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UNIT 1: INTRODUCTION TO MACROECONOMY

Contents
1.0 Aims and Objectives
1.1 Introduction
1.1.1 The Problems of Aggregation
1.1.2 Total Output: National Products, National Expenditure, National Income
1.1.3 Macroeconomics Equilibrium
1.2 The Background of Macroeconomic Theory
1.2.1 The New Classical School
1.2.2 The New Keynesians
1.3 Macroeconomic Models
1.3.1 The AD-AS Model
1.3.1.1 The Classical Economists
1.3.1.2 The Keynesians
1.3.1.3 The Monetarists
1.3.1.4 The New Classical Economists
1.4 Circular Flow the Closed and Open Macro Models
1.5 Summary
1.6 Key Words
1.7 Answers to Check Your Progress
1.8 Examination Questions
1.9 References

1.0 AIMS AND OBJECTIVES

Aims – we now start out study of the economy as a whole and we are going to consider many of
the main aggregates in the economy. Basic concepts of macroeconomics in contrast with
microeconomics will be introduced. Major developments in macro-economics will be reviewed
by considering the prominent contributors to the filled. The macroeconomics controversies over
the AS-AD model expressed by different economists will be reviewed using illustrative

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diagrams. At last the circular flows of the closed and open macro models will be presented
which these later discussed in detail.

Objectives –
After learning this unit, you will be able to:
 Explain the meaning of an economic aggregate, particularly the total value of a country’s
output.
 Assess the problems involved in aggregation.
 Define the terms national product, national expenditure, national income, consumption,
saving and investment and show how they are linked in the circular flow of income
 Define the terms aggregate demand and aggregate supply, and explain the meaning of
macro equilibrium
 Differentiate the different kinds of macro economists forwarded based on their schools
of orientation.
 Distinguish easily the two, three and four macro-model.

1.1 INTRODUCTION

Concepts and definitions

Before coming to the specific prints of macroeconomics let’s start our discussion from the
general definitions of the concept of economics.
 Economics is a science that explains how society makes decisions about consumption,
production and the exchange of goods and services.
 Economics is the study how people allocate scarce resources that have alternative uses
among virtually competing ends.
 Economics is the study of how society decides what gets produced, how and for whom.

In general it is the study of material welfare thus studied as the science of wealth.

Nowadays several branches of economics are existing. Among which the followings are
worthwhile mentioning:
 Labor economics * Industrial economics

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 Land economics * Agricultural economics
 Monetary economics * Trade economics
 Resource economics * Defense economics
 Urban economics * Health economics
 Rural economics * Development economics
 Energy economics * Environmental economics
 Transition economics etc

Despite all the above-mentioned areas, nearly all-economic issues fall into two categories
 Microeconomics and
 Macroeconomics

The words are derived from the Greek, the term micros meaning small, while macros means
large. Microeconomics involves in the study of issues that do not encompass the entire economy
and are in this sense “small”; it examines the economic behavior of individuals (household
members, business managers, government officials) or of relatively small groups of them (such
as all the people operating in the market for teff or all the firms producing garments)

In microeconomics one analyzes a small sector of the economy on the assumption that changes
in that factor are too small to affect the rest of the economy thus can assume “ceteris paribus”
Latin word meaning all other factors remain constant.

Macroeconomics is thus the study of issues that are economy-wide or “large”, it examines the
economy as a whole and concerned with the combined, aggregate effects of millions of
individual choices on such variables as notional output, the overall level of employment, the
general level of prices. Because these aggregates are large in relation to the national economy, a
change in one macro variable tends to affect all other variables. Therefore it is wrong to assume
ceteris paribus in macro-analysis. Indeed the main purpose of macroeconomic study is to
analyze how other things change in relation to each other. For example if total demand increases
then total supply or price will increase. In either case income rises meaning that there is a
continuous flow of causation among the various macro variables:

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Level of employment
Demand  Supply and prices income  demand and goes on like this.

Macroeconomics is interesting because it deals with important economic issues and problems of
the day. Regarding what macroeconomists study there are several questions which need be
answered such as why have some countries experienced rapid growth in incomes over the past
century while others stay mired in poverty? Why do some countries high rates of unemployment
or inflation while others maintain stable economy? Macroeconomics considers many of the
world’s most pressing economic problems like persistent unemployment, rapids inflation,
balance of payment difficulties, economic stagnation and unequal distributions of income and
wealth. In order to analyze these problems, are must first identify, measure and consider the
determinants of the main aggregates in the economy. The most important aggregates are:
 The economy’s total output of goods and services
 The total demand for this output
 Total employment and unemployment
 The general price level
 The balance of payments
 The rate of economic growth

All aggregates are made up of their constituent parts for example, we see later that the total
demand for a country’s output consists of the sum of individual demands and can be written as
follows:
AD = C + I + G + X – M
Where AD is aggregate demand, C is the sum of all individual consumers’ demands for goods
and services, I is the sum of all individual firm’s demands for investment goods, G is the
governments demand for goods and services, X is the total foreign demand for the country’s
exports and M is the demand for imports. One important point that are have to remember here is
that to analyze the main determinants of aggregates like these, it is necessary first to have an
understanding of the behavior of the individual economic agents. This means that we must be
aware of the microeconomic theories of consumer behavior or the firm of public sector activity
and of distribution because Micro- and Macroeconomics are intimately linked.

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1.1.1 The problems of aggregation

Problems arise in aggregation largely because of the difficulty of finding an appropriate unit of
measurement. In adding up the total output of a country, there is no single physical unit of
measurement that can be used: the millions of different types of goods and services are all
measured in different units for example, in tones, meters, etc and which is practically difficult to
add these different units. The problem is overcome, at least partially, by using money as the unit
of measurement this greatly simplifies the adding up, but it gives rise to the problem of
distinguishing between real and nominal values.

If the value of total output should double from say, Birr 10 Billion to Birr 20 billion, this does
not necessarily mean that total output itself has doubled: part of the increase may indeed be due
to an increase in physical output, but part may be due to an increase in prices. The problem with
value measurements is that there necessarily have a price and quantity component and it is not
always easy to separate the two. To estimate real output, it is necessary to deflate the value of
total output by an appropriate price index. This converts total output measured in current prices
to total output measured in constant prices.

Another problem with aggregates is that they hide their constituent elements. For example, an
increase in the economy’s total output tells us nothing about who receives that output. A rise in
total output accompanied by a charge in the distribution of income, which makes some people
better off and others worse off, cannot necessarily be interpreted as an improvement in the
country’s living standards. Distributional factors should always be borne in mind when
considering the effects of changes in aggregate variables.

1.1.2 Total output: national product, national expenditure, national income

In principle, the value of an economy’s total output can be measured in three ways. The figure
below shows the flow of income and spending in a simple model of an economy. The two main
economic agents in the flow diagram are households and firms. The households can be thought
of as the owners of factors of production, the services of which they sell to firms in exchange for
income (in the form of wages, salaries, interest, rent and profit). We can easily see in the
diagram that, all profits are assumed to be distributed to households and not retained by the
firms. The firms use the factors of production to produce the many different types of goods and

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services, which they then sell to households (whose spending is called consumption), the
government, foreigners (who buy exports and other firms (whose spending on capital goods is
called investment). The diagram also shows that the part of

Fig 1. The circular flow of income and spending


Income

Households Firms

Saving Consumption Investment


Taxes Taxes
Government
Transfer payments Government spending

Foreign trade
Imports Exports

Household income which is not spent on consumption is either saved, spent on revenue to
finance government spending, including transfer payments (such as pensions, unemployment
benefits and student scholarships). The term consumption is the total expenditure by households,
on production is the total expenditure by firms on goods and services which are not for current
consumption; that is, real capital goods like factories, machines, bridges, all goods which yield a
flow of consumer goods and services in future periods. Saving is that part of disposable income
(that is, income less taxes) which is not spent in the current period. It follows that disposable
income minus saving equals consumption.

The three ways of measuring the annual value of total output in an economy are by calculating
its national product, national product, national expenditure and national income. Consider news
also the following concepts:
 National product – The sum of the value of all final goods and services produced during
the year. All final goods and services produced must be included, whether they are to be
sold to consumers are to the government, or they are to be sold abroad as exports, or

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whether they are to capital goods to be sold to other firms by excluding intermediate
good.
 National expenditure – The sum of all the spending on the final goods and services
produced during the year. Such an aggregate will only equal the value of total output if
those goods, which are produced but not sold, are also included. It is the sum of
consumption of domestically produced goods, investment, government expenditure and
exports.
 National Income – It is because goods and services are produced by factors of
production that income is created in an economy. This is the sum of all incomes (that is,
wages, salaries, interest, rent and profits) of all factors of production, those producing
intermediate goods as well as those producing final goods by excluding transfer
payments.

1.1.3 Macroeconomic Equilibrium

 Aggregate demand – As we have mentioned in the section 1.1, aggregate demand is the
total demand for all final goods and services in an economy over a period of time and
consists of the sum of the demands of consumers, firms, the government and foreigners.
National expenditure is the actual amount of money spent on goods and services over a
given period of time, whereas aggregate demand is the total value that households, firms,
the government and foreigners plan to spend out of their respective incomes over that time
period: in other words, it is the total amount they are willing and able to spend. National
expenditure, then, can be called actual expenditure, while aggregate demand can be called
planned expenditure. The actual and planned measurements will differ if total output
should take short of or exceed total demand – in the former case, some demand will be
unsatisfied because insufficient goods have been produced: in the latter case, some net
addition to stocks will occur since too many goods have been produced.
 Aggregate supply – Aggregate supply may be defined as the total value of all final goods
and services that all firms in the economy wish to supply over some time period. National
income is the value of the actual amount produced and so is necessarily equal to the
national product and expenditure. Aggregate supply, on the other hand, is the amount that

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firms want to produce given the general level of wages and prices. The two will only be
equal:
a) If wages and prices are such that firms plan to produce what is currently being
produced.
b) If firms are able to implement their production plans successfully
 Equilibrium – in the microeconomic market for a single good, an equilibrium is said to
exist when the demand for the good is equal to the supply of it. Similarly in
macroeconomics, we can say that the equilibrium level of national income has been
reached when there are no economic forces operating to change the level of national
income. This occurs when the total demand for the goods and services (aggregate demand)
is equal to the total supply of these goods and services (aggregate supply). That is, for the
equilibrium level of income to be achieved, we require that:
Aggregate demand = Aggregate supply
Only when this condition is satisfied we can say that the total value of goods and services that
households and the other economic agents want to buy is equal to the total value that firms want
to produce.

The relationship between aggregate demand and the price level is likely to be a negative one in
other words, the AD curve will be down-ward sloping from left to right as indicated the diagram
below.

The relationship between aggregate supply and the price level is likely to be a positive one,
giving an upward sloping AS curve. The point at which the two curves intersect determines the
equilibrium level of real national income (OY 1) and the equilibrium price level (OP1). This
model, the AD – AS model, is at the heart of modern macroeconomics and this will be discussed
in the next section 1.3.

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Figure 3. Equilibrium in the macro- economy

AS 1
Price Level

P1

AD 1

Real National Income


The intersection of the aggregate demand and aggregate supply curves determines the
equilibrium level of real income and the equilibrium price level.

For equilibrium, we require that the aggregate demand for the economy’s goods and services
should be just equal to the total value of goods and services produced. As we saw previously
aggregate demand consists of C + I + G + X – M. The total value of goods and services
produced is measured by the national income (Y). The income received is either spent on
consumer goods or withdrawn in the form of savings and taxes (that is, Y = C + S + T). So, as a
condition for equilibrium, we can write:

AD = Y
C+I+G+X–M=C+S+T
I+G+X=S+T+M
Investment, government spending and exports are sometimes called injections (J) into the flow
of income, while savings, taxes and imports are sometimes called withdrawals (W) from that
flow. Thus, the condition for equilibrium could be written more simply as:
J=W

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Fig. Determination of the equilibrium level of income

60
450

50
AD = C + I + 6 + X - M
AD, (USD bil.)

40

30
W=S+T+M
20
J=I+G+X
10

0
10 20 30 40 50 60

National Income (USD bil.)

The total injections, total withdrawals and aggregate demand lines for an economy are drawn
with 450 line in the above diagram. The 45 0 line joins together all those points which are
equidistant from the two axes. The graph shows that there are two ways identifying the
equilibrium level of income.
a) Where aggregate demand is equal to national income (that is where AD line cuts the 450
line)
b) Where total injections equal total withdrawals. Therefore, the equilibrium level of
income is determined at a point where AD = Y and W = J.

To express the above in mathematical equations let’s consider the following few point:
 The supply of output available to the economy consists of domestic production plus the
level of import. (M + Y)
 The sum of the demands of the household, business, government and foreign sectors
constitute the aggregate demand

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 Under equilibrium condition
M+Y=C+I+G+X
 Rearranging the terms we find
Y = C + I + G + (X – M) -----------------(1)
Next let’s denote
S = Saving
T = Taxes
Yd = Disposable income of the households
Let’s again assume income receipts are divided between household and government sectors:
Y = Y2 + T Since Yd can be either spent on consumption (c) or saved (s), we obtain
Y = C + S + T-------------------------------------(2)
Under macroeconomic equilibrium equations 1 and 2 are equal which this is
C + I + G + (X – M) = C + S + T
I+G+X = S+T+M
Injections leakages
Which this illustrates again under macro equilibrium condition total leakages are equal to total
injections.

1.2 THE BACK GROUND OF MACROECONOMIC THEORY

Macroeconomic theory is probably the most controversial topic in economics. Through at least
the mid – 1930’s, economists were generally agreed that the dominant variable determining the
price level and the business cycle was the quantity of Money existing in a country. Central
banks control the money supply to eliminate the threats of depression and inflation.

The great depression of the 1930s was an immense psychological shock to these economists. It
was thought the central bank was doing all it could and that seemed to be no help at all. In Great
Britain John Maynrad Keynes published his book. The General Theory of Employment,
intersect and money in 1936. A model was presented which suggested that the quantity of
money is not very important – at least during depressions – and that investment, government
spending and taxation and exports are the key variables determining the business cycle. This
model, as systematized by Keynes’ followers, fairly swept the economic profession. It provided

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economists with sensible things to say about the depression. The Keynesian or income –
expenditure model was a firmly established orthodoxy by the 1950s.

The most dramatic macroeconomic development since 1920s to the 1980s was that in the 1930.
What economic theory needed during the 1930s was an explanation of the disastrous experience
of those year. How could an economy plunge to a predicament in which a quarter of a notion’s
resources were idle? Keynes provided a theory to explain this phenomenon. It was so successful
that it began a Keynesian era in macroeconomic theory that stood in sharp contrast to the
classical theory that had prevailed over the preceding century or more.

In the early years following the appearance of Keynes’ General Theory, macroeconomic theory
could be neatly divided into two parts – classical and Keynesian. Keynes chose to contrast the
ideas he presented in the General Theory with the prevailing ideas as classical. In economic
theory, the term “classical” had been coined by Karl Marx, who used it to cover the theories of
David Ricardo, James Mill and their predecessors. Keynes extended the term to include the
followers of Ricardo those who adopted and perfected the theory of the Ricardian economics,
including Mill, Marshall, Edge worth and Pigou. This is now the generally accepted meaning of
“classical” in its application to macroeconomic theory.

Despite the tremendous success of Keynes’ work, it did not by any means put an end to the
further development of classical macroeconomics. New and different formulations or
reconstructions of classical theory appeared under the 1950s in the area of growth theory that
gave us neoclassical growth models. Beginning in the 1950s and continuing to the present has
been the work of another extension of classical macroeconomic theory known as monetarism, to
called because of the critical role its assigns to money as a determinant of what happens in the
economy. Keynes’ General Theory began what came to be called the Keynesian revolution; the
work of the monetarists, especially that of Milton Friedman, during the 1960s and 1970s, gained
so much influence that it may be regarded as a counter revolution. Finally, in the 1970s came the
latest theoretical development with roots in classical theory: The new classical economics that
builds on the old by inserting the concept of rational expectations.

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As these developments were occurring on the classical side, there were also changes on the
Keynesian side. Neo-Keynesians dominantly British and post Keynesians, predominantly
American emerged whose ideas moved beyond the Keynesian Orthodoxy.

From our discussion we can easily observe that there have long been two main intellectual
traditions in macroeconomics. One school of thought believes that markets work best if left to
themselves: The other believes that government intervention can significantly improve the
operation of the economy. In the 1960s, the debate on these questions involved monetarists, led
by Micton Friedman on one side, and Keynesians, including Franco Modigliani and James
Tobin, on the other. In the 1970s, the debote on much the same issues brought to the fore a new
group th4e new classical macroeconomists, who by and large replaced the monetarists in
keeping up the argument against using active government policies to try to improve economic
performance. On the other side are third- generation Keynesians; they may not share many of
the detailed beliefs Keynesians three or four decades ago, except the belief that government
policy can help the economy perform better.

1.2.1 The New Classical School

The New classical macroeconomics, which developed in the 1970s, remained influential in the
1980s. This school of macroeconomics which includes among its leaders Robert Lukas, Thomas
Sargent, Robert Baro and Edward Prescott and Neil Wallace of the University of Minnesota,
shares many policy views with Friedman. It sees the world as one in which individuals act
rationally in their self-interest in markets that adjust rapidly to changing conditions. The
government is claimed, is likely only to make things worse by intervening. Their approach is a
challenge to traditional macroeconomics, which sees a role for useful government action in an
economy that is viewed as adjusting sluggishly with slowly responding prices, poor information
and social customs impeding the rapid clearing of markets.

The central working assumptions of the new classical school are three:
 Economic agents maximize – Households and firms make optimal decisions. This means
that they use all available information in reaching decisions and that those decisions are
the best possible in the circumstances in which they find themselves.

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 Expectations are rational – which means they are statistically the best predictions of the
future that can be made using the available information. Indeed, the new classical school is
sometimes described as the rational expectations school, even though rational expectations
is only one part of the theoretical approach of the new classical economists. Rational
expectations imply that people will eventually come to understand whatever government
policy is being used, and thus that it is not possible to fool most of the people all the time
or even most of the time.
 Markets Clear – There is no reason why firms or workers would not adjust wages or prices
if that would make them better off. Accordingly prices and wages adjust in order to equate
supply and demand; in other words, markets clear.

One dramatic implication of these assumptions, which seem so reasonable individually, is that
there is no possibility for involuntary unemployment. Any unemployed person who really wants
a job will offer to cut his or her wage until the wage is low enough to attract an offer from some
employer. Similarly, any one with an excess supply of goods on the shelf will cut prices so as to
sell. Flexible adjustment of wages and prices leaves all individuals all the time in a situation in
which they work as much as they want and firms produce as much as they want.

The essence of the new classical approach is the assumption that markets are continuously in
equilibrium. In particular new classical macroeconomists regard as incomplete or unsatisfactory
any theory that leaves open the possibility that private individuals could make themselves better
off by trading among themselves.

Adherents of the new classical school do not doubt that the great depression did take place, and
they recognize that the measured unemployment rate occasionally reaches more than 10 percent.
But they have developed explanations that try to account for high unemployment even when the
new classical premises hold.

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1.2.2 The New Keynesians

The new classical group remains highly inthential in today’s macroeconomics. But new
generations of scholars, the new Keynesians, mostly trained in the Keynesian tradition but
moving beyond it, emerged in the 1980s. The group includes among others George Akerlof and
Janet Yellen and David Romer of the University of California. Berkely, Oliver Blanchard of
MIT, Greg Mankiw and Lary summers of Harvard and Ben Bernanke of Princeton University.
They do not believe that markets clear all the time but seek to understand and explain exactly
why markets fail.

The New Keynesians argue that markets sometimes do not clear even when individuals are
looking out for their own interests. Both information problems and costs of changing prices lead
to some price rigidities, which help cause macroeconomic fluctuations in output and
employment. For example, in the labor market, firms that cut wages not only reduce the cost of
labor but are also likely to wind up with poorer quality labor force. Thus they will be reluctant
to cut wages. If it is costly for firms to change the prices they charge and the wages they pay, the
economy wide level of wages and prices may not be flexible enough to avoid occasional periods
of even high unemployment.

To wind out our discussion on schools of macroeconomics let’s say some words on the
controversies which are existing among contemporary economists. There is no denying that
there are conflicts of opinion and even theory between different camps. And because
macroeconomics is about the real world, the differences that exist are sure to be highlighted in
political and other discussions of economic policy.

It is also the case, though, that there are significant areas of agreement and that the different
groups, through discussion and research, continually evolve new areas of consensus and a
sharper idea of where precisely the differences lie. In general in the main streams of
macroeconomic thinking there are conflicts of opinion as there are significant areas of
agreement.

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1.3 MACROECONOMIC MODELS

At times during the century, it was easy to be a macroeconomist. The decades before 1930
provide one example, the 1950s and 1960s provide another. During those times, a broad
consensus existed among economists virtually all of them held the same economic vision; they
agreed with one another on what was the best model of the macro economy and what role, if
any, the government should play in it. The 1990s are quite another mater. The sure answers as to
what causes fluctuations in the real GNP, along with associated changes in the levels of
unemployment and prices have given way to uncertainty. Trusted macro-models of just 25 years
ago are after viewed as useless relics of a bygone age. In short, macroeconomics has entered a
period of confusion and division among its practitioners, but it is also a period of excitement as
new, perhaps better models are being build. In our following discussion we will learn much
about a model of aggregate demand and supply based on the views of the major schools of
macroeconomic thought.

1.3.1 The AD – AS Model

Figure 1. The Model of Aggregate Demand and Aggregate Supply (The AD – AS model)
P SRAS3
LRAS
P2 f
GNP deflator
SRAS1

a
P1 b
AD2
P0
Deflationary Gap c AD1

QReal GNP
0
Q2<Qn
U2 > Un Q2=Qn
U2 = Un

where:

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P – GNP deflator
Q – Real GNP
LRAS – Long run aggregate supply
SRAS – Short-run aggregate supply
AD – Aggregate demand
Qn – natural level of output
Un – natural rate of unemployment
Now let’s consider figure 1 first by focusing on point a of panel (a), which pictures an economy
in long-run macro equilibrium. The actual level of national output Q2 equals the natural level of
Qn; thus, there is full employment and the actual employment rate U 2 equals the natural rate Un.
Only frictional and structural unemployment exists.

Now let’s assume aggregate demand falls from AD 2 to AD1 and a new short-run macro
equilibrium is established at point b. As the demand for all kinds of products falls, prices and
production fall throughout the economy. The economy’s price level falls from p2 to p1 and the
real GNP from Q2 to Q1. The unemployment rate, now at U1, exceeds the natural rate.
Macroeconomists expect a deflationary gap to happen next: A possibly slow process of falling
prices and input costs might eventually establish a new long-run equilibrium at point c. These
wordings point to this century’s first major controversy among macroeconomists. The so called
classical economists thought the restoration of full employment from a position such as b in our
graph would occur very rapidly, as a falling prices pushed the economy to c – without any action
on the part of government. The so-called Keynesian economists held a different view. As they
saw it, in the absence of government intervention, the removal of the deflationary gap would be
painfully slow, above-natural rates of unemployment would persist for a long time, and all the
while people would be producing a real GNP that fell short of the nation’s potential, Q n. The
Keynesians therefore, recommended immediate government action to stimulate aggregate
demand whenever there was a deflationary gap. In our example, they would have government
raise AD1 to AD2, which would quickly restore the level of full employment, not at c but at a.

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Panel b
LRAS

SRAS3
P4 f

e
P3 AD3

P2 a
AD2

Q Inflationary gap
0
Q2=Qn
U2 = Un Q3>Qn
U3 < Un

The Keynesian were much more ready, however, to accept the classical economists view of
what happens when aggregate demand rises while the economy is at full employment. The
inflationary gap is going to be reviewed here in panel b. Once again focus the economy at point
a, in a position where in the real GNP equals Q2 and, thus, the full employment level. Let
aggregate demand rise from AD2 to AD3. The short run consequence is a general rise in prices
and outputs throughout the economy. Graphically, this is shown by a move from a to e; a rise in
the general price level from p2 to p3 is accompanied by a rise in the real GNP from Q2 to Q3.

Accordingly to unemployment rate falls below the natural rate. Eventually, however, the
economy moves from e to f, a matter on which both classical and Keynesian economists agree.
Eventually unusually law unemployment U3 is expected to push wages up, and unusually high
production levels, associated with a real GNP of Q3, push up the prices of non labor inputs as
well. Before long, the general price level rises (as from p 3 to p4) and the level of production falls
back to the natural level of output Qn.

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1.3.1.1 The Classical Economists

Economists such as Adam Smith (1723 – 1790), David Ricardo (1722 – 1823) Jean – Baptiste
say (1767 –1832), Alfred Marsall (1842 – 1924), and Arthur C. Pigou (1877 – 1959) who wrote
about macroeconomic issues prior to the 1930s (before macroeconomics existed as a separate
discipline), are now called classical economists. Their view of the world featured markets for
resources, goods and quickly equate quantities demanded and supplied via the establishment of
equilibrium prices. These economists were confident that whatever quantities of human, natural
and capital resources were confident that whatever quantities of human, natural and capital
resources were supplied by their owners (at the prevailing equilibrium prices) would also be
used by firms.

Except for grief periods of adjustment, the economy’s output would always equal the full
employment output (or what later economists were to call the natural level of output Qn). Any
involuntary unemployment of resources would quickly lower resource prices and establish full-
employment – through an increase in quantity demanded, a decrease in quantity supplied, or a
combination of both. Changes in aggregate demand or aggregate supply would in no way alter
this conclusion.

As the classical economists saw it, after resource markets have reached equilibrium, the full
employment output Qn is being produced. The level of aggregate demand merely determines the
general level of prices. Thus, if the full employment real GNP Q n equals say, Birr 4000 million
at base year prices, and people spend Birr 4000 million in accordance, say, with aggregate
demand curve AD2 in Figure 1, a macroeconomic equilibrium will occur at point a. Then the
general price level P2 will equal that of the base year. If people instead spend more Birr, in
accordance, say, with aggregate demand curve AD3, the same physical output will simply sell
for more. The economy will move a to e and quickly to f, the general price level will settle at P 4,
above the base year level. Similarly, if people spend fewer dollars, in accordance with AD 1,
goods markets will rapidly adjust in the opposite direction; the same physical output will sell for
less as the economy moves from a to b and quickly on to c. The general price level will settle at
P1, below the base year level.

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Under these circumstances, argued the classical economists, deliberate governmental
intervention to raise or lower aggregate demand makes no sense. Full employment is assured
through flexible input prices; the sale of full employment output is assured through flexible
output prices. A government that raised AD would only raise the price level, thus creating
inflation. A government that lowered AD would only lower the price level, thus bringing about
deflation. Its policy, however, would have no effect on output, employment, and unemployment.
The best policy, therefore, was one of “laissez-faire,” of leaving things alone.

Over time, the classical economists argued, the quantities of resources would grow, technical
advances would occur, and the economy’s full employment output would grow. Once again,
flexible input prices would assure its production. A greater labor supply, for example, would
lower wages, so would a lower demand for labor that might accompany a laborsaving technical
advance. And wages would fall to whatever level was needed to encourage the full use of labor
resources. Given the higher aggregate supply of goods and an unchanged level of aggregate
demand, the extra physical output would quickly be sold at lower prices. Thus, “Supply would
create its own demand,” as stated in say’s law.

1.3.1.2 The Keynesians

In 1936, in the midst of the Great Depression, the British economist John Maynrad Keynes
challenged the views of his classical predecessors in a now famous work, The General Theory
of Employment, Interest and Money. As Keynes saw it, despite massive involuntary
unemployment of resources, no rapid downward adjustment of resource prices was occurring to
return the economy to full employment. Among the reasons were minimum wage laws and
widespread bargaining agreements between firms and labor unions. In addition there was little
evidence that say’s law was working well. No rapid downward adjustment of output prices was
assuring that any output produced could also be sold. The economics of the world seemed to be
stuck at a position such as b in figure 1. Neither input prices were falling sufficiently to
encourage the full use of resources nor were output prices falling fast enough to assure the full
sale of output produced.

In such a situation of downward price inflexibility, argued Keynes, the classical prescription of
laissez-faire had become irrelevant. Government demand management now made sense.

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Starting at a position of massive unemployment, such as b in figure 1, an increase in aggregate
demand from AD1 to AD2 would move the economy from b to a and, thus, back to the full
employment. And the government, noted Keynes, had two major tools in its possession to
accomplish this desirable goal. One of these tools is expansionary fiscal policy. It involves a
deliberate decrease in tax rates or increase in transfer payments such as unemployment benefits
or welfare payments, to encourage extra consumer and business spending (C and I) or an
increase in the governments own purchases of commodities and services (G). Another tool is
expansionary monetary policy, a deliberate increase in the notion’s money supply that reduces
interest rates and encourage people – consumers, businesses, and governments – to borrow
money and increase their spending on commodities and services. Keynes concluded that
concretionary government policies that reduced aggregate demand could only make the
depression worse. Yet in the 1930s, many governments were doing just that. They raised tax
rates, reduced government purchases, and lowered the money supply, which raised interest rates.

In subsequent decades, Keynes gained many followers throughout the world who, naturally
enough, are called Keynesians. A list of well known Keynesians includes Paul Samuelson,
Franco Modigliani and James Tobin (all Nobel Prize Winners), as well as Arthur Okun, Walter
Heller, and Gardner Ackley. These economists were optimistic that the government, by
managing the level of aggregate demand, could assure full employment without inflation year
after year. The Keynesians, however, have not been without their critics.

13.1.3 The Monetarists

Economists such as Micton Friedman (Nobel Prize Winner), Karl Brunner, and Allen Meltzer
have argued that Keynesian interventionist policies designed to eliminate unemployment are
likely to do more harm than good. As they see it, the government, being neither omniscient nor
omnipotent, is unlikely to succeed in establishing a long-run macro equilibrium such as point a
in figure 1. Starting at a position such as b, the government may raise its own spending (G) and
– through lower taxes, higher transfer payments, and easier credit – stimulate private spending
(C + I) so much as to shift the aggregate demand from AD1 to AD3. This would move the
economy to point e. The resultant inflation may then induce the government to cut aggregate
demand to AD1, placing the economy in position b. Then another stimulus will be called for,
possibly shifting the economy to point e (more inflation), only to be fallowed by a rapid

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reversal, possibly shifting the economy to b (unemployment). Such stop-go policies that
continually turn the aggregate demand off and on, merely exacerbate the business cycle.

As monetarists see, a better policy would be a constitutional amendment that took all discretion
away from “inevitably bungling” fiscal policy makers and marndated an annual balancing of the
government budget. Beyond that the monetary authorities might be instructed by the parliament
to increase the money supply by fixed annual percentage, such as 3 percent, in order to
accommodate the gradual growth of the potential output over time. Because of their advocacy of
the fixed money growth rule, these economists are also known as monetarists.

1.3.1.4 The New Classical Economists

Another group of economists known as the new classical economists (including Robert whereas,
Thomas Sargent, Neil Wallsce and Robert Barro) have come to conclusions about
macroeconomic demand management that are similar to those of the classical economists. Their
argument, too, can be stated most easily in reference to the model of aggregate demand and
aggregate supply.
These economists reject the adaptive expectations hypothesis, according to which people adjust
their behavior on the basis of past economic events and react to unexpectedly low prices by
producing less (moving from a to e in panel (b) of Fig. 1 from a to b in panel (a). Instead these
economists put forth a rational expectations hypothesis, according to which rational decision
makers use all available information. They look not only backwards but also forward; they base
their behavior not only on past experience but also on what they can easily predict about the
future from current events.

Consider an economy at point a in panel (b). If the government increase aggregate demand from
AD2 to AD3 and this fact is well advertised, say the new classical economists, the economy will
not follow the cumbersome path from a to e and then to f as people slowly realize that prices are
higher than they anticipated when they signed their long-term input delivery contracts and, thus,
insist on a different deal when contracts are renewed. Instead, say the new classical economists,
rational producers who see the government raise aggregate demand will anticipate the entire
future chain of events: higher output prices, dissatisfied input suppliers, renegotiated contracts
with higher input prices, hence higher costs of production. They will therefore, not increase

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output because the anticipated higher costs of production will cancel the incentive for higher
production that higher output prices provide. Thus, the economy will instantly move from a to f,
just as the classical economists would have thought, without even a temporary rise in the real
GNP along the route from a to f via a detour fast e.

Likewise, consider an economy at point a in panel (a). If the government decreases aggregate
demand from AD2 to AD1 and this fact is no secret, the new classical economists say the
economy will not follow the path from a to b and then to c. Rational producers who see the
government lower aggregate demand will anticipate the entire future chain of events: lower
output prices, dissatisfied input buyers, renegotiated contracts with lower input prices, hence
lower costs of production. These producers will, therefore, not decrease output because the
anticipated lower costs of production that lower output prices provide. Thus, the economy will
instantly move from a to c, just as the classical economists would have thought, without even a
temporary decline in the real GNP along the detour from a to c via b.

The new classical economists, thus, believe that demand management policy (Keynesian) will
be frustrated by the actions of rational people with rational expectations of rational people with
rational expectations about the policies.

1.4 CIRCULAR FLOWS OF THE CLOSED AND OPEN MACRO MODELS

A Simple Hypothetical Economic Model

Circular Flow and Economic Activity

It means a continual circular movement of money and goods in the economy. That is between
households and business firms.

Through different economic activities such as production, consumption, capital formation etc.,
those economic units are linked up with each other.

Keynes was the first to note the fact of circular flow of economic activity. Consumers spend
their incomes on goods and services produced by business and production units. They pay them
(to factors) in the form of wages, rent, interest and profits. This payment forms the income of
the factors which is again spent. In other words, what are ‘costs’ to businesses are ‘incomes’ to

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the factors such as the workers and the resource owners. It is the expenditure of consumers that
determines the income of the producers. That is more expenditure means more income for the
producers which leads to greater production.

Once we understand this we understand the circular flow of economic activity.


Now let us see the Keynesian: an approach of income which fells us the most important
condition which must be fulfilled before the economy is said to be in equilibrium. That is the
important condition of saving being equal to investment.

One of the important conditions for the economy to be in equilibrium is that its circular flow of
economic activities among different sectors of the economy must be maintained. That is, what
ever is earned in the form of income (Y) by the factors of production must be spent either on
consumption (c) or an investment (I)
Y=C+I
Now the balance between the two sides is maintained so the circular flow of economic activity
has been maintained and the economy is in a state of macro equilibrium.

This circular flow of economic activity is maintained not only in two sector closed simple
economy but also in three sector and four sector open economy which we are going to discuss
later.

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Two Sector Model

I
Resource
Markets

II IV
Business Household
Sector MoneyMedium of exchange
Money Sector

Product Goods & Services


Markets
Expenditures
III
In a two-sector model of a simple economy we consider household sector and business firms.
Household economic resources or factors of production. These resources are human resources,
non-human resources, (capital) or both. Households are consumers and controllers of the factors
of production. But business sector employs the factors of production (inputs) and produces final
output for sale.

These basic exchanges are known as real flows. Flows of goods and services in one direction are
matched with the flows of money in the other direction. In the resource markets the household
sector supplies economic resources to satisfy the demand of the business sector. Business sector
makes use of these resources (inputs) in the production and supplies final goods and services
through product market.

The economic agents in the business sectors are called ‘producers’ and economic agents in the
household sector are called ‘consumers’. Mainly there are two broad types of transactions that
take place between producers and consumers. From the producers side the transactions take
place in the form of, 1. Purchase of factor services from the house hold sector and 2. Sale of
final output to the household sector.

On the other hand, the transactions in the consumers side take place in the form of i. Sale of
factor services to the business sector and ii. Purchase of final output from business sector.

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In the two sector simple economy the circular flow of economic activity is based on the
following assumptions
1. The economy is closed
2. Production takes place only in the business sector
3. Producers sell all that they produce
4. Consumers spend all their incomes on consumption
5. There are no external transactions involved like government expenditure.

By taking these assumptions, production should equal sales and income equals expenditure.
Then, the circular flow is complete. However, the real working of the economy adds some
complications in this model. These complications are caused by injections and leakages.
Injections are factors which increase spending flow, while leakages are factors which tend to
reduce spending.
Three Sector Model

Income Payments

Factor Services

Household Business
(Income) (output)

Goods & Services

Consumption Expenditure

Saving Capital Intended


Market Investment

Monetary
The three sector model of a simplePolicy
economy shows the circular flow of economic activity
involving government transactions. Government incurs expenditure on goods and services and
gets receipts in the form of takes.

26
When there is a new source of injection in the form of government purchase and expenditure on
goods and services, it will affect the affects of the tax leakage. If the government purchase from
the business sector are equal to the amount by which the taxes reduce consumption, total
business sales will again equal production and the circular flow of the economy involving three
sectors will be maintained.
Four Sector Model
Income Payments

Factor Services

Household Business
Disposable Production
Income

Goods & Services

Consumption Expenditure

Saving Capital Intended


Market Investment

Monetary
Policy

Taxes Government Government


Purchases

Fiscal
Policy

Business
Sector

Foreign Sector Government Sector


Investment
 Leakage Financial Sector  Leakage
 Imports  Taxes
- Leakage
 Injection  Injection
 Saving 27
 Exports  Government
- Injection
Spending
 Investment
Savings

Househol
d Sector

The four sector model includes foreign trade and transactions taking place in foreign trade
sector. When the household sector purchase goods from abroad and imports them into the
economy, the expenditure represents a leakage from the circular flow. This leakage can be off
setted by the expenditures incurred by foreigners on domestic goods and services (exports)
which increase injections.

The import and export flows pass to the sector through ‘balance of payments’ which is
influenced by various types of foreign trade policies.

To maintain the circular flow at equilibrium, the total leakage must equal to total injections.
However, in the four sector open model leakages would consist of imports besides saving and
taxes, and injections would consist of exports besides investment and government expenditure.

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The symbolic representation can be shown as follows:
Y = C + I + G + (X – M)
where Y = Net national product
C = Consumption expenditure
I = Investment
G = Government expenditure
X – M = Net trade balance (the different between exports and imports)
Therefore,
C+S+T=C+I+G
or
S+T+M=I+G+X
where
S = Saving
T = Taxes
X = Exports
M = Imports

This shows that injections must equal leakages to maintain circular flow of economic
activities in the four sector open economy.

Check Your Progress

1. ____________ studies the economic behavior of households, firms and industries.


2. ____________ studies the economy as a whole.
3. The components of aggregate demand are ____________, _______________,
___________, and _______________.
4. The three ways of measuring the annual value of total output is done by calculating the
economy’s ________, __________, and _________.
5. The famous Keynes’ book which was written in 1936 was ______________.
6. The central working assumptions of new classical are _________, _________ and
__________
7. During ____________ gap actual output is below potential output.

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8. During ____________ gap an actual unemployment rate is below the natural
unemployment rate.
9. “Supply would create its own demand”. This is ___________’s law.
10. State the sectors that participate in the two, three and four sector macro models.

1.5 SUMMARY

 Macroeconomics deals with the economy as a whole and is concerned with the
determination of large a aggregates, such as national income, consumption and
investment.
 The main problem of aggregation is that of finding an appropriate unit of measurement.
Aggregates also hide movements in their constituent parts.
 National product, national expenditure and national income are different ways of
measuring the total value of all final goods and services produced over a period of time.
In principle, they should all yield identical results.
 Unlike in early times during this century, macroeconomists in the 1990’s do not share a
common economic vision. They disagree with one another as to what constitutes the best
model of the macro economy and what role, if any, the government can and should play
in it.
 The model of aggregate demand and aggregate supply can be used to illustrate major
controversies among different schools of economic thought, such as classical
economists.
 Aggregate demand is the sum of the demands for goods and services by consumers,
businesses, the government and foreign residents.
 Aggregate supply is the total value of all goods and services that all firms in the
economy wish to supply over a given time period.
 The intersection of aggregate demand and aggregate supply determines the equilibrium
level of real national income.
 Injections are additional spending items in the circular flow of income that do not begin
with household consumption.

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 Withdrawals are those parts of national income that are not used to buy domestically
produced consumer goods.

1.6 KEY WORDS

1. National Product: The sum of the value of all final goods and services produced during
the year.
2. National Expenditure: the sum of all the spending on the final goods and services
produced during the year.
3. National Income: The sum of all incomes of all factors of production, those producing
intermediate goods as well as those producing final goods by excluding transfer
payments.
4. Aggregate demand: The total demand for all final goods and services in an economy
over a period of time and consists of the sum of the demands of consumers, firms, the
government and foreigners.
5. Aggregate supply: The total value of all final goods and services that all firms in the
economy wish to supply over some time period.
6. Equilibrium: A situation where the demand for the goods is equal to its supply.

1.7 ANSWER TO CHECK YOUR PROGRESS

1. Microeconomics
2. Macroeconomics
3. C + I + G + NX
4. National product, national income and national expenditure.
5. The General Theory of Employment, Interest and Money.
6. Economic agents maximize; Expectations are rational; Markets clear
7. Deflationary
8. Inflationary
9. Say's law
10. Two sector model – C + I
Three sector model – C + I + G
Four sector model – C + I + G + NX

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1.8 EXAMINATION QUESTIONS

1. Describe what a deflationary and inflationary gaps are by associating your explanation
with output, unemployment and future expectations to charges is wages and other input
costs.
2. Explain what Demand Management Policy is.
3. Using equations show how total injections are equal to total leakages.

1.9 REFERENCES

 Edward Sapiro (199), Macroeconomic Analysis, Galgotia publications Ltd., New Delhi
 Gupta, R.D. Rana, A.S. (1993), Keynes post-Deynesian Economics, Kalyanti Puthishers,
New Delhi.
 Rudiger Dornbusch & Stanley Fisher (1994), Macroeconomics, Mc Growltill, New
York.
 Thomas F. Dernburg and Duncan M. McDougoll (1972) Nacro-economics, McGrawltill
Book Company, New York.

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