3. 3.1 Basic Macroeconomic Problems
Unemployment: a situation where labor,
machines,land& buildingsstandidle.
but the term is oftenassociated with
unemployment of labor.why?
Unemployedpeopleare those people who
are :
willing andable to work, and
actively seekingfor job
but donot find any.
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4. …Unemployment…
It hasto bestressedthat:
1. Unemployment mustbe involuntary
2. Does not include unemployable persons who
are not capable of work because of mental or
physical disability.
3. Fullemploymentdoesnot meanzero
unemployment
Workers may switch from one job toanother
jobs. Frictional & structuralUEalwaysexist.
Thus,someworkersalwaysremain unemployed
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6. 1. Frictional Unemployment:includessearch
unemploymentandwait unemployment.
Somewill be voluntarily switchingjobs.
May be fired &are seekingre-employment.
May be laid off from their jobs becauseof
seasonalnature of the productionprocess.
E.g.the constructionindustry,agricultural
harvest.
Youngworkersmaybesearchingfor their first
jobs.
…Unemployment…
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7. 2. Structuralunemployment:
Causedbychangesin the structureof
demandand technology.
Someskillswill belessdemandedor may
becomeobsoletefor variousreasons(no
readily marketabletalents).
While frictionally unemployed workershavesalable
skills,structurally unemployed workersare not
readily re-employable with out re-training and
possiblygeographic relocation.
…Unemployment…
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9. …Unemployment…
9
3. CyclicalUnemployment:
Under the recessionphaseof the business cycle,
i.e. bythe deficiencyof total spending.
unemployment attributable to the lackofjob
vacancies– i.e., to aninadequate level of
aggregatedemand(AD)
Asthe overall demandfor goods&
services(AD)decreases,employmentfalls
&unemployment rises.
Thus,sometimes it is calleddeficient-demand
unemployment.
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10. MeasuringUnemployment :
i. Thoseunder 15 yearsof ageandthosewho are
institutionalized (e.g. peoplein mental hospitals&in
prison)are not includedin the laborforce
ii. Adultswhoare potential workers& for some
…Unemployment…
iii.
10
reasonare not employable&are not seeking work
(e.g. beinghomemakers,in schoolor retired)- not
in LF
Thelabor force:peoplewho are able and willing to
work. Someof them are employed andsomeof
them are unemployed.
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11. UnemploymentRate: is the percentageof
the labor force(LF)that isunemployed.
UR= Numberof Unemployed(100%)
TheLF
Where, the LF=numberof employed+
numberof unemployed=E+UE
…Unemployment…
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12. …Unemployment…
12
FullEmployment(FE):
Doesnot necessarilymeanzerounemployment
but cyclicalunemployment is zero.
It islessthan 100 %employment of the LF
as frictional & structuralunemployment are
unavoidable.
TheFEunemployment rate isequalto the sum
of frictional & structuralunemployment.
Also referred to asthe natural rateof
unemployment (NRUE)
Thus,FE>=NRUE
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13. 3.2 Objectivesof Macroeconomics
Macroeconomicobjectivesand priorities:
May varyfrom countryto country
mayvaryovertime in a specific country
Commonmacroeconomicobjectivesare :
Increasingnational output
Reducingunemployment
Stabilizing prices
Maintaining foreigntrade balance
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14. 1. IncreasingNational Output
It is about increasingthe amount of goodsand
servicesin the economy.
It aimsat:
Achievinghighlevel & rate of growthin
output
Reducingthe effect of the BusinessCycle
Question:
Whyare economiesconcernedwith increasing
national output?
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15. 2. ReducingUnemployment
It is about increasing employment level for
the workforce and reducing the number of
unemployedpeoplein the work force:
Questions:
Whyshouldwe careabout unemployment?
Define the workforce andthe unemployed.
Howisthe unemployment level related with
the businesscycle?
Whyshouldwe maintain this objective aslong
aswe are able to increasenational output?
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17. Stabilizingprices…
What isinflation? Hyperinflation? deflation?
Inflation: Arise in the general price levelas
measured by the CPI,GDPdeflator,etc.
Hyperinflation: an extreme caseof inflation.
Deflation: is just the opposite ofinflation
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18. Stabilizingprices…
Isinflation alwaysgoodfor sellers/buyers?
Whenthere isinflation:
Revenueof businesses increases,
Theyhire more workers to produce &sell more
output-employment increases
Unemployment decreases
People’s income & their capacity to buy more &
more goods & services increases-increasesY&AD
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19. Stabilizingprices…
Isinflation alwaysgoodfor sellers/buyers?
Wheninflation rate isvery high:
Thepurchasing power of money deceasesas
goods & services become moreexpensive
People’s standard of living isadversely
affected
Costof production by firms may evenincrease
due to rise in the price of inputs
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20. Stabilizingprices…
What happensduringDeflation?
Increase the purchasing power of buyers’income,
asit decreasesprices of goods/services.
Discourage investment assupply should decrease
when the selling pricedecreases.
Unlesscausedby adecline in input prices, this
will decrease supply, total output,employment
and subsequently the income that goesto the
owners of factors ofproduction.
Causefall in effective demand-adversely affect
AD
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21. Stabilizingprices…
What we meanbymaintainingprice
stability?Doesit meanzeroinflation rate?
Maintaining pricestability: isabout making
patternsin pricechangespredictable.
It is about keepingthe inflation ratelow.
Usually, an inflation rate that is notexceeding
5 %is considered asnormal and desirable.
Maintaining it at asingledigit isgenerally
acceptable.
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22. Stabilizing prices…
Whydogovernmentsandeconomistsworry
about sharpprice fluctuations?
Whenthere isasharpchangein price levels:
It deteriorates the confidenceof investors
Socialwellbeing becomes unstable/unpredictable
Economicdecisionsandagreementsof companies
andindividuals get distorted.
Gainersandlosers(e.g., borrowersVslenders).
Businesspeople cannotconfidently anticipate the
gainfrom acertain contract or transaction.
Nationscannotattract FDI.
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23. Inflation…
…Inflation…
23
Typesof Inflation
1. Demand-PullInflation: DDsideinflation
Happenswhen the economy wants to spend
beyond its capacity (excessdemand). AD>AS
Inflation is described as"too muchmoney
chasingtoo few goods".
Demand-pull inflation isthe "too much
money"side of the inflation equation.
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24. Inflation…
… Inflation…
24
2. Cost-Pushor Supply-Side Inflation:
It is the "too few Goods"sideof theinflation
equation.
There will be shortage of supply ofgoods and
services even when demand is not excessive.
Both output & employment may bedeclining
while the general price level isincreasing.
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25. Inflation…
… Inflation…
25
Sourcesof cost-push inflation:
1) An increasein nominal wages
2) An increasein the priceof other inputs
E.g.increasein priceof raw materials &energy
Note: in real world practice, it isdifficult to
distinguishbetween demand-Pull &Cost-Push
inflation since the real world is morecomplex.
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27. …ForeignTrade Balance…
OpenEconomies:
Make trade relations with othercountries.
Import goods and services from other;
countries & export theirs to other countries.
Borrow money from & lend to other countries;
Imitate foreign technologies or selltheir
inventions abroad;
Their people travel abroad &others come in
(for businessor pleasure).
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28. …ForeignTrade Balance…
What doesabalancedtrade mean?
The net gain from international trade depends on
the magnitude of imports(M) and exports(X).
If Imports >exports=>a trade deficit : the
nation hasnot earned foreign currency during
that period that is enough to cover the expenses
to finance itsimports.
If Imports <exports=>a trade surplus(excess
foreign currency supply over its demand).
If imports =exports=>a balanced trade.
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29. …ForeignTrade Balance…
If imports exceedexports,the countryneed
to confront with two choices
Option1: rundownits foreigncurrency
reserves.
Option2: borrow foreigncurrencyfrom
abroad.
Option1 is not sustainable asthe NBcannot
go on running down the limited reserves
(which is reserved for periods ofemergency).
Option2 causesaccumulation of external
debt and may lead to debtcrisis.
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30. …ForeignTrade Balance…
HugeExternal debt:
May causeanation tosink in the debt trap
May impose anegative impact on econ growthby
discouraging investment and
reducing the public funds that could have been used
for infrastructure dev’t (becauseof debt servicing).
May reduce the sovereignty of the nation in
pursuing its economic policies and political
freedom.
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31. …ForeignTrade Balance…
Questions:
Istrade deficit always bad?
Whendoyouthink istrade deficit bad?
What dowe meanbycurrency depreciation?
Isdepreciation of the localcurrencygoodor
badfor the trade balance?
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32. …ForeignTrade Balance…
Tradedeficit isnot alwaysbad :
Indeed, developing countries need to
import more capital goods that helpthem
increase their investment;
Aslong asthe imports are more of
investment goods, the deficit may notbe
bad.
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33. …ForeignTrade Balance…
Atrade deficit issaidto bebad when:
Its magnitudeisvery large- running down the
foreign currency reservesbecomesunsustainable
It persistsover longperiod of time - debt trap,
Imports are more of consumergoods,because
such imports:
will not expand the PPFof thecountry
will not help it reduce its imports (thru import
substitution) or increase its exports (export
promotion).
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34. …ForeignTrade Balance…
Effectof Exchangerate (ER)ontrade balance:
Exchangerate (ER)affects the trade balance.
Suppose1 dollar issoldfor 18 Birr.Thus,the
exchangerate, e=dollar/1 Birr =
0.056 dollarsper 1 birr.
If the Exchangeraterisesfrom 0.056 to 0.083
dollarsper Birr,the Birr will berelatively
expensive.
In this case,it costs12 Birr(rather than 18
Birr) to buyone dollar.
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35. …ForeignTrade Balance…
Asaresult:
Imports will increase,because
importers will be able to buy more dollar with
the sameamount of Birr, and canbuy more
foreign goodsnow.
Exportswill decrease,because
exporters convert sameamount of dollarsin
to alesser amount of Birr than before; this
discourages them, and reduceexports.
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36. 3.3 Macro EconomicPolicies
GuidingQuestions
What isapolicy instrument?
What doyouthink isfiscalpolicy?What are
the instruments?
What doesmonetarypolicymean?What are
the instruments?
What doesincomepolicy mean?
What istrade policy?
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38. Instruments:FiscalPolicy
1. FiscalPolicy
It consists of twoinstruments:
Taxation(revenue) and
Governmentexpenditure: further divided in
to two categories:
Government purchases of goods and services
Transfer payments and subsidies
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39. Instruments:FiscalPolicy…
Transfer payments: are payments made to a
targeted group of households to boost their
income.
E.g.Pensionpayments, unemployment
benefits, payments to support the elderly,etc.
Subsidies:especial incentives made to
targeted private businesses to help them
under conditions of loss & uncertainty or to
help consumersindirectly.
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40. Instruments:FiscalPolicy…
Taxationaffectsthe overall economy.How?
By reducing HHs’disposable income & reduce
their spending ong&s.
Bylowering the demand for g&s, which in turn
reduces output, income andemployment.
By affecting prices of inputs and output, and
thereby influence the behavior of producers
and the incentive to produce.
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43. Instruments:FiscalPolicy…
Howdoesthishappen?This measure:
Increasesthe demand for g/s byHHs,
businesses and itself
Encourage producers to employ more
resources (invest more) and producemore
Public investment leads to ahigher output by
the government and amore conducive
environment for the private sector (e.g.
investment in infrastructure)
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47. Instruments: Monetary Policy
2. Monetary Policy:
It is the management of anation’smoney,
credit and the banking systemingeneral.
Money consists of the means of exchangeor
method of payment.
There is ademand for & supply of moneyand
hasaprice - the interest rate.
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49. Instruments:Monetary Policy
Howismonetary policyusedin achievingthe
macroobjectives?E.g.,
NBEmay:
Reducethe problem of inflation, byreducing
moneysupply.
Reducesinterest rates(by making borrowing
cheaper) and increasingmoneysupply–
demand for both consumption and
investment good increasesto increase
investment, output andemployment.
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50. Instruments: Income Policy
3. Incomepolicies:
Meant for controlling wages/prices
E.g.priceceilings& price floors.
When inflation tends to be uncontrollable,
the traditional waysof slowing inflationmay
be ineffective & costly.
In suchcases,governmentsmayopt for
other measures,suchas:
Wageandpricecontrolsor Wageandprice
guidelines .
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51. Instruments:IncomePolicy
Incomepoliciesare the mostcontroversial.
Many proponents of the market system
believe that they are ineffective &interfere
with freemarkets.
Most high income countries useit onlyin
periods of emergency.
What about in ourcountry?Doesthe
governmentuseincomepolicy often?
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55. Instruments: FTP…
Governmentmayusesuchtrade policies to:
Discourage the import and consumptionof
socially lessdesirable goods;
Protect domestic infant industries;
Encouragethe production of some goodsthat
are expected to earn higher foreigncurrency.
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59. Introduction
In real world situations, economic
expansion/ growthisnot steady&economic
activitiesfluctuate.
Duringthe expansionperiod, jobsare easy
to find but pricesare rising.
Duringthe depressionperiod, jobsare
scarcebut pricesare stableor even falling.
Thus,achievingmacroeconomicstability is
not easytaskto the government.
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60. 4.1 TheBusinessCycleandthe Output Gap
TheBusinessCycle::Irregular fluctuationsor
upsanddownsin real GDP overtime.
Recession
RGDP
Peak
Recovery Time
Trend path of
RGDPat full
employment
Trough
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61. TheBusinessCycle …
Overtime real GDPchangesor fluctuatesand
Output isnot alwaysat its trend level.
Thus,four phasesof business cycles:
I. Peak(boom) Phase
II. Recession(contraction)
III. Trough(Depression) phase
IV. Recovery(expansion) phase
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62. I. Peak(boom) Phase
Islocated at cyclicalpeak
Economic activity is high relative to trend.
Theeconomy is at full employment andclose
to capacity.
Theprice level may rise…..inflation resulted
TheBusinessCycle …
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63. II. Recession(contraction)phase
It is aperiod atwhich:
total output, income, employment andtrade
decline.
Theprice level is likely to fall only if the
recession is severeand prolonged
TheBusinessCycle …
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64. TheBusinessCycle …
III. Trough(Depression)Phase:
During this phase:
Various indicators of business activity stopfalling
Theeconomy hasreached alowest point from which
recovery begins.
There is an excessiveamount of unemployment, idle
productive resource, & business failures because of
low demand for theirproducts.
Highest unemployment, lowest AD& henceAS
TheBusinessCycle …
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65. TheBusinessCycle …
IV. Recovery(expansion) phase
During this period:
Employment of factors ofproduction
increases
RealGDP(output) increases
AD& ASincreases
TheBusinessCycle …
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66. TheOutput Gap
Theoutput gapmeasuresthe difference
between actual output andthe output the
economycouldproduceat full employment
giventhe existing resources.
Output Gap=Potential Output - Actualoutput
Potential Output: the output the economy
could produce at full employment giventhe
existing resources.
Duringrecession,moreresourcesbecome
unemployed & actualoutput fallsbelow
potential output.
Thisincreases the output gap.
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68. 4.3. Inflation
Theincreasein the general(average) level of prices
Thisdoes not mean that all prices are rising;some
prices may be relatively constant & othersfalling.
Inflation isanincreasein the averagelevel of prices,
not a changein anyspecific price.
Theaverageprice is determined by finding the
averageprice of alloutput:
Arise in the averageprice is called inflation
Afall in the averageprice is calleddeflation
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69. 4.3. Inflation
Inflation: anindexnumberiscalculated& used
usingthe following steps:
1) Abaseyear isselected
2) Astandard market 'basket' of goodsrepresentative
of the spendinghabit of a typical consumeris
selected.
3) Thestandard market basketisvalued at baseyear
pricesandexpressedas 100.
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70. Inflation…
4)Thesamebasketisrevalued at current prices.
5)Thecostof the currentbasketisthen
expressedasapercentageof the base year.
Thus,if the averageprice( costof living) had
risenby5 %,the indexfor the currentyear
would be105.
PriceIndex =Cost of basketin current year x100
Costof the basketin baseyear
4.3. Inflation
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72. Example(worksheet-2, No.7)
Suppose that the Bureau of Labor Statistics
surveys (BLS) chooses 2009 as its base year
and decided that the basket of goodsin this
economyconsistof onepizza& 2 beers.
A. What isthe costof the basket in each year:
2009, 2010, and2011?
B. Still using2009 asthe base year, what isthe
CPIin eachyear: 2009, 2010, and2011?
C. What isthe inflation rate in 2010 and2011?
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73. Solution
A. What isthe costof the basketin eachyear:
2009, 2010, and2011?
2009:($2 per pizza)x(1 pizza)+($1 per beer) x
(2 beers)=$2+$2 =$4
2010:($4 per pizza)x(1 pizza)+($2 per beer) x
(2 beers)=$4+$4 =$8
2011:($4 per pizza)x(1 pizza)+($2 per beer) x
(2 beers)=$4+$4 =$8
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74. B.Using2009 asthe baseyear,what isthe CPI
in eachyear: 2009, 2010, and 2011?
2009: (Costof the basketin 2009)/(Cost of the
basketin the baseyear) x100 =($4/$4) x100 =100
2010: (Costof the basketin 2010)/(Cost of the
basketin the baseyear) x100 =($8/$4) x100 =200
2011: (Costof the basketin 2011)/(Cost of the
basketin the baseyear) x100 =($8/$4) x100 =200
Solution…
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75. Solution…
C.What isthe inflation rate in 2010 and 2011?
2010: (CPIin 2010 – CPIin 2009)/(CPI in 2009)
x100 =(200-~-100)/100 x100 = 100%
2011: (CPIin 2011 – CPIin 2010)/(CPI in 2010)
x100 =(200-~-200)/200 x100 = 0%
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76. Inflation…
4.3. Inflation
76
TypesandCausesofInflation
1. Demand-PullInflation:
Happenswhen the economy wants to spend
beyond its capacity (excessdemand). AD>AS
Inflation is described as"too muchmoney
chasingtoo few goods".
Demand-pull inflation isthe "too much
money"side of the inflation equation.
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77. Inflation…
Theinflation rate: annual%changein prices
from year 1 to year 2 is calculated from theprice
index (PI):
Annual%priceChange=Year2 PI- Year1 PI
Year1 Price Index
We havedifferent typesof price indexes:
1. ConsumerPriceIndex (CPI)
2. ProducersPriceIndex (PPI)
3. TheGDPDeflator =(NGDP/RGDP)* 100
4.3. Inflation
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78. Inflation…
4.3. Inflation
78
Sourcesof cost-push inflation:
1) An increasein nominal wages
2) An increasein the priceof other inputs
E.g.increasein priceof raw materials &energy
Note: in real world practice, it isdifficult to
distinguishbetween demand-Pull &Cost-Push
inflation since the real world is morecomplex.
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79. Inflation…
2. Cost-Pushor Supply-Side Inflation:
It is the "too few Goods"sideof theinflation
equation.
There will be shortage of supply ofgoods and
services even when demand is not excessive.
Both output & employment may bedeclining
while the general price level isincreasing.
4.3. Inflation
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80. Inflation…
4. 3. Inflation
80
Effectsof Inflation:
Leadsto arbitrary redistribution of realincome
Different income groups will be affected in
different ways– there are losersandgainers.
Thelosersare thosewhoseincomesare fixed,
or relatively fixed in moneyterms
e.g., People who get salaries or pensions.
Gainers-e.g. salespersons who work on commission
basis
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81. Inflation…
4.3. Inflation
Theeffect dependsonthe type of inflation::
During ademand-pull inflation, profits tendto
rise; during cost-push inflation, profits
decrease.
Debtors (borrowers) tend to gain andlenders
tend to lose. Thismay:
Encourage spending rather than saving and
lending, and hence reduces funds for investment.
Increase interest rates ascreditors demand
additional return asacompensation for the falling
value of money.
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82. Stagesof Inflation: four major phases
1.Creepinginflation :Inflation rate <3%(low) per annum
Almost normal
2.Walkinginflation :Inflation rate 3-10%per annum
awarningsignalfor the governmentto control
3.Runninginflation :Inflation rate 10-20%per annum
Seriouslydeterioratingpurchasingpower
4.Hyperinflation / Galloping:inflation rate >20%per annum
harshto aneconomyaltogether
E.g.Germany, Russia, Greece ,Hungary,&Australia.
4.3. Inflation
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83. 4.4 Shocksto the Economy& Approachesto
AbsorbShocks
Shockscanbe either positiveornegative
we haveDemandside&supplyside shocks
Demand Shocks:
Exogenouschangesonthe demandsidearising
from the product,capital, or forexmarket.
Theseshockswill first shift aggregatedemand
& then alter output&employment.
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84. Shocksto aneconomy…
SupplyShocks(Priceshocks):
Exogenousshocksthat alter the costof
producinggoods/servicesandtheir prices.
Examples:
Adroughtthat destroyscrops
Anew environmental protection law against
emissionsof pollutants
Anincreasein union aggressiveness
Thecreation of amonopoly overimportant natural
resources.
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85. Shocksto theEconomy…
Thereare approachesto minimize
Unemployment & Inflation, & AbsorbShocks
Fiscalpolicyandmonetary policiesaffect the AD
of the economy- demandmanagementPolicies
1. FiscalPolicy(FP)
Thefiscalpolicyinstruments (T& G)are usedto
adjust aggregatedemand (Y=C+I+G+XN)
Consider the following two scenariosto
understand how fiscal policyfunctions.
Approachesto AbsorbShocks
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86. SENARIO1: TheCaseof ExcessDemand
Excessdemandleadsto demand-Pull
inflation.
Measuresto reduceexcessAD:
1. Increasingtax ratesto reducedisposable
incomeof citizens, or
2. ReducingGov't own demand for final goods
andservicesbycutting its spending, or
3. Usea combinationof thesetwo instruments.
Approachesto AbsorbShocks:FP
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87. Shocksto theEconomy…
SENARIO2: TheCaseof DeficientDemand:
Leadsto a declinein economicactivities, a rise
in unemploymentanda declinein pricelevels.
Themeasuresto increaseAD are:
1. reduce tax ratesto increasedisposableincomeof
citizens,or
2. increaseits own demand for final goodsand
servicesbyincreasingits spending, or
3. Usea combinationof thesetwo instruments.
Approachesto AbsorbShocks:FP
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88. Advantagesof FiscalPolicy
1. Stabilization effects- try to adjustsAD& AS
2. Distribution of resources-may be usedin
discriminatorymanner to alter thegeographical
and sectoral distribution of resources.
E.g.Reducingtax for strategicindustries& increasing
tax for lessstrategic ones
3. Reduceincomeinequalities andwealth- may also
be usedto reduceincomeinequalities and wealth
E.g.Applyprogressivetaxes& socialsecurity benefits
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89. Shocksto theEconomy…
Difficulties of FiscalPolicies
1. Governmentexpenditures maybecomeinflexible
downwards.
High resistance against reduction of expenditureon
education, health services, pensions,etc.
Oncesome long-term projects are begun, it is very
difficult and costly to postpone and reschedulethem.
2. Time lag andlargetax administration work.
3. Taxriseto reduceADmayreduceASbyreducing
the incentive to work and invest.
4. Reactionbyorganizedlabor. e.g. labor union
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90. Shocksto theEconomy…
2. Monetary Policy(MP):
Its fundamental objectivesare:
T
oexpandthe supplyof moneyin the longrun to
meet the demand for moneyin a growing
economy, &
T
oadjustthe moneysupplyto reduceeconomic
fluctuations in the short-run.
Approachesto AbsorbShocks
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91. Shocksto theEconomy…
Approachesto AbsorbShocks:MP
TheCause-effectchainrelation between
monetarypolicyandoutput/employment
1) National Bank'smonetary policyinfluences
the sizeof commercialbank reserves….
2) Whichinfluencesthe supplyof money….
3) Whichinfluencesthe interest rate and
availability of bankcredit….
4) Whichinfluencesinvestmentspending,
output, employmentandthe pricelevel.
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93. Monetary PolicyInstruments
1. OpenMarket Operation (OMO)
Refersto the purchase& saleofgovernment
securities(bonds)by the national bank(NB).
When national banksellssecuritiesto
households& private firms:
Money iscollected from the market (circulation)
Money supplydecreases
Inflation maybe reduced
When national bankbuy securities:
Money ispumpedin to the economy
Money supplyincreases
Inflation mayarise(increase)
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94. Monetary PolicyInstruments…
2. Changesin the required reserve ratio(rr)
Commercial banksare required to hold a
certain fraction of their deposits on reserve,
either ascashin their own vaults or in the
national bank(NB).
Bychangingthe legalreserveratio, the NBcan
changethe amountof bankloans&thus the
amountof moneyin the economy.
what will happento the moneysupply:
A. If rr increasesfrom 5%to 10%?
B. If rr decreasefrom 10%to 5%?
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95. Monetary PolicyInstruments…
3. Credit Ceilings
CreditCeilingsare restrictions bythe National
Bankonthe amount of credit that commercial
banksmakeavailable to businesses& households.
E.g.,the required reserveratio beingunchanged,
the NBcantell the commercialbanksthat over
the comingperiod, creditsmaygrowbyonly x
percent.
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96. 4. National Bank(NB)Lending
Evenif the NBdoesnot lendmoneyto
households&businesses,it lendsmoneyto
commercialbanks.
If the NBwants moneysupplyto increase,it
canincreasethe amount of moneythat it
lendsto commercialbanks.
If it wants to decreasesMS, it reducesthe
amount of money available for lending to
CBs.
Monetary PolicyInstruments…
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97. 5. Bankrate andDiscountrate
TheBankRateisthe interest rate that the NB
chargesonthe credit it givesto commercial banks.
Thediscountrate isthe interest rate that the NB
chargesthe commercialbankswhen they take
moneybyoffering (discounting) bonds&
import/export billsat the discountwindow that the
NBopensfor commercialbanks.
Anincreasein the bankrate & the discountrate
makesborrowingbycommercialbanksexpensive
&reduce the amount of moneythat they canborrow.
Thisin turn reducesthe amount of moneycirculating
in the economy(i.e. decreasesmoney supply).
Monetary PolicyInstruments…
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98. Monetary PolicyInstruments…
6. Interest RateControls
In manydevelopingcountriesincluding
Ethiopia,the deposit& loan interestrates
are fixed bythe monetary authorities.
Increasesin the loan rate- makescredit by
businesses &households expensive & reduce
the quantity of money circulating in the
economy-decreasesMS.
Decreasesin the loan rate-increasesMS.
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99. In summary
1. Explain:
A. Businesscycle
B. Unemployment
C. Inflation
D. Shocksto theEconomy
2. Analyze:
A. Theeffect of macroeconomicinstability
B. Businesscycle& output Gap
C. Unemployment& inflation
D. Approachesto absorbshocks: Policies
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101. 5.1 AggregateDemand(AD)
ADisa schedule,graphicallyrepresentedasa
curve,showingthe variousamountsof real
output that domesticconsumers,businesses,
government& foreignbuyerscollectively
desireto purchaseat eachpossibleprice
level.
CeterisParibus,the lower the pricelevel, the
larger will bethe real GDPthesebuyerswill
purchase.
The relationship between the priceleveland
ADisinverseor negative. 101
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103. AggregateDemand…
Thereare 3 justifications for downwardsloping
ofAD.
1. Wealth or RealBalanceEffect:
↑P→ decreasespurchasing power (real value)
of wealth (particularly, assetwith fixed money
value) →decreasesdemand for spending to
restore assets→decreasesreal GDPdemanded
Conversely,adecline in the price level will
increase the real value or purchasing power ofa
person’s wealth and increasespending.
5.1 AggregateDemand…
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104. AggregateDemand…
2. Interest RateEffect:
Givenfixed supplyof moneyin the short
run, an↑ in P→increasesthe demandfor
money→increasespriceof money( ↑
interest rate) →reducesinterest sensitive
expenditures→decline in the total quantity
of real outputdemanded
Therefore , arisein the pricelevel leadsto
increasein interest rateswhichin turn leads
to lower levelsof aggregatedemand
5.1 AggregateDemand…
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105. AggregateDemand…
3. Foreignpurchaseseffect:
If pricelevel risesin Ethiopiarelative to foreign
countries:
Ethiopianbuyerswill purchasemore imports
andfewer domesticallyproducedgoods.
Similarly, the restof the world will buyfewer
Ethiopiangoods,reducingour exports.
Risein our pricelevel →increasesour imports
andreducesourexports→reducingthe amount
of net export spending→reducesthe amount
of real outputdemanded.
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106. AggregateDemand…
5.1 AggregateDemand…
106
Determinants ofAggregate Demand:
Other things being constant, a ∆ in P
,will result
in a ∆ in the quantity of real GDPdemanded;
However, if one or more of those “other things”
change, the entire ADcurve shifts to the left or
right.
Werefer to those “other things”asdeterminants
of aggregatedemand,i.e. they “determine” the
location of the aggregate demandcurve.
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108. Factorsthat shift the aggregatedemand curve:
1. Changein consumer
spending
Consumer wealth
Cons.expectations
2. Changein Investment
spending
Interest Rates
Profit. expectations
5.1 AggregateDemand…
Cons.indebtedness
T
axes
BusinessT
axes
Technology
Degree of ExcessCapacity
3. Changein
4. Changein NXspending
National IncomeAbroad
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15overnment spending108
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109. AggregateDemand…
5.1 AggregateDemand…
109
1. Changein consumerspending (C)
When consumers buy lessoutput than before
at eachpossible pricelevel,
Consumer spending decreases
ADcurve shifts leftward from AD1to AD3
ConsumerWealth: includes all consumer assets,
including financial assetssuch asstocks and physical
assetssuchashouses and land.
Asharp decline in the real value of consumer assets
forces people to save more (buy fewer products) to
restore their wealth. ThisdecreasesAD.
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110. AggregateDemand…
ConsumerExpectations:
Expectationof a risein real incomeand
higher inflation in the future, increase
currentspendingonconsumptiongoodsand
services→ ↑AD
ConsumerIndebtedness:
Highlevelsof indebtednessfrom pastbuying
financedbyinstallment loans…reduces
present spendingto payoff their existing
debt.
5.1 AggregateDemand…
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112. AggregateDemand…
5.1 AggregateDemand…
2. Changein InvestmentSpending(I)
Adeclinein investment spendingby
businesseswill shift the ADcurve leftward.
Anincreasein the desiredamount of
investment goodswill increaseAD.
Thefactorsthat couldalter investment
spendingare consideredbelow.
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113. AggregateDemand…
a) InterestRates:
An increase in the interest rate caused by a
factor other than a changein the price level
(e.g., decrease in MS) will lower investment
spending& reduceAD,ceteris paribus.
b) Profit expectationsoninvestment projects:
Improved profit expectations on investment
projects will increase the demand for capital
goodsandshift the ADcurve rightward.
5.1 AggregateDemand…
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115. AggregateDemand…
5.1 AggregateDemand…
115
e) Degreeof excesscapacity:
Arisein excesscapacity-unusedexisting
capital
will retard the demand for new capital goods
andreduceaggregate demand.
Firmsoperating well below capacityhave
little incentiveto build new factories/plants.
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116. AggregateDemand…
3. Changein Government Spending:
Anincreasein governmentpurchasesof real
output at eachpricelevel will increase
aggregatedemandsolongastaxesand
interest rates donot changeasa result.
Why?
Areductionin governmentspendingwill
reduceaggregatedemand.
5.1 AggregateDemand…
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117. AggregateDemand…
4. Changein Net Export Spending:
Increasesin net exportscausedbyfactorsother
than changesin the pricelevel pushout
aggregatedemandcurve rightward.
a higherlevel of Ethiopian exportsconstitutesan
increasedforeign demandfor Ethiopian goods.
Similarly, areductionof ourimports implies an
increaseddomesticdemandfor Ethiopian produced
products
Let’sseethis in relation to the incomeof aforeign
nation & the exchangerate in the domestic…
5.1 AggregateDemand…
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118. AggregateDemand…
a. National IncomeAbroad:
Risingnational incomein aforeignnation
(a tradingpartner) increasesthe foreign
demandfor ourgoods,increasingaggregate
demandin Ethiopia.
b. ExchangeRates:
Depreciation of our currency increases the
demand for our exports and decreases the
demandfor imports, increasingNXandAD.
5.1 AggregateDemand…
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119. 5.2 AggregateSupply(AS)
Aggregatesupply(AS):
Isa schedule,graphically representedbya
curve,showingthe level of the aggregate
quantityof real domesticoutput supplied
by all firmsin an economy at different
price level.
It showsthe direct (positive)relationship
between the real quantity of goodsand
servicessuppliedandthe price level.
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120. Thedifference between the shortrun andthe long
run aggregatesupplyisbasedoninput prices
behaviourin the two time horizon.
Input prices are:
flexible in the longrun andcanrespondto
changesin supplyand/or demand
stickyin the shortrun- in the SR,manypricesare
“stuck”at somepredetermined level.
5.2 AggregateSupply(AS)…
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121. AggregateSupply ….
Becausepricesbehavedifferently in the
short runandin the longrun, economic
policeshavedifferent effectsoverdifferent
time horizons.
Whyinput pricesare non-flexible in the
short run?
Thereare two commonreasonswhy
input prices,particularly nominal
wages,are stuckin the short run.
5.2 AggregateSupply(AS)…
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122. AggregateSupply
TworeasonswhySRpricesare sticky:
1) Workersmaynot immediately beaware of the
existenceof a higheror lower pricelevel…and
will not adjust their wage demandsaccordingly.
2) Many employeesare hired underfixedwage
contracts.
In the longrun, however, workersgain full
information andworkersandemployersare freed
from their existinglabor contractsandcan
negotiate changesin nominal wagesand salaries.
5.2 AggregateSupply(AS)…
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123. ShortRunAggregate Supply(SRAS)
It indicates a positive relationship b/n the price
level and the aggregate real output supplied in
the economy.
Whythe SRAScurveisupward sloping?
Owners of productive resources seetheir
nominalwages& profits increasingbut donot
perceivethe increasein the pricesof goodsand
servicesthey purchase,i.e., theyperceiveasif
they are better off with the risein pricelevel.
Thus,they becomewilling to supplymore =>an
increasein real output supplied.
Thesebehaviouriscalledas“money illusion”
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125. SRAS…
SRAS…
Ahorizontal (Keynesian)range:
Wherein the Plevel remainsconstantwhile domestic
output varies
Thecaseof a depressed economy
Highdegree of excesscapacityandhighrate of UE
possibleto expandoutput without raisingthe Plevel.
Intermediate Range:
Wherein both real output andthe pricelevel are
variable.
That is,anexpansionof ADandreal output is
accompaniedbyarisingPlevel.
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126. SRAS…
SRAS…
126
Averticalrange:
Wherein RGDPisconstant(at the absolute full-
capacitylevel) andonly the pricelevel can vary.
Noinvoluntary unemployment, andit isnot
possibleto increasereal output any further.
Employersbid amongthemselvesfor labor and
drive upwages,andthereby prices rise.
AnyincreaseinADwill result in a risingpricelevel
but nochangein output level.
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128. SRAS…
Changes inphysical resources (“supplysideshocks”)
are the main factorsshiftingSRAScurve(determinants
of SRAS).
A. A↓in AS(le†ward shi† of thecurve)
a prolongedandwidespreaddroughtwhichresulted in a
massivecrop failure.
the destructionof productivecapacitythroughwar,or some
other disaster suchasflood or earthquake.
↑ in Plevel and ↓ in RGDP ( for a givenAD)
B. An↑ inAS(rightward shi† of the curve)
Goodcropseason,technologicalprogress,discoveryof
minerals…
↓ in Plevel and ↑ in RGDP ( for a givenAD)
SRAS…
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129. LongRunAggregateSupply(LRAS)
Isthe long run level of real output (which is
sustainable) given the quantity & quality of
the economy’sexistingresources.
LRAScurveshowsthe relationship b/n price
andreal output suppliedin the absenceof
“moneyillusion”.i.e. With noinformation gap
about real moneybalanceor PPof money.
Nouniversalagreement onthe lengthof time
it takesto gofrom ashort runto alongrun
aggregatesupply.
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130. Derivation of LRAScurve
Initial equilibrium output (where AD1 and
SRAS3intersect) =Q0i.e. point‘a’
Suppose that the government has applied
stimulating fiscal policy instruments which
shiftsthe ADcurveto the right.
It leads to the establishment of new short run
equilibrium whereAD2& SRAS3intersected
=>dueto money illusion
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131. Derivation of LRAScurve...
In the absenceof moneyillusion, the suppliers
havereturned the level of their supplyto the
initial level (the new equilibrium point iswhere
the AD2& SRAS2intersected,‘b’).
Bythe sametrend equilibrium point ‘c’has
established,whereAD3andSRAS1are
intersected.
Connectingpoint a, b, andcwill giveusthe
vertical longrun aggregatesupply curve.
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133. Shift in the LRAScurve
Shift in LRAScurve
P
TheLRAScurve is
LRAS1 LRAS2
vertical, at full
employment.
LRASisnot affected by
shortrunchangesin the
pricelevel.
In the normal economic
performance, the LRAS
hasto increaseat least
asrapidly aspopulation
growth.
RGDP
Q2
Q1
AD
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134. Determinants of LRAS
Determinants of LRASare factorswhich
affect the productivecapacityof the
economy:
Thelevel of spendingonnew technology;
Longterm foreigndirect investment ;
Migration andpopulationgrowth;
Educationandtraining (human capital);
Competition in productandlabor markets
(whichimprovesefficiency & productivity);
Effectivesupply-sidepolicy.
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135. Determinants of LRAS...
Thechangein the determinants of ASprimarily
affectsthe per unit costof production.
Thedeterminants canbe groupedinto 3 categories:
a. Changein input prices
Domesticresourceavailability,
Pricesof imported resources,
Market power (how competitivethe resourcemarket is)
b. Changein productivity
Labourproductivity(Y/L)
Capitalproductivity(Y/K)
135
c. Changein legal-institutional environment
Include businesstaxes& subsidies
Licensingprocedures,rule enforceability
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137. Equilibrium Output ndPrice Levels
SREquilibrium LREquilibrium
Price
L
evel
SRAS
LRAS
RealDomestic Output
AD
Pe
RealDomestic Output
AD
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