 3.3.3.1. Concepts and Theories of Macroeconomics

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

Short-Run Aggregate Supply (SRAS)

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

Figure 1.8: Long Run Aggregate Supply (LRAS) Curve

Agribusiness Management: Macroeconomics

Figure 1.9: Equilibrium States of the Economy

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

This is known as a Paasche, or current-weighted, price index.

Agribusiness Management: Macroeconomics

This is a so-called Laspeyres, or base-weighted, price index.

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

3.3.3.2. National Income Accounting

Concepts and Definition of GNP and GDP

Agribusiness Management: Macroeconomics

Measuring GNP and GDP National Accounts

Approaches to Measure GNP The output approach

Agribusiness Management: Macroeconomics

The expenditure approach

The Income Approach

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

3.3.3.3. Macroeconomic Problems

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

Inflation and Money

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

The Effects of Inflation on the Society

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

Reasons for and Types of Unemployment

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

Job Loss, Job Finding, and the Natural Rate of Unemployment

Now we can solve for U/L to find

Agribusiness Management: Macroeconomics

Tradeoffs between Inflation and Unemployment

Agribusiness Management: Macroeconomics

Agribusiness Management: Macroeconomics

3.3.3.4. Macroeconomic Policies

Fiscal Policy Fiscal Policy and Aggregate Demand

Agribusiness Management: Macroeconomics

The fiscal policy transmission mechanism

Agribusiness Management: Macroeconomics