Macroeconomics study notes

1.1 What are economics and macroeconomics?

Why does economics exist? Two simple facts

1. Human wants are unlimited. Whenever people get something, they want something else: a better phone, a bigger house, more education.
2. Resources are limited (scarce). There is only so much land, labour, money and time.

Because wants are endless but resources are limited, a society must choose what to produce, how to produce it and who gets it. Economics studies those choices.

The two branches: micro and macro

1.2 What macroeconomics studies

Macroeconomics covers nine main areas. Economists and policymakers use them to understand trends and make better decisions.

1.3 The goals of macroeconomic policy

The macroeconomic policy of any country tries to achieve four main objectives.

Goal 1: Economic growth

This means growth in output (GDP). In macroeconomic models the letter Y stands for output or GDP. A growing Y means more goods and services for people.

Goal 2: Stability of the economy

This means keeping three things low or steady:

• Inflation (written π): the rate at which prices rise.
• Interest rate (r): the price of borrowing money.
• Exchange rate: for example, how many birr you pay for one US dollar.

Goal 3: Reducing unemployment

The slides pay special attention to cyclical unemployment, the kind that macro policy can actually fix. There are three types:

• Cyclical: caused by a recession or downturn in the economy.
• Structural: a mismatch between the skills jobs need and the skills workers have.
• Frictional: people who are temporarily between jobs.

The slides also link cyclical unemployment to poverty. Poverty has many causes: socio-economic backwardness, natural hazards, war, and poor governance or poor policy. Cyclical unemployment can become long-lasting unless policymakers use macroeconomic instruments (fiscal, monetary and others) well.

Goal 4: A stable balance of payments

In practice this means a stable exchange rate and exports more or less equal to imports.

1.4 The main macroeconomic problems

Industrial nations want economic growth, full employment and stable prices. They often struggle because of: inflation, business fluctuations, income inequality, and budget and trade deficits.

The course focuses on three major problems, because they are vital for understanding income and employment trends:

1. Business cycles (ups and downs in activity)
2. Inflation (rising prices)
3. Unemployment (people without jobs)

Two more are added later in the chapter: trade deficits and budget deficits.

1.5 Problem 1: Business cycles

Four linked variables move together in waves: employment, income, output and the price level. If you plot them over time you get a wave-like line. That is why it is called a "cycle". These waves are also called business fluctuations.

The four phases

What causes business cycles?

Economists give several explanations. They are not rivals; real cycles may involve all of them.

Controlling the business cycle

Controlling cycles matters for the stability of a modern mixed economy, because swings disrupt progress. Cycles cannot be completely eliminated, but they can be reduced with stabilisation policies, which come in two categories: monetary policy and fiscal policy.

Central banks use tools such as adjusting the discount rate, open-market operations and changing reserve ratios (each is explained in section 1.9). Good fiscal policy cannot remove every recession or inflation episode, but it can keep the economy close to its full-employment path.

1.6 Problem 2: Inflation

• It is a significant and ongoing rise, not small or one-off price increases.
• Not all prices rise at the same rate. Inflation is measured with a price index that reflects average consumer or producer prices.
• It is different from deflation, which means falling prices.

Causes of inflation

Inflation has two main types of cause.

(a) Demand-pull inflation

It happens when demand for goods and services exceeds supply at current prices. The classic phrase is "too much money chasing too few goods." Causes:

• Increased government expenditure boosts demand.
• Increase in the money supply raises purchasing power and prices.
• Increased investment stimulates demand.
• Wage increases not matched by higher productivity raise the price level.
• Black money (unaccounted wealth) is spent on non-essential goods and drives prices up.
• Deficit financing adds to money supply growth.
• Credit expansion encourages more spending and demand.

(b) Cost-push inflation

It comes from rising production costs and under-use of resources. Causes:

• Production setbacks: shortages of raw materials, power failures, strikes or bad weather reduce supply.
• Hoarding: firms and households speculatively keep goods off the market, restricting supply and pushing prices up.

The costs of inflation

Inflation is seen as a social problem because it reduces purchasing power, so people feel poorer even when wages rise. The costs fall into two groups: expected inflation and unexpected inflation.

Costs of expected inflation

Costs of unexpected inflation (usually more damaging)

When inflation turns out different from what people expected, someone wins and someone loses.

Inflation and economic growth

Inflation comes in grades: moderate, galloping and hyperinflation (the most severe). Moderate inflation is often seen as helpful for growth, especially in developing economies. But if unchecked, inflation can turn into hyperinflation and wreck development.

1.7 Problem 3: Unemployment

Unemployment directly hurts people: lower living standards and psychological distress. That is why job creation is a major political topic.

Key terms for measuring unemployment

Types of unemployment

Other unemployment terms

Linking the business cycle, output gap, Okun's law and the Phillips curve

The business cycle is the regular pattern of expansion (recovery) and contraction (recession) around the trend growth path of GDP. Three ideas connect it to unemployment and inflation.

1. The output gap

2. Okun's law

There is a negative relationship between real GDP growth and changes in unemployment. When growth is faster than the trend rate, the unemployment rate falls. The trend rate is the normal or average growth rate an economy can sustain over time without causing major inflation or unemployment changes.

3. The Phillips curve

The Phillips curve shows a trade-off between inflation and unemployment: lower unemployment tends to come with higher inflation, and vice versa.

1.8 Problems 4 and 5: Trade deficit and budget deficit

The trade deficit

The budget deficit

1.9 Instruments of macroeconomic policy

Policy instruments are economic variables that the government controls and that can affect one or more macroeconomic goals. A nation has two major kinds of policy: fiscal policy and monetary policy. The slides also cover exchange rate policy.

1. Fiscal policy

A. Government expenditure

It affects the relative size of collective (public) spending and private consumption. It takes two forms:

• Government purchases: spending on goods and services the government buys (roads, school buildings, teachers' salaries).
• Transfer payments: money given to target groups such as the elderly or the unemployed to help them live. Nothing is produced in exchange.

B. Taxation

Taxes affect the economy in two ways:

1. They change people's disposable income, leaving them more or less to spend.
2. They directly affect the prices of goods and factors of production, which alters incentives and behaviour.

Two directions of fiscal policy

2. Monetary policy

The money supply is the quantity of money available in an economy. In most economies today, which use fiat money, the government controls the money supply, because legal restrictions give it a monopoly on printing money. Just as taxes and government purchases are fiscal instruments, control over the money supply is called monetary policy.

Tool 1: Open-market operations

The central bank (the "Fed" in your slides' US example) buys and sells government bonds.

Tool 2: Interest rates

• Central banks set benchmark interest rates, which influence borrowing costs.
• Lower rates: borrowing is cheaper, so people borrow and spend more, increasing the money supply.
• Higher rates: borrowing is dearer, so borrowing falls, reducing the money supply.

Tool 3: Reserve requirements

The reserve requirement (the cash reserve ratio, CRR) is the percentage of deposits banks must keep as reserves rather than lend.

• Lower CRR: banks can lend more, so the money supply increases.
• Higher CRR: lending is restricted, so the money supply decreases.
• During a depression, the central bank lowers the CRR so commercial banks can give more credit.

3. Exchange rate policy

This is how a country manages the value of its currency relative to other currencies. It influences international trade, investment and domestic prices. It involves choosing an exchange-rate system and deciding the rate at which foreign-exchange transactions happen.

1.10 The state of macroeconomics: schools of thought

Economic ideas have changed over time. The main focus of all these schools is how to achieve national development and better economic performance. The schools, in rough order of time:

1. Mercantilists and Physiocrats (together called the pre-classical schools)
2. Classical
3. Neoclassical
4. Keynesian
5. Monetarist
6. New Keynesian

A little history

Economic thinking is very old. Archaeological findings show early societies already saved resources and divided labour while hunting and gathering. Ancient civilisations such as Egypt, Babylon, Axum, China and Greece relied on trade and taxation. Thinkers like Plato and Aristotle shaped early economics.

Until the 18th century, scholars focused mostly on micro issues. Macroeconomics emerged with Adam Smith's The Wealth of Nations (1776).

1. Mercantilists (16th to 18th century)

A European theory with strong state intervention and regulation. Main features:

• Accumulating wealth, especially gold and silver
• A favourable balance of trade through export surpluses
• Colonies to supply raw materials
• Protectionism through tariffs and subsidies
• Creating monopolies

Supporters included Jean-Baptiste Colbert and Thomas Mun. Critics said it caused inefficiency and reduced competition, although some mercantilist ideas still influence modern policy.

2. Physiocrats (18th century, France)

• They said agriculture is the main source of wealth. Land is the source of all wealth.
• They believed in a natural order of economic processes.
• They criticised mercantilism for focusing on trade and industry. True prosperity, they argued, comes from agriculture.
• Farmers were the key players, producing the surplus that sustains the rest of society.
• They wanted minimal government intervention (laissez-faire).
• Their leading figure developed the Tableau Économique, a model of how resources flow between sectors of society. (This was François Quesnay.)

3. Classical school (late 18th to 19th century): non-interventionist

• Growth depends on factors of production and technology.
• Markets naturally reach equilibrium without government help. Prices and wages adjust to keep the economy at full employment.
• Key figures: Adam Smith, David Hume, David Ricardo, John Stuart Mill, Knut Wicksell and Irving Fisher.
• Government actions often distort markets. Fiscal and monetary policy do not significantly affect real variables such as GDP.
• The central idea is the "invisible hand": individuals pursuing their own self-interest unintentionally benefit society.
• Free markets and individual liberty are essential for growth and prosperity.

4. Neoclassical school (from about 1870): non-interventionist

It introduced two key ideas:

• Marginal analysis: decisions are made by comparing the additional cost or benefit of one more unit.
• Equilibrium analysis: finding the point where demand equals supply and the market is in balance.

Alfred Marshall was the leading figure. He refined supply and demand, stressing how they interact to set prices and quantities, and he advanced marginal analysis through marginal utility. His work underpins modern microeconomic theory.

5. Keynesians (interventionist)

• Growth also depends on aggregate (total) spending.
• To stimulate spending, they want active government involvement through fiscal and monetary policy, especially in the short run, rather than waiting for markets to adjust over the long run.
• Their support grew after the Great Depression of 1929, which showed the limits of classical theories that assumed markets adjust automatically.
• Markets often fail to clear because of price rigidities (wages and prices do not fall easily) and weak aggregate demand, which leads to stagnation and high unemployment.
• Remedies: more government spending to create demand and jobs, and tax cuts to raise disposable income and consumer spending.

6. Monetarism (led by Milton Friedman)

Milton Friedman, an American economist, received the 1976 Nobel Prize in Economic Sciences for work on consumption analysis, monetary history and theory, and the complexity of stabilisation policy. Unlike Keynesians, who prefer fiscal spending, monetarists favour intervention through the money supply and interest rates (monetary policy).

Classical versus neoclassical (the slides' comparison)

7. New Keynesians

• Microfoundations: macroeconomics should be explained through the behaviour of individual agents (households and firms).
• Sticky prices and wages: they adjust slowly because of contracts and frictions, causing temporary imbalances.
• Role of expectations: what people expect about the future shapes what they do today.
• Policy effectiveness: monetary and fiscal policy can stabilise the economy, with interest-rate changes seen as effective for influencing inflation and output.

Summary table of the schools

Quick check: Chapter 1

Try each question first, then open it to see the answer.

Unit summary: Chapter 1 (30 questions)

Chapter 1 is mostly about ideas and reasoning, so about two-thirds of these questions are logic. A third are short calculations on the formulas you met (rates, gaps, reserves and exchange rates). The questions follow the order of the chapter.

20 logic questions + 10 calculation questions = 30 in total. Answers are hidden: try first, then open.

Economics, goals and problems (1.1 to 1.4)

Business cycles (1.5)

Inflation (1.6)

Unemployment and output (1.7)

Trade and budget deficits (1.8)

Policy instruments (1.9)

Schools of thought (1.10)

2.0 Why we measure national income

Why is it important?

• Tracks total output: shows how much the country produces, and so the size and strength of its economy.
• Reveals economic trends: shows whether the economy is growing, shrinking or fluctuating, like a health check.
• Guides policy decisions: governments use the data to design policies for jobs, investment and performance.
• Evaluates sector contributions: shows how agriculture, manufacturing and services each contribute.
• Compares living standards: allows comparison across countries using income and output per person.

2.1 The concepts of national income: GDP and GNP

Gross Domestic Product (GDP)

Four rules about what GDP includes:

Gross National Product (GNP)

2.2 Three ways to measure GDP

There are three alternative approaches, and all three should give the same answer:

1. The expenditure approach (add up spending)
2. The income approach (add up incomes)
3. The output or value-added approach (add up the value created at each stage)

Approach 1: The expenditure approach

Add up everything spent on final goods and services. There are four spending categories, each with a different buyer:

1. Consumption (C)

Household spending on final goods and services. It is the largest part of GDP. Three kinds:

• Non-durable goods: short-lived items (food, clothing).
• Durable goods: long-lasting items (cars, TVs).
• Services: personal services (healthcare, haircuts, legal advice).

2. Investment (I)

Spending by businesses on goods for future use, not immediate consumption. Three kinds:

• Business fixed investment: new equipment and buildings to expand or replace capacity.
• Residential investment: new housing purchases (resale homes are excluded).
• Inventory investment: goods produced but not yet sold. They are still counted in GDP.

3. Government spending (G)

Spending at all levels (federal, regional, local) on goods and services that benefit society: education, healthcare, national defence, roads and infrastructure, water and sewage, postal services. They count in GDP because they serve households and support economic activity (roads help trade and transport).

4. Net exports (NX = X − M)

• Exports (X): goods and services sold abroad. Added to GDP.
• Imports (M): goods and services bought from abroad. Subtracted from GDP, because they are already included inside C, I or G, but were not produced at home.

What is not counted (expenditure approach)

Count only current, productive purchases of final goods and services. Leave out:

• Old goods: used cars and so on. It is just a change of ownership.
• Non-productive spending: government transfer payments (pensions, social security) and the buying of stocks and bonds. These are financial transfers, not real output.
• Intermediate goods: goods used up to make other goods, such as flour for bread (to avoid double counting).

Approach 2: The income approach

Instead of spending, add up all the incomes earned from producing goods and services. That means all payments to the four factors of production: labour, capital, land and entrepreneurship. In other words, wages, interest, rent and profits together equal GDP (conceptually).

Proprietors' income and corporate profits together are called profit, the residual income left after paying rent, interest, wages and other costs.

Two adjustments to reach GDP at market prices

1. Add indirect business taxes minus subsidies (to move from factor cost to market prices).
2. Add depreciation, also called the capital consumption allowance (to move from net to gross).

Approach 3: The output (value-added) approach

Many goods are sold not to final users but to other firms as intermediate goods. To avoid double counting, there are two correct methods:

1. Count only the value of final goods and services, or
2. Add up the value added by every firm at each stage.

2.3 Other social accounts: from GDP down to disposable income

The national accounts include other income measures that differ slightly from GDP. Think of it as a staircase from GDP down to the money people can actually spend.

A. GNP

Add factor income (wages, profit, rent) received from the rest of the world, and subtract factor income paid to the rest of the world. (See 2.1.)

B. Net national product (NNP)

Subtract depreciation, the part of the economy's plants, equipment and houses that wears out during the year. In the national accounts depreciation is called the consumption of fixed capital.

C. National income (NI)

National income measures how much everyone in the economy (the country's own resources) has earned. We subtract indirect business taxes (sales or VAT, excise and property taxes) from NNP. These taxes create a wedge between the price customers pay and the price firms receive. Firms never receive that wedge, so it is not part of their income.

D. Personal income (PI)

This is the income that actually reaches individuals. Start from NI and:

• Subtract corporate profits that people do not receive: corporate taxes + retained (undistributed) earnings. (Slide form: subtract all corporate profits, then add back dividends, which people do receive.)
• Add government transfer payments to individuals (pensions, benefits).
• Subtract social insurance contributions.
• Add personal interest income and subtract net interest. (The net amount is the "government interest to persons" line in the table below.)

E. Disposable personal income (DPI)

The income individuals have to spend or save after paying taxes.

2.4 Nominal versus real GDP

The problem with nominal GDP

Since GDP = Σ P×Q, it can rise because quantities rose or because prices rose. But people's standard of living depends on the quantity of goods and services, not on the prices.

Two ways to calculate real GDP

Worked example: teff, soft drinks and machinery

A hypothetical country produces only three products. Prices are in birr.

Notice: quantities did not change at all. Only prices rose.

Step 1: Nominal GDP in each year

Step 2: What does nominal growth say?

Step 3: Real GDP, using 2010/11 prices for both years

2.5 The GDP deflator and the Consumer Price Index (CPI)

2.5.1 The GDP deflator

Inflation rate from the deflator

Three purposes of the GDP deflator

1. It is an implicit measure of inflation.
2. It separates nominal GDP into a quantity part and a price part:
   Nominal GDP = Real GDP × GDP deflator
   Real GDP measures quantities; the deflator measures prices.
3. It "deflates" nominal GDP to real GDP. That is how it earned its name: it takes inflation out of nominal GDP.

2.5.2 The Consumer Price Index (CPI)

The CPI is set to 100 in the base year. That is the benchmark against which other years are compared. Governments, businesses and individuals use it to understand the cost of living; economists and policymakers use it to measure inflation and adjust monetary policy.

Who calculates it in Ethiopia

• The Central Statistical Authority (CSA) computes the CPI and reports it monthly.
• The CSA chooses the market basket from periodic Consumer Expenditure Surveys.
• Reference period (base): 2010/11 (2003 E.C.).

The three steps

1. Find the cost of the CPI basket at base-period prices.
2. Find the cost of the same basket at current-period prices.
3. Calculate the CPI for the base and the current period.

Inflation rate from the CPI

The CPI inflation is 21.64%, the same as the deflator result here. In this example the basket and the economy's output are the same three goods, so the two measures match. In real life they usually differ.

How the CPI differs from the GDP deflator

2.6 GDP and welfare

GDP is a reasonably accurate and very useful measure of national economic performance. But it is not, and was never intended to be, an index of social welfare (how well people are actually doing). It leaves out several important things:

Quick check: Chapter 2

Unit summary: Chapter 2 (30 questions)

Chapter 2 is about measurement, so about two-thirds of these questions are calculations. A third test whether you understand why each rule exists. The questions follow the order of the chapter.

10 logic questions + 20 calculation questions = 30 in total. Answers are hidden: try first, then open.

Purpose of NIA, GDP and GNP (2.0 and 2.1)

Expenditure approach (2.2)

Income and value-added approaches (2.2)

From GNP to disposable income (2.3)

Nominal and real GDP (2.4)

GDP deflator and CPI (2.5)

GDP and welfare (2.6)

Formula sheet

Chapter 1

Chapter 2